Commission File No.: 000-25805

 

 

(540) 347-2700

 

(Registrant’s telephone number, including area code)

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes  o      No  þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  o      No  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o      No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.    o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark if the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)  Yes  o      No  þ

 

The aggregate market value of the registrant’s common shares held by “non-affiliates” of the registrant, based upon the closing sale price of its common stock on the NASDAQ Capital Market on June 30, 2009, was $48.9 million. Shares held by each executive officer, director and holder of 10% or more of the registrant’s outstanding common stock have been excluded as shares held by affiliates. Such determination of affiliate status is not a conclusive determination for other purposes.

 

The registrant had 3,620,544 shares of common stock outstanding as of March 10, 2010.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive proxy statement for the 2009 Annual Meeting of Shareholders to be held on May 18, 2010 are incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

 

general market rates of interest influence deposit flows and costs of funds. Lending activities are affected by the demand for financing of real estate and other types of loans, which in turn is affected by the interest rates at which such financing may be offered and other factors affecting local demand and availability of funds. The Bank faces strong competition in the attraction of deposits (its primary source of lendable funds) and in the origination of loans. See “Competition” below.

 

As of December 31, 2009, the Company had total consolidated assets of $568.5 million, total loans net of allowance for loan losses of $462.8 million, total consolidated deposits of $466.0 million, and total consolidated shareholders’ equity of $42.6 million.

 

LENDING ACTIVITIES

 

The Bank offers a range of lending services, including real estate, consumer and commercial loans, to individuals as well as small-to-medium sized businesses and other organizations that are located in or conduct a substantial portion of their business in the Bank’s market area. The Bank’s total loans, net of allowance, at December 31, 2009 were $462.8 million, or 81.4% of total assets. The interest rates charged on loans vary with the degree of risk, maturity, and amount of the loan, and are further subject to competitive pressures, money market rates, availability of funds and government regulations. The Bank has no foreign loans, sub-prime loans or loans for highly leveraged transactions.

 

The Bank’s general market area for lending consists of Fauquier and Prince William Counties, Virginia and the neighboring communities. There is no assurance that this area will experience economic growth. Continued adverse economic conditions in any one or more of the industries operating in Fauquier or Prince William Counties, the continued slow-down in general economic conditions, and/or declines in the market value of local commercial and/or residential real estate may continue to have an adverse effect on the Company and the Bank.

 

The Bank’s loans are concentrated in three major areas: real estate loans, commercial loans, and consumer loans. Approximately 6.3% and 2.2% of the Bank’s loan portfolio at December 31, 2009 consisted of commercial and consumer loans, respectively. The majority of the Bank’s loans are made on a secured basis. As of December 31, 2009, approximately 88.4% of the loan portfolio consisted of loans secured by mortgages on real estate. Income from loans decreased $471,000 to $26.5 million for 2009 compared with $26.9 million for 2008 due to the decline in market interest rates. No material part of the Bank’s business is dependent upon a single or a few customers, and the loss of any single customer would not have a materially adverse effect upon the Bank’s business.

 

LOANS SECURED BY REAL ESTATE

 

ONE TO FOUR (“1-4”) FAMILY RESIDENTIAL LOANS.   The Bank’s 1-4 family residential mortgage loan portfolio primarily consists of conventional loans, generally with fixed interest rates with 15 or 30 year terms, and balloon loans with fixed interest rates, and 3, 5, 7, or 10-year maturities but utilizing amortization schedules of 30 years or less. As of December 31, 2009, the Bank’s 1-4 family residential loans amounted to $193.7 million, or 41.4% of the total loan portfolio. Substantially the Bank’s entire single-family residential mortgage loans are secured by properties located in the Bank’s service area. The Bank requires private mortgage insurance if the principal amount of the loan exceeds 80% of the value of the property held as collateral.

 

CONSTRUCTION LOANS.   The majority of the Bank’s construction loans are made to individuals to construct a primary residence. Such loans have a maximum term of twelve months, a fixed rate of interest, and loan-to-value ratios of 80% or less of the appraised value upon completion. The Bank requires that permanent financing, with the Bank or some other lender, be in place prior to closing any construction loan. Construction loans are generally considered to involve a higher degree of credit risk than single-family residential mortgage loans. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion. The Bank also provides construction loans and lines of credit to developers. Such loans generally have maximum loan-to-value ratios of 80% of the appraised value upon completion. The loans are made generally with a variable rate of interest. The majority of construction loans are made to selected local developers for the building of single-family dwellings on either a pre-sold or speculative basis. The Bank limits the number of unsold units under construction at one time. Loan proceeds are disbursed in stages after inspections of the project indicate that such disbursements are for costs already incurred and that have added to the value of the project. Construction loans include loans to developers to acquire the necessary land, develop the site and construct the residential units. As of December 31, 2009, the Bank’s construction loans totaled $33.0 million, or 7.0% of the total loan portfolio.

 

COMMERCIAL REAL ESTATE LOANS.   Loans secured by commercial real estate comprised $186.5 million, or 39.8% of total loans at December 31, 2009, and consist principally of commercial loans for which real estate

constitutes a source of collateral. $100.3 million or 53.8% of commercial real estate loans are owner-occupied. Commercial real estate loans generally involve a greater degree of risk than single-family residential mortgage loans because repayment of commercial real estate loans may be more vulnerable to adverse conditions in the real estate market or the economy.

 

CONSUMER LOANS

 

The Bank’s consumer loan portfolio consists primarily of loans to individuals for various consumer purposes, but includes some business purpose loans that are payable on an installment basis. The Bank offers a wide variety of consumer loans, including installment loans, credit card loans, and other secured and unsecured credit facilities. Approximately 70% of these loans, on a dollar-value basis, are for terms of seven years or less, and are secured by liens on motor vehicles of the borrowers. An additional 5% of consumer loans are secured by other personal assets of the borrower, and the remaining 25% are made on an unsecured basis. Consumer loans are made at fixed and variable rates, and are often based on up to a seven-year amortization schedule. The consumer loan portfolio was $10.4 million or 2.2% of total loans at December 31, 2009.

 

COMMERCIAL LOANS

 

The Bank’s commercial loans include loans to individuals and small-to-medium sized businesses located primarily in Fauquier and Prince William Counties for working capital, equipment purchases, and various other business purposes. Equipment or similar assets secure approximately 85% of the Bank’s commercial loans, on a dollar-value basis, and the remaining 15% of commercial loans are on an unsecured basis. Commercial loans have variable or fixed rates of interest. Commercial lines of credit are typically granted on a one-year basis. Other commercial loans with terms or amortization schedules longer than one year will normally carry interest rates that vary with the prime lending rate and other financial indices and will be payable in full in three to five years.

 

Loan originations are derived from a number of sources, including existing customers and borrowers, walk-in customers, advertising, and direct solicitation by the Bank’s loan officers. Certain credit risks are inherent in originating and keeping loans on the Bank’s balance sheet. These include interest rate and prepayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions, and risks inherent in dealing with individual borrowers. In particular, longer maturities increase the risk that economic conditions will change and adversely affect our ability to collect. The Bank attempts to minimize loan losses through various means. In particular, on larger credits, the Bank generally relies on the cash flow of a debtor as the source of repayment and secondarily on the value of the underlying collateral. In addition, the Bank attempts to utilize shorter loan terms in order to reduce the risk of a decline in the value of such collateral. The commercial loan portfolio was $29.3 million or 6.3% of total loans at December 31, 2009.

 

DEPOSIT ACTIVITIES

 

Deposits are the major source of the Bank’s funds for lending and other investment activities. The Bank considers its regular savings, demand, negotiable order of withdrawal (“NOW”), premium NOW money market deposit accounts, and non-brokered time deposits under $100,000 to be core deposits. These accounts comprised approximately 74.1% of the Bank’s total deposits at December 31, 2009. Generally, the Bank attempts to maintain the rates paid on its deposits at a competitive level. Time deposits of $100,000 and over made up approximately 25.9% of the Bank’s total deposits at December 31, 2009. During 2009, time deposits of $100,000 and over generally paid interest at rates the same or higher than certificates of less than $100,000. The majority of the Bank’s deposits are generated from Fauquier and Prince William Counties. Included in interest-bearing deposits at December 31, 2009 were $57.3 million of brokered deposits, or 12.3% of total deposits. Of the brokered deposits, $31.1 million or 6.4% of total deposits represent a reciprocal arrangement for existing Bank customers who desire FDIC insurance for deposits above current limits.

 

INVESTMENTS

 

The Bank invests a portion of its assets in U.S. Government-sponsored corporation and agency obligations, state, county and municipal obligations, corporate obligations, mutual funds, FHLB stock and equity securities. The Bank’s investments are managed in relation to loan demand and deposit growth, and are generally used to provide for the investment of excess funds at reduced yields and risks relative to yields and risks of the loan portfolio, while providing liquidity to fund increases in loan demand or to offset fluctuations in deposits. The Bank does not currently engage in any off-balance sheet hedging activities. The Bank’s total investments, at fair value, were

$40.5 million, or 7.1% of total assets at December 31, 2009. During 2009, income from investments totaled $810,000, consisting of $1.58 million of interest and dividend income, partially offset by a loss of $772,000 associated with recognition of other than temporary impairment on investment in pooled trust-preferred securities and Silverton Bank common stock.

 

GOVERNMENT SUPERVISION AND REGULATION

 

GENERAL.   Bank holding companies and banks are extensively regulated under both federal and state law. The following summary briefly addresses certain provisions of federal and state laws that apply to the Company or the Bank. This summary does not purport to be complete and is qualified in its entirety by reference to the particular statutory or regulatory provisions.

 

EFFECT OF GOVERNMENTAL MONETARY POLICIES.   The earnings and business of the Company and the Bank are affected by the economic and monetary policies of various regulatory authorities of the United States, especially the Federal Reserve. The Federal Reserve, among other things, regulates the supply of credit and money and setting interest rates in order to influence general economic conditions within the United States. The instruments of monetary policy employed by the Federal Reserve for those purposes influence in various ways the overall level of investments, loans, other extensions of credits, and deposits, and the interest rates paid on liabilities and received on assets. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

 

EMERGENCY ECONOMIC STABILIZATION ACT OF 2008.   Deteriorating market conditions in 2008 led to the enactment of the Emergency Economic Stabilization Act of 2008 (the “EESA”) on October 3, 2008. The EESA authorized the Troubled Asset Relief Plan (“TARP”) with an objective to ease the downturn in the credit cycle. The TARP provided up to $700 billion to the U.S. Department of the Treasury (the “Treasury”) to buy mortgages and other troubled assets, to provide guarantees and to inject capital into financial institutions. As part of the $700 billion TARP, the Treasury established a Capital Purchase Program (“CPP”), which allows the Treasury to purchase up to $250 billion of senior preferred shares issued by U.S. financial institutions. The EESA also temporarily raised the basic limit on federal deposit insurance coverage from $100,000 to $250,000 per depositor until December 31, 2009, and accelerated the date on which the Federal Reserve will begin paying interest on required and excess reserve balances. On May 20, 2009, President Obama signed the Helping Families Save Their Homes Act, which extended the temporary increase in the limit on federal deposit insurance coverage to $250,000 per depositor to December 31, 2013. The limit will decrease to $100,000 on January 1, 2014. The Company, after considerable analysis and deliberation, chose not to participate in the CPP.

 

SARBANES-OXLEY ACT OF 2002.   The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), including the filing of annual, quarterly, and other reports with the Securities and Exchange Commission (the “SEC”). As an Exchange Act reporting company, the Company is directly affected by the Sarbanes-Oxley Act of 2002 (the “SOX”), which is aimed at improving corporate governance, internal controls and reporting procedures. The Company is complying with applicable SEC and other rules and regulations implemented pursuant to the SOX and intends to comply with any applicable rules and regulations implemented in the future.

 

FINANCIAL SERVICES MODERNIZATION LEGISLATION.   The Gramm-Leach-Bliley Financial Services Modernization Act of 1999 (the “GLB Act”) was intended to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers under a “financial holding company” structure. Under the GLB Act, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect to become “financial holding companies.” As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, insurance agency activities, merchant banking and other activities that the Federal Reserve determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLB Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. Although the Company could qualify to become a financial holding company under the GLB Act, it does not contemplate seeking to do so unless it identifies significant specific benefits from doing so. The GLB Act has not had a material effect on the Company operations. However, to the extent that the GLB Act permits banks, securities firms and insurance companies to affiliate with each other, the financial services industry may have experienced further consolidation

resulting in a growing number of financial institutions that offer a wider variety of financial services than the Company currently offers and that can aggressively compete in the markets the Company currently serves.

 

BANK HOLDING COMPANY REGULATION.   The Company is a one-bank holding company, registered with the Federal Reserve under the Bank Holding Company Act of 1956 (the “BHC Act”). As such, the Company is subject to the supervision, examination, and reporting requirements of the BHC Act and the regulations of the Federal Reserve. The Company is required to furnish to the Federal Reserve an annual report of its operations at the end of each fiscal year and such additional information as the Federal Reserve may require pursuant to the BHC Act. The BHC Act generally prohibits the Company from engaging in activities other than banking or managing or controlling banks or other permissible subsidiaries and from acquiring or retaining direct or indirect control of any company engaged in any activities other than those activities determined by the Federal Reserve to be sufficiently related to banking or managing or controlling banks. With some limited exceptions, the BHC Act requires every bank holding company to obtain the prior approval of the Federal Reserve before: acquiring substantially all the assets of any bank; acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or merging or consolidating with another bank holding company. In addition, and subject to some exceptions, the BHC Act and the Change in Bank Control Act, together with the regulations promulgated thereunder, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company.

 

BANK REGULATION.   The Bank is chartered under the laws of the Commonwealth of Virginia. The FDIC insures its deposits to the maximum extent provided by law. The Bank is subject to comprehensive regulation, examination and supervision by the Federal Reserve and to other laws and regulations applicable to banks. These regulations include limitations on loans to a single borrower and to the Bank’s directors, officers and employees; restrictions on the opening and closing of branch offices; requirements regarding the maintenance of prescribed capital and liquidity ratios; requirements to grant credit under equal and fair conditions; and requirements to disclose the costs and terms of such credit. State regulatory authorities also have broad enforcement powers over the Bank, including the power to impose fines and other civil or criminal penalties and to appoint a receiver in order to conserve the Bank’s assets for the benefit of depositors and other creditors.

 

The Bank is also subject to the provisions of the Community Reinvestment Act of 1977 (“CRA”). Under the terms of the CRA, the appropriate federal bank regulatory agency is required, in connection with its examination of a bank, to assess the bank’s record in meeting the credit needs of the community served by that bank, including low-and moderate-income neighborhoods. The regulatory agency’s assessment of a bank’s record is made available to the public. Such assessment is required of any bank that has applied to (i) charter a national bank, (ii) obtain deposit insurance coverage for a newly chartered institution, (iii) establish a new branch office that will accept deposits, (iv) relocate an office, or (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution. In the case of a bank holding company applying for approval to acquire a bank or other bank holding company, the Federal Reserve will assess the record of each subsidiary bank of the applicant bank holding company, and such records may be the basis for denying the application. The Bank received a rating of “satisfactory” at its last CRA performance evaluation as of February 28, 2008.

 

DIVIDENDS.   Dividends from the Bank constitute the primary source of funds for dividends to be paid by the Company. There are various statutory and contractual limitations on the ability of the Bank to pay dividends, extend credit, or otherwise supply funds to the Company, including the requirement under Virginia banking laws that cash dividends only be paid out of net undivided profits and only if such dividends would not impair the capital of the Bank. The Federal Reserve also has the general authority to limit the dividends paid by bank holding companies and state member banks, if the payment of dividends is deemed to constitute an unsafe and unsound practice. The Federal Reserve has indicated that banking organizations should generally pay dividends only if (1) the organization’s net income available to common shareholders over the past year has been sufficient to fund fully the dividends and (2) the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality and overall financial condition. The Bank does not expect any of these laws, regulations or policies to materially impact its ability to pay dividends to the Company.

 

INSURANCE OF DEPOSITS.   The Bank’s deposit accounts are insured by the FDIC up to applicable maximum limits. The FDIC issues regulations, conducts periodic examinations, requires the filing of reports and generally supervises the operations of its insured banks. Any insured bank that is not operated in accordance with or does not conform to FDIC regulations, policies and directives may be sanctioned for non-compliance. Proceedings may be instituted against any insured bank or any director, officer, or employee of an insured bank engaging in

unsafe and unsound practices, including the violation of applicable laws and regulations. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose.

 

Under current regulations, FDIC-insured depository institutions pay insurance premiums at rates based on their assessment risk classification, which is determined, in part, based on the institution’s capital ratios and on factors that the FDIC deems relevant to determine the risk of loss to the FDIC. In 2007, the annual assessment rates changed to a range of 5-43 basis points, an increase from the 0-27 basis point range that had been in effect since 1996. In 2009, the base assessment rate range for Risk Category 1 institutions increased to 7-24 basis points as part of the FDICs Restoration Plan for the Deposit Insurance Fund (“DIF”). This increase was necessary to replenish the DIF due to the number of recent failures of FDIC-insured institutions. The amount an institution is assessed is based upon statutory factors that include the balance of insured deposits as well as the degree of risk the institution poses to the DIF and may be reviewed semi-annually.

 

On May 22, 2009, the FDIC voted to levy a special assessment on insured institutions as part of the FDIC]s efforts to rebuild the DIF and help maintain public confidence in the banking system. The special assessment was 5 basis points on each FDIC-insured depository institution’s assets, minus its Tier 1 capital, as of June 30, 2009. On September 30, 2009, the Company paid a special assessment of $241,315. On November 12, 2009, the FDIC voted to require insured institutions to prepay slightly over three years of estimated insurance assessments. The pre-payment allows the FDIC to strengthen the cash position of the DIF immediately without immediately impacting earnings of the industry. During the fourth quarter of 2009, the Company pre-paid estimated assessments of $2,430,625 for 13 quarters starting in the fourth quarter of 2009 through fourth quarter of 2012.

 

TEMPORARY LIQUIDITY GUARANTEE PROGRAM.   On October 14, 2008, the FDIC enacted the Temporary Liquidity Guarantee Program (“TLGP”) to strengthen confidence and encourage liquidity in the banking system. Pursuant to the TLGP, the FDIC guaranteed certain senior unsecured debt issued by participating financial institutions issued on or after October 14, 2008 and before June 30, 2009; and provided full FDIC deposit insurance coverage for non-interest bearing transaction accounts at participating FDIC-insured institutions through December 31, 2009 (“Transaction Account Guarantee Program”). All FDIC-insured institutions were covered under the program until December 5, 2008, at no cost. After December 5, 2008, the cost for institutions electing to participate was a 10-basis-point surcharge applied to balances covered by the noninterest-bearing deposit transaction account guarantee and 75 basis points of the eligible senior unsecured debt guaranteed under the program. The Company elected to participate in both the unlimited coverage for noninterest-bearing transaction accounts and the debt guarantee program.

 

On June 3, 2009, the FDIC amended the TLGP to provide a limited extension of the debt guarantee program. Effective October 1, 2009, the FDIC also extended the full FDIC deposit insurance coverage for noninterest-bearing transaction accounts at participating FDIC-insured institutions through June 30, 2010. As part of the extension, insured institutions electing to continue participation will pay an increased assessment ranging from 15-25 basis points depending on the entity’s Risk Category. The Company elected to continue its participation in the Transaction Account Guarantee Program.

 

CAPITAL REQUIREMENTS.   The federal bank regulatory authorities have adopted risk-based capital guidelines for banks and bank holding companies that are designed to make regulatory capital requirements more sensitive to differences in risk profile among banks and bank holding companies. The resulting capital ratios represent qualifying capital as a percentage of total risk-weighted assets and off-balance sheet items. The guidelines establish minimums, and the federal regulators have noted that banks and bank holding companies contemplating significant expansion programs should maintain all ratios well in excess of the minimums and should not allow expansion to diminish their capital ratios. The current guidelines require all bank holding companies and federally regulated banks to maintain a minimum risk-based total capital ratio equal to 8%, of which at least 4% must be Tier 1 capital. Tier 1 capital includes common stockholders’ equity, retained earnings, qualifying perpetual preferred stock, and certain hybrid capital instruments, but excludes goodwill and most other intangibles and excludes the allowance for loan and lease losses. Tier 2 capital includes the excess of any preferred stock not included in Tier 1 capital, mandatory convertible securities, certain hybrid capital instruments, subordinated debt and intermediate term-preferred stock, and general reserves for loan and lease losses up to 1.25% of risk-weighted assets. As of December 31, 2009, the Bank had a total risk-based capital ratio of 12.13% and a Tier 1 risk-based capital ratio of 10.89%, and the Company had a total risk-based capital ratio of 12.21% and a Tier 1 risk-based capital ratio of 10.97%.

 

Each of the federal regulatory agencies has also established leverage capital ratio guidelines for banking organizations (Tier 1 capital to average tangible assets, or the “leverage ratio”). These guidelines generally provide

for a minimum leverage ratio of 4.0% for banks and bank holding companies (3% for institutions receiving the highest rating on the CAMELS financial institution rating system.) As of December 31, 2009, the Bank had a leverage ratio of 8.67%, and the Company had a leverage ratio of 8.68%.

 

The FDIC Improvement Act of 1991 (“FDICIA”) made a number of reforms addressing the safety and soundness of deposit insurance funds, supervision, accounting, and prompt regulatory action with respect to insured institutions such as the Bank which have total assets of $250 million or more. Annual full-scope, on-site regulatory examinations are required of all insured depository institutions. The cost for conducting an examination of an institution may be assessed to the institution, with special consideration given to affiliates and any penalties imposed for failure to provide information requested. Insured state banks also are precluded from engaging as principal in any type of activity that is impermissible for a national bank, including activities relating to insurance and equity investments. FDICIA also re-codified current law under the Federal Reserve Act restricting extensions of credit to insiders.

 

FDICIA also contains “prompt corrective action” provisions pursuant to which banks are classified into one of five categories based upon capital adequacy, ranging from “well capitalized” to “critically undercapitalized” and which require (subject to certain exceptions) the appropriate federal banking agency to take prompt corrective action with respect to an institution which becomes “significantly undercapitalized” or “critically undercapitalized”.

 

The FDIC has issued regulations to implement the “prompt corrective action” provisions of FDICIA. In general, the regulations define the five capital categories as follows: (i) an institution is “well capitalized” if it has a total risk-based capital ratio of 10% or greater, has a Tier 1 risk-based capital ratio of 6% or greater, has a leverage ratio of 5% or greater and is not subject to any written order or directive to meet and maintain a specific capital level for any capital measure; (ii) an institution is “adequately capitalized” if it has a total risk-based capital ratio of 8% or greater, has a Tier 1 risk-based capital ratio of 4% or greater, and has a leverage ratio of 4% or greater; (iii) an institution is “undercapitalized” if it has a total risk-based capital ratio of less than 8%, has a Tier 1 risk-based capital ratio that is less than 4% or has a leverage ratio that is less than 4%; (iv) an institution is “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6%, a Tier 1 risk-based capital ratio that is less than 3% or has a leverage ratio that is less than 3%; and (v) an institution is “critically undercapitalized” if its “tangible equity” is equal to or less than 2% of its total assets. The FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring new election of directors, and requiring the dismissal of directors and officers. The Bank was notified by the Federal Reserve Bank of Richmond that, at December 31, 2009, both the Company and the Bank were considered “well capitalized.”

 

FEDERAL HOME LOAN BANK OF ATLANTA.   The Bank is a member of the FHLB of Atlanta, which is one of twelve regional FHLBs that provide funding to their members for making housing loans as well as loans for affordable housing and community development lending. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. It makes loans to its members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank is required to purchase and maintain stock in the FHLB in an amount equal to at least 5% of the aggregate outstanding advances made by the FHLB to the Bank. In addition, the Bank is required to pledge collateral for outstanding advances. The borrowing agreement with the FHLB of Atlanta provides for the pledge by the Bank of various forms of securities and mortgage loans as collateral.

 

USA PATRIOT ACT.   The USA PATRIOT Act became effective on October 26, 2001 and provides for the facilitation of information sharing among governmental entities and financial institutions for the purpose of combating terrorism and money laundering. Among other provisions, the USA PATRIOT Act permits financial institutions, upon providing notice to the United States Treasury, to share information with one another in order to better identify and report to the federal government concerning activities that may involve money laundering or terrorists’ activities. The USA PATRIOT Act is considered a significant banking law in terms of information disclosure regarding certain customer transactions. Certain provisions of the USA PATRIOT Act impose the obligation to establish anti-money laundering programs, including the development of a customer identification program, and the screening of all customers against any government lists of known or suspected terrorists. Although

it does create a reporting obligation and a cost of compliance, the USA PATRIOT Act has not materially affected the Bank’s products, services, or other business activities.

 

MORTGAGE BANKING REGULATION.   The Bank’s mortgage banking activities are subject to the rules and regulations of, and examination by the Department of Housing and Urban Development, the Federal Housing Administration, the Department of Veterans Affairs and state regulatory authorities with respect to originating, processing and selling mortgage loans. Those rules and regulations, among other things, establish standards for loan origination, prohibit discrimination, provide for inspections and appraisals of property, require credit reports on prospective borrowers and, in some cases, restrict certain loan features, and fix maximum interest rates and fees. In addition to other federal laws, mortgage origination activities are subject to the Equal Credit Opportunity Act, Truth-in-Lending Act, Home Mortgage Disclosure Act, Real Estate Settlement Procedures Act, and Home Ownership Equity Protection Act, and the regulations promulgated under these acts. These laws prohibit discrimination, require the disclosure of certain basic information to mortgagors concerning credit and settlement costs, limit payment for settlement services to the reasonable value of the services rendered and require the maintenance and disclosure of information regarding the disposition of mortgage applications based on race, gender, geographical distribution and income level.

 

CONSUMER LAWS AND REGULATIONS.   The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Credit Reporting Act, and the Fair Housing Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits, making loans to or engaging in other types of transactions with such customers.

 

LOANS TO INSIDERS

 

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and some affiliated entities of any of the foregoing, may not exceed, together with all other outstanding loans to such person and affiliated entities, the bank’s loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100 million, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and their respective affiliates, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000 or 5% of capital and surplus (up to $500,000). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons.

 

FUTURE REGULATORY UNCERTAINTY

 

Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, the Company cannot forecast how federal regulation of financial institutions may change in the future and impact its operations. Although Congress in recent years has sought to reduce the regulatory burden on financial institutions with respect to the approval of specific transactions, the Company fully expects that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.

 

COMPETITION

 

The Company encounters strong competition both in making loans and in attracting deposits. In one or more aspects of its business, the Bank competes with other commercial banks, savings and loan associations, credit unions, finance companies, mutual funds, insurance companies, brokerage and investment banking companies, and other financial intermediaries. Most of these competitors, some of which are affiliated with bank holding companies, have substantially greater resources and lending limits, and may offer certain services that the Bank

does not currently provide. In addition, many of the Bank’s non-bank competitors are not subject to the same level of federal regulation that governs bank holding companies and federally insured banks. Recent federal and state legislation has heightened the competitive environment in which financial institutions must conduct their business, and the potential for competition among financial institutions of all types has increased significantly. To compete, the Bank relies upon specialized services, responsive handling of customer needs, and personal contacts by its officers, directors, and staff. Large multi-branch banking institutions tend to compete based primarily on price and the number and location of branches while smaller, independent financial institutions tend to compete primarily on price and personal service.

 

EMPLOYEES

 

As of December 31, 2009, the Company and the Bank employed 137 full-time employees and 28 part-time employees compared with 131 full-time and 25 part-time employees as of December 31, 2008. The growth in employees was due to the opening of two branch locations during 2009. No employee is represented by a collective bargaining unit. The Company and the Bank consider relations with employees to be good.

 

AVAILABLE INFORMATION

 

The Company files annual, quarterly and current reports, proxy statements and other information with the SEC. The Company’s SEC filings are filed electronically and are available to the public over the internet at the SEC’s website at http://www.sec.gov . In addition, any document filed by the Company with the SEC can be read and copied at the SEC’s public reference facilities at 100 F Street, N.E., Washington, D.C. 20549. Copies of documents can be obtained at prescribed rates by writing to the Public Reference Section of the SEC at 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the public reference room by calling 1-800-SEC-0330. The Company’s website is http://www.fauquierbank.com . The Company makes its SEC filings available through this website under “Investor Relations,” “Documents” as soon as practicable after filing or furnishing the material to the SEC. Copies of documents can also be obtained free of charge by writing to Secretary, Fauquier Bankshares, Inc. at 10 Courthouse Square, Warrenton, Virginia 20186 or by calling 540-347-2700.

 

The Company has a high concentration of loans secured by both residential and commercial real estate and a downturn in either or both real estate markets, for any reason, may continue to increase the Company’s credit losses, which would negatively affect its financial results.

 

The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Most of the Company’s loans are secured by real estate (both residential and commercial) in its market area. At December 31, 2009, approximately 41.4% and 39.8% of the Company’s $468 million loan portfolio were secured by post-construction residential and commercial real estate including farmland, respectively, with construction loans representing an additional 7.0% of its loans secured by real estate. Changes in the real estate market, such as the greater deterioration in market value of collateral, or a greater decline in local employment, could adversely affect the Company’s customers ability to pay these loans, which in turn could impact the Company’s profitability. There has been a slowdown in the housing market across our geographical footprint, reflecting declining prices and excess inventories of houses to be sold. Repayment of our commercial loans is often dependent on the cash flow of the borrower, which may become unpredictable in the current economy. If the value of real estate serving as collateral for the loan portfolio were to continue to decline materially, a significant part of the loan portfolio could become under-collateralized. If the loans that are secured by real estate become troubled when real estate market conditions are declining or have declined, in the event of foreclosure, the Company may not be able to realize the amount of collateral that was anticipated at the time of originating the loan. In that event, the Company might have to increase the provision for loan losses, which could have a material adverse effect on its operating results and financial condition.

 

If the Company’s allowance for loan losses becomes inadequate, its results of operations may be adversely affected.

 

The Company maintains an allowance for loan losses that it believes is a reasonable estimate of known and inherent losses in the Company’s loan portfolio. Through periodic review of the Company’s loan portfolio, it determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of the Company’s customers relative to their financial obligations with us. The amount of future losses is susceptible to changes in economic and other market conditions, including changes in interest rates and collateral values that are beyond the Company’s control, and these future losses may exceed current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult, and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more seasoned portfolios. Although the Company believes the allowance for loan losses is a reasonable estimate of known and inherent losses in the its loan portfolio, it cannot fully predict such losses or that the loan loss allowance will be adequate in the future. Excessive loan losses could have a material impact on its financial performance.

 

Federal and state regulators periodically review the Company’s allowance for loan losses and may require us to increase the provision for loan losses or recognize further loan charge-offs, based on judgments different than those of management. Any increase in the amount of the Company’s provision or loans charged-off as required by these regulatory agencies could have a negative effect on its operating results.

 

The Company may incur losses if it is unable to successfully manage interest rate risk.

 

The Company’s profitability depends in substantial part upon the spread between the interest rates earned on investments and loans and interest rates paid on deposits and other interest-bearing liabilities. The Company may selectively pay above-market rates to attract deposits as it has done in some of the Company’s marketing promotions in the past. Changes in interest rates will affect the Company’s operating performance and financial condition in diverse ways including the pricing of securities, loans and deposits, which, in turn, may affect the growth in loan and retail deposit volume. The Company attempts to minimize the Company’s exposure to interest rate risk, but cannot eliminate it. The Company’s net interest income will be adversely affected if market interest rates change so that the interest it pays on deposits and borrowings increases faster than the interest earned on loans and investments. Changes in interest rates also affect the value of the Company’s loans. An increase in interest rates could adversely affect the Company’s borrowers’ ability to pay the principal or interest on existing loans or reduce their desire to borrow more money. This may lead to an increase in nonperforming assets or a decrease in loan originations, either of which could have a material and negative effect on the Company’s results of operations. The Company’s net interest spread will depend on many factors that are partly or entirely outside its control, including competition, federal economic, monetary and fiscal policies, and economic conditions generally. Fluctuations in market rates are

neither predictable nor controllable and may have a material and negative effect on the Company’s business, financial condition and results of operations.

 

The Company’s profitability may suffer because of rapid and unpredictable changes in the highly regulated environment in which the Company operates.

 

The Company is subject to extensive supervision by several governmental regulatory agencies at the federal and state levels. Recently enacted, proposed and future banking legislation and regulations have had, will continue to have, or may have a significant impact on the financial services industry. These regulations, which are intended to protect depositors and not the Company’s shareholders, and the interpretation and application of them by federal and state regulators, are beyond its control, may change rapidly and unpredictably and can be expected to influence its earnings and growth. The Company’s success depends on its continued ability to maintain compliance with these regulations. Failure to comply with existing or new laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have an adverse effect on the Company’s business, financial condition and results of operations. Regulatory changes may increase costs, limit the types of financial services and products offered and/or increase the ability of non-banks to offer competing financial services and products and thus place other entities that are not subject to similar regulation in stronger, more favorable competitive positions, which could adversely affect the Company’s growth.

 

Increases in FDIC insurance premiums may adversely affect our earnings.

 

During 2008 and 2009, higher levels of bank failures have dramatically increased resolution expenses and depleted the fund resources of the FDIC. As result, the FDIC has increased assessment rates and imposed special assessments during 2009. We may be required to pay even higher premiums than the recently increased levels.

 

The Company depends on the services of its key personnel, and a loss of any of those personnel would disrupt operations and result in reduced revenues.

 

The Company’s success depends upon the continued service of the senior management team and upon their ability to attract and retain qualified financial services personnel. Competition for qualified employees is intense. In the Company’s experience, it can take a significant period of time to identify and hire personnel with the combination of skills and attributes required in carrying out its strategy. If the Company loses the services of key personnel, or are unable to attract additional qualified personnel, its business, financial condition, results of operations and cash flows could be materially adversely affected.

 

The Company’s future success is dependent on its ability to compete effectively in the highly competitive banking industry.

 

The Northern Virginia and the greater Washington, D.C. metropolitan area in which the Company operates is considered highly attractive from an economic and demographic viewpoint, and is therefore a highly competitive banking and mortgage banking market. The Company faces vigorous competition from other banks and other financial service institutions in the Company’s market area. A number of these banks and other financial institutions are significantly larger and have substantially greater access to capital and other resources, larger lending limits, wider branch networks, and larger marketing budgets. To a limited extent, the Company also competes with other providers of financial services, such as money market mutual funds, brokerage firms, consumer finance companies, insurance companies and governmental organizations which may offer more favorable financing than it can. Many of the Company’s non-bank competitors are not subject to the same extensive regulations and/or tax laws that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. Failure to compete effectively to attract new customers and/or retain existing customers may reduce or limit the Company’s margins and market share and may adversely affect its results of operations and financial condition.

 

If the Company needs additional capital in the future to continue its growth, it may not be able to obtain it on terms that are favorable. This could negatively affect its performance and the value of the Company’s common stock.

 

The Company’s business strategy calls for continued growth. The Company anticipates that it will be able to support the Company’s growth strategy primarily through the generation of retained earnings. However, it may need to raise additional capital in the future to support the Company’s growth and to maintain capital levels. The capital and credit markets have experienced unprecedented levels of volatility and disruption over the last two years. In

some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers underlying financial strength. The Company’s ability to raise capital through the sale of additional securities will depend primarily upon its financial condition and the condition of financial markets at that time, and may not be able to obtain additional capital when needed on terms that are satisfactory to us. This could negatively affect the Company’s performance and the value of common stock. The Company’s growth may be constrained if it is unable to raise additional capital as needed.

 

The Company is subject to a variety of operational risks, including reputational risk, legal risk, compliance risk, the risk of both internal and external fraud and/or theft, all of which may adversely affect our business and the results of operations.

 

In additional to the monetary losses of these operational risks,

 

The Company may be adversely affected if it is unable to successfully implement the Company’s branch network expansion.

 

The Company anticipates that it will need to expand its branch network to support its growth strategy. However, the timing and cost of entry into new branch locations is substantial, and the economic payback on new branches may be impeded and delayed, which could negatively constrain the Company’s growth, and adversely affect its performance and the value of common stock.

 

The Bank’s ability to pay dividends is subject to regulatory limitations which may affect the Company’s ability to pay its obligations and pay dividends.

 

The Company is a separate legal entity from the Bank and its subsidiaries and does not have significant operations which generate cash. It currently depends on the Bank’s cash and liquidity, transferred to the Company as dividends from the Bank, to pay the Company’s operating expenses and dividends to shareholders. No assurance can be made that in the future the Bank will have the capacity to pay the necessary dividends or that the Company will not require dividends from the Bank to satisfy the Company’s obligations. The availability of dividends from the Bank is limited by various statutes and regulations. It is possible, depending upon the financial condition of the Company and other factors, that the state and/or federal bank regulators could assert that payment of dividends or other payments by the Bank are an unsafe or unsound practice. In the event the Bank is unable to pay sufficient dividends to the Company, the Company may not be able to service its obligations as they become due, or pay dividends on the Company’s common stock. Consequently, the inability to receive dividends from the Bank could adversely affect the Company’s financial condition, results of operations, cash flows and prospects.

 

The Company’s recent operating results may not be indicative of future operating results.

 

The Company’s historical results of operations are not necessarily indicative of future operations.

 

If the Company cannot maintain its corporate culture as it grows, its business could be harmed.

 

The Company believes that a critical contributor to its success has been its corporate culture, which focuses on building personal relationships with its customers. As the Company’s organization grows, and management is required to implement more complex organizational management structures, it may find it increasingly difficult to maintain the beneficial aspects of the Company’s corporate culture. This could negatively impact future success.

 

Changes in accounting standards may affect the Company’s performance.

 

The Company’s accounting policies and methods are fundamental to how it records and reports its financial condition and results of operations. From time to time there are changes in the financial accounting and reporting standards that govern the preparation of the Company’s financial statements. These changes can be difficult to predict and can materially impact how it records and reports the Company’s financial condition and statements of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in restating prior period financial statements.

The Company’s disclosure controls and procedures may not prevent or detect all errors or acts of fraud.

 

The Company’s disclosure controls and procedures are designed to reasonably assure that information required to be disclosed by the Company in reports it files or submits under the Exchange Act is accumulated and communicated to management, and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company believes that any disclosure controls and procedures or internal controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or omission. Additionally, controls can be circumvented by individual acts, by collusion by two or more people and/or by override of the established controls. Accordingly, because of the inherent limitations in the Company’s control systems and in human nature, misstatements due to error or fraud may occur and not be detected.

 

The Company’s information systems may experience an interruption or breach in security.

 

The Company relies heavily on communications and information systems to conduct the Company’s business. Any failure, interruption or breach of security of these systems could result in failures or disruptions in the Company’s customer relationship management, transaction processing systems and various accounting and data management systems. While it has policies and procedures designed to prevent and/or limit the effect of the failure, interruption or security breach of the Company’s communication and information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur, or, if they do occur, they will be adequately addressed on a timely basis. The occurrence of failures, interruptions or security breaches of the Company’s communication and information systems could damage the Company’s reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on its financial condition and results of operations.

 

 

 

 

 

All of these properties are in good operating condition and are adequate for the Company’s and the Bank’s present and anticipated future needs. The Bank maintains comprehensive general liability and casualty loss insurance covering its properties and activities conducted in or about its properties. Management believes this insurance provides adequate protection for liabilities or losses that might arise out of the ownership and use of these properties.

 

PART II

 

The Company’ five year stock performance graph is set forth below:

 

Total Return Performance

 

 

 

The following table sets forth the high and low sales prices as reported by NASDAQ for the Company’s common stock and the amounts of the cash dividends paid for each full quarterly period within the two most recent fiscal years.

 

 

The Company’s future dividend policy is subject to the discretion of the Board of Directors (“the Board”) and will depend upon a number of factors, including future earnings, financial condition, cash requirements, and general business conditions. The Company’s ability to pay cash dividends will depend entirely upon the Bank’s ability to pay dividends to the Company. Transfers of funds from the Bank to the Company in the form of loans, advances and cash dividends are restricted by federal and state regulatory authorities. As of December 31, 2009, the aggregate amount of unrestricted funds that could be transferred from the Bank to the Company without prior regulatory approval totaled $5.34 million.

 

In September 1998, the Company announced a stock repurchase program for its common stock. Initially, the program authorized the Company to repurchase up to 73,672 shares of its common stock through December 31, 1999. Annually, the Board resets the amount of shares authorized to be repurchased during the year under the buyback program. On January 15, 2009, the Board authorized the Company to repurchase up to 106,929 shares (3% of the shares of common stock outstanding on January 1, 2009) beginning January 1, 2009. No shares of common stock were repurchased during 2009. On January 21, 2010, the Board authorized the Company to repurchase up to 107,840 shares (3% of the shares of common stock outstanding on January 1, 2010) beginning January 1, 2010.

 

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operation” and the consolidated financial statements and accompanying notes included elsewhere in this report. The historical results are not necessarily indicative of results to be expected for any future period.

 

 

 

 

A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors as one factor in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in our estimates. In addition, GAAP itself may change from one previously acceptable accounting method to another method. Although the economics of the Company’s transactions would be the same, the timing of events that would impact the Company’s transactions could change.

 

ALLOWANCE FOR LOAN LOSSES.   The allowance for loan losses is an estimate of the losses that may be sustained in our loan portfolio. The allowance is based on three basic principles of accounting: (i) ASC 450 “Contingencies” (previously Statement of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies”) which requires that losses be accrued when they are probable of occurring and estimable, (ii) ASC 310 “Receivables” (previously SFAS No. 114, “Accounting by Creditors for Impairment of a Loan”) which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance and (iii) SEC Staff Accounting Bulletin No. 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” which requires adequate documentation to support the allowance for loan losses estimate.

 

The Company’s allowance for loan losses has two basic components: the specific allowance and the general allowance. Each of these components is determined based upon estimates that can and do change when the actual events occur. The specific allowance is used to individually allocate an allowance for larger balance, non-homogeneous loans. The specific allowance uses various techniques to arrive at an estimate of loss. First, analysis of the borrower’s overall financial condition, resources and payment record, the prospects for support from financial guarantors, and the fair market value of collateral are used to estimate the probability and severity of inherent losses. Then the migration of historical default rates and loss severities, internal risk ratings, industry and market conditions and trends, and other environmental factors are considered. The use of these values is inherently subjective and our actual losses could be greater or less than the estimates. The general allowance is used for estimating the loss on pools of smaller-balance, homogeneous loans; including 1-4 family mortgage loans, installment loans, other consumer loans, and outstanding loan commitments. Also, the general allowance is used for the remaining pool of larger balance, non-homogeneous loans which were not allocated a specific allowance upon their review. The general allowance begins with estimates of probable losses inherent in the homogeneous portfolio based upon various statistical analyses. These include analysis of historical and peer group delinquency and credit loss experience, together with analyses that reflect current trends and conditions. The Company also considers trends and changes in the volume and term of loans, changes in the credit process and/or lending policies and procedures, and an evaluation of overall credit quality. The general allowance uses a historical loss view as an indicator of future losses. As a result, even though this history is regularly updated with the most recent loss information, it could differ from the loss incurred in the future. The general allowance also captures losses that are attributable to various economic events, industry or geographic sectors whose impact on the portfolio have occurred but have yet to be recognized in the specific allowances.

 

Specifically, the Company uses both external and internal qualitative factors when determining the non-loan-specific allowances. The external factors utilized include: unemployment in the Company’s defined market area of Fauquier County, Prince William County, and the City of Manassas (“market area”), as well as state and national unemployment trends; new residential construction permits for the market area; bankruptcy statistics for the Virginia Eastern District and trends for the United States; and foreclosure statistics for the market area and the state. Quarterly, these external qualitative factors as well as relevant anecdotal information are evaluated from data compiled from local periodicals such as The Washington Post, The Fauquier Times Democrat , and The Bull Run Observer , which cover the Company’s defined market area. Additionally, data is gathered from the Federal Reserve Beige Book for the Richmond Federal Reserve District , Global Insight ’s monthly economic review, the George Mason School of Public Policy Center for Regional Analysis, and daily economic updates from various other sources. Internal Bank data utilized includes: loans past due aging statistics, nonperforming loan trends, trends in collateral values, loan concentrations, loan review status downgrade trends, and lender turnover and experience trends. Both external and internal data is analyzed on a rolling six quarter basis to determine risk profiles for each qualitative factor. Ratings are assigned through a defined matrix to calculate the allowance consistent with authoritative accounting literature. A narrative summary of the reserve allowance is produced quarterly and reported directly to the Company’s board of directors. The Company’s application of these qualitative factors to the allowance for loan losses has been consistent over the reporting period.

 

The Company employs an independent outsourced loan review function, which annually substantiates and/or adjusts internally generated risk ratings and loan impairment calculations. This independent review is reported

directly to the Company’s board of directors’ audit committee, and the results of this review are factored into the calculation of the allowance for loan losses.

 

EXECUTIVE OVERVIEW

 

This discussion is intended to focus on certain financial information regarding the Company and the Bank and may not contain all the information that is important to the reader. The purpose of this discussion is to provide the reader with a more thorough understanding of our financial statements. As such, this discussion should be read carefully in conjunction with the consolidated financial statements and accompanying notes contained elsewhere in this report.

 

The Bank is the primary independent community bank in its immediate market area as measured by deposit market share. It seeks to be the primary financial service provider for its market area by providing the right mix of consistently high quality customer service, efficient technological support, value-added products, and a strong commitment to the community.

 

Net income of $3.42 million in 2009 was a 6.4% decrease from 2008 net income of $3.65 million. The Company and the Bank’s primary operating businesses are in commercial and retail lending, deposit accounts and core deposits, and assets under WMS management. Loans, net of reserve, increased 6.5% from year-end 2008 to year-end 2009, compared with an increase of 6.3% from year-end 2007 to year-end 2008. Deposits increased 16.4% from year-end 2008 to year-end 2009, compared with a decrease of 1.1% from year-end 2007 to year-end 2008. The market value of assets under WMS management increased 24.6% from 2008 to 2009, but decreased 18.1% from 2007 to 2008. The changes in assets under WMS management reflect, in large part, the changes in the overall U.S. and international bond and stock markets.

 

Net interest income is the largest component of net income, and equals the difference between income generated on interest-earning assets and interest expense incurred on interest-bearing liabilities. Future trends regarding net interest income are dependent on the absolute level of market interest rates, the shape of the yield curve, the amount of lost income from non-performing assets, the amount of prepaying loans, the mix and amount of various deposit types, and many other factors, as well as the overall volume of interest-earning assets. These factors are individually difficult to predict, and when taken together, the uncertainty of future trends compounds. Based on management’s current projections, net interest income may increase in 2010 as average interest-earning assets increase, but this may be offset in part or in whole by a possible contraction in the Bank’s net interest margin resulting from competitive market conditions and a flat or inverted yield curve. A steeper yield curve is projected to result in an increase in net interest income, while a flatter or inverted yield curve is projected to result in a decrease in net interest income. The Bank is also subject to a moderate decline in net interest income due to the overall increase in market interest rates.

 

The Bank’s non-performing assets totaled $7.1 million or 1.24% of total assets at December 31, 2009, as compared with $4.3 million or 0.83% of total assets at December 31, 2008. The provision for loan losses was $1.7 million for 2009 compared with $3.2 million for 2008. Loan chargeoffs, net of recoveries, totaled $1.0 million or 0.22% of total average loans for 2009, compared with $2.6 million or 0.62% of total average loans for 2008.

 

Management seeks to continue the expansion of its branch network. The Bank opened new branch offices in Bristow, Virginia and Haymarket, Virginia, its ninth and tenth full-service branch offices, respectively, during 2009. The Bank is looking toward these new retail markets for growth in deposits and WMS income. Management seeks to increase the level of its fee income WMS through the increase of its market share within its marketplace.

The following table presents a quarterly summary of earnings for the last two years.

 

 

2009 COMPARED WITH 2008

 

Net income of $3.42 million in 2009 was a 6.4% decrease from 2008 net income of $3.65 million. Earnings per share on a fully diluted basis were $0.95 in 2009 compared to $1.03 in 2008. Profitability as measured by return on average equity decreased from 8.65% in 2008 to 8.08% in 2009. Profitability as measured by return on average assets decreased from 0.73% in 2008 to 0.64% in 2009. The year to year decline in net income was primarily due to the $2.68 million increase in operating expenses from 2008 to 2009, partially offset by the $1.83 million increase in net interest income.

 

2008 COMPARED WITH 2007

 

Net income of $3.65 million in 2008 was a 26.3% decrease from 2007 net income of $4.95 million. Earnings per share on a fully diluted basis were $1.03 in 2008 compared to $1.39 in 2007. Profitability as measured by return on average equity decreased from 12.16% in 2007 to 8.65% in 2008. Profitability as measured by return on average assets decreased from 1.01% in 2007 to 0.73% in 2008.

 

NET INTEREST INCOME AND EXPENSE

 

2009 COMPARED WITH 2008

 

Net interest income increased $1.83 million or 9.4% to $21.28 million for the year ended December 31, 2009 from $19.45 million for the year ended December 31, 2008. The increase in net interest income was due to the Company’s net interest margin increasing from 4.25% in 2008 to 4.30% in 2009, and the impact of total average earning assets increasing from $465.4 million in 2008 to $502.6 million in 2009. The percentage of average earning assets to total assets increased in 2009 to 93.8% from 92.9% in 2008.

 

Total interest income decreased $764,000 or 2.6% to $28.07 million in 2009 from $28.84 million in 2008. This decrease was due to the 61 basis point decrease in the average yield on assets, partially offset by the increase in total average earning assets of $37.2 million or 8.0%, from 2008 to 2009. The yield on earning assets declined from 6.27% in 2008 to 5.66% in 2009 due to the decline in market interest rates in the economy at large over the last two years.

Average loan balances increased 6.9% from $424.7 million in 2008 to $454.1 million in 2009. The tax-equivalent average yield on loans decreased to 5.88% in 2009 compared with 6.41% in 2008. Together, this resulted in a $471,000 decrease in interest and fee income from loans for 2009 compared with 2008.

 

Average investment security balances decreased $146,000 from $37.4 million in 2008 to $37.3 million in 2009. The tax-equivalent average yield on investments decreased from 5.20% in 2008 to 4.57% in 2009. Together, there was a decrease in interest and dividend income on security investments of $244,000 or 13.4%, from $1.83 million in 2008 to $1.58 million in 2009. On a tax-equivalent basis, the year-to-year decrease in interest and dividend income on security investments was $242,000.

 

Interest income on deposits at other banks decreased from $36,000 in 2008 to $20,000 in 2009 due to the decline in interest rates paid on these deposits from 1.77% in 2008 to 0.18% in 2009. Interest income on federal funds sold decreased from $33,000 during 2008 to less than $1,000 during 2009 as average balances and yield declined $1.1 million and 244 basis points, respectively, from 2008 to 2009.

 

Total interest expense decreased $2.59 million or 27.6% from $9.39 million in 2008 to $6.80 million in 2009 primarily due to the decline in market interest rates in the economy. Interest paid on deposits decreased $1.70 million or 23.3% from $7.30 million in 2008 to $5.60 million in 2009. Average time deposit balances increased $55.8 million from 2008 to 2009 while the average rate on time deposits decreased from 3.67% to 2.55% resulting in an increase of $39,000 in interest expense from 2008 to 2009. Average NOW deposit balances decreased $5.7 million from 2008 to 2009 while the average rate on NOW accounts decreased from 0.95% to 0.46% resulting in $439,000 less interest expense in 2009. Average money market account deposit balances decreased $24.0 million from 2008 to 2009 while the average rate on money market account deposits decreased from 2.03% to 0.81% resulting in $1.30 million less interest expense in 2009.

 

Interest expense on federal funds purchased decreased $77,000 from 2008 to 2009 due to the decline in the average rate paid from 2.18% in 2008 to 1.19% in 2009, as well as the decline in average federal funds borrowed from $5.4 million in 2008 to $3.5 million in 2009. Interest expense on FHLB of Atlanta advances decreased $719,000 from 2008 to 2009 due to the decline in the average rate paid from 3.66% in 2008 to 1.96% in 2009, partially offset by the $5.2 million increase in average FHLB advances. The average rate on total interest-bearing liabilities decreased from 2.42% in 2008 to 1.61% in 2009.

 

2008 COMPARED WITH 2007

 

Net interest income increased $524,000 or 2.8% to $19.45 million for the year ended December 31, 2008 from $18.93 million for the year ended December 31, 2007. The increase in net interest income was due to the Company’s net interest margin increasing from 4.19% in 2007 to 4.25% in 2008, and the impact of total average earning assets increasing from $457.5 million in 2007 to $465.4 million in 2008. The percentage of average earning assets to total assets decreased in 2008 to 92.9% from 93.1% in 2007.

 

Total interest income decreased $2.36 million or 7.6% to $28.84 million in 2008 from $31.19 million in 2007. This decrease was due to the 60 basis point decrease in the average yield on assets, partially offset by the increase in total average earning assets of $7.9 million or 1.7%, from 2007 to 2008. The yield on earning assets declined from 6.87% in 2007 to 6.27% in 2008 due to the decline in market interest rates in the economy at large.

 

Average loan balances increased 2.2% from $415.5 million in 2007 to $424.7 million in 2008. The tax-equivalent average yield on loans decreased to 6.39% in 2008 compared with 7.07% in 2007. Together, this resulted in a $2.22 million decrease in interest and fee income from loans for 2008 compared with 2007.

 

Average investment security balances decreased $1.9 million from $39.3 million in 2007 to $37.4 million in 2008. The tax-equivalent average yield on investments increased from 5.00% in 2007 to 5.20% in 2008. Together, there was a decrease in interest and dividend income on security investments of $77,000 or 4.0%, from $1.90 million in 2007 to $1.83 million in 2008. On a tax-equivalent basis, the year-to-year decrease in interest and dividend income on security investments was $16,000. Interest income on federal funds sold decreased $58,000 from 2007 to 2008 as average balances and yield declined $573,000 and 242 basis points, respectively, from 2007 to 2008.

Total interest expense decreased $2.88 million or 23.5% from $12.27 million in 2007 to $9.39 million in 2008 primarily due to the decline in market interest rates in the economy. Interest paid on deposits decreased $2.55 million or 25.9% from $9.85 million in 2007 to $7.30 million in 2008. Average money market account balances decreased $7.7 million from 2007 to 2008 while their average rate decreased from 3.31% to 2.03% over the same period resulting in $1.41 million less interest expense in 2008. Average time deposit balances decreased $1.4 million from 2007 to 2008 while the average rate on time deposits decreased from 4.44% to 3.67% resulting in $1.02 million less interest expense in 2008. Average NOW deposit balances increased $11.9 million from 2007 to 2008 while the average rate on NOW accounts decreased from 1.27% to 0.95% resulting in $124,000 less interest expense in 2008.

 

Interest expense on federal funds purchased decreased $125,000 from 2007 to 2008 due to the decline in the average rate paid from 5.42% in 2007 to 2.18% in 2008. Interest expense on FHLB of Atlanta advances decreased $33,000 from 2007 to 2008 due to the decline in the average rate paid from 5.28% in 2007 to 3.66% in 2008, partially offset by the $14.3 million increase in average FHLB advances. The average rate on total interest-bearing liabilities decreased from 3.30% in 2007 to 2.42% in 2008.

The following table sets forth information relating to the Company’s average balance sheet and reflects the average yield on assets and average cost of liabilities for the periods indicated and the average yields and rates paid for the periods indicated. These yields and costs are derived by dividing income or expense by the average daily balances of assets and liabilities, respectively, for the periods presented.

 

 

RATE/VOLUME ANALYSIS

 

The following table sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning asset and interest-bearing liability, information is provided on changes attributable to changes in volume (change in volume multiplied by old rate); and changes in rates (change in rate multiplied by old volume). Changes in rate-volume, which cannot be separately identified, are allocated proportionately between changes in rate and changes in volume.

 

 

 

 

PROVISION FOR LOAN LOSSES, ALLOWANCE FOR LOAN LOSSES, AND ASSET QUALITY

 

The provision for loan losses was $1.71 million for 2009, $3.23 million for 2008 and $717,000 for 2007. The amount of the provision for loan loss for 2009, 2008, and 2007 was based upon management’s continual evaluation of the adequacy of the allowance for loan losses, which encompasses the overall risk characteristics of the loan portfolio, trends in the Bank’s delinquent and non-performing loans, estimated values of collateral, and the impact of economic conditions on borrowers. Greater weight is given to the loss history by loan category, prolonged changes in portfolio delinquency trends by loan category, and changes in economic trends. There can be no assurances, however, that future losses will not exceed estimated amounts, or that increased amounts of provisions for loan losses will not be required in future periods.

 

The decrease in the provision for loan losses from 2008 to 2009 was largely in response to the decrease in net loan charge-offs in 2009. The increase in the provision for loan losses from 2007 to 2008 was largely in response to the increase in net loan charge-offs in 2008, as well as the impact of a slowing economy, declining real estate values, and continued growth in new loan originations during 2008. Loan charge-offs, net of recoveries, totaled $1.0 million

for 2009, $2.6 million for 2008, and $1.0 million for 2007. Loan charge-offs during 2009 were largely provided for in the allowance during 2008.

 

LOAN PORTFOLIO

 

At December 31, 2009, 2008, and 2007, net loans accounted for 81.4%, 84.5%, and 83.5% of total assets, respectively, and were the largest category of the Company’s earning assets. Loans are shown on the balance sheets net of unearned discounts and the allowance for loan losses. Interest is computed by methods that result in level rates of return on principal. Loans are charged-off when deemed by management to be uncollectible, after taking into consideration such factors as the current financial condition of the customer and the underlying collateral and guarantees.

 

Authoritative accounting guidance requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. The guidance also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

 

A loan is considered impaired when there is an identified weakness that may reasonably limit the Bank’s ability to collect all principal and interest amounts according to the contractual terms of the loan agreement. Factors involved in determining impairment include, but are not limited to, expected future cash flows, financial condition of the borrower, and the current economic conditions. A performing loan may be considered impaired if the factors above indicate a need for impairment. A loan on non-accrual status may not necessarily be impaired if it is in the process of collection or if the shortfall in payment is insignificant. A delay of less than 30 days or a shortfall of less than 5% of the required principal and interest payments generally is considered “insignificant” and would not indicate an impairment situation, if in management’s judgment the loan will be paid in full. Loans that meet the regulatory definitions of doubtful or loss generally qualify as impaired loans under authoritative accounting guidance. As is the case for all loans, charge-offs for impaired loans occur when the loan or portion of the loan is determined to be uncollectible.

 

The Bank considers all consumer installment loans and residential mortgage loans to be homogenous loans. These loans are not subject to individual impairment under authoritative accounting guidance.

 

ASSET QUALITY

 

Non-performing assets, in most cases, consist of loans, other real estate owned, repossessed property such as automobiles and pooled trust preferred securities that are 90 days or more past due and for which the accrual of interest has been discontinued. Management evaluates all loans and investments that are 90 days or more past due, as well as borrowers that have suffered financial distress, to determine if they should be placed on non-accrual status. Factors considered by management include the net realizable value of collateral, if any, and other resources of the borrower that may be available to satisfy the delinquency.

 

Loans are placed on non-accrual status when they have been specifically determined to be impaired or when principal or interest is delinquent for 90 days or more, unless the loans are well secured and in the process of collection. Any unpaid interest previously accrued on such loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest payments received on such loans are applied as a reduction of the loan principal balance. Interest income on other non-accrual loans is recognized only to the extent of interest payments received.

 

Non-performing assets totaled $7.1 million or 1.24% of total assets at December 31, 2009, as compared with $4.3 million or 0.83% of total assets at December 31, 2008 and $2.1 million, or 0.43% of total assets at December 31, 2007. Included in non-performing assets at December 31, 2009 were $1.1 million of non-performing pooled trust preferred securities, as well as $2.5 million of other real estate owned , $3.4 million of nonaccrual loans and $54,000 of repossessed autos.

Non-performing loans, other real estate owned, and other repossessed assets totaled $5.9 million or 1.26% of total loans, other real estate owned, and other repossessed assets at December 31, 2009, as compared with $4.3 million or 0.97% of total loans, other real estate owned, and other repossessed assets at December 31, 2008 and $2.1 million, or 0.51% of total loans, other real estate owned, and other repossessed assets at December 31, 2007.

 

The allowance for loan losses as a percentage of non-performing loans was 160.8%, 395.7% and 219.6% at December 31, 2009, 2008 and 2007, respectively. The reason for the decline in this coverage ratio from 2008 to 2009 was primarily due to the underlying collateral value of the new loans added to non-performing in 2009, and the relative levels of allowance needed for these specific loans. Specifically, non-performing loans increased $2.2 million from 2008 to 2009 primarily due to the addition of three commercial real estate loans totaling $2.2 million. The allowance for loan losses specifically allocated for these three loans totaled approximately $287,000, or a coverage ratio of approximately 13%.

 

The number of non-performing loan relationships decreased from thirty-two at December 31, 2007 to nineteen at December 31, 2008, and twenty at December 31, 2009. The reduction in the number of non-performing loan relationships from the end of 2007 to the end of 2008 and continued into 2009 was primarily due to the reduction in non-performing consumer loans, primarily auto loans, over that same time period. The Bank’s other real estate owned consists of two properties with a total value, net of cost to sell, of $2,480,000 at December 31, 2009 compared with two properties with a total value, net of cost to sell, of $3,034,000 at December 31, 2008 and none at 2007. At December 31, 2009, one property has a net value of approximately $2.03 million and consists of 47 acres of undeveloped land in Opal, Virginia, and the second property has a net value of $451,000 and consists of a single family house located in Haymarket, Virginia.

 

Loans that were 90 days past due and accruing interest totaled $354,000, $102,000, $770,000 at December 31, 2009, 2008, and 2007, respectively. No loss is anticipated on any loan 90 days past due and accruing interest.

 

Additionally, there were seven loans totaling $855,000 that were accruing interest at December 31, 2009, but which were considered impaired and were allocated $355,000 of specific loan loss reserves. There are no loans, other than those disclosed above as either non-performing or impaired, where information known about the borrower has caused management to have serious doubts about the borrower’s ability to repay. There was one pooled trust preferred security with a market value of $786,000 that was current and accruing interest at December 31, 2009, but which was considered impaired.

 

At December 31, 2009, there are no other interest-bearing assets that would be subject to disclosure as either non-performing or impaired.

 

At December 31, 2009, no concentration of loans to commercial borrowers engaged in similar activities exceeded 10% of total loans. The largest industry concentrations at December 31, 2009 were approximately 5.2% of loans to the hospitality industry (hotels, motels, inns, etc.). For more information regarding the Bank’s concentration of loans collateralized by real estate, please refer to the discussion under “Risk Factors” in Item 1A of this report entitled “We have a high concentration of loans secured by real estate and the continued downturn in the real estate market, for any reason, may increase our credit losses, which would negatively affect our financial results.”

 

Based on recently enacted regulatory guidelines, the Bank is now required to monitor the commercial investment real estate loan portfolio for: (a) concentrations above 100% of Tier 1 capital and loan loss reserve for construction and land loans and (b) 300% for permanent investor real estate loans. As of December 31, 2009, construction and land loans are $33.9 million or 59.2% of the concentration limit, while permanent investor real estate loans (by NAICS code) are $118.4 million or 206.4% of the concentration level.

Total loans on the balance sheet are comprised of the following classifications as of December 31, 2009, 2008, 2007, 2006, and 2005.

 

 

Of the $186.5 million of commercial real estate outstanding at December 31, 2009, $100.3 million are owner-occupied properties.

 

The following table sets forth certain information with respect to the Bank’s non-accrual, restructured and past due loans, as well as foreclosed assets, at the dates indicated: