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 office is located in Wake County, 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, 2006, the Company had total assets of $104.3 million, total deposits of $84.0 million and total stockholders' equity of $18.8 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 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, 2006. 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."
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 Association's proximity to the Research Triangle Park, to Raleigh-Durham International Airport and to the City of Raleigh, the state capital, should result in the future growth in the Association's market area.
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 63.62% to 20,596 by 2006. Residential households totaled 7,750 in Wake Forest in 2006. The median household income in Wake Forest was $71,158 in 2006. Wake County's and Franklin County's populations were 748,815 and 54,429 in 2005, respectively.
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.
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, 2006. 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 $42.6 million and $48.7 million for the years ended September 30, 2006 and 2005, respectively.
The following table sets forth the dollar amounts in each loan category at September 30, 2006 that are contractually due after September 30, 2007, 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, 2006, the Association's total loans were $76.6 million, of which $24.3 million or 31.65% were one-to four-family residential mortgage loans. Of the one- to four-family residential mortgage loans outstanding at that date, 34.57%, or $8.4 million, were fixed-rate loans and 65.43%, or $15.9 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.
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 Federal Home Loan Mortgage Corporation ("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. 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, 2006, the Association had $23.6 million (net of undisbursed loan funds of $13.3 million) of residential construction loans which amounted to 30.74% of the Association's net loans outstanding. The largest residential construction loan in the Association's portfolio at September 30, 2006 was $831,700, 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, 2006, the Association had no commercial construction loans outstanding.
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, 2006, the Association's commercial real estate mortgage portfolio was $12.4 million, or 16.21% of total loans outstanding. The largest commercial real estate loan in the Association's portfolio at September 30, 2006 was $1.7 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, 2006, the Association's equity line portfolio was $2.3 million, or 3.04% 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.
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, 2006, the Association's total land loan portfolio was $14.6 million or 19.06% of total loans outstanding and its multi-family loan portfolio was $427,000 or 0.56% 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, 2006, the Association's savings account loan portfolio totaled $179,500 or 0.23% 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.
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.
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 $1,670,150 of assets classified as "Substandard" at September 30, 2006. The classified assets include three loans totaling $666,350 and a foreclosed commercial tract amounting to $1,003,800.
The foreclosed commercial property consists 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 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 is in the process of applying for brownfields status for the site, which should make the tract more attractive to prospective developers of the property. Although the Company does not currently believe the contamination will have a detrimental effect on the potential development of the property, the agencies are expected to be able to assist the Company in determining the extent of any required clean-up and ongoing monitoring steps that will be required. 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 the current year, the Company expensed $170,500 in environmentally related cost for this property.
The Association also had one loan amounting to $578,750 classified as "Special Mention". The loans classified "Substandard" at September 30, 2006 were comprised of two residential property loans totaling $209,000 and one commercial property loan totaling $457,350, which consists of two mini-storage facilities and an office building on 3.6 acres in Wendell, N.C. The loan classified as "Special Mention" consists of a 43 acre horse facility. At this time, the Company believes that the fair market value of all these properties is higher than the outstanding loan balances and no loss on the ultimate disposition of any of these loans is expected. All of the loans classified as "Substandard" have been placed on non-accrual status.
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, 2006, the Association's allowance for loan losses was $1,042,500, or 1.34% of total loans, as compared to $850,000 or 1.14% of total loans at September 30, 2005. The Association had non-performing loans of $666,350 and $770,850 at September 30, 2006 and September 30, 2005, respectively. The Association provided $192,500 in additional loan loss provisions during 2006. During the current year, the Association did not charge off any loans. The Association provided $119,600 in additional loan loss provisions during 2005 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 value of the property at the date of acquisition, establishing a new cost basis with any resulting write-down charged to the allowance for loan losses. Thereafter, an allowance for losses on real estate owned is established if the cost of a property exceeds its current fair value less estimated sales costs. The Association obtains an appraisal on a real estate owned property as soon as practicable after it takes possession of the real property. The Association will generally reassess the value of real estate owned at least quarterly thereafter.
During 2006, the Association did not report any gains or losses from the sale of REO and incurred $170,500 in foreclosure related expenses from holding foreclosed properties. During 2005, the Association did not report any gains or losses from the sale of foreclosed property but incurred $91,650 in foreclosure related expenses and losses on the sale of REO. The policy for loans secured by real estate, which comprise the bulk of the Association's portfolio, is to establish loss reserves in accordance with the Association's asset classification process, based on GAAP. At September 30, 2006, the Association had one piece of REO totaling $1,003,800 on a convenience store and adjacent tract of land as described above.
The following table sets forth activity in the Association's allowance for loan losses and the allowance for losses on real estate owned at or for the periods indicated.
The following table sets forth the Association's allowance for loan losses allocated by loan category and the percent of loans in each category to total loans at the dates indicated.
INVESTMENT ACTIVITIES
The Association's investment policy permits it to invest in U.S. government obligations, certain securities of various government-sponsored agencies, certificates of deposit of insured banks and savings institutions, federal funds, and overnight deposits at the Federal Home Loan Bank of Atlanta. At September 30, 2006, the Association held FHLMC stock with an amortized cost of $8,000 and a current market value of $540,850 and Federal Home Loan Bank stock with a cost and market value of $197,600. At September 30, 2006, the Association held $23.8 million in investments, including short-term interest earning deposits.
The following table sets forth activity in the Association's investments portfolio for the periods indicated:
(1) The net unrealized gain at September 30, 2006 and 2005 relates to available for sale securities in accordance with Statement of Financial Accounting Standards ("SFAS") No. 115. The net unrealized gain is presented in order to reconcile the "Amortized Cost" of the Association's securities portfolio to the "Carrying Cost," as reflected in the Statements of Financial Condition.
Amortized cost and fair value of the Association's investments at the dates indicated are as follows:
(1) Equity securities consist of FHLMC common stock.
(2) The difference between "Amortized Cost" and "Fair Value" represents net unrealized gains at September 30, 2006 and 2005 on available for sale securities in accordance with SFAS No. 115.
Sources of Funds
General. Deposits, loan and security repayments and prepayments and cash flows generated from operations are the primary sources of the Association's funds for use in lending and for other general purposes.
Deposits. The Association offers a variety of deposit accounts with a range of interest rates and terms. The Association's deposits consist of regular (passbook) savings accounts, NOW accounts, checking accounts, money market deposit accounts, IRAs and certificates of deposit. Certificates of deposit are offered with maturities of up to 60 months. At September 30, 2006, the Association's core deposits (which the Association considers to consist of NOW accounts, money market deposit accounts and regular savings accounts) constituted 34.50% of total deposits. The flow of deposits is influenced significantly by general economic conditions, changes in money market rates, prevailing interest rates and competition. The Association's deposits are obtained predominantly from the areas located near its office location. The Association relies primarily on customer service and long-standing relationships with customers to attract and retain these deposits. However, market interest rates and rates offered by competing financial institutions significantly affect the Association's ability to attract and retain deposits. The Association does not use brokers to obtain deposits.
The following table presents the deposit activity of the Association for the periods indicated.
At September 30, 2006, the Association had $24.3 million in jumbo certificate of deposits (accounts in amounts over $100,000) maturing as follows:
The distribution of the Association's deposits and the related weighted average interest rates are as follows:
Borrowings. The Association historically has not used borrowings as a source of funds. However, the Association may obtain advances from the Federal Home Loan Bank as an alternative to retail deposit funds and may do so in the future as part of its operating strategy. These advances would be collateralized primarily by certain of the Association's mortgage loans and secondarily by the Association's investment in capital stock of the Federal Home Loan Bank. See "Regulation--Federal Banking Regulation--Federal Home Loan Bank System." Such advances may be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The maximum amount that the Federal Home Loan Bank will advance to member institutions, including the Association, fluctuates from time to time in accordance with the policies of the OTS and the Federal Home Loan Bank. At September 30, 2006, neither the Company nor the Association had any borrowings outstanding.
PERSONNEL
As of September 30, 2006, the Company had no employees who were compensated through the Company.
As of September 30, 2006, the Association had 11 employees, nine of which were full-time employees. In the last three years, the Association has experienced a low turnover rate among its employees and, as of September 30, 2006, ten of the eleven employees had been with the Association for more than 5 years and 6 had been with the Association more than 10 years. The employees are not represented by a collective bargaining unit and the Association considers its relationship with its employees to be good. See Part III, Item 10 "Executive Compensation" for a description of certain compensation and benefit programs offered to the Association's employees.
REGULATION
GENERAL
The Company and the MHC are regulated as savings and loan holding companies by the OTS. The Association, as a federal stock savings bank, is subject to regulation, examination and supervision by the OTS and the FDIC. The Association must file reports with the OTS concerning its activities and financial condition. The Company and the MHC are also required to file reports with, and otherwise comply with the rules and regulations of the OTS. The Company is also required to file reports with, and otherwise comply with, the rules and regulations of the SEC under the federal securities laws.
Any change in such laws and regulations, whether by the OTS, the FDIC, or through legislation, could have a material adverse impact on the Company and the Association and their operations and stockholders.
FEDERAL BANKING REGULATION
Activity Powers. The Association derives its lending and investment powers from the Home Owners' Loan Act, as amended (the "HOLA"), and the regulations of the OTS. Under these laws and regulations, the Association may invest in mortgage loans secured by residential and commercial real estate; commercial and consumer loans; certain types of debt securities; and certain other assets. The Association may also establish service corporations that may engage in activities not otherwise permissible for the Association, including certain real estate equity investments and securities and insurance brokerage. The Association's authority to invest in certain types of loans or other investments is limited by federal law and regulation.
Loans-to-One-Borrower Limitations. The Association is generally subject to the same limits on loans to one borrower as a national bank. With specified exceptions, the Association's total loans or extensions of credit to a single borrower cannot exceed 15% of the Association's unimpaired capital and surplus. The Association may lend additional amounts up to 10% of its unimpaired capital and surplus, if the loans or extensions of credit are fully-secured by readily-marketable collateral. The Association currently complies with applicable loans-to-one-borrower limitations.
QTL Test. Under federal law, the Association must comply with the qualified thrift lender, or "QTL" test. Under the QTL test, the Association is required to maintain at least 65% of its "portfolio assets" in certain "qualified thrift investments" in at least nine months of the most recent 12-month period. "Portfolio assets" means, in general, the Association's total assets less the sum of:
o liquid assets up to 20% of total assets;
o goodwill and other intangible assets; and
o office property.
The Association may also satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986. The Association met the QTL test at September 30, 2006, and in each of the prior 12 months, and therefore is a "qualified thrift lender." For purposes of calculating compliance with the QTL test, we use the cost basis of our investment in our Freddie Mac common stock, rather than the current market value of the stock.
If the Association fails the QTL test and is unable to correct that failure for a period of time, it must either operate under certain restrictions on its activities or convert to a bank charter.
Capital Requirements. OTS regulations require the Association to meet three minimum capital standards:
(1) a tangible capital ratio requirement of 1.5% of tangible capital to adjusted total assets;
(2) a leverage ratio requirement of 3% of core capital to such adjusted total assets, if a savings association has been assigned the highest composite rating of 1 under the Uniform Financial Institutions Ratings System or 4% or more if the savings association has not been assigned the highest composite rating; and
(3) a risk-based capital ratio requirement of 8% of core and supplementary capital to total risk-weighted assets; provided that the amount of supplementary capital used to satisfy this requirement may not exceed 100% of core capital.
In determining compliance with the risk-based capital requirement, the Association must compute its risk-weighted assets by multiplying its assets and certain off-balance sheet items by risk-weights, which range from 0% for cash and obligations issued by the United States Government or its agencies to 100% for consumer and commercial loans, as assigned by the OTS capital regulation based on the risks that the OTS believes are inherent in the type of asset.
Tangible capital is defined, generally, as common stockholders' equity (including retained earnings), certain non-cumulative perpetual preferred stock and related earnings, non-withdrawable accounts and pledged deposits that qualify as core capital and minority interests in equity accounts of fully consolidated subsidiaries, and certain investments in and loans to non-includable subsidiaries engaged in activities not permissible for a national bank. Core capital is defined similarly to tangible capital, but core capital also includes certain qualifying supervisory goodwill and certain purchased credit card relationships. Supplementary capital includes cumulative and other perpetual preferred stock mandatory convertible subordinated debt, mandatorily redeemable preferred stock, perpetual subordinated debt, income certificates, net worth certificates, mutual capital certificates, non-withdrawable accounts and pledged deposits included in core capital and allowance for loan and ease losses, as defined. In addition, up to 45% of unrealized gains on available-for-sale equity securities with a readily determinable fair value may be included in tier 2 capital. The allowance for loan and lease losses, as defined, is includable in tier 2 capital to a maximum of 1.25% of risk-weighted assets, and the amount of supplementary capital that may be included as total capital cannot exceed the amount of core capital.
At September 30, 2006, the Association met each of its capital requirements.
Community Reinvestment Act. Under the Community Reinvestment Act ("CRA"), as implemented by OTS regulations, the Association has a continuing and affirmative obligation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for the Association nor does it limit its discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the OTS, in connection with its examination of the Association, to assess the Company's record of meeting the credit needs of its community and to take the record into account in its evaluation of certain applications by the Association. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Association received a "Satisfactory" CRA rating in its most recent examination.
CRA regulations rate an institution based on its actual performance in meeting community needs. In particular, the system focuses on three tests:
o a lending test, to evaluate the institution's record of making loans in its assessment areas;
o an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses in its assessment area or a broader area that includes its assessment areas; and
o a service test, to evaluate the institution's delivery of services through its retail banking channels and the extent and innovativeness of its community development service.
Transactions with Affiliates. The Association's authority to engage in transactions with its "affiliates" is limited by the OTS regulations and by Sections 23A and 23B of the Federal Reserve Act (the "FRA"). In general, these transactions must be on terms which are as favorable to the Association as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the Association's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the Association. In addition, the OTS regulations prohibit a savings association from lending to any of its affiliates that is engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary.
The Federal Reserve Board's ("FRB's") Regulation W as made applicable to federal savings banks by the OTS regulations.
Loans to Insiders. The Association's authority to extend credit to its directors, executive officers and principal shareholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the FRB. Among other things, these provisions require that extensions of credit to insiders (a) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and (b) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the Association's capital. In addition, extensions of credit in excess of certain limits must be approved by the Association's Board of Directors.
Section 402 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Association that are subject to the insider lending restrictions of Section 22(h) of the FRA.
Enforcement. The OTS has primary enforcement responsibility over federal savings associations, including the Association. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices.
Standards for Safety and Soundness. As required by federal law, the OTS has adopted a set of guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, asset quality, earnings standards, and compensation, fees and benefits. In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines.
In addition, the OTS adopted regulations that authorize, but do not require, the OTS to order an institution that has been given notice that it is not satisfying these safety and soundness standards to submit a compliance plan. If, after being notified, an institution fails to submit an acceptable plan or fails in any material respect to implement an accepted plan, the OTS must issue an order directing action to correct the deficiency, may issue an order directing corrective actions and may issue an order directing other actions of the types to which an undercapitalized association is subject under the "prompt corrective action" provisions of federal law. If an institution fails to comply with such an order, the OTS may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Limitation on Capital Distributions. The OTS imposes various restrictions or requirements on the Association's ability to make capital distributions, including cash dividends. A savings institution that is the subsidiary of a savings and loan holding company must file a notice with the OTS at least 30 days before making a capital distribution. The Association must file an application for prior approval if the total amount of its capital distributions, including the proposed distribution, for the applicable calendar year would exceed an amount equal to the Association's net income for that year plus the Association's retained net income for the previous two years.
The OTS may disapprove of a notice or application if:
o the Association would be undercapitalized following the distribution;
o the proposed capital distribution raises safety and soundness concerns; or
o the capital distribution would violate a prohibition contained in any statute, regulation or agreement.
Liquidity. The Association is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation.
Prompt Corrective Action Regulations. Under the OTS prompt corrective action regulations, the OTS is required to take certain, and is authorized to take other, supervisory actions against undercapitalized savings associations. For this purpose, a savings association would be placed in one of the following four categories based on the association's capital:
o well-capitalized;
o adequately capitalized;
o undercapitalized; or
o critically undercapitalized.
At September 30, 2006, the Association met the criteria for being considered "well-capitalized."
When appropriate, the OTS can require corrective action by a savings association holding company under the "prompt corrective action" provisions of federal law.
Insurance of Deposit Accounts. The FDIC merged the Bank Insurance Fun and the Savings Association Insurance Fund (the "SAIF") to form the Deposit Insurance Fund (the "DIF") on March 31, 2006. The Association is a member of the DIF and pays its deposit insurance assessments to the DIF.
Effective January 1, 2007, the FDIC established a risk-based assessment system for determining the deposit insurance assessments to be paid by insured depository institutions. Under the assessment system, the FDIC assigns an institution to one of four risk categories, with the first category having two sub-categories, based on the institutions most recent supervisory and capital evaluations, designed to measure risk. Assessment rates currently range from 0.005% of deposits for an institution in the highest sub-category of the highest category to 0.43% of deposits for an institution in the lowest category. The FDIC is authorized to raise the assessment rates as necessary to maintain the required reserve ratio of 1.25%. The FDIC allows the use of credits for assessments previously. We believe that we have credit that will offset the assessment for calendar 2007 and possibly 2008.
In addition, all FDIC insured institutions are required to pay assessments to the FDIC at an annual rate of approximately 0.0124% of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the SAIF. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.
Federal Home Loan Bank System. The Association is a member of the Federal Home Loan Bank (the "FHLB") of Atlanta, which is one of the regional FHLBs making up the FHLB System. Each member of the FHLB of Atlanta must maintain a minimum investment in FHLB of Atlanta stock in an amount equal to the sum of (i) approximately 0.25% of the member's total assets, up to a maximum of $25 million, (ii) 4.5% of the member's outstanding advances, (iii) 4.5% of the outstanding assets purchased from the member and held by the FHLB under master commitments, and (iv) 8.0% of any Affordable Multi-Family Participation Program loans purchased from the member. Any advances from a FHLB must be secured by specified types of collateral, and all long-term advances may be obtained only for the purpose of providing funds for residential housing finance.
FHLBs are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of earnings that the FHLBs can pay as dividends to their members and also could result in the FHLBs imposing a higher rate of interest on advances to their members. If dividends were reduced or interest on future FHLB advances were increased, the Association's net interest income would be adversely affected.
Federal Reserve System. Under regulations of the FRB, the Association is required to maintain noninterest-earning reserves against its transaction accounts. FRB regulations generally require that reserves of 3% must be maintained against aggregate transaction accounts of over $8.5 million and up to $45.8 million, subject to adjustment by FRB in excess of $42.1 million. The first $8.5 million of otherwise reservable balances, subject to adjustments by FRB, are exempted from the reserve requirements. The Association is in compliance with these requirements. Because required reserves must be maintained in the form of either vault cash, a noninterest-bearing account at a Federal Reserve bank or a pass-through account as defined by FRB, the effect of this reserve requirement is to reduce the Association's interest-earning assets, to the extent the requirement exceeds vault cash.
For aggregate transaction accounts over $45.8 million, an initial reserve of $1,119,000 is required plus 10% of that portion of the aggregate transaction accounts over $45.8 million.
Prohibitions Against Tying Arrangements. Federal savings banks are subject to the prohibitions of 12 U.S.C. ss. 1972 on certain tying arrangements. A depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
USA Patriot Act. The Association is subject to the Bank Secrecy Act, as amended by the USA PATRIOT Act which gives the federal government powers to address money laundering and terrorist threats through enhanced domestic security measures, expanded surveillance powers, and increased information sharing and broadened anti-money laundering requirements. Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among financial institutions, bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.
Among other requirements, the USA PATRIOT Act imposes the following obligations on financial institutions:
o All financial institutions must establish risk-based anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.
o Any financial institutions must implement a written customer identification program appropriate for issuer, location and type of business.
o Financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) must establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.
o Financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and are subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks.
Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on BHCA and Bank Merger Act applications.
HOLDING COMPANY REGULATION
The Company and the MHC are savings and loan holding companies regulated by the OTS. As such, the Company and the MHC are registered with and are subject to OTS examination and supervision, as well as certain reporting requirements. In addition, the OTS has enforcement authority over the Company and the MHC and any of their non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings institution. Unlike bank holding companies, federal savings and loan holding companies are not subject to any regulatory capital requirements or to supervision by the Federal Reserve System.
Restrictions Applicable to the Company. Because the Company was organized after May 4, 1999, under the Gramm-Leach-Bliley Act (the "GLB Act"), it is prohibited from engaging in non-financial activities. The Company's activities are generally restricted to:
o furnishing or performing management services for a savings institution subsidiary of such holding company;
o conducting an insurance agency or escrow business;
o holding, managing, or liquidating assets owned or acquired from a savings institution subsidiary of such company;
o holding or managing properties used or occupied by a savings institution subsidiary of such company;
o acting as trustee under a deed of trust;
o any other activity (a) that the FRB, by regulation, has determined to be permissible for bank holding companies under Section 4(c) of the Bank Holding Company Act of 1956 ("BHCA"), unless the Director of the OTS, by regulation, prohibits or limits any such activity for savings and loan holding companies, or (b) in which multiple savings and loan holding companies were authorized by regulation to directly engage on March 5, 1987;
o purchasing, holding, or disposing of stock acquired in connection with a qualified stock issuance if the purchase of such stock by such holding company is approved by the Director of the OTS; and
o any activity permissible for financial holding companies under section 4(k) of the BHCA.
Permissible activities which are deemed to be financial in nature or incidental thereto under section 4(k) of the BHCA include:
o lending, exchanging, transferring, investing for others or safeguarding money or securities;
o insurance activities or providing and issuing annuities, and acting as principal, agent or broker;
o financial, investment or economic advisory services;
o issuing or selling instruments representing interests in pools of assets that a bank is permitted to hold directly;
o underwriting, dealing in, or making a market in securities;
o activities previously determined by the FRB to be closely related to banking;
o activities that bank holding companies are permitted to engage in outside of the U.S.;
o merchant banking activities; and
o portfolio investments made by an insurance company.
In addition, the Company cannot be acquired or acquire a company unless the acquirer or target (as the case may be) is engaged solely in financial activities.
Restrictions Applicable to Activities of Mutual Holding Companies. Under federal law, a mutual holding company, such as the MHC, may engage only in the following activities:
o investing in the stock of a savings institution;
o acquiring a mutual association through the merger of such association into a savings institution subsidiary of such holding company or an interim savings institution subsidiary of such holding company;
o merging with or acquiring another holding company, one of whose subsidiaries is a savings institution;
o investing in a corporation the capital stock of which is available for purchase by a savings institution under federal law or under the law of any state where the subsidiary savings institution or association is located; and
o the permissible activities described above for non-grandfathered savings and loan holding companies.
If a mutual holding company acquires or merges with another holding company, the holding company acquired or the holding company resulting from such merger or acquisition may only invest in assets and engage in activities listed above, and it has a period of two years to cease any non conforming activities and divest any non-conforming investments.
Restrictions Applicable to All Savings and Loan Holding Companies. Federal law prohibits a savings and loan holding company, including the Company and the MHC, directly or indirectly, from acquiring:
o control as defined under HOLA of another savings institution (or a holding company parent) without prior OTS approval;
o through merger, consolidation, or purchase of assets, another savings institution or a holding company thereof, or acquiring all or substantially all of the assets of such institution (or a holding company) without prior OTS approval; or
o control of any depository institution not insured by the FDIC (except through a merger with and into the holding company's savings institution subsidiary that is approved by the OTS).
A savings and loan holding company may not acquire as a separate subsidiary an insured institution that has a principal office outside of the state where the principal office of its subsidiary institution is located, except:
o in the case of certain emergency acquisitions approved by the FDIC;
o if such holding company controls a savings institution subsidiary that operated a home or branch office in such additional state as of March 5, 1987; or
o if the laws of the state in which the savings institution to be acquired is located specifically authorize a savings institution chartered by that state to be acquired by a North Carolina savings institution.
Federal Securities Laws. The Company's common stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Company is subject to information, proxy solicitation, insider trading restrictions, and other requirements under the Exchange Act.
The Sarbanes-Oxley Act. The Company is subject to the Sarbanes-Oxley Act of 2002 ("SOX") which implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from corporate wrongdoing. As previously noted, Section 402 of the SOX prohibits the extension of personal loans to directors and officers or issuers (as defined in SOX). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, which is subject to the insider lending restrictions in Section 22(h) of the FRA. The Sarbanes-Oxley Act's principal legislation and the derivative legislation and rule making promulgated by the SEC includes:
o the creation of an independent accounting oversight board;
o auditor independence provisions which restrict non-audit services that accountants may provide to their audit clients;
o additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements;
o the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;
o an increase the oversight of, and enhancement of certain requirements relating to audit committees of public companies and how they interact with the company's independent auditors.
o requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer;
o requirement that companies disclose whether at least one member of the committee is a "financial expert" (as such term will be defined by the Securities and Exchange Commission) and if not, why not;
o expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods;
o a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions;
o disclosure of a code of ethics and filing a Form 8-K for a change or waiver of such code;
o mandatory disclosure by analysts of potential conflicts of interest; and
o a range of enhanced penalties for fraud and other violations.
Although we anticipate that we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.
FEDERAL AND STATE TAXATION
FEDERAL TAXATION
General. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company, the Association or the MHC. The Association was last audited for its taxable year ended September 30, 1993.
For federal income tax purposes, the Company and the Association report their income using a taxable year ending September 30 and the accrual method of accounting. The Company, the Association and the MHC file separate income tax returns and each reports its income on the same basis as the Association now reports its income. Because the MHC owns less than 80% of the outstanding common stock of the Company, the MHC and the Company are not permitted to file such returns on a consolidated basis. The Company and the Association may file their returns on a consolidated basis, but have elected to file separately. The Company and the Association have entered into a tax sharing agreement which governs the apportionment of taxable income between the entities. The Company, the MHC and the Association are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Association's tax reserve for bad debts discussed below.
Bad Debt Reserves. The Association, as a "small bank" (one with assets having an adjusted tax basis of $500 million or less) is permitted to maintain a reserve for bad debts with respect to "qualifying loans," which, in general, are loans secured by certain interests in real property, and to make, within specified formula limits, annual additions to the reserve which are deductible for purposes of computing the Association's taxable income. Pursuant to the S Job Protection Act of 1996, the Association recaptured (took into income) over a multi-year period a portion of the balance of its bad debt reserve as of September 30, 1988.
Distributions. To the extent that the Association makes "non-dividend distributions" to the Company, such distributions will be considered to have been made from the Association's "base year reserve," i.e., its reserve as of September 30, 1988, and then from the Association's supplemental reserve for losses on loans, to the extent thereof, and an amount based on the amount distributed (but not in excess of the amount of such reserves) will be included in the Association's income. Non-dividend distributions include distributions in excess of the Association's current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of the Association's current or accumulated earnings and profits will not be so included in the Association's income.
The amount of additional taxable income created from a non-dividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if, after the Reorganization, the Association makes a non-dividend distribution to the Holding Company, approximately one and one-half times the amount of such distribution (but not in excess of the amount of such reserves) would be includible in income for federal income tax purposes, assuming a 34% federal corporate income tax rate. The Association does not intend to pay dividends that would result in a recapture of any portion of its tax bad debt reserves.
Corporate Alternative Minimum Tax. The Code imposes an alternative minimum tax ("AMT") on alternative minimum taxable income ("AMTI") at a rate of 20%. Only 90% of AMTI can be offset by net operating loss carryovers of which the Association currently has none. AMTI is adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. Thus, the Association's AMTI is increased by an amount equal to 75% of the amount by which the Association's adjusted current earnings exceeds its AMTI (determined without regard to this adjustment and prior to reduction for net operating losses). The Association does not expect to be subject to the AMT.
Although the corporate environmental tax of 0.12% of the excess of AMTI (with certain modifications) over $2.0 million has expired, under current Administration proposals, such tax will be retroactively reinstated for taxable years beginning after December 31, 1997 and before January 2009.
Dividends Received Deduction. As the owner of more than 20% of the stock of the Company, the MHC may deduct from its income 80% of dividends received from the Company. (A 70% dividends received deduction generally applies with respect to dividends received by a corporation if such corporation owns less than 20% of the stock of the corporation paying the dividend).
STATE TAXATION
Under North Carolina law, the corporate income tax is 6.90% of federal taxable income as computed under the Code, subject to certain prescribed adjustments. An annual state franchise tax is imposed at a rate of .0015 applied to the greatest of the institution's (i) capital stock, surplus and undivided profits, (ii) investment in tangible property in North Carolina or (iii) 55% of the appraised valuation of property in North Carolina.
