Item 1. Business - -----------------
General
Heritage Bancorp, Inc. ("Company"), a Delaware corporation, was organized in November 1997 for the purpose of becoming the holding company for Heritage Federal Savings and Loan Association, which changed its name to Heritage Federal Bank ("Bank") upon its conversion from a federal mutual savings and loan association to a federal stock savings bank. The Bank's conversion was completed on April 6, 1998 through the sale of 4,628,750 shares of common stock by the Company at a price of $15.00 per share.
The Bank, chartered in 1948, is a federally chartered savings bank located in Laurens, South Carolina. The Bank is regulated by the Office of Thrift Supervision ("OTS"), its primary federal regulator, and by the Federal Deposit Insurance Corporation ("FDIC"), the insurer of its deposits. The Bank's deposits are insured by the FDIC's Savings Association Insurance Fund ("SAIF"). The Bank has been a member of the Federal Home Loan Bank ("FHLB") System since 1948.
The Bank is a community oriented financial institution that operates out of four offices in the Upstate region of South Carolina. The Bank's principal business is attracting deposits from the general public and using those funds to originate residential mortgage loans. The Bank emphasizes the origination of adjustable rate mortgage ("ARM") loans and generally holds its loans for long- term investment purposes.
Market Area and Competition
The Company conducts operations out of its main office in Laurens, South Carolina (in Laurens County) and three branch offices in Upstate South Carolina: in Belton (in Anderson County), Ware Shoals (in Greenwood County) and Simpsonville (in Greenville County). Most of the Company's depositors live in the areas surrounding the Company's offices and most of the Company's loans are made to persons in the counties in which its branches are located, as well as in the Columbia, South Carolina metropolitan area.
Laurens County, with an estimated population of 62,000, is located to the east of the Greenville-Spartanburg-Anderson metropolitan area. Although a rural county, the completion of U.S. Interstate Routes I-26 and I-385 has provided access to the larger population and employment centers of Columbia and Greenville-Spartanburg-Anderson. The Company's Belton and Simpsonville branches are within the Greenville-Spartanburg-Anderson metropolitan area, while the Ware Shoals branch is in a rural area between Laurens and the city of Greenwood. South Carolina's economy, historically dependent on the textile industry, has expanded into a broad variety of employment sectors in recent years as the textile industry has declined. The development of major transportation routes, low cost of living and labor, and aggressive marketing by local and state government have resulted in an increase in industrial development. As a result, the Company's market areas have reported increases in population, households and income in recent years.
The Bank faces intense competition in its primary market area for the attraction of deposits (its primary source of lendable funds) and in the origination of loans. Its most direct competition for deposits has historically come from commercial banks, credit unions, other thrifts operating in its market area, and other financial institutions, such as brokerage firms and insurance companies. Particularly in times of high interest rates, the Bank has faced additional significant competition for investors' funds from short-term money market securities and other corporate and
government securities. The Bank's competition for loans comes from commercial banks, thrift institutions, credit unions and mortgage bankers. Such competition for deposits and the origination of loans may limit the Bank's growth in the future.
Lending Activities
General. At September 30, 1999, the Company's total loans receivable portfolio amounted to $295.4 million, or 94.1% of total assets at that date. The Company has traditionally concentrated its lending activities on mortgage loans, with such loans amounting to $280.9 million, or 95.1% of total loans receivable at September 30, 1999. At that date, $186.5 million, or 63.2%, of the Company's total loans receivable had adjustable interest rates. In addition to one-to four-family mortgage loans, the Company originates construction loans, commercial real estate loans, home equity loans, savings account loans, commercial business loans and consumer loans. All of the Company's mortgage loan portfolio is secured by real estate, either as primary or secondary collateral, located in North Carolina or South Carolina.
Loan Portfolio Analysis. The following table sets forth the composition of the Company's loan portfolio (excluding loans held-for-sale) at the dates indicated. The Company had no concentration of loans exceeding 10% of total loans receivable other than as disclosed below.
The following table sets forth certain information at September 30, 1999 regarding the dollar amount of loans maturing in the Company's portfolio based on their contractual terms to maturity, but does not include scheduled payments or potential prepayments. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as becoming due within one year. Loan balances do not include undisbursed loan proceeds, unearned discounts, unearned income and allowance for loans losses.
The following table sets forth the dollar amount of all loans due after September 30, 2000, which have fixed interest rates and have floating or adjustable interest rates.
Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of a loan is substantially less than its contractual term because of prepayments. In addition, due-on-sale clauses on loans generally give the Company the right to declare loans immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of a mortgage loan tends to increase, however, when current mortgage loan market rates are substantially higher than rates on existing mortgage loans and, conversely, tends to decrease when rates on existing mortgage loans are substantially higher than current mortgage loan market rates.
One- to Four-Family Real Estate Loans. The Company has concentrated its lending activities on the origination of loans secured by first mortgages on one- to four-family residences located in South Carolina. The Company offers ARM loans at rates and terms competitive with market conditions. At September 30, 1999, $158.9 million, or 85.2%, of the Company's one- to four-family real estate loans were subject to periodic interest rate adjustments. Substantially all of the Company's ARM loans are underwritten and documented in accordance with
guidelines established by Freddie Mac, even though the Company originates ARM loans primarily for its own portfolio. The Company originates for its portfolio ARM loans that provide for an interest rate that adjusts every year or that is fixed for three or ten years and then adjusts every year after the initial period. The Company's ARM loans generally provide for annual and lifetime interest rate adjustment limits of 1% and 4%, respectively. The Company's ARM loans adjust based on the National Median Cost of Funds Index. This index is a lagging market index, which means that upward adjustments in this index may occur more slowly than changes in the Company's cost of interest-bearing liabilities, especially during periods of rapidly increasing interest rates. The Company's ARM loans are typically based on a 30-year amortization schedule. The initial rate on most of the Company's ARM loans is .75% to 1% below the fully indexed rate for the loan.
The Company offers fixed-rate, one- to four-family mortgage loans with maturities ranging from ten to 30 years. These loans are fully amortizing with monthly payments sufficient to repay the total amount of the loan with interest by the end of the loan term. Generally, they are underwritten and documented in accordance with guidelines established by Freddie Mac. In recent years, as part of its asset/liability management, the Company has retained for its portfolio fixed-rate loans with terms of ten to 15 years. The Company determines whether to sell or retain fixed-rate loans with terms of more than 15 years on a case-by-case basis.
The Company also offers loans to individuals for the construction and acquisition of their personal residence. Such loans are made on the same terms as the Company's one- to four-family mortgage loans, but provide for the payment of interest only during the construction phase, which is usually six months. At the end of the construction phase, the loan converts to a permanent mortgage loan.
The Company offers second mortgage loans, although these have become less popular since the introduction of home equity lines of credit. The Company's second mortgage loans have fixed interest rates and terms of up to ten years. At September 30, 1999, the Company had $778,000 of second mortgage loans included in its one- to four-family mortgage loans.
Borrower demand for ARM loans versus fixed-rate mortgage loans is a function of the level of interest rates, the expectations of changes in the level of interest rates and the difference between the initial interest rates and fees charged for each type of loan. The relative amount of fixed-rate mortgage loans and ARM loans that can be originated at any time is largely determined by the demand for each in a competitive environment.
The retention of ARM loans in the Company's loan portfolio helps reduce the Company's exposure to changes in interest rates. There are, however, unquantifiable credit risks resulting from the potential of increased costs due to changed rates to be paid by the borrower. It is possible that, during periods of rising interest rates, the risk of default on ARM loans may increase as a result of repricing and the increased payments required by the borrower. In addition, although ARM loans allow the Company to increase the sensitivity of its asset base to changes in the interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits. Because of these considerations and its use of a lagging market index, the Company has no assurance that yields on ARM loans will be sufficient to offset increases in the Company's cost of funds. The Company believes these risks, which have not had a material adverse effect on the Company to date, generally are less than the risks associated with holding fixed-rate loans in portfolio during a rising interest rate environment.
The Company generally requires title insurance insuring the status of its lien or an acceptable attorney's opinion on all loans where real estate is the primary source of security. The Company also requires that fire and casualty insurance (and, if appropriate, flood insurance) be maintained in an amount at least equal to the outstanding loan balance.
The Company's one- to four-family residential mortgage loans typically do not exceed 80% of the appraised value of the security property. Pursuant to its underwriting guidelines, the Company can lend up to 95% of the appraised value of the property securing a one- to four-family residential loan; however, the Company generally requires private mortgage insurance on the portion of the principal amount that exceeds 80% of the appraised value of the security property.
Builder Construction Loans. The Company originates residential construction loans to local home builders, generally with whom it has an established relationship. The Company's construction loans to builders generally have fixed interest rates and are for a term of one year. Such loans to builders are typically made with a maximum loan to value ratio of 80%. These loans are made either on a pre-sold or speculative (unsold) basis. However, the Company generally limits the number of outstanding loans on unsold homes under construction to individual builders, with the amount dependent on the financial strength of the builder, the present exposure of the builder, the degree of loan concentration and prior sales of homes in the development.
Prior to making a commitment to fund a construction loan, the Company requires an appraisal of the property by a state-licensed and qualified appraiser. The Company's staff or a paid inspector also reviews and inspects each project prior to disbursement of funds during the term of the construction loan. Loan proceeds are disbursed after inspection of the project based on percentage of completion.
Construction lending affords the Company the opportunity to earn higher interest rates with shorter terms to maturity relative to single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. The nature of these loans is such that they are generally more difficult to evaluate and monitor. If the estimate of construction cost proves to be inaccurate, the Company may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, the Company may be confronted with a project whose value is insufficient to assure full repayment. Projects may also be jeopardized by disagreements between borrowers and builders and by the failure of builders to pay subcontractors. Loans to builders to construct homes for which no purchaser has been identified carry more risk because the payoff for the loan is dependent on the builder's ability to sell the property prior to the time that the construction loan is due.
The Company has attempted to minimize the foregoing risks by, among other things, limiting its construction lending primarily to residential properties. It is also the Company's general policy to obtain personal guarantees from financially capable parties where the loan is made to a corporation or other legal entity.
The Company this year began purchasing builder construction loans from two mortgage companies. These loans are secured by residential properties with maturities of one year or less and are made on either a pre-sold or speculative basis. The properties securing these loans are located in various North and South Carolina markets in which the Company buys other first mortgage loans. These loans carry all of the greater risks inherent with construction lending as mentioned above. In addition, brokered loans are generally considered to be riskier than loans that the Company originates itself. To mitigate some of this risk, the Company routinely conducts inspections of the properties under construction.
At September 30, 1999, the largest amount of construction loans outstanding to one builder was $4.2 million, all of which was for speculative construction.
Commercial Real Estate Loans. The Company originates mortgage loans for the acquisition and refinancing of commercial real estate properties. The majority of the Company's commercial real estate loans are secured by office buildings, churches, retail shops and warehouses, all of which are located in South Carolina. Occasionally, the Company makes land acquisition and development loans. At September 30, 1999, the Company's largest commercial real estate loan was $1.8 million and is collateralized by commercial and industrial sites at Gaffney, South Carolina.
Most of the Company's commercial real estate loans have adjustable interest rates and 15-year terms. The Company requires appraisals of all properties securing commercial real estate loans. Appraisals are performed by an independent appraiser designated by the Company and are reviewed by management.
Commercial real estate lending affords the Company an opportunity to receive interest at rates higher than those generally available from one- to four-family residential lending. However, loans secured by such properties usually are greater in amount and are more difficult to evaluate and monitor, and, therefore, involve a greater degree of risk than one- to four-family residential mortgage loans. Because payments on loans secured by commercial properties are often dependent on the successful operation and management of the properties, repayment of such loans
may be affected by adverse conditions in the real estate market or the economy. The Company seeks to minimize these risks by limiting the maximum loan- to-value ratio to 80% and strictly scrutinizing the financial condition of the borrower, the cash flow of the project, the quality of the collateral and the management of the property securing the loan. The Company also obtains loan guarantees from financially capable parties based on a review of personal financial statements.
Commercial Loans. The Company does not actively solicit commercial loans. However, the Company may originate such loans on a limited basis, generally to customers who are well known to the Company. Commercial loans are prime based, variable rate loans and are collateralized by various business assets. The terms for commercial loans vary with the business purpose of the loan and the normal business cycle of the borrower. The Company also obtains personal guarantees from financially capable parties when the loan is made to a corporation or other legal entity.
Commercial lending affords the Company an opportunity to earn higher interest rates as compared with residential lending. However, commercial lending involves greater risk than residential mortgage and other real estate secured lending. As collateral-based lending, real estate secured loans are made on established loan-to-collateral values and the liquidation of the real estate is considered as a primary source of repayment in case the borrower defaults. Notwithstanding, business assets held as collateral for commercial loans in default may be an insufficient source of repayment due to obsolescence, illiquidity, uncollectibility, or shrinkage, among other reasons. Therefore, the repayment of a commercial loan depends largely on the creditworthiness of the borrower and the success of the borrower's business.
Savings Account Loans. The Company offers loans secured by savings deposits. At September 30, 1999, loans collateralized by savings accounts totalled $1.1 million, or 0.4% of total loans receivable. Generally, such loans are made up to 90% of the account balance.
Home Equity Loans. The Company originates home equity loans in the form of lines of credit. At September 30, 1999, the Company had $9.4 million of home equity loans and unused commitments to extend credit under home equity loans of $9.2 million. Most of these loans are made to existing customers. The Company's home equity loans have variable interest rates tied to the prime lending rate as published in The Wall Street Journal. The Company imposes a maximum loan-to- value ratio of 90% after considering the unpaid balances of both the first and second mortgage loans on the collateralized property.
The Company's home equity loans may have greater credit risk than one-to four-family residential mortgage loans because they are secured by mortgages subordinated to an existing first mortgage on the property, which, in most cases, is held by the Company.
Consumer Loans. The Company originates consumer loans secured by automobiles, boats and other consumer items, as well as unsecured loans for personal use.
Loan Solicitation and Processing. The Company's lending activities are subject to the written, non-discriminatory, underwriting standards and loan origination procedures established by the Board of Directors and management. Loan originations come from a number of sources. The customary sources of loan originations are realtors, walk-in customers, referrals and existing customers. The Company also uses two mortgage brokers to originate loans. For the year ended September 30, 1999, the Company originated $18.2 million of loans, or 28.8% of total originations, through these brokers. All loans originated through these mortgage brokers are underwritten by the Company pursuant to the Company's underwriting guidelines.
All single-family residential mortgage loans up to $300,000 and all other loans up to $200,000 must be approved by two members of the Loan Committee. All loans in excess of such amounts but below $500,000 must be approved by a committee consisting of the President, two Vice Presidents in charge of lending operations and two outside Directors. All loans of $500,000 or more must be approved by the Board of Directors.
Loan Originations, Purchases and Sales. While the Company originates both adjustable-rate and fixed-rate loans, its ability to generate each type of loan depends upon relative customer demand for loans in its primary market area. During the years ended September 30, 1999, 1998 and 1997, the Company originated $63.3 million, $67.7 million and $45.1 million of loans, respectively. Of the $63.3 million of loans originated in the year ended September 30, 1999, $45.7 million, or 72.2%, had adjustable rates of interest.
The Company purchases loans from two South Carolina based mortgage banking companies. These mortgage loans consist of single family residential loans, commercial mortgage loans, and builder construction mortgage loans. Except for single family residential loans written to Freddie Mac guidelines, all loans are underwritten by the Company. All of the properties securing these loans are located in North and South Carolina. The Company anticipates that it will continue to purchase loans from time to time to supplement its own originations.
The Company sells loans in order to manage the interest rate risk associated with holding long-term, fixed-rate mortgages, to enable the Company to offer a wide variety of mortgage products, and to earn origination fees and premiums. In 1995, the Company established a relationship with another financial institution pursuant to which the Company sells fixed-rate, one- to four-family mortgage loans with terms in excess of 15 years. The Company currently does not retain servicing rights on the loans that it sells.
The following table sets forth total loans originated, purchased, sold and repaid during the periods indicated.
Loan Commitments. The Company issues commitments for mortgage loans conditioned upon the occurrence of certain events. Such commitments are made in writing on specified terms and conditions and are honored for up to 30 days from approval, depending on the type of transaction. At September 30, 1999, the Company had loan commitments (excluding undisbursed portions of interim construction loans of $41.6 million) of $2.3 million and unused lines of credit of $9.2 million. See Notes 4 and 9 of Notes to the Consolidated Financial Statements.
Loan Fees. In addition to interest earned on loans, the Company receives income from fees in connection with loan originations, loan modifications, late payments and for miscellaneous services related to its loans. Income from these activities varies from period to period depending upon the volume and type of loans made and competitive conditions.
The Company charges loan origination fees which are calculated as a percentage of the amount borrowed or charged as a flat fee on the amount borrowed, depending on the loan program. In accordance with applicable accounting procedures, loan origination fees and discount points in excess of loan origination costs are deferred and recognized over the contractual remaining lives of the related loans on a level yield basis. Discounts and premiums on loans purchased are accreted and amortized in the same manner. At September 30, 1999, the Company had $373,000 of deferred loan fees. The Company recognized $113,000, $123,000 and $151,000 of deferred loan fees during the years ended September 30, 1999, 1998 and 1997, respectively, in connection with loan refinancings, payoffs, sales and ongoing amortization of outstanding loans.
Nonperforming Assets and Delinquencies. When a borrower fails to make a required payment on a loan, the Company attempts to cure the deficiency by contacting the borrower and seeking the payment. A late notice is mailed 15 days after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency continues, additional
contact is made either through additional notices or other means and the Company will attempt to work out a payment schedule. While the Company generally prefers to work with borrowers to resolve such problems, the Company will institute foreclosure or other proceedings, as necessary, to minimize any potential loss.
Loans are placed on nonaccrual status generally if, in the opinion of management, principal or interest payments are not likely to be made in accordance with the terms of the loan agreement, or when principal or interest is past due more than 90 days. Interest accrued but not collected at the date the loan is placed on nonaccrual status is reversed against income in the current period. Loans may be reinstated to accrual status when payments are 90 days or less past due and, in the opinion of management, collection of the remaining past due balances can be reasonably expected.
The Company's Board of Directors is informed on a monthly basis of the amounts of loans delinquent more than 30, 60 and 90 days, all loans in foreclosure and all foreclosed and repossessed property owned by the Company.
The following table sets forth information with respect to the Company's nonperforming assets and restructured loans within the meaning of SFAS No. 15 at the dates indicated.
Interest income that would have been recorded for the year ended September 30, 1999 had nonaccruing loans been current in accordance with their original terms amounted to $56,000. The amount of such interest included in interest income on such loans for the year ended September 30, 1999 amounted to $26,000. Interest income that would have been recorded for the year ended September 30, 1999 had restructured loans been current in accordance with their original terms and the amount of interest included in interest income on such loans for that period were, in both cases, immaterial.
Real Estate Owned. Real estate acquired by the Company as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. When property is acquired it is recorded at fair market value
at the date of foreclosure. Subsequent to foreclosure, real estate owned is carried at the lower of the foreclosed amount or fair value, less estimated selling costs. At September 30, 1999, the Company had no real estate owned.
Restructured Loans. Under generally accepted accounting principles ("GAAP"), the Company is required to account for certain loan modifications or restructuring as a "troubled debt restructuring." In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Company for economic or legal reasons related to the borrower's financial difficulties grants a concession to the borrower that the Company would not otherwise consider. A debt restructuring or loan modification for a borrower does not necessarily always constitute a troubled debt restructuring, however, and a troubled debt restructuring does not necessarily result in a nonaccrual loan. The Company had $423,000 of restructured loans as of September 30, 1999, which consisted of four one- to four-family loans.
Asset Classification. The OTS has adopted various regulations regarding problem assets of savings institutions. The regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, OTS examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified as loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. If an asset or portion thereof is classified as loss, the insured institution establishes specific allowances for loan losses for the full amount of the portion of the asset classified as loss. All or a portion of general loan loss allowances established to cover possible losses related to assets classified substandard or doubtful can be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses generally do not qualify as regulatory capital. Assets that do not currently expose the insured institution to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated "special mention" and monitored by the Company.
The following table sets forth the number and amount of classified loans by loan category at September 30, 1999.
Allowance for Loan Losses. In originating loans, the Company recognizes that losses will be experienced and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan. The allowance method is used in providing for loan losses. Accordingly, all loan losses are charged to the allowance and all recoveries are credited to it. The allowance for loan losses is established through a provision for loan losses charged to operations. The provision for loan losses is based on management's periodic evaluation of such factors as the delinquency status of loans, current economic conditions, the net realizable value of the underlying collateral and prior loan loss experience.
At September 30, 1999, the Company had an allowance for loan losses of $1,356,000. Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be significantly and adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while the Company believes it has established its existing allowance for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Company's loan portfolio, will not request the Company to increase significantly its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that substantial increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect the Company's financial condition and results of operations.
The following table sets forth an analysis of the Company's allowance for loan losses.
The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated. Management believes that the allowance can be allocated by category only on an approximate basis. The allocation of the allowance to each category is not necessarily indicative of future losses and does not restrict the use of the allowance to absorb losses in any other category.
Investment Activities
The Bank is permitted under federal law to invest in various types of liquid assets, including U.S. Government obligations, securities of various federal agencies and of state and municipal governments, deposits at the FHLB- Atlanta, certificates of deposit of federally insured institutions, certain bankers' acceptances and federal funds. Subject to various restrictions, the Bank may also invest a portion of its assets in commercial paper and corporate debt securities. Savings institutions like the Bank are also required to maintain an investment in FHLB stock. The Bank is required under federal regulations to maintain a minimum amount of liquid assets.
SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," requires that investments be categorized as "held to maturity," "trading securities" or "available for sale," based on management's intent as to the ultimate disposition of each security. SFAS No. 115 allows debt securities to be classified as "held to maturity" and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold those securities to maturity. Securities that might be sold in response to changes in market interest rates, changes in the security's prepayment risk, increases in loan demand, or other similar factors cannot be classified as "held to maturity." Debt and equity securities held for current resale are classified as "trading securities." Such securities are reported at fair value, and unrealized gains and losses on such securities would be included in earnings. The Company does not currently use or maintain a trading account. Debt and equity securities not classified as either "held to maturity" or "trading securities" are classified as "available for sale." Such securities are reported at fair value, and unrealized gains and losses on such securities are excluded from earnings and reported as a net amount in a separate component of equity.
The Company's investment policies limit investments to obligations of the U.S. Treasury and U.S. Government agencies, Federal Funds and overnight deposits and mortgage-backed securities, such as those issued by Fannie Mae and Freddie Mac. The Company's investment policy does not permit engaging directly in hedging activities or purchasing high risk mortgage derivative products. Investments are made based on certain considerations, which include the interest rate, yield, settlement date and maturity of the investment, the Company's liquidity position, and anticipated cash needs and sources (which, in turn, include outstanding commitments, upcoming maturities, estimated deposits and anticipated loan amortization and repayments). The effect that the proposed investment would have on the Company's credit and interest rate risk and risk- based capital is also considered.
The Company purchases investment securities to provide for necessary liquidity for day-to-day operations. The Company also purchases investment securities when investable funds exceed loan demand. In recent years, the
Company's investment securities purchases have been limited to U.S. Treasury and U.S. Government agency obligations.
The following table sets forth the amortized cost and fair value of the Company's securities, by accounting classification and by type of security, at the dates indicated.
The following table sets forth certain information regarding the carrying value, weighted average yields and maturities or periods to repricing of the Company's debt securities and mortgage-backed securities at September 30, 1999. U.S. Treasury obligations and certain U.S. Government agency obligations are exempt from state taxation. Their yields, however, have not been computed on a tax equivalent basis for purposes of the table.
Deposit Activities and Other Sources of Funds
General. Deposits are the major external source of funds for the Company's lending and other investment activities. In addition, the Company also generates funds internally from loan principal repayments and prepayments and maturing investment and mortgage-backed securities. Scheduled loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are influenced significantly by general interest rates and money market conditions. Borrowings from the FHLB-Atlanta may be used to compensate for reductions in the availability of funds from other sources. Presently, the Company has no other borrowing arrangements.
Deposit Accounts. A substantial number of the Company's depositors reside in South Carolina. The Company's deposit products include NOW accounts, money market accounts, regular passbook savings and term certificate accounts. Deposit account terms vary with the principal difference being the minimum balance deposit, early withdrawal penalties and the interest rate. The Company reviews its deposit mix and pricing weekly. The Company does not utilize brokered deposits, nor has it aggressively sought jumbo certificates of deposit. To attract larger deposits, from time to time the Company has paid bonus rates on large deposits.
The Company believes it is competitive in the interest rates it offers on its deposit products. The Company does not seek to pay the highest deposit rates but competitive rates. The Company determines the rates paid based on a number of conditions, including rates paid by competitors, the Company's interest rate spread, loan demand and deposit balances.
The following table indicates the amount of the Company's jumbo certificate accounts by time remaining until maturity as of September 30, 1999. Jumbo certificate accounts have principal balances of $100,000 or more.
Jumbo Certificate Maturity Period Accounts --------------- -------------- (In thousands)
Three months or less.................................... $17,657 Over three months through six months.................... 15,731 Over six months through 12 months....................... 12,979 Over 12 months.......................................... 15,145 ------- Total............................................. $61,512 =======
The following table sets forth the balances (inclusive of interest credited) and changes in dollar amounts of deposits in the various types of accounts offered by the Company between the dates indicated.
The following table sets forth the amount of time deposits in the Company categorized by rates at the dates indicated.
The following table sets forth the amount of time deposits in the Company categorized by maturities at September 30, 1999.
The following table sets forth the deposit activity of the Company for the periods indicated.
Borrowings. The Bank has the ability to use advances from the FHLB-Atlanta to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB-Atlanta functions as a central reserve bank providing credit for savings associations and certain other member financial institutions. As a member of the FHLB-Atlanta, the Bank is required to own capital stock in the FHLB-Atlanta and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities that are obligations of, or guaranteed by, the U.S. Government or agencies thereof), provided certain creditworthiness standards have been met. Advances are made pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based on the financial condition of the member institution and the adequacy of collateral pledged to secure the credit.
See Note 7 of Notes to the Consolidated Financial Statements for further information on the Bank's borrowings.
Subsidiary Activities
The only subsidiary of the Company is the Bank. Under OTS regulations, the Bank generally may invest up to 3% of its assets in service corporations, provided that at least one-half of investment in excess of 1% is used primarily for community, inner-city and community development projects. The Bank does not have any subsidiaries.
Personnel
As of September 30, 1999, the Company had 37 full-time and 4 part-time employees, none of whom is represented by a collective bargaining unit. The Company believes its relationship with its employees is good.
REGULATION AND SUPERVISION
General
As a savings and loan holding company, the Company is required by federal law to file reports with, and otherwise comply with, the rules and regulations of the OTS. The Bank is subject to extensive regulation, examination and supervision by the OTS, as its primary federal regulator, and the FDIC, as the deposit insurer. The Bank is a member of the FHLB-Atlanta and its deposit accounts are insured up to applicable limits by the SAIF managed by the FDIC. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other savings institutions. The OTS and/or the FDIC conduct periodic examinations to test the Bank's safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the OTS, the FDIC or the Congress, could have a material adverse impact on the Company, the Bank and their operations. Certain of the regulatory requirements applicable to the Bank and to the Company are referred to below or elsewhere herein. The description of statutory provisions and regulations applicable to savings institutions and their holding companies set forth in this report does not purport to be a complete description of such statutes and regulations and their effects on the Company and the Bank.
Holding Company Regulation
The Company is a nondiversified unitary savings and loan holding company within the meaning of federal law. As a unitary savings and loan holding company, the Company generally is not restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a qualified thrift lender. See "Regulation and Supervision--QTL Test." Upon any non-supervisory acquisition by the Company of another savings institution or savings bank that meets the qualified thrift lender test and is deemed to be a savings institution by the OTS, the Company would become a multiple savings and loan holding company (if the acquired institution is held as a separate subsidiary) and generally would be limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain activities authorized by OTS regulation.
A savings and loan holding company is prohibited from, directly or indirectly, acquiring more than 5% of the voting stock of another savings institution or savings and loan holding company, without prior written approval of the OTS and from acquiring or retaining control of a depository institution that is not insured by the FDIC. In evaluating applications by holding companies to acquire savings institutions, the OTS considers the financial and managerial resources and future prospects of the Bank and institution involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community and competitive factors.
The OTS may not approve any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (1) the approval of interstate supervisory acquisitions by savings and loan holding companies and (2) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings and loan holding company acquisitions.
Although savings and loan holding companies are not subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, federal regulations do prescribe such restrictions on subsidiary savings institutions as described below. The Bank must notify the OTS 30 days before declaring any dividend to the Company. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the OTS and the agency has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution.
Prior approval of the OTS is necessary before a "change in control" occurs in a savings and loan holding company such as the Company. A "change in control" may occur upon a person or entity's acquisition (alone or acting in concert) of 10% or more of the Company's stock.
Federal Savings Institution Regulation
Business Activities. The activities of federal savings institutions are governed by federal law and regulations. These laws and regulations delineate the nature and extent of the activities in which federal associations may engage. In particular, many types of lending authority for federal associations, e.g., commercial, non-residential real property loans and consumer loans, are limited to a specified percentage of the institution's capital or assets. In addition, certain activities, such as mergers and acquisitions, and branching, are subject to the pri or approval of the OTS.
Capital Requirements. The OTS capital regulations require savings institutions to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% (3% for institutions receiving the highest rating on the CAMELS financial institution examination rating system) leverage ratio and an 8% risk- based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS financial institution rating system), and, together with the risk- based capital standard itself, a 4% Tier I risk-based capital standard. The OTS regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions generally must deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank.
The risk-based capital standard for savings institutions requires the maintenance of Tier I (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight factor of 0% to 100%, assigned by the OTS capital regulation based on the risks believed inherent in the type of asset. Tier I (core) capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, and minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.
The capital regulations also incorporate an interest rate risk component. Savings institutions with "above normal" interest rate risk exposure are subject to a deduction from total capital for purposes of calculating their risk-based capital requirements. For the present time, the OTS has deferred implementation of the interest rate risk component. At September 30, 1999, the Bank met each of its mandated capital requirements.
The following table presents the Bank's capital position at September 30, 1999.
Prompt Corrective Regulatory Action. The OTS is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution's degree of undercapitalization. Generally, a savings institution that has a ratio of total capital to risk-weighted assets of less than 8%, a ratio of Tier I (core) capital to risk-weighted assets of less than 4%, or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be "undercapitalized." A savings institution that has a total risk-based capital ratio less than 6%, a Tier I capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be "significantly undercapitalized" and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be "critically undercapitalized." Subject to a narrow exception, the OTS is required to appoint a receiver or conservator for an institution that is "critically undercapitalized." The regulation also provides that a capital restoration plan must be filed with the OTS within 45 days of the date a savings institution receives notice that it is "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." Compliance with the plan must be guaranteed by any parent holding company in an amount of up to the lesser of 5% of the institution's assets or the amount which would bring the institution into compliance with all capital standards. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The OTS also could take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.
Insurance of Deposit Accounts. Deposits of the Bank presently are insured by the SAIF. The FDIC maintains a risk-based assessment system by which institutions are assigned to one of three categories based on their capitalization and one of three subcategories based on examination ratings and other supervisory information. An institution's assessment rate depends upon the categories to which it is assigned. Assessment rates for SAIF member institutions are determined semiannually by the FDIC and currently range from zero basis points for the healthiest institutions to 27 basis points for the riskiest.
In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation ("FICO") to recapitalize the predecessor to the SAIF. During 1999, FICO payments for SAIF members, including the Bank, approximated 6.10 basis points, while Bank Insurance Fund ("BIF") members paid 1.22 basis points. By law, there will be equal sharing of FICO payments between SAIF and BIF members beginning on January 1, 2000.
The FDIC has authority to increase insurance assessments. A significant increase in SAIF insurance premiums would likely have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what insurance assessment rates will be in the future.
Insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition or violation that might lead to its termination of deposit insurance.
Loans to One Borrower. Federal law provides that savings institutions are generally subject to the limits on loans to one borrower applicable to national banks. A savings institution may not make a loan or extend credit to a
single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily-marketable collateral. At September 30, 1999, the Bank's limit on loans to one borrower was $9.7 million, and the Bank's largest aggregate outstanding balance of loans to one borrower was $6 million.
QTL Test. Federal law requires savings institutions to meet a qualified thrift lender test. Under the test, a savings association is required to either qualify as a "domestic building and loan association" under the Internal Revenue Code or maintain at least 65% of its "portfolio assets" (total assets less: (1) specified liquid assets up to 20% of total assets; (2) intangibles, including goodwill; and (3) the value of property used to conduct business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least nine months out of each 12 month period.
A savings institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. As of September 30, 1999, the Bank met the qualified thrift lender test. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered "qualified thrift investments."
Limitation on Capital Distributions. OTS regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to shareholders of another institution in a cash-out merger. The rule effective in 1998 established three tiers of institutions based primarily on an institution's capital level. An institution that exceeded all capital requirements before and after a proposed capital distribution ("Tier I Bank") and had not been advised by the OTS that it was in need of more than normal supervision, could, after prior notice but without obtaining approval of the OTS, make capital distributions during the calendar year equal to the greater of (1) 100% of its net earnings to date during the calendar year plus the amount that would reduce by one-half the excess capital over its capital requirements at the beginning of the calendar year or (2) 75% of its net income for the previous four quarters. Any additional capital distributions required prior regulatory approval. At June 30, 1999, the Bank was a Tier I Bank. Effective April 1, 1999, the OTS's capital distribution regulation changed. Under the new regulation, an application to and the prior approval of the OTS will be required prior to any capital distribution if the institution does not meet the criteria for "expedited treatment" of applications under OTS regulations (i.e., generally, safety and soundness, compliance and Community Reinvestment Act examination ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with OTS. If an application is not required, the institution must still provide prior notice to OTS of the capital distribution. In the event the Bank's capital fell below its regulatory requirements or the OTS notified it that it was in need of more than normal supervision, the Bank's ability to make capital distributions could be restricted. In addition, the OTS could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if the OTS determines that such distribution would constitute an unsafe or unsound practice.
Liquidity. The Bank is required to maintain an average daily balance of specified liquid assets equal to a monthly average of not less than a specified percentage of its net withdrawable deposit accounts plus short-term borrowings. This liquidity requirement is currently 4%, but may be changed from time to time by the OTS to any amount within the range of 4% to 10%. Monetary penalties may be imposed for failure to meet these liquidity requirements. The Bank has never been subject to monetary penalties for failure to meet its liquidity requirements.
Assessments. Savings institutions are required to pay assessments to the OTS to fund the agency's operations. The general assessments, paid on a semi- annual basis, are computed upon the savings institution's total assets, including consolidated subsidiaries, as reported in the Bank's latest quarterly thrift financial report.
Transactions with Related Parties. The Bank's authority to engage in transactions with "affiliates" (e.g., any company that controls or is under common control with an institution, including the Bank and its non-savings institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution's capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. The transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.
The Bank's authority to extend credit to executive officers, directors and 10% shareholders ("insiders"), as well as entities such persons control, is also governed by federal law. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. Recent legislation created an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. The law limits both the individual and aggregate amount of loans the Bank may make to insiders based, in part, on the Bank's capital position and requires certain board approval procedures to be followed.
Enforcement. The OTS has primary enforcement responsibility over savings institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to institution of receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The FDIC has the authority to recommend to the Director of the OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the Director, the FDIC has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.
Standards for Safety and Soundness. The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the OTS determines that a savings institution fails to meet any standard prescribed by the guidelines, the OTS may require the institution to submit an acceptable plan to achieve compliance with the standard.
Federal Home Loan Bank System
The Bank is a member of the FHLB System, which consists of 12 regional FHLBs. The FHLB-Atlanta provides a central credit facility primarily for member institutions. The Bank, as a member of the FHLB-Atlanta, is required to acquire and hold shares of capital stock in the FHLB-Atlanta in an amount at least equal to 1.0% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its advances (borrowings) from the FHLB-Atlanta, whichever is greater. The Bank was in compliance with this requirement with an investment in FHLB-Atlanta stock at September 30, 1999, of $1.7 million. FHLB-Atlanta advances must be secured by specified types of collateral and all long-term advances may only be obtained for the purpose of providing funds for residential housing finance.
The FHLBs are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members.
Federal Reserve System
The Federal Reserve Board regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: for accounts aggregating $46.5 million or less (subject to adjustment by the Federal Reserve Board), the reserve requirement is 3%; and for accounts aggregating greater than $46.5 million, the reserve requirement is $1.395 million plus 10% (subject to adjustment by the Federal Reserve Board between 8% and 14%) against that portion of total transaction accounts in excess of $46.5 million. The first $4.9 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The Bank complies with the foregoing requirements.
TAXATION
Federal Taxation
General. The Company and the Bank report their income on a fiscal year, consolidated basis and the accrual method of accounting, and are subject to federal income taxation in the same manner as other corporations with some exceptions, including particularly the Bank's reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company or the Bank. For its 1999 taxable year, the Company is subject to a maximum federal income tax rate of 34%.
Bad Debt Reserves. For fiscal years beginning prior to December 31, 1995, thrift institutions which qualified under certain definitional tests and other conditions of the Internal Revenue Code were permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad debt reserve. A reserve could be established for bad debts on qualifying real property loans (generally secured by interests in real property improved or to be improved) under (i) the percentage of taxable income method or (ii) the experience method. The reserve for nonqualifying loans was computed using the experience method.
Congress repealed the reserve method of accounting for bad debts for tax years beginning after 1995 and required savings institutions to recapture (i.e., take into income) certain portions of their accumulated bad debt reserves. Thrift institutions eligible to be treated as "small banks" (assets of $500 million or less) are allowed to use the experience method applicable to such institutions, while thrift institutions that are treated as large banks (assets exceeding $500 million) are required to use only the specific charge-off method. Thus, the percentage of taxable income method of accounting for bad debts is no longer available for any financial institution.
A thrift institution required to change its method of computing reserves for bad debts will treat such change as a change in method of accounting, initiated by the taxpayer, and having been made with the consent of the Internal Revenue Service. Any Section 481(a) adjustment required to be taken into income with respect to such change generally will be taken into income ratably over a six-taxable year period, beginning with the first taxable year beginning after 1995, subject to a 2-year suspension if the "residential loan requirement" is satisfied.
Under the residential loan requirement provision, the required recapture will be suspended for each of two successive taxable years, beginning with the Bank's 1996 taxable year, in which the Bank originates a minimum of certain residential loans based upon the average of the principal amounts of such loans made by the Bank during its six taxable years preceding its current taxable year.
Distributions. If the Bank makes "non-dividend distributions" to the Company, such distributions will be considered to have been made from the Bank's unrecaptured tax bad debt reserves (including the balance of its reserves as of December 31, 1987) to the extent thereof, and then from the Bank's supplemental reserve for losses on loans, to the extent thereof, and an amount based on the amount distributed (but not in excess of the amount of such reserves) will be included in the Bank's income. Non-dividend distributions include distributions in excess of the Bank's current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of
stock, and distributions in partial or complete liquidation. Dividends paid out of the Bank's current or accumulated earnings and profits will not be so included in its income.
The amount of additional taxable income triggered by a non-dividend is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if the Bank makes a non-dividend distribution to the Company, approximately one and one-half times the amount of such distribution (but not in excess of the amount of such reserves) would be includable in income for federal income tax purposes, assuming a 35% federal corporate income tax rate. The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.
State Taxation
Delaware. As a Delaware holding company not earning income in Delaware, the Company is exempted from Delaware corporate income tax, but is required to file an annual report with and pay an annual franchise tax to the State of Delaware.
South Carolina. The provisions of South Carolina tax law mirror the Internal Revenue Code, with certain modifications, as it relates to savings and loans and banks. The Bank is subject to South Carolina income tax at the rate of 6%. This rate of tax is imposed on savings banks in lieu of the general state business corporation income tax. The Bank's state income tax returns have not been audited within the last five years.
For additional information regarding taxation, see Note 8 of Notes to Consolidated Financial Statements contained in this report.
Item 2.
Item 2. Properties - -------------------
At September 30, 1999, the net book value of the Company's properties (including land and buildings), fixtures, furniture and equipment was $4.0 million. The following table sets forth certain information regarding the Company's offices at September 30, 1999, all of which are owned.
___________________________ (1) The Bank occupied a smaller facility at the same location from 1955 to 1995.
Item 3.
Item 3. Legal Proceedings - --------------------------
Periodically, there have been various claims and lawsuits involving the Bank, such as claims to enforce liens, condemnation proceedings on properties in which the Bank holds security interests, claims involving the making and servicing of real property loans and other issues incident to the Bank's business. Neither the Company nor the Bank is a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Company.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders - ------------------------------------------------------------
No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 1999.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters - -----------------------------------------------------------------------------
The Company's common stock has been listed on the Nasdaq National Market since the Company's initial public offering on April 7, 1998. According to the records of the Company's transfer agent, the Company had approximately 1,300 stockholders of record as of December 6, 1999. This number does not reflect stockholders who hold their shares in "street name." The following table sets forth the high and low sale price of the Company's common stock and dividends paid in each fiscal quarter since the Company's initial public offering.
High Low Dividend -------- ------- -------- Fiscal 1999: Fourth Quarter............. $17.500 $16.750 0.15 Third Quarter.............. $22.875 $16.250 4.00 Second Quarter............. $22.500 $20.000 0.15 First Quarter.............. $21.375 $12.500 --
High Low Dividend -------- ------- -------- Fiscal 1998: Fourth Quarter............. $20.000 $16.125 0.15 Third Quarter.............. $22.375 $19.000 --
Item 6.
Item 6. Selected Financial Data - -------------------------------
__________________________ (1) Includes a $1.9 million compensation charge related to the $4.00 per share cash distribution. (2) Includes one-time SAIF assessment of $1.2 million. (3) As the Company's initial public offering closed on April 6, 1998, earnings per share for all fiscal years prior to September 30, 1999 are not presented.
_______________________ (1) Net income divided by average total assets. (2) Net income divided by average total equity. (3) Difference between weighted average yield on interest-earning assets and weighted average cost of interest-bearing liabilities. (4) Net interest income as a percentage of average interest-earning assets. (5) Dividends declared per share divided by net income per share. (6) Nonperforming loans consist of loans accounted for on a nonaccrual basis. (7) Nonperforming assets consist of nonperforming loans and real estate acquired in settlement of loans, but exclude restructured loans.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and - ------------------------------------------------------------------------- Results of Operations - ---------------------
General
Management's discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and accompanying Notes thereto contained elsewhere in this report.
Operating Strategy
The Company's business consists principally of attracting retail deposits from the general public and using these funds to originate mortgage loans secured by one- to four-family residences located in South Carolina. The Company also originates commercial real estate loans, home equity loans, builder construction loans, commercial loans and consumer loans. The Company intends to continue to fund its assets primarily with retail deposits, although FHLB- Atlanta advances are used as a supplemental source of funds.
The Company's profitability depends primarily on its net interest income, which is the difference between the income it receives on its loan and investment portfolio and its cost of funds, which consists of interest paid on deposits and borrowings. Net interest income is also affected by the relative amounts of interest-earning assets and interest-bearing liabilities. When interest-earning assets equal or exceed interest-bearing liabilities, any positive interest rate spread will generate net interest income. The level of other operating income and expenses also affects the Company's profitability. Other operating income includes service charges and fees, gain on sale of mortgage loans and gain on sale of investments. Other operating expenses primarily include compensation and benefits, occupancy and equipment expenses, deposit insurance premiums and data processing expenses. The Company's results of operations also are affected significantly by general economic and competitive conditions, particularly changes in market interest rates, government legislation and regulation and monetary and fiscal policies.
The Company's business strategy is to operate as a well capitalized, profitable and independent financial institution dedicated to financing home ownership and providing quality customer service. In this fiscal year, the Company sought to reallocate its mortgage lending portfolio loans by increasing its originations of builder construction and commercial real estate loans for the purpose of increasing overall loan yield and size of the loan portfolio. As these types of loans generally present more risk than one- to four-family mortgage loans, the Company has increased its allowance for loan loss. The Company believes that its current mortgage loan portfolio is now balanced to yield an attractive return with acceptable risk and intends to maintain the composition of the portfolio at its approximate current levels. To manage interest risk, the Company will continue to place emphasis on origination of adjustable-rate loans and fixed-rate loans with a maturity of less than fifteen years. While the Company continues to rely heavily on certificates of deposit as its primary source of funds, in fiscal 1999 a greater emphasis was placed on attracting transaction accounts. Consequently, the higher cost of funds generally associated with certificates of deposit has been mitigated by growth in lower cost checking and money market accounts. A lower cost of funds contributes to a higher interest rate spread and increased profitability. However, any future inability to attract and retain lower cost deposits, as well as changes in market interest rates, could lower the Company's interest rate spread and reduce its profitability.
Comparison of Financial Condition at September 30, 1999 and 1998
Total assets increased $8.8 million, or 2.9%, to $313.7 million from $304.9 million at September 30, 1998. Loans receivable increased $55.2 million, or 28.1%, to $252.0 million from $196.8 million. Builder construction and commercial mortgage loans increased by $68.7 million, or 266.7%. One- to four- family mortgage loans increased $12.6 million or 7.3%. Mortgage-backed securities increased to $10.1 million from $1.7 million. Mortgage-backed securities in the amount of $10.0 million were purchased with FHLB advances. Investment securities increased to $29.3 million from $24.0 million. Growth in brokered loans resulted in a decrease in loan origination fees. Cash and cash equivalents decreased $60.4 million, or 81.7%, to $13.5 million from $73.9 million as the Company used cash during the 1999 fiscal year to fund loan growth, pay a $4.00 per share distribution on June 22, 1999, and purchase investment securities.
Total liabilities increased $29.5 million, or 14.1%, from $209.6 million to $239.1 million. Deposit accounts increased $278,000, from $206.1 million to $206.4 million. During fiscal 1999, the Company borrowed $30 million in FHLB advances to help fund loan growth and to purchase mortgage-backed securities.
Total equity decreased $20.7 million, or 21.8%, from $95.3 million to $74.6 million. The decrease is primarily the result of the Company's payment of the cash distribution and the repurchase of shares of its stock.
Comparison of Operating Results for the Years Ended September 30, 1999 and 1998
Net Income. Net income decreased $1.1 million, or 31.4%, to $2.4 million for the year ended September 30, 1999 from $3.4 million for the year ended September 30, 1998. The decrease in net income was primarily the result of an increase in employee compensation and benefit expense and an increase in data processing fees. The Company paid a cash distribution to stockholders of $4.00 a share on June 22, 1999 that resulted in a one-time charge of $1.9 million to employee compensation and benefit expense.
Net Interest Income. Net interest income increased $2.7 million, or 34.5%, from fiscal year 1998 to fiscal year 1999, due to an increase in the average balance of interest-earning assets, primarily growth in the loan portfolio, and a decrease in interest expense of $1.0 million, or 8.4%.
Total interest income increased $1.7 million, or 8.6%, from fiscal 1998 to fiscal 1999. Interest income on loans receivable increased $2.0 million as a result of an increase of $24.9 million, or 12.8%, in the average balance of loans. Yield on the average balance of loans receivable was essentially unchanged. The growth in interest income on loans was partially offset by a reduction in interest income on mortgage-backed securities, as the Company reduced the average balance of these investments. The average balance of interest-earning assets increased to $292.7 million in 1999 from $272.2 million in 1998. The increase in the average balance was due to an increase in the average balance of loans receivable partially offset by a decrease in interest- bearing overnight funds. The yield on the Company's interest-earning assets increased to 7.37% from 7.30% as a result of market trends and the investment of lower yielding overnight funds into higher yielding loans.
Total interest expense decreased $1.0 million, or 8.4%, from fiscal 1998 to fiscal 1999. The average balance of interest-bearing liabilities decreased $17.4 million, or 7.7%, while the average rate paid decreased to 5.30% from 5.34%. Interest paid on passbook, NOW and money market accounts increased a total of $104,000 primarily because of an increase in the average balance and rate of such accounts. Interest paid on certificates of deposit decreased $1.3 million because of a decrease in the average balance of such accounts. This was partially offset by an increase in the average rate paid on certificates of deposit to 5.55% from 5.53%. Interest paid on FHLB advances was $203,000 for fiscal 1999 compared to no interest paid in fiscal 1998.
Provision for Loan Losses. Provisions for loan losses are charged to operations to bring the total allowance for loan losses to a level considered by management to be adequate to provide for estimated losses based on management's evaluation of such factors as the delinquency status of loans, current economic conditions, the net realizable value of the underlying collateral and prior loan loss experience. The provision for loan losses was $596,000 in fiscal year 1999 compared with a net recovery of $105,000 in fiscal 1998. At September 30, 1999, the Company's allowance for loan losses totaled $1.4 million, which equaled 0.54% of total loans. Although management uses the best information available, future adjustments to the allowance may be necessary due to changes in economic, operating, regulatory and other conditions that may be beyond the Company's control. While the Company maintains its allowance for loan losses at a level which it considers to be adequate to provide for estimated losses, there can be no assurance that further additions will not be made to the allowance for loan losses or that actual losses will not exceed the estimated amounts.
Other Income. Other income decreased $34,000, or 13.8%, to $212,000 for fiscal 1999 from $246,000 for fiscal 1998. Substantially all of the Company's other income is derived from service charges and fees. Service charges and fees totaled $188,000 in fiscal 1999 compared with $228,000 in fiscal 1998. Growth in brokered loans resulted in a decrease in loan origination fees. Gain on sale of mortgage loans increased to $43,000 in fiscal 1999 from $18,000 in fiscal 1998 as a result of an increase in loan sales in 1999. The Company had a loss of $20,000 on sale of investments in fiscal 1999 compared to no loss on sale of investments in fiscal 1998.
Other Operating Expenses. Other operating expenses were $5.8 million in fiscal 1999 compared to $2.9 million in fiscal 1998. Employee compensation and benefits expense increased $2.4 million, or 138.5%, primarily as a result of a $4.00 a share cash distribution on June 22, 1999 to stockholders of record that resulted in a one-time charge of $1.9 million to employee compensation and benefit expense. The increase is also the result of compensation expenses associated with the Management Recognition and Development Plan and normal payroll growth.
Income Taxes. The provision for income taxes increased to $2.0 million for fiscal 1999 from $1.9 million for fiscal 1998. Although income before income taxes decreased for fiscal 1999, a portion of the cash distribution charge to compensation expense was not deductible for income tax purposes.
Comparison of Operating Results for the Years Ended September 30, 1998 and 1997
Net Income. Net income increased $1.5 million, or 76.0%, to $3.4 million for the year ended September 30, 1998 from $2.0 million for the year ended September 30, 1997. The increase was primarily the result of an increase in interest income, a decrease in interest expense on FHLB borrowings, a recovery of loan losses and a decline in deposit insurance premiums. This was offset by an increase in employee compensation and real estate operations expense.
Net Interest Income. Net interest income increased $2.3 million, or 42.0%, to $7.9 million for fiscal 1998 from $5.5 million for fiscal 1997. The Company's interest rate spread increased 20 basis points to 1.96% for fiscal 1998 from 1.76% for fiscal 1997 as the Company experienced a 17 basis point decrease in the yield on its interest-earning assets and a 37 basis point decrease in the cost of its interest-bearing liabilities.
Total interest income increased $2.1 million, or 11.9%, from fiscal 1997 to fiscal 1998. Interest income on loans receivable increased $756,000 largely as a result of an increase of $5.5 million, or 2.9%, in the average balance of loans and a 16 basis point increase in the yield on loans receivable for the year ended September 30, 1998. The growth in interest income on loans was partially offset by a reduction in interest income on mortgage-backed securities, as the Company reduced the average balance and yield of these investments. The average balance of interest-earning assets increased to $272.2 million in 1998 from $237.9 million in 1997. The increase in the average balance was due in part to funds received from the proceeds of the initial public offering and an increase in the average balance of loans receivable. The yield on the Company's interest- earning assets decreased to 7.30% from 7.47% as a result of market trends and the investment of the offering proceeds in lower yielding, short term investments.
Total interest expense decreased $220,000, or 1.8%, from fiscal 1997 to fiscal 1998. The average balance of interest-bearing liabilities increased $10.6 million, or 4.96%, while the average rate paid decreased to 5.34% from 5.71%. Interest paid on passbook, NOW and money market accounts decreased a total of $35,000 primarily because of a decrease in the average balance and rate of such accounts. Interest paid on certificates of deposit increased $41,000 because of an increase in the average balance of such accounts. This was partially offset by a decrease in the average rate paid on certificates of deposit to 5.53% from 5.91%. Interest paid on FHLB advances decreased $226,000 as a result of no borrowings in the year ended September 30, 1998.
Provision for Loan Losses. The provision for loan losses was a net recovery of $105,000 in fiscal year 1998 compared with a provision of $337,000 in fiscal 1997. This recovery came as the result of a loan previously classified as a loss being paid off. Additionally, the Company added $10,000 to the allowance for loan losses to provide for estimated losses on specific problem loans. It was not necessary for the Company to add to the allowance for loan losses based on its re-evaluation of the risks inherent in the loan portfolio because upon analysis current reserves proved adequate. At September 30, 1998, the Company's allowance for loan losses totalled $760,000 which equaled 0.36% of total loans.
Other Income. Other income increased $44,000, or 21.8%, to $246,000 for fiscal 1998 from $202,000 for fiscal 1997. Service charges and fees totalled $228,000 in fiscal 1998 compared with $206,000 in fiscal 1997. Gain on sale of mortgage loans increased to $18,000 in fiscal 1998 from $6,000 in fiscal 1997 as a result of an increase in loan sales in 1998. The Company had no sale of investments in fiscal 1998 resulting in no gains or losses compared to a loss of $13,000 in fiscal 1997.
Other Operating Expenses. Other operating expenses were $2.9 million in fiscal 1998 compared to $2.4 million in fiscal 1997. Employee compensation and benefits expense increased $263,000, or 18.1%, as a result of normal wage increases and new costs associated with the implementation of the Employee Stock Ownership Plan. Expense from real estate operations was $69,000 in fiscal year 1998 compared with income of $167,000 in fiscal 1997 as a result of gains on sales of real estate owned.
Income Taxes. The provision for income taxes increased to $2.0 million for fiscal 1998 from $1.1 million for fiscal 1997. The income tax provision was higher in fiscal 1998 because of higher taxable income.
Average Balances, Interest and Average Yields/Costs
The following table sets forth certain information for the periods indicated regarding average balances of assets and liabilities as well as the total dollar amounts of interest income from average interest-earning assets and interest expense on average interest-bearing liabilities and average yields and costs. Such yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented.
____________________ (1) Loans receivable, net includes loans held-for-sale and nonaccrual loans. Interest on loans receivable does not include interest on nonaccrual loans. (2) Yield information does not give affect to changes in fair value that are reflected as a component of equity. (3) Does not include escrow balances.
Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on the interest income and interest expense of the Company. Information is provided with respect: (i) to effects attributable to changes in volume (changes in volume multiplied by prior rate); and (ii) to effects attributable to changes in rate (changes in rate multiplied by prior volume). The net change attributable to the combined impact of volume and rate has been allocated proportionately to the change due to volume and the change due to rate.
__________________________ (1) Does not include interest on nonaccrual loans.
Asset and Liability Management
Quantitative Aspects of Market Risk. The Company does not maintain a trading account for any class of financial instrument nor does the Company engage in hedging activities or purchase high-risk derivative instruments. Furthermore, the Company is not subject to foreign currency exchange rate risk or commodity price risk. For information regarding the sensitivity to interest rate risk of the Company's interest-earning assets and interest-bearing liabilities, see the tables under "Lending Activities--Maturity of Loan Portfolio," "--Investment Activities" and "--Deposit Activities and Other Sources of Funds."
Qualitative Aspects of Market Risk. The Company's principal financial objective is to achieve long-term profitability while reducing its exposure to fluctuating market interest rates. The Company has sought to reduce the exposure of its earnings to changes in market interest rates by attempting to manage the mismatch between asset and liability maturities and interest rates. The principal element in achieving this objective is to increase the interest-rate sensitivity of the Company's interest-earning assets by retaining for its portfolio loans with interest rates subject to periodic adjustment to market conditions and selling fixed-rate one-to-four-family mortgage loans with terms over 15
years. In addition, the Company maintains an investment portfolio of U.S. Treasury and U.S. Government agency obligations with contractual maturities of between one and five years. The Company relies on retail deposits as its primary source of funds. Management believes retail deposits, compared to brokered deposits, reduce the effects of interest rate fluctuations because they generally represent a more stable source of funds.
The Company uses interest rate sensitivity analysis to measure its interest rate risk by computing changes in NPV (net portfolio value) of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. NPV represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 400 basis point increase or decrease in market interest rates with no effect given to any steps that management might take to counter the effect of that interest rate movement. Using data compiled by the FHLB, the Company receives a report which measures interest rate risk by modeling the change in NPV over a variety of interest rate scenarios.
The following table is provided by the FHLB and sets forth the change in the Company's NPV at September 30, 1999, based on FHLB assumptions, that would occur in the event of an immediate change in interest rates, with no effect given to any steps that management might take to counteract that change.
Basis Point ("bp") Estimated Change in Change in Rates Net Portfolio Value ------------------ ------------------- (In thousands)
+300 (14,340) +200 (8,538) +100 (3,796) 0 -- (100) 3,184 (200) 5,734 (300) 7,431
The above table illustrates, for example, that an instantaneous 200 basis point increase in market interest rates at September 30, 1999 would reduce the Company's NPV by approximately $8.5 million, or 12.4%, at that date.
The following table prepared with information supplied by the FHLB presents the Company's financial instruments that are sensitive to changes in interest rates, categorized by expected maturity.
Certain assumptions utilized by the FHLB in assessing the interest rate risk of savings associations within its region were utilized in preparing the preceding tables. These assumptions relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others.
As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing tables. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as ARM loans, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.
Liquidity and Capital Resources
The Company's primary sources of funds are customer deposits, proceeds from principal and interest payments on and the sale of loans, maturing securities and FHLB advances. While maturities and scheduled amortization of loans are a predictable source of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.
The Company must maintain an adequate level of liquidity to ensure the availability of sufficient funds to fund loan originations and deposit withdrawals, to satisfy other financial commitments and to take advantage of investment opportunities. The Company generally maintains sufficient cash and short-term investments to meet short-term liquidity
needs. At September 30, 1999, cash and cash equivalents totalled $13.5 million, or 4.3% of total assets, and investment securities classified as available-for- sale totalled $25.8 million. At September 30, 1999, the Company also maintained a credit facility of $47.1 million with the FHLB-Atlanta. The Company has not drawn on this credit facility.
OTS regulations require savings institutions to maintain an average daily balance of liquid assets (cash and eligible investments) equal to at least 4.0% of the average daily balance of its net withdrawable deposits and short-term borrowings. The Company's actual liquidity ratio at September 30, 1999 was 23.85%.
The Company's primary investing activity is the origination of one- to four-family mortgage loans. During the years ended September 30, 1999, 1998 and 1997, the Company originated $42.2 million, $43.5 million and $37.0 million of such loans, respectively. At September 30, 1999, the Company had loan commitments totalling $2.3 million, unused lines of credit of $9.2 million and undisbursed loans in process totalling $41.6 million. The Company anticipates that it will have sufficient funds available to meet current loan commitments. Certificates of deposit that are scheduled to mature in less than one year from September 30, 1999 totalled $137.6 million. Historically, the Company has been able to retain a significant amount of its deposits as they mature.
OTS regulations require the Bank to maintain specific amounts of regulatory capital. As of September 30, 1999, the Bank complied with all regulatory capital requirements as of that date with tangible, core and risk-based capital ratios of 20.3%, 20.3% and 35.5%, respectively.
Year 2000 Issues
As the year 2000 approaches, the Bank's information and data processing system has been assessed to insure appropriate operation after December 31, 1999. Many such systems in use worldwide may not be able to interpret dates after December 31, 1999 properly because such systems allow only two digits to indicate the year in a date. Programmers initially used a two-digit dating system that has become integrated into applications and hardware which could cause systems to function improperly or fail on January 1, 2000. The problem could reside in computer programs, computer hardware, or electronic devices that reference dates in the course of their functions. Also, the Bank has considered the potential problems that Year 2000 could pose for third party service providers.
Year 2000 risk is present in virtually all of the Bank's normal operating activities. To confront these risks, the Bank has developed a Year 2000 Plan, which has been reviewed by senior management and the Board of Directors. The plan contains a review of Bank systems that could be affected by Year 2000 problems along with an assessment of the potential impact that Year 2000 system problems could pose to the Bank's normal operation. Management categorized Year 2000 potential risks as critical, important, or noncritical. Critical issues were those that would cause the Bank to lose its data communication and data processing capability and thus render normal operations virtually impossible. Noncritical issues were those that would pose an inconvenience but could be readily remediated through a manual or alternate processing system. Important issues were those that would cause some disruption to administrative or management functions but would cause no immediate operational problems and could be handled easily in a non-automated manner.
Management has determined the more critical aspects of the Bank's operations that could be affected are the Bank's interaction with its data processing provider and the proper operation of its internal computer system. While other areas of concern, such as payroll and accounting services and mortgage escrow and tax services could pose some inconvenience and delays in normal operations, problems in those areas would be noncritical and could be readily corrected.
The Bank has requested and received Year 2000 readiness certifications from third party service providers whose services have been deemed critical to Bank operations. For critical systems, contingency plans have been developed that make provisions for alternate and/or manual processing. These plans are being prepared for four possible scenarios ranging from minor system anomalies to complete system dysfunctionality. The worst case scenario would be the inability to use the internal computer system, the inability to communicate with the data processing provider, and the data processing provider's dysfunctionality. Management feels that its preparation exceeds what is necessary for the most reasonably likely worst case scenario.
The Office of Thrift Supervision has conducted three independent audits of the Bank's Year 2000 progress. As a part of their regulatory oversight of all thrift institutions, the OTS conducted a final interview audit in November 1999.
The Bank's primary data processing provider is FiServ. FiServ has developed a Year 2000 Plan and provides the Bank with periodic updates. FiServ completed all program maintenance associated with its Year 2000 Plan in November 1998, and has certified that its data processing systems are Year 2000 compliant. FiServ's Year 2000 activities are also monitored by the OTS. The Bank began testing its software and hardware interfaces in conjunction with FiServ's system in November, 1998, and concluded that further testing would be beneficial. That testing was begun in January, 1999 with successful off-line testing of the software and hardware interfaces. A new accounts software upgrade was completed and tested in February, 1999, and a final successful online testing with FiServ was performed in April, 1999. By September, 1999, hardware was added to upgrade data processing report reception, and climate control in the main office. All data processing systems critical to the Bank's operation have now been successfully tested.
The Bank has utilized third party consultants to analyze its hardware and local area network needs to upgrade the Bank's software interfaces.
FiServ is also monitoring the Year 2000 status of third party vendors providing data exchange functions relating to the Bank. FiServ has developed a comprehensive list of these vendors for its clients and evaluated the vendors as to the critical nature of their functions relating to the Bank. Testing has been completed on vendors considered most critical with tests on important but noncritical vendors continuing.
The Bank has identified only one significant commercial borrower with Year 2000 exposure. The Company requested, received, and reviewed the borrower's certification of compliance. Most of the Company's loans are borrower owned, single-family residences and involve minimal Year 2000 risk to the Bank.
With successful testing having been completed in the most critical areas of operations, the Company continues to focus attention on employee and customer awareness of Year 2000 issues and contingency planning. Employee training and customer awareness plans have been implemented concentrating on readiness and employee/customer interaction. Contingency plans were successfully tested in July 1999 to provide for the possibility of FiServ's dysfunctionality or the Bank's inability to communicate with FiServ and continue to be monitored.
The external costs associated with the Bank's Year 2000 compliance are expected to be less than $50,000. The Bank does not track internal costs as these are related to normal payroll costs. At this time, it is not possible to make a reasonable estimate of the costs to the Company if the Bank or any critical third party provider failed to complete Year 2000 measures as scheduled. However, those costs would likely have a material impact on the Company.
Impact of Accounting Pronouncements and Regulatory Policies
See Note 1 to the Consolidated Financial Statements for a discussion of the anticipated impact of recently issued accounting statements.
Effect of Inflation and Changing Prices
The financial statements and related financial data presented herein have been prepared in accordance with GAAP, which require the measurement of financial position and operating results be in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation is reflected in the increased cost of the Company's operations. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution's performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Item 7a.
Item 7a. Quantitative and Qualitative Disclosures About Market Risk - --------------------------------------------------------------------
For a discussion of the Company's market risk, see "Asset and Liability Management" under Item 7 of this Form 10-K.
Item 8.
Item 8. Financial Statements and Supplementary Data - -----------------------------------------------------
The financial statements listed in the index to Consolidated Financial Statement at Item 14 of this Form 10-K are incorporated by reference into this Item 8 of Part II of this Form 10-K.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and - ------------------------------------------------------------------------- Financial Disclosure - --------------------
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant - ------------------------------------------------------------
Executive Officers
The following table sets forth certain information regarding the executive officers of the Company.
Name Age (1) Position - ---- ------- --------
J. Edward Wells........... 60 Chairman of the Board, President, Chief Executive Officer and Secretary Edwin I. Shealy........... 52 Chief Financial Officer and Treasurer
The following table sets forth certain information regarding the executive officers of the Bank.
Name Age (1) Position - ---- ------- ------------
J. Edward Wells......... 60 President, Chief Executive Officer and Director Edwin I. Shealy......... 52 Chief Financial Officer and Treasurer James H. Wasson, Jr..... 55 Vice President and Secretary John M. Swofford........ 54 Vice President Will B. Ferguson........ 42 Vice President
______________________ (1) As of September 30, 1999.
J. Edward Wells is the President and Chief Executive Officer of the Bank, positions he has held since 1972. Mr. Wells joined the Bank in 1967.
Edwin I. Shealy is the Chief Financial Officer and Treasurer of the Bank, positions he has held since 1990.
James H. Wasson, Jr. is Secretary and Vice President of the Bank responsible for mortgage lending, positions he has held since 1977. Mr. Wasson has been employed by the Bank since 1968.
John M. Swofford is a Vice President of the Bank and manager of the Bank's Laurens branch, positions he has held since 1988. From 1976 to 1988, Mr. Swofford served as the manager of the Bank's Simpsonville branch.
Will B. Ferguson is a Vice President of the Bank, a position he has held since 1995. Mr. Ferguson has been employed by the Bank since 1984.
The information contained under the section captioned "Proposal 1 -- Election of Directors" contained in the Company's Proxy Statement is incorporated herein by reference. Reference is made to the cover page of this report for information regarding compliance with Section 16(a) of the Exchange Act.
Item 11.
Item 11. Executive Compensation - --------------------------------
The information contained under the sections captioned "Executive Compensation" and "Directors' Compensation" in the Proxy Statement is incorporated herein by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management - ------------------------------------------------------------------------
(a) Security Ownership of Certain Beneficial Owners
Information required by this item is incorporated herein by reference to the section captioned "Stock Ownership" in the Proxy Statement.
(b) Security Ownership of Management
The information required by this item is incorporated herein by reference to the section captioned "Stock Ownership" in the Proxy Statement.
(c) Changes in Control
The Company is not aware of any arrangements, including any pledge by any person of securities of the Company, the operation of which may at a subsequent date result in a change in control of the Company.
Item 13.
Item 13. Certain Relationships and Related Transactions - --------------------------------------------------------
The information set forth under the section captioned "Transactions with Management" in the Proxy Statement is incorporated herein by reference.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K - ---------------------------------------------------------------------------
(a) The following documents are filed as part of this report:
1. Financial Statements Page ----
Independent Auditors' Report................................... Consolidated Balance Sheets as of September 30, 1999 and 1998.. Consolidated Statements of Income for the Years Ended September 30, 1999, 1998 and 1997............................ Consolidated Statements of Stockholders' Equity for the Years Ended September 30, 1999, 1998 and 1997........ Consolidated Statements of Cash Flows for the Years Ended September 30, 1999, 1998 and 1997............................ Notes to Consolidated Financial Statements.....................
2. Financial Statement Schedules
All schedules have been omitted as the required information is either inapplicable or included in the Consolidated Financial Statements or related Notes contained in the Annual Report.
3. Exhibits
The exhibits listed below are filed as part of this Annual Report on Form 10-K or are incorporated by reference herein.
3.1 Certificate of Incorporation of Heritage Bancorp, Inc. (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1 (File No. 333-41857)) 3.2 Bylaws of Heritage Bancorp, Inc. (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1 (File No. 333-41857)) 10.1 Employment Agreement with J. Edward Wells (incorporated by reference to the Company's Form 10-K for the year ended September 30, 1998) 10.2 Form of Severance Agreement for Executive Officers (incorporated by reference to the Company's Form 10-K for the year ended September 30, 1998) 10.3 Heritage Federal Bank Employee Severance Compensation Plan (incorporated by reference to the Company's Form 10-K for the year ended September 30, 1998) 10.4 Heritage Bancorp, Inc. 1998 Stock Option Plan (incorporated by reference to the Company's Registration Statement on Form S-8 (File No. 333-77303)) 10.5 Heritage Bancorp, Inc. Management Recognition and Development Plan (incorporated by reference to the Company's Registration Statement on Form S-8 (File No. 333-77303)) 21 Subsidiaries of the Registrant 23 Consent of Independent Auditors 27 Financial Data Schedule
(b) Reports on Form 8-K
No Reports on Form 8-K were filed during the quarter ended September 30, 1999.
Deloitte & Touche LLP 1200 NationsBank Plaza 7 North Laurens Street Greenville, South Carolina 29601 telephone: (864) 240-5700 facsimile: (864) 235-8563
INDEPENDENT AUDITORS' REPORT
Board of Directors Heritage Bancorp, Inc.:
We have audited the accompanying consolidated balance sheets of Heritage Bancorp, Inc. and its subsidiary (the "Company") as of September 30, 1999 and 1998, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended September 30, 1999. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at September 30, 1999 and 1998, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 1999 in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
November 5, 1999 Greenville, South Carolina
HERITAGE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS SEPTEMBER 30, 1999 AND 1998 (In Thousands of Dollars) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
HERITAGE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 (In Thousands of Dollars, Except Per Share Data) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
HERITAGE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 (In Thousands of Dollars) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
HERITAGE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 (In Thousands of Dollars)
- --------------------------------------------------------------------------------
HERITAGE BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 (In Thousands of Dollars) - -------------------------------------------------------------------------------
See notes to consolidated financial statements.
HERITAGE BANCORP, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS YEARS ENDED SEPTEMBER 30, 1999, 1998 AND 1997 - -------------------------------------------------------------------------------
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Conversion to Capital Stock Form of Ownership - Heritage Bancorp, Inc. (the "Corporation") was incorporated under Delaware law in November 1997 by Heritage Federal Savings and Loan Association (the "Association") in connection with the conversion of the Association from a federally chartered mutual savings and loan association to a federally chartered stock savings and loan association, the issuance of the Association's stock to the Corporation and the offer and sale of the Corporation's common stock by the Corporation (the "Conversion").
On April 7, 1998, the Corporation issued approximately 4.6 million shares of common stock for proceeds of approximately $69.4 million (net of costs of $1.4 million). The Association issued all of its outstanding capital stock to the Corporation in exchange for one-half of the net proceeds from the sale of the Corporation's stock. The Corporation accounted for the purchase of the Association in a manner similar to a pooling of interest whereby assets and liabilities of the Association maintain their historical cost basis in the consolidated company.
In April 1998, the Association changed its name to Heritage Federal Bank (the "Bank").
Principles of Consolidation - The accompanying consolidated financial statements include the accounts of the Corporation and its wholly owned subsidiary, the Bank (collectively referred to herein as the "Company"). All significant intercompany balances and transfers have been eliminated in consolidation. The following is a description of the more significant accounting policies which the Company follows in preparing and presenting its consolidated statements.
Basis of Accounting - The accounting and reporting policies of the Company conform to generally accepted accounting principles and, additionally, the Bank conforms to reporting practices generally followed within the savings and loan industry.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the valuation of real estate owned.
Cash and Cash Equivalents - For purposes of reporting cash flows, cash and cash equivalents includes cash on hand, federal funds sold, overnight interest-bearing deposits and amounts due from depository institutions.
Investment and Mortgage-Backed Securities - Debt securities that the Company has the positive intent and ability to hold to maturity are classified as "held-to-maturity" securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling in the near term are classified as "trading" securities and reported at fair value with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity or trading securities are classified as "available-for-sale" securities and reported at fair value with unrealized gains and losses excluded from earnings and reported, net of taxes, as a separate component of equity. No securities have been classified as trading securities.
Realized gains and losses on investment securities are recognized at the time of sale based upon the specific identification method.
Loans - Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal amounts, adjusted for any charge-offs, allowance for loan losses and any deferred fees or costs on originated loans and unamortized premiums or discounts on purchased loans.
Discounts and premiums on purchased residential real estate loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for anticipated prepayments.
Loan origination fees and certain direct origination costs are capitalized and recognized as an adjustment of the yield of the related loan.
Nonaccrual loans are those loans on which the accrual of interest has ceased. Loans are placed on nonaccrual status if, generally, in the opinion of management, principal or interest is not likely to be paid in accordance with the terms of the loan agreement, or when principal or interest is past due more than 90 days. Interest accrued but not collected at the date a loan is placed on nonaccrual status is reversed against interest income in the current period. Interest income on nonaccrual loans is recognized only to the extent received in cash.
Restructured loans are those for which concessions, such as the reduction of interest rates or deferral of interest or principal payments, have been granted due to a deterioration in the borrowers' financial condition. The difference between interest that would have been recognized under the original terms of nonaccrual and renegotiated loans and interest actually recognized on such loans was not a material amount for the years ended September 30, 1999, 1998 and 1997.
Allowances for Losses - The Company maintains allowances for loan losses. Provisions for losses are charged to income when, in the opinion of management, losses are probable.
The allowance for loan losses is based upon management's evaluation of the loan portfolio. The evaluation considers such factors as the delinquency status of loans, current economic conditions, the fair value of the underlying collateral and prior loan loss experience.
Recovery of the carrying value of loans is dependent to some extent on future economic, operating and other conditions that may be beyond the Company's control. Unanticipated future adverse changes in such conditions could result in material adjustments to allowances (and future results of operations).
Loans Held-for-Sale - Loans intended for sale in the secondary market are stated at the lower of cost or estimated market value as determined by outstanding commitments from investors, or current investor market yield requirements, calculated on an aggregate basis. Net unrealized losses are recognized in a valuation allowance by charges against income.
Office Properties and Equipment - Office properties and equipment are stated at cost less accumulated depreciation. Depreciation is computed over the estimated useful lives of the related assets using straight-line and accelerated methods.
Real Estate Acquired in Settlement of Loans - Real estate acquired in settlement of loans initially is stated at fair value at the date of foreclosure, thereby establishing a new cost basis. Valuations are performed periodically by management and allowances for losses are established when the cost of real estate acquired in settlement of loans exceeds fair value less estimated costs to sell. Revenues, expenses and additions to the valuation allowance related to real estate acquired in settlement of loans are charged to operations.
Fair values are based primarily on independent appraisals of market value. Recovery of estimated fair value is dependent to a great extent on economic, operating and other conditions that may be beyond the Company's control. Accordingly, these estimates are particularly susceptible to changes that could result in a material adjustment in the near term.
Advertising Costs - The Company expenses advertising costs as incurred.
Income Taxes - Provisions for income taxes are based on amounts reported in the statements of income (after exclusion of nontaxable income such as interest on municipal securities) and include changes in deferred income taxes. Deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.
Earnings Per Share - As the Company's initial public offering closed on April 7, 1998, earnings per share for the years ended September 30, 1998 and 1997 are not presented.
Basic earnings per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the year adjusted for the weighted average number of unallocated shares held by the Employee Stock Ownership Plan ("ESOP"). Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options (Note 11) were converted into common stock using the treasury stock method.
A reconciliation of the weighted average shares outstanding for the year ended September 30, 1999 follows:
Basic shares 4,179,576 Dilutive impact of stock options 66,947 ---------
Diluted shares 4,246,523 =========
Recently Issued Accounting Standards - The Financial Accounting Standards Board ("FASB") recently issued four new accounting standards that will affect accounting, reporting and disclosure of financial information by the Company. Adoption of these standards is not expected to have a material impact on the financial condition or results of operations. The following is a summary of the standards and their required implementation dates:
. SFAS No. 130, Reporting Comprehensive Income - This statement establishes standards for reporting and disclosure of comprehensive income and its components (revenues, expenses, gains and losses). This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income (including, for example, unrealized holding gains and losses on available-for-sale securities) be reported in a financial statement similar to the statement of income and retained income. The accumulated balance of other comprehensive income is disclosed separately from retained income in the equity section of the balance sheet. The Company adopted this statement for the fiscal year ended September 30, 1999.
. SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information - This statement establishes standards for the way public business enterprises report information about operating segments and establishes standards for related disclosures about products and services, geographic areas and major customers. Operating segments are components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. Information required to be disclosed includes segment profit or loss, certain specific revenue and expense items, segment assets and certain other information. The Company adopted this statement for the fiscal year ended September 30, 1999. As a community-oriented financial institution, substantially all of the Company's operations involve the delivery of loan and deposit products to customers. Management makes operating decisions and assesses performance based on an ongoing review of these community banking operations, which constitute the Company's only operating segment for financial reporting purposes under SFAS No. 131.
. SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities- This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities. The new standard requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. SFAS No. 137 delayed the implementation date for this standard and, as a result, it will become effective for the Company for the fiscal year beginning October 1, 2000. The Company is in the process of evaluating the effect of SFAS No. 133 on its financial position and results of operations, and therefore is unable to estimate the effect of the adoption.
Reclassifications - Certain 1998 and 1997 amounts have been reclassified to conform with the 1999 presentation.
2. INVESTMENT SECURITIES
Investment securities at September 30, 1999 and 1998 are summarized as follows (in thousands of dollars):
The amortized cost and fair value of debt securities at September 30, 1999, by contractual maturity, follow (in thousands of dollars):
There were no gross realized gains on sales of available-for-sale securities in fiscal 1999, 1998 and 1997. Gross realized losses on sales of available-for-sale investment securities were $20,000 in fiscal 1999, none in fiscal 1998 and $13,000 in fiscal 1997.
Investment securities totaling $900,000 at September 30, 1999 were pledged as collateral for public deposits.
3. MORTGAGE-BACKED SECURITIES
Fixed rate mortgage-backed securities are classified as held-to-maturity investments and consist of the following types of investments (in thousands of dollars):
The amortized cost and fair value of mortgage-backed securities by contractual maturity, was as follows at September 30, 1999 (in thousands of dollars):
4. LOANS RECEIVABLE
Loans receivable consist of the following (in thousands of dollars):
Subsequent to August 9, 1989, the Bank may not make loans to one borrower in excess of 15% of unimpaired capital under regulations of the Office of Thrift Supervision ("OTS"). At September 30, 1999, the Company had loans outstanding to individual borrowers ranging up to $6 million and was in compliance with this regulation.
The Bank periodically sells mortgage loans in the secondary market. Generally such loans are sold without recourse and servicing is retained. Servicing loans for others consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors and foreclosure processing. Loan servicing income is recorded on the accrual basis and includes servicing fees received from investors as well as certain charges collected from borrowers, such as late payment fees. At September 30, 1999, 1998 and 1997, the Bank serviced loans for others with total balances outstanding of $3.0 million, $4.1 million and $5.4 million, respectively, and held borrowers' escrow balances in the amounts of $26,000, $32,000 and $41,000, respectively.
The following is a reconciliation of the allowance for loan losses for the years ended September 30, 1999, 1998 and 1997 (in thousands of dollars):
The total principal amount of impaired loans recognized in conformity with FASB Statement No. 114, as amended by FASB Statement No. 118, was immaterial at September 30, 1999 and 1998.
Directors and officers of the Company are customers of the institution in the ordinary course of business. Deposits and loans of directors and officers have terms consistent with those offered to other customers. At September 30, 1999 and 1998, loans to officers or directors of the Company totaled approximately $477,000 and $503,000, respectively.
5. OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are summarized as follows (in thousands of dollars):
September 30, -------------------- 1999 1998
Land $ 233 $ 237 Land improvements 271 271 Office buildings 3,592 3,457 Furniture, fixtures and equipment 1,329 1,254 Total 5,425 5,219 Less accumulated depreciation (1,392) (1,116) -------- --------
Office properties and equipment - net $ 4,033 $ 4,103 ======== ========
6. DEPOSIT ACCOUNTS
Deposit accounts are as follows (in thousands of dollars):
September 30, -------------------- 1999 1998 Account Type
Passbook Accounts (1999 - 1.94%; 1998 - 2.7%) $ 9,589 $ 9,946 -------- -------- NOW Accounts (1999 - .76%; 1998 - 2.1%) 5,290 2,627 -------- -------- Money Market Deposit Accounts (1999 - 4.24%; 1998 - 3.0%) 9,471 828 -------- -------- Certificates of Deposit: 2.01-3.00% 1,131 - 3.01-4.00% 347 5,198 4.01-5.00% 70,718 2,338 5.01-6.00% 96,210 137,246 6.01-7.00% 12,693 46,895 7.01-8.00% 933 1,026 -------- -------- Total certificates of deposit 182,032 192,703 -------- --------
Total $206,382 $206,104 ======== ========
Weighted average rate: Savings certificates 5.28% 5.82% All deposit accounts 4.95% 5.62%
At September 30, 1999, deposit accounts with balances of $100,000 and greater totaled approximately $61.5 million. Deposits in excess of $100,000 are not federally insured. The Company does not accept brokered deposits.
Maturities of certificates of deposits (in thousands of dollars):
Year Ended September 30, 1999
Maturing: Within 1 year $ 137,618 After 1 but within 2 years 41,039 After 2 but within 3 years 2,726 After 3 but within 4 years 414 After 4 but within 5 years 235 ---------
Total $ 182,032 =========
Interest expense by type of deposit is summarized as follows (in thousands of dollars):
Years Ended September 30, ----------------------------------- 1999 1998 1997
Demand accounts: Passbook $ 201 $ 304 $ 340 NOW and Money Market Accounts 297 90 89 Certificate accounts 10,299 11,616 11,575 --------- --------- ---------
Total $ 10,797 $ 12,010 $ 12,004 ========= ========= =========
7. SHORT-TERM AND LONG-TERM BORROWING ARRANGEMENTS WITH FEDERAL HOME LOAN BANK OF ATLANTA
The following table summarizes information regarding short-term Federal Home Loan Bank of Atlanta ("FHLB") advances (in thousands):
The following table summarizes information regarding long-term FHLB advances at September 30, 1999; there were no long-term FHLB advances at September 30, 1998 (in thousands):
Maturity Date Amount Rate
August 9, 2009 $ 14,000,000 4.950% August 13, 2009 $ 6,000,000 6.385%
The long-term FHLB advances listed above have conversion provisions which allow the FHLB to request that the advance be converted into a three month LIBOR-based floating rate advance. The $14 million advance could be converted on a quarterly basis beginning on February 7, 2000. The $6 million advance could be converted on August 13, 2004.
The Company pledged as collateral for these borrowings its FHLB stock and has entered into blanket collateral agreements with the FHLB whereby the Company maintains, free of other encumbrances, qualifying mortgages (as defined) with unpaid principal balances, when discounted at 75% of the unpaid principal balances, of at least 100% of total advances.
Additionally, the Company may borrow under various line of credit programs with the FHLB. Any amounts advanced to the Company under these programs are secured by the Company's investment securities and bear interest at an adjustable rate with interest payable monthly. At September 30, 1999 and 1998, the Company had no amounts outstanding with the FHLB under these lines of credit.
8. INCOME TAXES
The tax effects of significant items comprising the Company's net deferred tax liability as of September 30, 1999 and 1998 are as follows (in thousands of dollars):
The net deferred tax liability at September 30, 1999 and 1998 is included in "other liabilities" in the balance sheet.
The provision for income taxes is summarized as follows (in thousands of dollars):
Years Ended September 30, -------------------------------- 1999 1998 1997
Current provision: Federal $ 2,289 $ 1,842 $ 553 State 223 159 13 ------- ------- -------
Total current 2,512 2,001 566 ------- ------- -------
Deferred (benefit) provision: Federal (404) (61) 443 State (77) (11) 85 ------- ------- -------
Total deferred (481) (72) 528 ------- ------- -------
Total provision for income taxes $ 2,031 $ 1,929 $ 1,094 ======= ======= =======
No valuation allowance on deferred tax assets has been established as management believes that the existing deductible temporary differences will reverse during periods in which the Bank generates net taxable income.
In years ended September 30, 1996 and prior, the Bank was allowed under the Internal Revenue Code to deduct, subject to certain conditions, an annual addition to a reserve for bad debts ("reserve method") in determining taxable income. Legislation enacted in August 1996 repealed the reserve method effective for the Bank beginning with the fiscal year ended September 30, 1997.
Deferred income taxes have been provided on differences between the bad debt reserve for tax purposes determined under the formerly used reserve method and the loan loss allowance for financial accounting purposes only to the extent of differences arising subsequent to December 31, 1987. Under the legislation previously mentioned, the Bank was required to recapture the post-1987 tax bad debt reserve of approximately $834,000 into expense over a six-year period beginning with the fiscal year ended September 30, 1998. Since a deferred tax liability has been provided on this difference, the recapture will have no impact on equity or results of operations.
Retained earnings as of September 30, 1999 includes approximately $4.9 million representing reserve method bad debt reserves originating prior to December 31, 1987 for which no deferred income taxes are required to be provided. These reserves may be included in taxable income if the Bank pays dividends in excess of its accumulated earnings and profits (as defined by the Internal Revenue Code) or in the event of a distribution in partial or complete liquidation of the Bank.
Income taxes differed from amounts computed by applying the statutory federal rate of 34% to income before income taxes as follows (in thousands of dollars):
9. COMMITMENTS AND CONTINGENCIES
Loan Commitments - Loan commitments are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments extend over various periods of time with the majority of such commitments disbursed within a ninety day period. Commitments generally have fixed expiration dates or other termination clauses and may require payments of fees. Commitments to extend credit at fixed rates exposes the Company to some degree of interest rate risk. The Company evaluates each customer's creditworthiness on a case-by-case basis. The type or amount of collateral obtained varies and is based on management's credit evaluation of the potential borrower. At September 30, 1999, the Company had loan commitments, excluding undisbursed portions of interim construction loans, of approximately $2.3 million.
At September 30, 1999, the Company had approved home equity lines of credit approximating $18.6 million, of which approximately $9.4 million was in use and approximately $9.2 million was available for use.
The Company leases various property and equipment. The effect of these leases on the financial position or results of operations is insignificant.
The Company has no additional financial instruments with off-balance sheet risk.
Potential Impact of Changes in Interest Rates - The Company's profitability depends to a large extent on its net interest income, which is the difference between interest income from loans and investments and interest expense on deposits. Like most financial institutions, the Company's short-term interest income and interest expense are significantly affected by changes in market interest rates and other economic factors beyond its control. The Company's interest earning assets consist primarily of long-term, fixed rate and adjustable rate mortgage loans and investments which adjust more slowly to changes in interest rates than its interest bearing liabilities which are deposits. Accordingly, the Company's earnings could be affected adversely during periods of rising interest rates.
Litigation - The Company is involved in legal actions in the normal course of business. Management, based on advice of counsel, does not expect any material losses from current litigation.
Concentrations of Credit Risk - The Company's business activity is principally with customers located in South Carolina. Except for residential loans in the Company's market area, the Company has no other significant concentrations of credit risk.
Employment and Severance Agreement - Both the Corporation and the Bank have entered into an employment agreement with J. Edward Wells, Chief Executive Officer. The employment agreement establishes the duties and compensation of Mr. Wells and has been executed in order to ensure a stable and competent management base. The employment agreement provides for an initial term of three years. The Board of Directors may agree after conducting a performance evaluation of the executive, to extend an employment agreement on each anniversary date for an additional year. The employment agreement generally provides for the continued payment of specified compensation and benefits for the remaining term of the agreement after Mr. Wells is terminated, unless the termination is for "cause" as defined in the employment agreement. Additionally, the employment agreements provide for severance payments if employment is terminated following a change in control in the amount of 2.99 times the average annual compensation paid during the five years immediately preceding the change in control to the respective executive.
Severance Agreements - The Bank and the Corporation have entered into severance agreements with four senior officers ("officers") (none of whom have entered into employment agreements) with an initial term of two years. The Board of Directors may agree after conducting a performance evaluation of the officers, to extend an employment agreement on each anniversary date for an additional year. The severance agreements provide for severance payments in the amount of 2 times annual salary during the 12-month period preceding the change in control in connection with termination or other specified actions in the event of a change in control of the Company.
Employee Severance Compensation Plan ("Severance Plan") - In general, all employees (except for executives and officers who have entered into separate employment or severance agreements) are eligible to participate in the Severance Plan. Under the Severance Plan, employees terminated within 12 months of a change in control are entitled to a severance benefit up to 52 weeks of their current compensation based upon length of service.
10. BENEFIT PLANS
401(k) Plan - The Company provides retirement benefits by means of a 401(k) plan for substantially all employees over the age of twenty-one who have completed six months of employment. Under the plan, employees may defer from 1% to 10% of their compensation to be contributed to the plan. The Company is allowed to make discretionary contributions, subject to certain limitations. Participants are 100% vested upon participation in the plan.
Total expense under the retirement plan for the years ended September 30, 1999, 1998 and 1997 was approximately $28,000, $67,000 and $151,000, respectively.
The Company provides no other post-employment benefits.
Employee Stock Ownership Plan ("ESOP") - The ESOP is a noncontributory retirement plan adopted by the Company effective January 1, 1997 that includes all employees who meet minimum eligibility requirements. The ESOP acquired 370,000 shares of the Corporation's common stock in the Conversion at a price of $15 per share with proceeds of a loan from the Corporation in the amount of approximately $5.6 million. The Bank makes periodic cash contributions to the ESOP in an amount sufficient for the ESOP to make the scheduled payments under the note payable to the Corporation. In connection with the cash distribution (discussed in Note 12), the ESOP received approximately $1.4 million on its shares of the Company's common stock. The ESOP used these funds to prepay a portion of the ESOP's debt obligation to the Company resulting in a charge of approximately $1.2 million of compensation expense and the release of additional share to the plan participants.
The note payable has a term of 15 years, bears interest at 8.5% and requires a level quarterly payment of principal and interest of approximately $124,000. The note is collateralized by the shares of common stock held by the ESOP. As the note is repaid, shares are released from collateral based on the proportion of the payment in relation to total payments required to be made on the loan. The shares released from collateral are then allocated to participants based upon compensation. Compensation expense is determined by multiplying the per share market price of the Corporation's stock at the time the shares are committed to be released by the number of shares to be released. Any difference between the value of the released shares at market and cost is recorded as an addition or deduction to additional paid-in capital. The Company recognized approximately $1.5 million, including cash distribution, and $243,000 in compensation expense in the years ended September 30, 1999 and 1998, respectively, related to the ESOP.
The cost of the unallocated shares is reflected as a reduction of equity. Unallocated shares are considered neither outstanding shares for computation of basic earnings per share nor potentially dilutive securities for computation of diluted earnings per share. Dividends on unallocated ESOP shares are reflected as a reduction in the note payable (and the Bank's contribution reduced accordingly).
Shares released or committed to be released for allocation during the year ended September 30, 1999 and 1998 totaled 80,371 and 12,342, respectively. Shares remaining not released or committed to be released for allocation at September 30, 1999 and 1998 totaled 277,587 and 357,958 and had a market value of approximately $4.7 million and $6.2 million, respectively, based on the trading market price of the Company's stock at that date.
11. STOCK COMPENSATION PLANS
Management Recognition and Development Plan - On April 15, 1999, 185,150 shares of restricted stock were awarded to participants in the Heritage Bancorp, Inc. Management Recognition and Development Plan ("MRDP") that was approved at the Company's Annual Meeting of Stockholders on February 3, 1999. The restricted stock awards vest over a five-year period. The 185,150 shares of stock were issued from treasury stock on the date of the grant. The Company recorded the stock award at the market value on the date of grant ($18.75 per share) as unearned MRDP shares in stockholders' equity and will amortize the unearned MRDP shares to compensation expense over the vesting period.
As a result of the payment of the cash distribution (see Note 12), approximately $741,000 was paid on unvested shares included in the Company's MRDP and such payment was accounted for as compensation expense. Unearned MRDP shares were reduced (with a corresponding charge to additional paid-in capital) to reflect the reduction in the value of the shares held by the Plan.
Stock Option Plan - On April 15, 1999, the Company adopted the 1998 Heritage Bancorp, Inc. Stock Option Plan ("SOP"), which allows the granting to management and directors the option to purchase common stock of the Corporation ("options") aggregating to 416,588 shares. On April 15, 1999, the 416,588 options were granted to employees and non-employee directors. The exercise price equaled the fair market value of the shares on the date of grant; therefore, no compensation expense was recorded. The non-employee director options vest immediately and the employee options vest 50% on date of grant and 50% one year from date of grant. Each option has a term of 10 years.
A summary of stock option activity under the SOP is detailed as follows:
The following table summarized information about stock options outstanding at September 30, 1999:
Weighted Average Remaining Contractual Exercise Number Life in Price Outstanding Years
$15.10 416,588 9.5
In connection with the cash distribution (see Note 12), the exercise price of all options was adjusted in accordance with FASB Emerging Issues Task Force Issue No. 90-9 "Changes to Fixed Employee Stock Option Plans as a Result of Equity Restructuring." The weighted average reduction in exercise price was $3.65 per share.
The Company accounts for stock option awards using the intrinsic value method and has recognized no compensation expense for the year ended September 30, 1999. SFAS 123, Accounting for Stock-Based Compensation, permits the use of the intrinsic value method; however, requires the Company to disclose the pro forma net income and earnings per share as if the stock based compensation had been accounted for using the fair value method. Had the compensation costs for the Company's stock option plan been determined based on the fair value method, the Company's net income and earnings per share would have been reduced to the pro form amounts indicated below (in thousands except per share data):
Amount
Net income: As reported $ 2,356 Pro forma $ 1,623
Basic earnings per share: As reported $ 0.56 Pro forma $ 0.39
Diluted earnings per share: As reported $ 0.56 Pro forma $ 0.38
Weighted average fair value of an option share granted during the year $ 3.93
The fair value of stock options granted by the Company was estimated through the use of the Black-Scholes option pricing model applying the following assumptions:
Risk-free interest rate 5.05% Expected option life 5 years Expected volatility 25% Expected dividend yield 2%
12. EQUITY
Liquidation Account - At the time of Conversion, the Bank established a liquidation account totaling approximately $29.8 million for the benefit of eligible account holders as of June 30, 1996 and December 31, 1997 who continue to maintain their accounts at the Bank after the Conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the Bank, each eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held before any distribution may be made to the Corporation with respect to the Bank's capital stock.
Dividends - The Corporation's sources of income and funds for dividends to its stockholders are earnings on its investments and dividends from the Bank. The Corporation is not subject to any regulatory restrictions on the payment of dividends to its stockholders. However, the Bank's primary regulator, the Office of Thrift Supervision ("OTS"), has regulations that impose certain restrictions on payment of dividends to the Corporation.
Current regulations of the OTS allow the Bank (based upon its current capital level and supervisory status assigned by the OTS) to pay a dividend of up to 100% of net income to date during the calendar year, plus 50% of its surplus capital existing at the beginning of the calendar year. Supervisory approval is not required, but 30 days prior notice to the OTS is required. Any capital distribution in excess of this amount would require supervisory approval. Capital distributions are further restricted should the Bank's capital level fall below the full phased-in capital requirements of the OTS. In no case will the Bank be allowed to make a capital distribution in excess of the balance of the liquidation account. The Bank declared dividends to the Corporation amounting to $1.3 million and $694,000 in the years ended September 30,1999 and 1998, respectively.
Distributions - On June 22, 1999 the Corporation paid a cash distribution of $16.1 million, or $4.00 per share, to its stockholders. The distribution has been accounted for as a return of capital and reflected in the Company's financial records as a reduction of additional paid-in capital.
Share Repurchases - OTS regulations also place restrictions for a three-year period after the conversion on the Corporation with respect to repurchases of its common stock. Generally, the Corporation is not allowed to repurchase stock in the first year after Conversion, and is allowed to repurchase 5% of its outstanding shares in each of the next two years after Conversion. However, in the year ended September 30, 1999, the OTS approved two stock repurchase programs which allow the Corporation to purchase up to 416,588 shares of its common stock. During the year ended September 30, 1999, the Corporation purchased 387,130 shares of its common stock under these repurchase programs. Restrictions apply, unless the OTS approves a waiver for benefit plans.
Regulatory Capital Requirements - The Corporation is not subject to any regulatory capital requirements. However, the Bank is subject to various regulatory capital requirements administered by the federal financial institution regulatory agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification also are subject to qualitative judgments by the regulators about components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios. Under regulations of the OTS, the Company must satisfy certain minimum capital requirements, including a leverage capital requirement (expressed as a ratio of core or Tier I capital to adjusted total assets) and risk-based capital requirements (expressed as a ratio of core or Tier I capital and total capital to total risk-weighted assets). As an OTS regulated institution, the Bank also is subject to a minimum tangible capital requirement (expressed as a ratio of tangible capital to adjusted total assets). In measuring compliance with all three capital standards, institutions must deduct from their capital (with several exceptions primarily for mortgage banking subsidiaries and insured depository institution subsidiaries) their investments in, and advances to, subsidiaries engaged (as principal) in activities not permissible for national banks, and certain other adjustments. Management believes, as of September 30, 1999, that the Bank meets all capital adequacy requirements to which it is subject.
As of September 30, 1999 and 1998, the most recent respective notifications from the OTS classified the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table below. Management believes that there are no conditions or events that would have changed the Bank's category since the most recent notification.
The following is a reconciliation of the Bank's equity reported in the financial statements under generally accepted accounting principles to OTS regulatory capital requirements (in thousands of dollars):
The Bank's actual and required capital amounts and ratios are summarized as follows (in thousands of dollars):
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107, Disclosures About Fair Value of Financial Instruments, requires disclosure of fair value information regarding financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate a value. The stated and estimated fair value amounts of the Company's financial instruments, as of September 30, 1999 and 1998, are summarized below (in thousands of dollars):
The Company had off-balance sheet financial commitments, which include commitments to originate loans, undisbursed portions of interim construction loans and unused lines of credit (see Note 10). Since these commitments are based on current rates, the commitment amount is considered to be a reasonable estimate of fair value.
Estimated fair values were determined using the following methods and assumptions:
Cash and Cash Equivalents - Cash and cash equivalents have maturities of three months or less and, accordingly, the carrying amounts of such instruments are deemed to be reasonable estimates of fair value.
Mortgage-Backed Securities and Investment Securities - Fair values are based on quoted market prices where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Loans Receivable, Net - Fair values for loans are estimated by segregating the portfolio by type of loan and discounting scheduled cash flows using current market interest rates for loans with similar terms, reduced by an estimate of credit losses inherent in the portfolio.
Loans Held-for-Sale - Loans held-for-sale are valued at the lower of cost or market as determined by outstanding commitments from investors or current investor yield requirements calculated on an aggregate loan basis.
Federal Home Loan Bank Stock - Investment in stock of the FHLB is required by law for every federally insured savings institution. No ready market exists for this stock and it has no quoted market value. However, redemption of this stock has historically been at par value. Accordingly, the carrying amount is deemed to be a reasonable estimate of fair value.
Deposits - As required by SFAS No. 107, fair values for demand deposits, money market accounts and savings accounts are the amounts payable on demand as of the reporting date (i.e., their stated amounts). The fair value of certificates of deposit is estimated by discounting the contractual cash flows using current market interest rates for accounts with similar maturities.
FHLB Advances - Fair values for FHLB advances are estimated using a discounted cash flow technique that applies interest rates currently being offered on advances to a schedule of aggregate expected monthly maturities of FHLB advances.
Accrued Interest Receivable and Payable - The stated amounts of accrued interest receivable and payable approximate the fair value.
Limitations - Fair value estimates are made at a specific point in time, based on relevant market information and information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company's financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision. Changes in assumptions could significantly affect the estimates.
Fair value estimates are based on existing on-and-off balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. For example, a significant asset not considered a financial asset is premises and equipment. In addition, tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any of the estimates.
14. CONDENSED PARENT COMPANY FINANCIAL STATEMENTS
The following condensed balance sheets, as of September 30, 1999 and 1998 and condensed statements of income and cash flows for the year ended September 30, 1999 and the period from April 6, 1998 (date of incorporation) to September 30, 1998 for Heritage Bancorp, Inc. should be read in conjunction with the consolidated financial statements and the notes thereto (in thousands of dollars):
15. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
Summarized unaudited quarterly operating results for the years ended September 30, 1999 and 1998 are as follows (in thousands, except per share data):
(1) Heritage Bancorp, Inc.'s initial public offering closed on April 6, 1999. For purposes of earnings per share calculations for the third quarter, shares issued on April 6, 1999 have been assumed to be outstanding as of April 1, 1999.
(2) Includes a $1.9 million compensation charge related to the cash distribution of $4.00 per share.
SIGNATURES
Pursuant to the requirements of section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HERITAGE BANCORP, INC.
Date: December 27, 1999 By: /s/ J. Edwards Wells ----------------------------- J. Edward Wells President and Chief Executive Officer
Pursuant to the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.