SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended September 30, 1998
OR
[ ] TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________________ to ________________
Commission File No. 0-22219
NEWSOUTH BANCORP, INC.
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(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 56-1999749
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(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1311 CAROLINA AVENUE, WASHINGTON, NORTH CAROLINA 27889-2047
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(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (252) 946-4178
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Common stock, par value $.01 per share
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(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or such shorter period that the registrant was required to
file such reports) and (2) has been subject to such filing requirements for the
past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
As of December 10, 1998, the aggregate market value of the 3,282,401 shares of
Common Stock of the registrant issued and outstanding held by non-affiliates on
such date was approximately $59.1 million based on the closing sale price of
$18.00 per share of the registrant's Common Stock as listed on the Nasdaq
National Market System. For purposes of this calculation, it is assumed that
directors, executive officers and beneficial owners of more than 5% of the
registrant's outstanding voting stock are affiliates.
Number of shares of Common Stock outstanding as of December 10, 1998: 4,088,910.
DOCUMENTS INCORPORATED BY REFERENCE
The following lists the documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:
1. Portions of the Annual Report to Stockholders for the fiscal year
ended September 30, 1998. (Parts I, II and IV)
2. Portions of Proxy Statement for 1999 Annual Meeting of Stockholders.
(Part III)
<PAGE>
PART I
ITEM 1. BUSINESS
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GENERAL
NewSouth Bancorp, Inc. (the "Company") was incorporated under the laws of
the State of Delaware in October 1996 at the direction of the Board of Directors
of Home Savings Bank, SSB (the "Savings Bank") for the purpose of serving as the
holding company of the Savings Bank upon completion of its conversion from
mutual to stock form (the "Stock Conversion"), and then as a bank holding
company of NewSouth Bank (the "Bank") following the conversion of the Savings
Bank from a North Carolina-chartered savings bank to a commercial bank (the
"Bank Conversion"). The Stock Conversion and the Bank Conversion were completed
in April 1997 and the Company is now the holding company for the Bank. The
Company's principal business is overseeing the business of the Bank and
investing the portion of the net Stock Conversion proceeds retained by it.
NewSouth Bank. The Bank is a North Carolina-chartered commercial bank
headquartered in Washington, North Carolina and serves eastern North Carolina.
The Bank was chartered by the State of North Carolina in 1902 under the name The
Home Building and Loan Association. The Bank received federal insurance of its
deposits in 1959. In 1992, the Bank converted to a North Carolina-chartered
savings bank, at which time it adopted the name Home Savings Bank, SSB. Upon
completion of the Bank Conversion in April 1997, the Bank became a North
Carolina-chartered commercial bank and adopted its present name.
The Bank's principal business consists of attracting deposits from the
general public and investing these funds in loans secured by first mortgages on
owner-occupied, single-family residences in the Bank's market area, commercial
real estate loans, commercial business loans and consumer loans.
The Bank derives its income principally from interest earned on loans and
investments and, to a lesser extent, loan servicing and other fees and gains on
the sale of loans and investments. The Bank's principal expenses are interest
expense on deposits and borrowings and noninterest expense such as compensation
and employee benefits, office occupancy expenses and other miscellaneous
expenses. Funds for these activities are provided principally by deposits,
repayments of outstanding loans and investments and operating revenues.
MARKET AREA
Although the Company makes loans and obtains deposits throughout eastern
North Carolina, the Company's primary market area consists of Beaufort, Craven,
Lenoir, Nash, Pasquotank and Pitt Counties in North Carolina, which are the
counties in which the Bank's offices are located. As of September 30, 1998,
management estimates that more than 95% of deposits and 90% of loans came from
its primary market area.
The economy of the Company's primary market area is diversified, with
employment distributed among manufacturing, agriculture and non-manufacturing
activities. Major employers in the area include Weyerhaeuser Company, Dupont,
Abbott Laboratories, East Carolina University and Pitt Memorial Hospital. The
unemployment rate in the Company's market area is below the national average,
though higher than the unemployment rate for the State of North Carolina.
The Company estimates the population of its primary market area to be
approximately 430,000. This compares to a population of approximately 400,000 in
1990. The median household income of the Company's primary market area is
$23,256, as compared to $26,647 for North Carolina as a whole.
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LENDING ACTIVITIES
General. The Company's gross loan portfolio totaled $241.9 million at
September 30, 1998, representing 85.9% of total assets at that date. It is the
Company's policy to concentrate its lending within its market area. At September
30, 1998, $91.5 million, or 37.8% of the Company's gross loan portfolio,
consisted of single-family, residential mortgage loans. The Company's
construction loans totaled $27.8 million, or 11.5% of the Company's gross loan
portfolio, at September 30, 1998. The Company also originates a significant
amount of commercial real estate loans. At September 30, 1998, commercial real
estate loans amounted to $51.5 million, or 21.3% of the Company's gross loan
portfolio. In recent years, the Company has sought to increase originations of
commercial business loans and consumer loans. At September 30, 1998, commercial
business loans totaled $21.8 million, or 9.0% of the Company's gross loan
portfolio, and consumer loans totaled $48.4 million, or 20.0% of the Company's
gross loan portfolio. To a lesser extent, the Company also originates
multi-family residential and commercial real estate loans.
Loan Portfolio Composition. The following table sets forth selected data
relating to the composition of the Company's loan portfolio by type of loan at
the dates indicated. At September 30, 1998, the Company had no concentrations of
loans exceeding 10% of gross loans other than as disclosed below.
<TABLE>
<CAPTION>
At September 30,
--------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---------------- ---------------- ---------------- ---------------- ----------------
Amount % Amount % Amount % Amount % Amount %
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Residential mortgage loans:
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Single-family residential ........ $ 91,546 37.8% $ 67,959 31.7% $ 58,576 33.7% $ 67,736 43.0% $ 74,364 49.8%
Multi-family residential ......... 848 .4 946 .4 998 .6 2,315 1.5 2,412 1.6
Construction ..................... 27,817 11.5 33,249 15.5 35,240 20.3 32,062 20.4 31,663 21.2
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total residential mortgage loans 120,211 49.7 102,154 47.6 94,814 54.6 102,113 64.9 108,439 72.6
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Commercial loans:
Commercial real estate ........... 51,480 21.3 45,990 21.4 31,168 17.9 21,890 13.9 17,098 11.4
Commercial business .............. 21,823 9.0 16,449 7.7 10,328 6.0 3,698 2.4 1,777 1.2
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total commercial loans ......... 73,303 30.3 62,439 29.1 41,496 23.9 25,588 16.3 18,875 12.6
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Consumer loans:
Automobile ....................... 4,575 1.9 4,611 2.2 4,185 2.4 2,532 1.6 1,986 1.3
Savings account loans ............ 470 .2 617 .3 549 .3 661 .4 454 .3
Home equity loans ................ 22,898 9.5 21,665 10.1 17,949 10.3 15,514 9.9 11,930 8.0
Other ............................ 20,443 8.4 22,996 10.7 14,740 8.5 10,977 6.9 7,767 5.2
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total consumer loans ........... 48,386 20.0 49,889 23.3 37,423 21.5 29,684 18.8 22,137 14.8
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total ........................ 241,900 100.00% 214,482 100.00% 173,733 100.00% 157,385 100.00% 149,451 100.00%
-------- ====== -------- ====== -------- ====== -------- ====== -------- ======
Less:
Loans in process.................. 12,930 12,717 15,245 10,626 11,506
Deferred fees and discounts....... 606 731 456 341 289
Allowance for loan losses......... 3,365 3,249 2,351 1,877 1,977
-------- -------- -------- -------- --------
Total........................... $224,999 $197,785 $155,681 $144,541 $135,679
======== ======== ======== ======== ========
</TABLE>
3
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Loan Maturities. The following table sets forth certain information at
September 30, 1998 regarding the dollar amount of loans maturing in the
Company's portfolio based on their contractual terms to maturity, including
scheduled repayments of principal. Demand loans, loans having no stated schedule
of repayments and no stated maturity, and overdrafts are reported as due in one
year or less. The table does not include any estimate of prepayments which
significantly shorten the average life of mortgage loans and may cause the
Company's repayment experience to differ from that shown below. Loan balances
are net of loans in process.
<TABLE>
<CAPTION>
Due After Due After
1 Through 5 or More
Due One Year 5 Years After Years After
or Less September 30, 1998 September 30, 1998 Total
------- ------------------ ------------------ -----
(In thousands)
<S> <C> <C> <C> <C>
Real estate loans ...... $ 86,059 $ 51,469 $ 41,257 $178,785
Commercial ............. 17,285 12,925 1,137 31,347
Other .................. 7,511 10,684 643 18,838
-------- -------- -------- --------
Total ............. $110,855 $ 75,078 $ 43,037 $228,970
======== ======== ======== ========
</TABLE>
The following table sets forth at September 30, 1998 the dollar amount of
all loans due one year or more after September 30, 1998 which have predetermined
interest rates and have floating or adjustable interest rates.
Predetermined Floating or
Rate Adjustable Rates
------------- ----------------
(In thousands)
Real estate loans...................... $ 77,174 $ 15,548
Commercial............................. 9,836 4,228
Other.................................. 11,049 280
----------- -----------
Total.............................. $ 98,059 $ 20,056
=========== ===========
Scheduled contractual principal repayments of loans do not reflect the
actual life of such assets. The average life of loans can be substantially less
than their contractual terms because of prepayments. In addition, due-on-sale
clauses on loans generally give the Bank the right to declare a loan 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 mortgage loans tends to increase when current mortgage loan market rates
are substantially higher than rates on existing mortgage loans and, conversely,
decrease when current mortgage loan market rates are substantially lower than
rates on existing mortgage loans.
Originations, Purchases and Sales of Loans. The Bank generally has
authority to originate and purchase loans secured by real estate located
throughout the United States. Consistent with its emphasis on being a
community-oriented financial institution, the Bank concentrates its lending
activities in its market area.
The Bank's loan originations are derived from a number of sources,
including referrals from depositors and borrowers, repeat customers,
advertising, calling officers as well as walk-in customers. The Bank's
solicitation programs consist of advertisements in local media, in addition to
participation in various community organizations and events. Real estate loans
are originated by the Bank's loan personnel. All of the Bank's loan personnel
are salaried, and though the Bank does not compensate loan personnel on a
commission basis for loans originated, it does pay an incentive percentage of
closed mortgage loan volume once a defined threshold has been achieved by the
participant. With the exception of applications for boat or recreational vehicle
loans, which may be originated on an indirect basis through an arrangement with
dealers, loan applications are accepted at the Bank's offices. In addition, the
Bank has several salaried loan originators who travel to meet prospective
borrowers and take applications. In all cases, the Bank has final
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<PAGE>
approval of the application. Historically, the Bank generally has not purchased
loans. However, the Bank may in the future consider making limited loan
purchases, including purchases of commercial loans.
In recent years, the Bank has sold or exchanged for mortgage-backed
securities a significant amount of fixed-rate, single-family mortgage loans that
it originated. During the years ended September 30, 1998, 1997 and 1996, these
transactions totaled $54.1 million, $31.7 million and $53.2 million,
respectively. Such loans are sold to or exchanged with the Federal Home Loan
Mortgage Corporation ("FHLMC"). The Bank generally retains servicing on loans
sold or exchanged.
Loan Underwriting Policies. The Bank's lending activities are subject to
the Bank's written, non-discriminatory underwriting standards and to loan
origination procedures prescribed by the Bank's Board of Directors and its
management. Detailed loan applications are obtained to determine the borrower's
ability to repay, and the more significant items on these applications are
verified through the use of credit reports, financial statements and
confirmations. All loans are presented weekly by the management loan committee
to a loan committee of the Board of Directors of the Bank, made up of three
outside directors who serve on a rotating basis. The President does not serve on
the loan committee of the Board of Directors. Individual officers of the Bank
have been granted authority by the Board of Directors to approve consumer and
commercial loans up to varying specified dollar amounts, depending upon the type
of loan. In addition, committees of loan officers have loan authorities greater
than individual authorities. These authorities are based on aggregate borrowings
of an individual or entity. All loans to a single borrower aggregating in excess
of $500,000 must be approved by the full Board of Directors. On a monthly basis,
the full Board of Directors reviews the actions taken by the loan committee.
Applications for single-family real estate loans are underwritten and
closed in accordance with the standards of FHLMC. Generally, upon receipt of a
loan application from a prospective borrower, a credit report and verifications
are ordered to verify specific information relating to the loan applicant's
employment, income and credit standing. If a proposed loan is to be secured by a
mortgage on real estate, an appraisal of the real estate is usually undertaken
either by an appraiser approved by the Bank and licensed by the State of North
Carolina or by qualified Bank personnel. In the case of single-family
residential mortgage loans, except when the Bank becomes aware of a particular
risk of environmental contamination, the Bank generally does not obtain a formal
environmental report on the real estate at the time a loan is made. A formal
environmental report may be required in connection with nonresidential real
estate loans.
It is the Bank's policy to record a lien on the real estate securing a loan
and to obtain title insurance which insures that the property is free of prior
encumbrances and other possible title defects. Borrowers must also obtain hazard
insurance policies prior to closing and, when the property is in a flood plain
as designated by the Department of Housing and Urban Development, pay flood
insurance policy premiums.
With respect to single-family residential mortgage loans, the Bank makes a
loan commitment of between 15 and 30 days for each loan approved. If the
borrower desires a longer commitment, the commitment may be extended for good
cause and upon written approval. Fees of between $175 and $425 are charged in
connection with the issuance of a commitment letter. The interest rate is
guaranteed for the commitment period.
If the amount of a residential loan originated or refinanced exceeds 80% of
the lessor of the appraised value or contract price, the Bank's policy generally
is to obtain private mortgage insurance at the borrower's expense on that
portion of the principal amount of the loan that exceeds 80%. The Bank will make
a single-family residential mortgage loan with up to a 95% loan-to-value ratio
if the required private mortgage insurance is obtained. The Bank generally
limits the loan-to-value ratio on commercial real estate mortgage loans to 80%,
although the loan-to-value ratio on commercial real estate loans in limited
circumstances has been as high as 85%. The Bank limits the loan-to-value ratio
on multi-family residential real estate loans to 80%.
The Bank is subject to regulations that limit the amount the Bank can lend
to one borrower. See " -- Regulation -- Limits on Loans to One Borrower." Under
these limits, the Bank's loans-to-one-borrower were limited to $3.7
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<PAGE>
million at September 30, 1998. At that date the Bank had no lending
relationships in excess of the loans-to-one-borrower limit.
Interest rates charged by the Bank on loans are affected principally by
competitive factors, the demand for such loans and the supply of funds available
for lending purposes. These factors are, in turn, affected by general economic
conditions, monetary policies of the federal government, including the Federal
Reserve Board, legislative tax policies and government budgetary matters.
Single-Family Residential Real Estate Lending. The Bank historically has
been and continues to be an originator of single-family, residential real estate
loans in its market area. At September 30, 1998, single-family, residential
mortgage loans, excluding home improvement loans, totaled $91.5 million, or
37.8% of the Company's gross loan portfolio.
The Bank originates fixed-rate mortgage loans at competitive interest
rates. At September 30, 1998, $54.8 million, or 22.7%, of the Company's gross
loan portfolio was comprised of fixed-rate mortgage loans. Generally, the
Company retains fixed-rate mortgages with maturities 15 years or less while
fixed-rate loans with longer maturities may be retained in portfolio or sold in
the secondary market. The Bank also offers FHA and VA mortgage loans in its
market area, which are underwritten and closed by a correspondent lender.
The Bank also offers adjustable-rate residential mortgage loans. The
adjustable-rate loans currently offered by the Bank have interest rates which
adjust every one, three or five years from the closing date of the loan or on an
annual basis commencing after an initial fixed-rate period of one, three or five
years in accordance with a designated index (the primary index utilized by the
Bank is the weekly average yield on U.S. Treasury securities adjusted to a
constant comparable maturity equal to the loan adjustment period, as made
available by the Federal Reserve Board (the "Treasury Rate")), plus a stipulated
margin. The Bank offers adjustable-rate loans that meet FHLMC standards, as well
as loans that do not meet such standards. The Bank's adjustable-rate
single-family residential real estate loans that do not meet FHLMC standards
have a cap of generally 2% on any increase in the interest rate at any
adjustment date, and include a cap on the maximum interest rate over the life of
the loan, which cap generally is 3% to 4.5% above the initial rate. In return
for providing a relatively low cap on interest rate increases over the life of
the loan, the Bank's adjustable-rate loans provide for a floor on the minimum
interest rate over the life of the loan, which floor generally is the initial
rate. Further, the Bank generally does not offer "teaser" rates i.e., initial
rates below the fully indexed rate, on such loans. The adjustable-rate mortgage
loans offered by the Bank that do conform to FHLMC standards have a cap of 6%
above the initial rate over the life of a loan but do not include a floor, may
be offered with a teaser rate and have a 25 basis point lower margin above the
index on which the interest rate is based. All of the Bank's adjustable-rate
loans require that any payment adjustment resulting from a change in the
interest rate of an adjustable-rate loan be sufficient to result in full
amortization of the loan by the end of the loan term and, thus, do not permit
any of the increased payment to be added to the principal amount of the loan, or
so-called negative amortization. At September 30, 1998, $36.7 million, or 30.5%,
of the Company's residential mortgage loans were adjustable-rate loans.
The retention of adjustable-rate loans in the Company's portfolio helps
reduce the Company's exposure to increases or decreases in prevailing market
interest rates. However, there are unquantifiable credit risks resulting from
potential increases in costs to borrowers in the event of upward repricing of
adjustable-rate loans. It is possible that during periods of rising interest
rates, the risk of default on adjustable-rate loans may increase due to
increases in interest costs to borrowers. Further, although adjustable-rate
loans allow the Company to increase the sensitivity of its interest-earning
assets to changes in interest rates, the extent of this interest sensitivity is
limited by the initial fixed-rate period before the first adjustment and the
lifetime interest rate adjustment limitations. Accordingly, there can be no
assurance that yields on the Company's adjustable-rate loans will fully adjust
to compensate for increases in the Company's cost of funds.
Construction Lending. The Bank also offers residential and commercial
construction loans, with a substantial portion of such loans originated to date
being for the construction of owner-occupied, single-family dwellings in the
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<PAGE>
Bank's primary market area. Residential construction loans are offered primarily
to individuals building their primary or secondary residence, as well as to
selected local developers to build single-family dwellings. Generally, loans to
owner/occupants for the construction of owner-occupied, single-family
residential properties are originated in connection with the permanent loan on
the property and have a construction term of six to 18 months. Such loans are
offered on a fixed-rate or adjustable-rate basis. Interest rates on residential
construction loans made to the owner/occupant have interest rates during the
construction period of 1% above the rate offered by the Bank on the permanent
loan product selected by the borrower. Upon completion of construction, the
permanent loan rate will be set at the rate then offered by the Bank on that
permanent loan product, except that if the permanent loan rate would be above
the construction loan rate then the borrower can maintain the same rate as on
the construction loan. Interest rates on residential construction loans to
builders are set at the prime rate plus a margin of between .50% and 1% or at
the Treasury Rate plus a margin of between 3% and 4.5%, and adjust annually.
Interest rates on commercial construction loans are based on the prime rate plus
a negotiated margin of between 0% and 1% and adjust annually, with construction
terms generally not exceeding 18 months. Advances are made on a percentage of
completed basis. At September 30, 1998, $27.8 million, or 11.5%, of the
Company's gross loan portfolio consisted of construction loans, virtually all of
which was secured by single-family residences.
Prior to making a commitment to fund a loan, the Bank requires both an
appraisal of the property by appraisers approved by the Board of Directors and a
study of the feasibility of the proposed project. The Bank also reviews and
inspects each project at the commencement of construction and either weekly or
biweekly during the term of the construction loan. The Bank generally charges a
.50% to 1% construction loan fee for speculative builder loans. For construction
loans to owner-occupants, the Bank generally charges a 1% construction loan fee
and a $425 commitment fee.
Construction financing generally is considered to involve a higher degree
of risk of loss than long-term financing on improved, occupied real estate. Risk
of loss on a construction loan is dependent largely upon the accuracy of the
initial estimate of the property's value at completion of construction or
development and the estimated cost (including interest) of construction. During
the construction phase, a number of factors could result in delays and cost
overruns. If the estimate of construction costs proves to be inaccurate and the
borrower is unable to meet the Bank's requirements of putting up additional
funds to cover extra costs or change orders, then the Bank will demand that the
loan be paid off and, if necessary, institute foreclosure proceedings, or
refinance the loan. If the estimate of value proves to be inaccurate, the Bank
may be confronted, at or prior to the maturity of the loan, with collateral
having a value which is insufficient to assure full repayment. The Bank has
sought to minimize this risk by limiting construction lending to qualified
borrowers (i.e., borrowers who satisfy all credit requirements and whose loans
satisfy all other underwriting standards which would apply to the Bank's
permanent mortgage loan financing for the subject property) in the Bank's market
area. On loans to builders, the Bank works only with selected builders with whom
it has experience and carefully monitors the creditworthiness of the builders.
Builder relationships are analyzed and underwritten annually by the Bank's
credit administration department.
Multi-Family Residential and Commercial Real Estate Lending. The Bank
originates commercial real estate loans, as well as a limited amount of
multi-family residential real estate loans, generally limiting such originations
to loans secured by properties in its primary market area and to borrowers with
whom it has other loan relationships. The Company's multi-family residential
loan portfolio consists primarily of loans secured by small apartment buildings,
and the commercial real estate loan portfolio includes loans to finance the
acquisition of small office buildings and commercial and industrial buildings.
Such loans generally range in size from $1.0 million to $3.4 million. At
September 30, 1998, multi-family residential and commercial real estate loans
totaled $1.0 million and $51.5 million, respectively, which amounted to .4% and
21.3%, respectively, of the Company's gross loan portfolio. Multi-family and
commercial real estate loans are originated either for 15 year terms with
interest rates that adjust every one, three or five years based on either the
prime rate as quoted in The Wall Street Journal plus a negotiated margin of
between 0% and 1% for shorter term loans or, for longer term loans, or the
Treasury Rate plus a negotiated margin of between 3% and 4.5%, or on a
fixed-rate basis with interest calculated on a 15 year amortization schedule
with a balloon payment due after five years.
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<PAGE>
Multi-family residential and commercial real estate lending entails
significant additional risks as compared with single-family residential property
lending. Multi-family residential and commercial real estate loans typically
involve larger loan balances to single borrowers or groups of related borrowers.
The payment experience on such loans typically is dependent on the successful
operation of the real estate project, retail establishment or business. These
risks can be significantly affected by supply and demand conditions in the
market for office, retail and residential space, and, as such, may be subject to
a greater extent to adverse conditions in the economy generally. To minimize
these risks, the Bank generally limits itself to its market area or to borrowers
with which it has prior experience or who are otherwise known to the Bank. It
has been the Bank's policy to obtain annual financial statements of the business
of the borrower or the project for which commercial or multi-family residential
real estate loans are made. In addition, in the case of commercial mortgage
loans made to a partnership or a corporation, the Bank seeks, whenever possible,
to obtain personal guarantees and annual financial statements of the principals
of the partnership or corporation.
Commercial Lending. The Company's commercial loans consist of loans secured
by commercial real estate and commercial business loans, which are not secured
by real estate. For a discussion of the Company's commercial real estate lending
see "-- Multi-Family and Commercial Real Estate Lending."
In recent years, the Bank has emphasized commercial business lending. The
Bank originates commercial business loans to small and medium sized businesses
in its market area. The Bank's commercial borrowers are generally small
businesses engaged in manufacturing, distribution or retailing, or professionals
in healthcare, accounting and law. Commercial business loans are generally made
to finance the purchase of inventory, new or used equipment or commercial
vehicles and for short-term working capital. Such loans generally are secured by
equipment and inventory, and, if possible, cross-collateralized by a real estate
mortgage, although commercial business loans are sometimes granted on an
unsecured basis. Such loans generally are made for terms of five years or less,
depending on the purpose of the loan and the collateral, with loans to finance
operating expenses made for one year or less, with interest rates that adjust at
least annually at a rate equal to the prime rate as stated in The Wall Street
Journal plus a margin of between 0% and 2%. Generally, commercial loans are made
in amounts ranging between $5,000 and $250,000. At September 30, 1998,
commercial business loans totaled $21.8 million, or 9.0% of the Company's gross
loan portfolio.
The Bank underwrites its commercial business loans on the basis of the
borrower's cash flow and ability to service the debt from earnings rather than
on the basis of underlying collateral value, and the Bank seeks to structure
such loans to have more than one source of repayment. The borrower is required
to provide the Bank with sufficient information to allow the Bank to make its
lending determination. In most instances, this information consists of at least
two years of financial statements, a statement of projected cash flows, current
financial information on any guarantor and any additional information on the
collateral. For loans with maturities exceeding one year, the Bank requires that
borrowers and guarantors provide updated financial information at least annually
throughout the term of the loan.
The Bank's commercial business loans may be structured as short-term loans,
term loans or as lines of credit. Short-term commercial business loans are for
periods of 12 months or less and are generally self-liquidating from asset
conversion cycles. Commercial business term loans are generally made to finance
the purchase of assets and have maturities of five years or less. Commercial
business lines of credit are typically made for the purpose of providing working
capital and are usually approved with a term of 12 months and are reviewed at
that time to see if extension is warranted. The Bank also offers standby letters
of credit for its commercial borrowers. The terms of standby letters of credit
generally do not exceed one year, and they are underwritten as stringently as
any commercial loan and generally are of a performance nature.
Commercial business loans are often larger and may involve greater risk
than other types of lending. Because payments on such loans are often dependent
on successful operation of the business involved, repayment of such loans may be
subject to a greater extent to adverse conditions in the economy. The Bank seeks
to minimize these risks through its underwriting guidelines, which require that
the loan be supported by adequate cash flow of the borrower, profitability of
the business, collateral and personal guarantees of the individuals in the
business. In addition, the Bank
8
<PAGE>
limits this type of lending to its market area and to borrowers with which it
has prior experience or who are otherwise well known to the Bank.
Consumer Lending. In recent years, the Bank has been successful in its
strategy of increasing its portfolio of consumer loans. The consumer loans
originated by the Bank include automobile loans, certificate of deposit loans,
home equity loans and miscellaneous other consumer loans, including unsecured
loans. At September 30, 1998, consumer loans totaled $48.4 million, or 20.0% of
the Company's gross loan portfolio.
The Bank's automobile loans are generally underwritten in amounts up to 90%
of the lesser of the purchase price of the automobile or, with respect to used
automobiles, the loan value as published by the National Automobile Dealers
Association. The terms of most such loans do not exceed 60 months. The Bank
requires that the vehicles be insured and the Bank be listed as loss payee on
the insurance policy.
The Bank makes certificate of deposit loans for up to 90% of the
depositor's account balance. The interest rate is normally 3% above the annual
percentage yield paid on the account and the account must be pledged as
collateral to secure the loan. Interest generally is billed on a quarterly
basis. At September 30, 1998, loans on certificates of deposit totaled $470,000,
or .2% of the Company's total loan portfolio.
At September 30, 1998, the Company had approximately $22.9 million in home
equity line of credit loans, representing approximately 9.5% of its gross loan
portfolio. The Company's home equity lines of credit have adjustable interest
rates tied to the prime interest rate plus a margin. The home equity lines of
credit require monthly payments until the loan is paid in full. Home equity
lines of credit are generally secured by subordinate liens against residential
real property. The Bank requires that fire and extended coverage casualty
insurance (and, if appropriate, flood insurance) be maintained in an amount at
least sufficient to cover its loan. Home equity loans are generally limited so
that the amount of such loans, along with any senior indebtedness, does not
exceed 85% of the value of the real estate security.
The Company offers credit card loans through its participation as a Visa
and MasterCard issuer. Management believes that providing credit card services
to its customers helps the Bank remain competitive by offering customers an
additional service, and the Bank does not actively solicit credit card business
beyond its customer base and market area. The rate currently charged by the Bank
on its credit card loans ranges from 11.5% to 17.5%, and the Bank is permitted
to change the interest rate on 30 days notice. Processing of bills and payments
is contracted to an outside servicer. At September 30, 1998, the Company had a
commitment to fund an aggregate of $3.4 million of credit card loans, which
represented the aggregate credit limit on credit cards, and had $668,000 of
credit card loans outstanding, representing 0.3% of its gross loan portfolio.
The Company intends to continue and expand credit card lending, but estimates
that at current levels of credit card loans, it makes little or no monthly
profit net of service expenses and write-offs.
Consumer lending affords the Company the opportunity to earn yields higher
than those obtainable on single-family residential lending. However, consumer
loans entail greater risk than do residential mortgage loans, particularly in
the case of loans which are unsecured (as is the case with credit card loans) or
secured by rapidly depreciable assets such as automobiles. Repossessed
collateral for a defaulted consumer loan may not provide an adequate source of
repayment of the outstanding loan balance as a result of the greater likelihood
of damage, loss or depreciation. The remaining deficiency often does not warrant
further substantial collection efforts against the borrower. In addition,
consumer and credit card loan collections are dependent on the borrower's
continuing financial stability, and thus are more likely to be adversely
affected by events such as job loss, divorce, illness or personal bankruptcy.
Further, the application of various state and federal laws, including federal
and state bankruptcy and insolvency law, may limit the amount which may be
recovered. In underwriting consumer loans, the Bank considers the borrower's
credit history, an analysis of the borrower's income and ability to repay the
loan, and the value of the collateral.
9
<PAGE>
Loan Fees and Servicing. The Bank receives fees in connection with late
payments and for miscellaneous services related to its loans. The Bank also
charges fees in connection with loan originations. These fees can consist of
origination, discount, construction and/or commitment fees, depending on the
type of loan. The Bank generally does not service loans for others except as set
forth below and except for mortgage loans originated and sold by the Bank with
servicing retained.
In addition, the Bank has developed a program to originate loans for a
local credit union. The Bank receives a $600 origination fee for each loan as
well as an annual servicing fee of .375% of the loan amount. All of these loans
are funded and closed in the name of the credit union. The Bank has explored the
possibility of developing similar arrangements with other institutions, although
none are currently planned.
Nonperforming Loans and Other Problem Assets. It is management's policy to
continually monitor its loan portfolio to anticipate and address potential and
actual delinquencies. When a borrower fails to make a payment on a loan, the
Bank takes immediate steps to have the delinquency cured and the loan restored
to current status. Loans which are delinquent more than 15 days incur a late fee
of 4% of the monthly payment of principal and interest due. As a matter of
policy, the Bank will contact the borrower after the loan has been delinquent 15
days. If payment is not promptly received, the borrower is contacted again, and
efforts are made to formulate an affirmative plan to cure the delinquency.
Generally, after any loan is delinquent 45 days or more, a default letter is
sent to the borrower. If the default is not cured after 30 days, formal legal
proceedings are commenced to collect amounts owed.
Loans generally are placed on nonaccrual status, and accrued but unpaid
interest is reversed, when, in management's judgment, it is determined that the
collectibility of interest, but not necessarily principal, is doubtful.
Generally, this occurs when payment is delinquent in excess of 90 days. Consumer
loans are generally charged off, or any expected loss is reserved for, after
they become more than 120 days past due. All other loans are charged off when
management concludes that they are uncollectible. See Note 5 of Notes to
Financial Statements.
Real estate acquired by the Bank as a result of foreclosure is classified
as real estate acquired through foreclosure until such time as it is sold and is
recorded at the lower of the estimated fair value of the underlying real estate
or the carrying amount of the loan. Costs relating to holding or improving such
real estate are charged against income in the current period. Any required
write-down of the loan to its fair value less estimated selling costs upon
foreclosure is charged against the allowance for loan losses. See Note 5 of
Notes to Financial Statements.
The following table sets forth information with respect to the Bank's
nonperforming assets at the dates indicated. At the dates shown, the Bank had no
restructured loans within the meaning of Statement of Financial Accounting
Standards No. 15.
<TABLE>
<CAPTION>
At September 30,
--------------------------------------------------
1998 1997 1996 1995 1994
------ ------ ------ ------ ------
(Dollars in thousands)
Loans accounted for on a nonaccrual basis:
Residential mortgage:
<S> <C> <C> <C> <C> <C>
Single-family ........................ $ 323 $ 298 $ 376 $ 413 $ 286
Construction ......................... 406 916 647 248 --
Commercial real estate ................. -- 16 -- -- --
Commercial business .................... 25 14 8 -- --
Consumer ............................... 48 18 3 20 53
------ ------ ------ ------ ------
Total nonperforming loans ............ $ 802 $1,262 $1,034 $ 681 $ 339
====== ====== ====== ====== ======
Percentage of total loans, net ........... .36% .64% .66% .47% .25%
====== ====== ====== ====== ======
Real estate owned ........................ $ 412 $ 358 $ 179 $ 69 $ 180
====== ====== ====== ====== ======
</TABLE>
10
<PAGE>
During the year ended September 30, 1998, additional gross interest income
of approximately $18,000 would have been recorded on loans accounted for on a
nonaccrual basis if the loans had been current throughout this period. Interest
on such loans included in income during the period amounted to approximately
$18,000.
At September 30, 1998, the Bank had no loans not classified as non-accrual,
90 days past due or restructured where known information about possible credit
problems of borrowers caused management to have serious concerns as to the
ability of the borrowers to comply with present loan repayment terms and may
result in disclosure as non-accrual, 90 days past due or restructured.
There were no loans accruing interest which were contractually past due 90
days or more at the end of any reported period.
At September 30, 1998, an analysis of the Bank's portfolio did not reveal
any impaired loans that needed to be classified under SFAS No. 114 or 118. A
loan is considered impaired, based on current information and events, if it is
probable that the Bank will be unable to collect the scheduled payments of
principal and interest when due according to the contractual terms of the loan
arrangement. Uncollateralized loans are measured for impairment based on the
present value of expected future cash flows discounted at the historical
effective interest rate, while all collateral dependent loans are measured for
impairment based on the fair value of the collateral. The Bank uses several
factors in determining if a loan is impaired. The internal asset classification
procedures include a thorough review of significant loans and lending
relationships and include the accumulation of related data. This data includes
loan payments status, borrowers' financial data and borrowers' operating factors
such as cash flows, operating income or loss, and various other matters.
At September 30, 1998, the Company had $802,000 of nonaccrual loans, which
consisted of seven single-family residential real estate loans totaling
$323,000, four single-family residential construction loans totaling $406,000,
two commercial business loans totaling $25,000, and six consumer totaling
$48,000.
At September 30, 1998, the Bank had $412,000 of real estate owned, which
consisted of three single-family residences.
Classified Assets. Federal regulations require that the Bank classify its
assets on a regular basis. In addition, in connection with examinations of
insured institutions, examiners have authority to identify problem assets and if
appropriate, classify them in their reports of examination. 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 loss is considered uncollectible and of such little value that
continuance as an asset of the institution is not warranted. Assets classified
as substandard or doubtful require a bank to establish general allowances for
loan losses. If an asset or portion thereof is classified loss, a bank must
either establish a specific allowance for loss in the amount of the portion of
the asset classified loss, or charge off such amount. The Bank regularly reviews
its assets to determine whether any assets require classification or
re-classification. At September 30, 1998, the Company had $3.8 million in
classified assets, including $2.0 million in assets classified as special
mention, $1.8 million in assets classified as substandard, no assets classified
as doubtful and $18,000 in assets classified as loss.
Allowance for Loan Losses. The Company's policy is to establish reserves
for estimated losses on delinquent loans when it determines that losses are
expected to be incurred on such loans. The allowance for losses on loans is
maintained at a level believed adequate by management to absorb potential losses
in the portfolio. Management's determination of the adequacy of the allowance is
based on an evaluation of the portfolio, past loss experience, current
11
<PAGE>
economic conditions, volume, growth and composition of the portfolio, and other
relevant factors. The allowance is increased by provisions for loan losses which
are charged against income.
Although management believes it uses the best information available to make
determinations with respect to the allowances for losses and believes such
allowances are adequate, future adjustments may be necessary if economic
conditions differ substantially from the economic conditions in the assumptions
used in making the initial determinations. Management anticipates that the
Company's allowance for loan losses will increase in the future as it implements
the Board of Directors' strategy of continuing existing lines of business while
gradually expanding commercial business and consumer lending, which loans
generally entail greater risks than single-family residential mortgage loans.
The following table sets forth an analysis of the Company's allowance for
loan losses for the periods indicated.
<TABLE>
<CAPTION>
Year Ended September 30,
--------------------------------------------------
1998 1997 1996 1995 1994
------ ------ ------ ------ ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Balance at beginning of period ...... $3,249 $2,351 $1,877 $1,977 $1,843
------ ------ ------ ------ ------
Loans charged-off:
Residential mortgage:
Single-family ................... -- -- 44 20 10
Commercial real estate ............ -- -- -- 76 --
Commercial business ............... 128 -- -- -- --
Consumer .......................... 74 72 19 26 68
------ ------ ------ ------ ------
Total charge-offs ................... 202 72 63 122 78
------ ------ ------ ------ ------
Recoveries:
Residential real estate mortgage:
Single-family residential ....... -- 33 25 -- --
Consumer .......................... 8 6 1 2 2
------ ------ ------ ------ ------
Total recoveries .................... 8 39 26 2 2
------ ------ ------ ------ ------
Net loans charged-off ............... 194 33 37 120 76
------ ------ ------ ------ ------
Provision for loan losses ........... 310 931 511 20 210
------ ------ ------ ------ ------
Balance at end of period ............ $3,365 $3,249 $2,351 $1,877 $1,977
====== ====== ====== ====== ======
Ratio of net charge-offs to average
loans outstanding during the period .09% .02% .02% .09% .06%
====== ====== ====== ====== ======
</TABLE>
12
<PAGE>
The following table allocates the allowance for loan losses by loan
category at the dates indicated. 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 category.
<TABLE>
<CAPTION>
At September 30,
----------------------------------------------------------------------------------------------
1998 1997 1996 1995 1993
------------------ ------------------ ------------------ ------------------ ------------------
Percent of Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in Loans in
Category to Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Residential mortgage ............. $1,071 31.8% $1,070 47.6% $1,037 54.6% $1,041 64.9% $1,137 72.6%
Commercial (1) ................... 1,598 47.5 1,456 23.3 879 23.9 517 16.3 497 12.6
Consumer ......................... 696 20.7 723 29.1 435 21.5 319 18.8 343 14.8
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total allowance for loan losses $3,365 100.00% $3,249 100.00% $2,351 100.00% $1,877 100.00% $1,977 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
</TABLE>
- ---------------
(1) Includes commercial real estate and commercial business loans.
13
<PAGE>
INVESTMENT ACTIVITIES
General. Interest income from mortgage-backed securities and investment
securities generally provides the second largest source of income to the Company
after interest on loans. The Bank's Board of Directors has authorized investment
in U.S. Government and agency securities, state government obligations,
municipal securities, obligations of the Federal Home Loan Bank ("FHLB") and
mortgage-backed securities. The Bank's objective is to use such investments to
reduce interest rate risk, enhance yields on assets and provide liquidity. At
September 30, 1998, the Company's mortgage-backed securities and investment
securities portfolio amounted to $27.0 million and $3.1 million, respectively.
At such date, the Company had an unrealized gain of $486,000, net of deferred
taxes, with respect to its securities, all of which are classified as available
for sale.
Investment and aggregate investment limitations and credit quality
parameters of each class of investment are prescribed in the Bank's investment
policy. The Bank performs analyses on mortgage-backed securities and investment
securities prior to forming mortgage pools and on an ongoing basis to determine
the impact on earnings and market value under various interest rate and
prepayment conditions. Securities purchases are subject to the oversight of the
Bank's Investment Committee consisting of four directors and are reviewed by the
Board of Directors on a monthly basis. The Bank's President has authority to
make specific investment decisions within the parameters determined by the Board
of Directors.
Mortgage-Backed Securities. At September 30, 1998, the Company's
mortgage-backed securities amounted to $27.0 million, or 9.6% of total assets.
Mortgage-backed securities represent a participation interest in a pool of
single-family or multi-family mortgages, the principal and interest payments on
which are passed from the mortgage originators through intermediaries that pool
and repackage the participation interest in the form of securities to investors
such as the Bank. Such intermediaries may include quasi-governmental agencies
such as FHLMC, FNMA and GNMA which guarantee the payment of principal and
interest to investors. Mortgage-backed securities generally increase the quality
of the Bank's assets by virtue of the guarantees that back them, are more liquid
than individual mortgage loans and may be used to collaterize borrowings or
other obligations of the Bank. At September 30, 1998, all of the Company's
mortgage-backed securities were backed by loans originated by the Bank and
swapped with the FHLMC in exchange for such mortgage-backed securities.
The FHLMC is a public corporation chartered by the U.S. Government and
owned by the 12 FHLBs and federally insured savings institutions. The FHLMC
issues participation certificates backed principally by conventional mortgage
loans. The FHLMC guarantees the timely payment of interest and the ultimate
return of principal on participation certificates. FHLMC securities are not
backed by the full faith and credit of the United States, but because the FHLMC
is not a U.S. Government-sponsored enterprise, these securities are considered
to be among the highest quality investments with minimal credit risks. The
maximum loan limit for FNMA and FHLMC currently is $227,150,
Mortgage-backed securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and having varying maturities. The
underlying pool of mortgages can be composed of either fixed-rate or
adjustable-rate loans. As a result, the risk characteristics of the underlying
pool of mortgages, (i.e., fixed-rate or adjustable-rate) as well as prepayment
risk, are passed on to the certificate holder. The life of a mortgage-backed
pass-through security thus approximates the life of the underlying mortgages.
Mortgage-backed securities generally yield less than the loans which
underlie such securities because of their payment guarantees or credit
enhancements which offer nominal credit risk. In addition, mortgage-backed
securities are more liquid than individual mortgage loans and may be used to
collateralize borrowings of the Bank in the event that the Bank determined to
utilize borrowings as a source of funds. Mortgage-backed securities issued or
guaranteed by the FHLMC (except interest-only securities or the residual
interests in CMOs) are weighted at no more than 20% for risk-based capital
purposes, compared to a weight of 50% to 100% for residential loans. See
"Regulation -- Regulation of the Bank -- Capital Requirements."
14
<PAGE>
At September 30, 1998, mortgage-backed securities with an amortized cost of
$26.3 million and a carrying value of $27.0 million were held as available for
sale, and no mortgage-backed securities were classified as held to maturity.
Mortgage-backed securities which are held to maturity are carried at cost,
adjusted for the amortization of premiums and the accretion of discounts using a
method which approximates a level yield. Mortgage-backed securities classified
as available for sale are carried at fair value. Unrealized gains and losses on
available for sale mortgage-backed securities are recognized as direct increases
or decreases in equity, net of applicable income taxes. See Notes 1 and 4 of the
Notes to Consolidated Financial Statements. At September 30, 1998, the Bank's
mortgage-backed securities had a weighted average yield of 7.18%.
At September 30, 1998, the average contractual maturity of the Company's
fixed-rate mortgage-backed securities was approximately 18 years. The actual
maturity of a mortgage-backed security varies, depending on when the mortgagors
prepay or repay the underlying mortgages. Prepayments of the underlying
mortgages may shorten the life of the investment, thereby adversely affecting
its yield to maturity and the related market value of the mortgage-backed
security. The yield is based upon the interest income and the amortization of
the premium or accretion of the discount related to the mortgage-backed
security. Premiums and discounts on mortgage-backed securities are amortized or
accreted over the estimated term of the securities using a level yield method.
The prepayment assumptions used to determine the amortization period for
premiums and discounts can significantly affect the yield of the mortgage-backed
security, and these assumptions are reviewed periodically to reflect the actual
prepayment. The actual prepayments of the underlying mortgages depend on many
factors, including the type of mortgage, the coupon rate, the age of the
mortgages, the geographical location of the underlying real estate
collateralizing the mortgages and general levels of market interest rates. The
difference between the interest rates on the underlying mortgages and the
prevailing mortgage interest rates is an important determinant in the rate of
prepayments. During periods of falling mortgage interest rates, prepayments
generally increase, and, conversely, during periods of rising mortgage interest
rates, prepayments generally decrease. If the coupon rate of the underlying
mortgage significantly exceeds the prevailing market interest rates offered for
mortgage loans, refinancing generally increases and accelerates the prepayment
of the underlying mortgages. Prepayment experience is more difficult to estimate
for adjustable-rate mortgage-backed securities.
Investment Securities. The Company's investment securities consist
primarily of securities issued by the U.S. Treasury. At September 30, 1998, the
Company's entire portfolio of investment securities was classified available for
sale and amounted to $3.1 million, including gross unrealized gains of $107,000.
The Company attempts to maintain a high degree of liquidity in its investment
securities portfolio by choosing those that are readily marketable. As of
September 30, 1998, the estimated average life of the Company's investment
securities portfolio was approximately 2 years. In addition, at September 30,
1998, the Company had $1.4 million of FHLB stock.
15
<PAGE>
The following table sets forth the scheduled maturities, carrying values,
amortized cost and average yields for the Company's investment securities and
mortgage-backed securities portfolio at September 30, 1998.
<TABLE>
<CAPTION>
One Year or Less One to Five Years Five to Ten Years More than Ten Years Total Investment Portfolio
----------------- ----------------- ----------------- ----------------- --------------------------
Carrying Average Carrying Average Carrying Average Carrying Average Carrying Amortized Average
Value Yield Value Yield Value Yield Value Yield Value Cost Yield
-------- ------- -------- ------- -------- ------- -------- ------- -------- ------ -------
(Dollars in thousands)
Securities available for sale:
U.S. government and agency
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
securities ............ $ -- --% $3,108 7.13% $ -- --% $ -- --% $3,108 $3,001 7.13%
Mortgage-backed securities -- -- -- -- 4,858 7.02 22,159 7.21 27,017 26,324 7.18
Securities held to maturity:
FHLB stock (1) ........... -- -- -- -- -- -- 1,364 7.50 1,364 1,364 7.50
------ ------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total ................. $ -- --% $3,108 7.13% $4,858 7.02% $23,523 7.23% $31,489 $30,689 7.19%
====== ====== ====== ====== ====== ====== ====== ====== ====== ====== ======
</TABLE>
- ---------------
(1) As a member of the FHLB of Atlanta, the Bank is required to maintain an
investment in FHLB stock, which has no stated maturity.
16
<PAGE>
The following table sets forth the carrying value of the Company's
investment securities and mortgage-backed securities portfolio at the dates
indicated.
At September 30,
-----------------------------
1998 1997 1996
------- ------- -------
(In thousands)
Securities available for sale:
U.S. government and agency securities ...... $ 3,108 $ 3,083 $ 5,107
State government obligations ............... -- -- 3,000
Mortgage-backed securities ................. 27,017 24,818 14,797
------- ------- -------
Total ................................... 30,125 27,901 22,904
Securities held to maturity:
FHLB stock ................................. 1,364 1,288 1,288
------- ------- -------
Total ................................... 1,364 1,288 1,288
------- ------- -------
Total ................................. $31,489 $29,189 $24,192
======= ======= =======
DEPOSIT ACTIVITY AND OTHER SOURCES OF FUNDS
General. Deposits are the primary source of the Bank's funds for lending,
investment activities and general operational purposes. In addition to deposits,
the Bank derives funds from loan principal and interest repayments, maturities
of investment securities and mortgage-backed securities and interest payments
thereon. Although loan repayments are a relatively stable source of funds,
deposit inflows and outflows are significantly influenced by general interest
rates and money market conditions. Borrowings may be used on a short-term basis
to compensate for reductions in the availability of funds, or on a longer term
basis for general operational purposes. The Bank has access to borrow from the
FHLB of Atlanta.
Deposits. The Bank attracts deposits principally from within its market
area by offering a variety of deposit instruments, including checking accounts,
money market accounts, statement and passbook savings accounts, Individual
Retirement Accounts, and certificates of deposit which range in maturity from
seven days to five years. Deposit terms vary according to the minimum balance
required, the length of time the funds must remain on deposit and the interest
rate. Maturities, terms, service fees and withdrawal penalties for its deposit
accounts are established by the Bank on a periodic basis. The Bank reviews its
deposit pricing on a weekly basis. In determining the characteristics of its
deposit accounts, the Bank considers the rates offered by competing
institutions, lending and liquidity requirements, growth goals and federal
regulations. Management believes it prices its deposits comparably to rates
offered by its competitors. The Bank does not accept brokered deposits.
The Bank attempts to compete for deposits with other institutions in its
market area by offering competitively priced deposit instruments that are
tailored to the needs of its customers. Additionally, the Bank seeks to meet
customers' needs by providing convenient customer service to the community,
efficient staff and convenient hours of service. Substantially, all of the
Bank's depositors are North Carolina residents. To provide additional
convenience, the Bank participates in the HONOR Automatic Teller Machine network
at locations throughout the United States, through which customers can gain
access to their accounts at any time. To better serve its customers, the Bank
has installed automatic teller machines at six office locations.
17
<PAGE>
The following tables set forth the distribution of the Bank's deposit
accounts at the dates indicated, the weighted average interest rates and the
change in dollar amounts for each category of deposits presented. Management
does not believe that the use of year-end balances instead of average balances
resulted in any material difference in the information presented.
<TABLE>
<CAPTION>
For the Year Ended September 30,
----------------------------------------------------------------------
1998 1997 1996
-------------------- -------------------- --------------------
Weighted Weighted Weighted
Average Average Average
Amount Rate Amount Rate Amount Rate
-------- -------- -------- -------- -------- --------
(Dollars in thousands)
Demand accounts:
<S> <C> <C> <C> <C> <C> <C>
Checking .............. $ 26,494 .42% $ 22,788 .61% $ 17,079 .61%
Money market .......... 16,379 3.62 14,712 4.19 10,256 4.20
Savings accounts ........ 6,398 1.78 6,456 2.00 7,020 2.00
-------- -------- -------- -------- -------- --------
Total .............. 49,271 1.66 43,956 2.01 34,355 1.96
Certificate accounts:
Less than 12 months (1) 30,155 4.89 41,814 5.28 52,962 5.32
12 - 14 months (1) .... 66,064 5.70 27,384 5.14 39,525 5.29
14 - 72 months (1) .... 59,145 5.71 61,962 5.89 44,371 6.02
-------- -------- -------- -------- -------- --------
Total .............. 155,364 5.54 131,160 5.53 136,858 5.54
-------- -------- -------- -------- -------- --------
Total deposits .......... $204,635 4.58% $175,116 4.65% $171,213 4.82%
======== ======== ======== ======== ======== ========
</TABLE>
- ---------------
(1) Original term.
18
<PAGE>
The following table indicates the amount of the Company's certificates of
deposit of $100,000 or more (in thousands) by time remaining until maturity as
of September 30, 1998. At such date, such deposits represented 12.4% of total
deposits and had a weighted average rate of 5.18%.
Maturity Period
(In thousands)
Three months or less....................... $ 1,724
Over three through six months.............. 723
Over six through 12 months................. 12,390
Over 12 months............................. 10,751
----------
Total.................................. $ 25,588
==========
At September 30, 1998, mortgage-backed securities with a carrying value of
$3.6 million were pledged as collateral for deposits from public entities.
Borrowings. Savings deposits historically have been the primary source of
funds for the Bank's lending, investment and general operating activities. The
Bank is authorized, however, to use advances from the FHLB of Atlanta to
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. The FHLB of Atlanta functions as a central reserve bank providing
credit for savings institutions and certain other member financial institutions.
As a member of the FHLB System, the Bank is required to own stock in the FHLB of
Atlanta and is authorized to apply for advances. Advances are pursuant to
several different programs, each of which has its own interest rate and range of
maturities. The Bank has a Blanket Agreement for advances with the FHLB under
which the Bank may borrow up to 25% of assets subject to normal collateral and
underwriting requirements. Advances from the FHLB of Atlanta are secured by the
Bank's stock in the FHLB of Atlanta and other eligible assets. During the years
ended September 30, 1998, 1997 and 1996, the Bank's borrowings consisted of FHLB
advances and retail repurchase agreements. Retail repurchase agreements
represent agreements to sell securities under terms which require the Bank to
repurchase the same or substantially similar securities by a specified date.
The following table sets forth certain information regarding short-term
borrowings by the Company at the dates and for the periods indicated:
<TABLE>
<CAPTION>
At or for the
Year Ended September 30,
-------------------------------
1998 1997 1996
------- ------- -------
(Dollars in thousands)
Amounts outstanding at end of period:
<S> <C> <C> <C>
FHLB advances ........................................... $ 9,500 $11,000 $ --
Federal funds purchased and securities
sold under repurchase agreements ...................... $ 2,432 $ 1,621 $1,040
Weighted average rate paid on:
FHLB advances ........................................... 6.00% 6.17% --
Federal funds purchased and securities sold under
agreements to repurchase .............................. 3.33% 4.67% 4.31%
Maximum amount of borrowings outstanding at any month end:
FHLB advances ........................................... $10,000 $13,000 $7,000
Federal funds purchased and securities
sold under repurchased agreements ..................... 2,652 1,645 1,040
19
<PAGE>
<CAPTION>
At or for the
Year Ended September 30,
-------------------------------
1998 1997 1996
------- ------- -------
(Dollars in thousands)
Approximate average short-term borrowings
outstanding with respect to:
<S> <C> <C> <C>
FHLB advances .............................. $ 1,071 $ 3,400 $ 2,250
Federal funds purchased and securities
sold under repurchase agreements ......... 1,918 1,218 582
Approximate weighted average rate paid on: (1)
FHLB advances .............................. 5.90% 5.78% 6.83%
Federal funds purchased and securities
sold under agreements to repurchase ...... 3.98% 4.56% 4.44%
</TABLE>
- ---------------
(1) Based on month-end balances.
COMPETITION
The Company faces strong competition in originating real estate, commercial
business and consumer loans and in attracting deposits. The Bank competes for
real estate and other loans principally on the basis of interest rates, the
types of loans it originates, the deposit products it offers and the quality of
services it provides to borrowers. The Bank also competes by offering products
which are tailored to the local community. Its competition in originating real
estate loans comes primarily from other commercial banks, savings institutions,
mortgage bankers and mortgage brokers. Commercial banks, credit unions and
finance companies provide vigorous competition in consumer lending. Competition
may increase as a result of the recent reduction of restrictions on the
interstate operations of financial institutions.
The Bank attracts its deposits through its branch offices primarily from
the local communities. Consequently, competition for deposits is principally
from other commercial banks, savings institutions, credit unions and brokers in
the Bank's primary market area. The Bank competes for deposits and loans by
offering what it believes to be a variety of deposit accounts at competitive
rates, convenient business hours, a commitment to outstanding customer service
and a well-trained staff. The Bank believes it has developed strong
relationships with local realtors and the community in general.
Management considers its primary market area for gathering deposits and
originating loans to be Beaufort, Craven, Lenoir, Nash, Pasquotank and Pitt
Counties in eastern North Carolina, which are the counties in which the Bank's
offices are located. The Bank originates loans throughout eastern North
Carolina.
EMPLOYEES
As of September 30, 1998, the Bank had 123 full-time and five part-time
employees, none of whom were represented by a collective bargaining agreement.
Management considers the Bank's relationships with its employees to be good.
DEPOSITORY INSTITUTION REGULATION
General. The Bank is a North Carolina-chartered commercial bank and its
deposit accounts are insured by the Savings Association Insurance Fund ("SAIF")
of the FDIC. The Bank is subject to supervision, examination and regulation by
the Commissioner and the FDIC and to North Carolina and federal statutory and
regulatory provisions governing such matters as capital standards, mergers,
subsidiary investments and establishment of branch offices. The FDIC also has
the authority to conduct special examinations. The Bank is required to file
reports with the Commissioner and the FDIC concerning its activities and
financial condition and will be required to obtain regulatory approval prior to
entering into certain transactions, including mergers with, or acquisitions of,
other depository institutions.
20
<PAGE>
As a federally insured depository institution, the Bank is subject to
various regulations promulgated by the Board of Governors of the Federal Reserve
System ("Federal Reserve Board"), including Regulation B (Equal Credit
Opportunity), Regulation D (Reserve Requirements), Regulations E (Electronic
Fund Transfers), Regulation Z (Truth in Lending), Regulation CC (Availability of
Funds and Collection of Checks) and Regulation DD (Truth in Savings).
The system of regulation and supervision applicable to the Bank establishes
a comprehensive framework for the operations of the Bank, and is intended
primarily for the protection of the FDIC and the depositors of the Bank. Changes
in the regulatory framework could have a material effect on the Bank that in
turn, could have a material effect on the Company.
Capital Requirements. The Federal Reserve Board and the FDIC have
established guidelines with respect to the maintenance of appropriate levels of
capital by bank holding companies with consolidated assets of $150 million or
more and state non-member banks, respectively. The regulations impose two sets
of capital adequacy requirements: minimum leverage rules, which require bank
holding companies and state non-member banks to maintain a specified minimum
ratio of capital to total assets, and risk-based capital rules, which require
the maintenance of specified minimum ratios of capital to "risk-weighted"
assets. The regulations of the FDIC and the Federal Reserve Board require bank
holding companies and state non-member banks, respectively, to maintain a
minimum leverage ratio of "Tier 1 capital" to total assets of 3.0%. Tier 1
capital is the sum of common stockholders' equity, certain perpetual preferred
stock (which must be noncumulative with respect to banks), including any related
surplus, and minority interests in consolidated subsidiaries; minus all
intangible assets (other than certain purchased mortgage servicing rights and
purchased credit card receivables), identified losses and investments in certain
subsidiaries. As a SAIF-insured, state-chartered bank, the Bank must also deduct
from Tier 1 capital an amount equal to its investments in, and extensions of
credit to, subsidiaries engaged in activities that are not permissible for
national banks, other than debt and equity investments in subsidiaries engaged
in activities undertaken as agent for customers or in mortgage banking
activities or in subsidiary depository institutions or their holding companies.
Although setting a minimum 3.0% leverage ratio, the capital regulations state
that only the strongest bank holding companies and banks, with composite
examination ratings of 1 under the rating system used by the federal bank
regulators, would be permitted to operate at or near such minimum level of
capital. All other bank holding companies and banks are expected to maintain a
leverage ratio of at least 1% to 2% above the minimum ratio, depending on the
assessment of an individual organization's capital adequacy by its primary
regulator. Any bank or bank holding companies experiencing or anticipating
significant growth would be expected to maintain capital well above the minimum
levels. In addition, the Federal Reserve Board has indicated that whenever
appropriate, and in particular when a bank holding company is undertaking
expansion, seeking to engage in new activities or otherwise facing unusual or
abnormal risks, it will consider, on a case-by-case basis, the level of an
organization's ratio of tangible Tier 1 capital to total assets in making an
overall assessment of capital.
In addition to the leverage ratio, the regulations of the Federal Reserve
Board and the FDIC require bank holding companies and state-chartered nonmember
banks to maintain a minimum ratio of qualifying total capital to risk-weighted
assets of at least 8.0% of which at least four percentage points must be Tier 1
capital. Qualifying total capital consists of Tier 1 capital plus Tier 2 or
supplementary capital items which include allowances for loan losses in an
amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and
preferred stock with a maturity of 20 years or more and certain other capital
instruments. The includible amount of Tier 2 capital cannot exceed the
institution's Tier 1 capital. Qualifying total capital is further reduced by the
amount of the bank's investments in banking and finance subsidiaries that are
not consolidated for regulatory capital purposes, reciprocal cross-holdings of
capital securities issued by other banks and certain other deductions. The
risk-based capital regulations assign balance sheet assets and the credit
equivalent amounts of certain off-balance sheet items to one of four broad risk
weight categories. The aggregate dollar amount of each category is multiplied by
the risk weight assigned to that category based principally on the degree of
credit risk associated with the obligor. The sum of these weighted values equals
the bank holding company or the bank's risk-weighted assets.
The federal bank regulators, including the FDIC, have proposed to revise
their risk-based capital requirements to ensure that such requirements provide
for explicit consideration of interest rate risk. Under the proposed rule, a
bank's interest rate risk exposure would be quantified using either the
measurement system set forth in the proposal or the bank's internal model for
measuring such exposure, if such model is determined to be adequate by the
bank's examiner.
21
<PAGE>
If the dollar amount of a bank's interest rate risk exposure, as measured under
either measurement system, exceeds 1% of the bank's total assets, the bank would
be required under the proposed rule to hold additional capital equal to the
dollar amount of the excess. Management has not determined what effect, if any,
the proposed interest rate risk component would have on the Bank's capital if
adopted as proposed. The FDIC has adopted a regulation that provides that the
FDIC may take into account whether a bank has significant risks from
concentrations of credit or nontraditional activities in determining the
adequacy of its capital. The Bank has not been advised that it will be required
to maintain any additional capital under this regulation. The proposed interest
rate risk component would not apply to bank holding companies on a consolidated
basis.
In addition to FDIC regulatory capital requirements, the North Carolina
Bank Commissioner requires that the Bank have adequate capitalization which is
determined based upon each Bank's particular set of circumstances. The Bank is
subject to the Commissioner's capital surplus regulation which requires
commercial banks to maintain a capital surplus of at least 50% of common
capital. Common capital is defined as the total of the par value of shares times
the number of shares outstanding.
Prompt Corrective Regulatory Action. Under the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA"), the federal banking regulators
are required to take prompt corrective action if an insured depository
institution fails to satisfy certain minimum capital requirements. All
institutions, regardless of their capital levels, are restricted from making any
capital distribution or paying any management fees if the institution would
thereafter fail to satisfy the minimum levels for any of its capital
requirements. An institution that fails to meet the minimum level for any
relevant capital measure (an "undercapitalized institution") may be: (i) subject
to increased monitoring by the appropriate federal banking regulator; (ii)
required to submit an acceptable capital restoration plan within 45 days; (iii)
subject to asset growth limits; and (iv) required to obtain prior regulatory
approval for acquisitions, branching and new lines of businesses. A
"significantly undercapitalized" institution may be subject to regulatory
demands for recapitalization, broader application of restrictions on
transactions with affiliates, limitations on interest rates paid on deposits,
asset growth and other activities, possible replacement of directors and
officers, and restrictions on capital distributions by any bank holding company
controlling the institution. Any company controlling the institution could also
be required to divest the institution or the institution could be required to
divest subsidiaries. The senior executive officers of a significantly
undercapitalized institution may not receive bonuses or increases in
compensation without prior regulatory approval and the institution is prohibited
from making payments of principal or interest on its subordinated debt. If an
institution's ratio of tangible capital to total assets falls below a "critical
capital level," the institution will be subject to conservatorship or
receivership within 90 days unless periodic determinations are made that
forbearance from such action would better protect the deposit insurance fund.
The federal banking regulators has adopted regulations implementing the
prompt corrective action provisions of FDICIA. Under these regulations, the
federal banking regulators will generally measure a depository institution's
capital adequacy on the basis of the institution's total risk-based capital
ratio (the ratio of its total capital to risk-weighted assets), Tier 1
risk-based capital ratio (the ratio of its core capital to risk-weighted assets)
and leverage ratio (the ratio of its core capital to adjusted total assets).
Under the regulations, an institution that is not subject to an order or written
directive by its primary federal regulator to meet or maintain a specific
capital level will be deemed "well capitalized" if it also has: (i) a total
risk-based capital ratio of 10% or greater; (ii) a Tier 1 risk-based capital
ratio of 6.0% or greater; and (iii) a leverage ratio of 5.0% or greater. An
"adequately capitalized" depository institution is an institution that does not
meet the definition of well capitalized and has: (i) a total risk-based capital
ratio of 8.0% or greater; (ii) a Tier 1 risk-based capital ratio of 4.0% or
greater; and (iii) a leverage ratio of 4.0% or greater (or 3.0% or greater if
the depository institution has a composite 1 CAMEL rating). An "undercapitalized
institution" is a depository institution that has (i) a total risk-based capital
ratio less than 8.0%; or (ii) a Tier 1 risk-based capital ratio of less than
4.0%; or (iii) a leverage ratio of less than 4.0% (or less than 3.0% if the
institution has a composite 1 CAMEL rating). A "significantly undercapitalized"
institution is defined as a depository institution that has: (i) a total
risk-based capital ratio of less than 6.0%; or (ii) a Tier 1 risk-based capital
ratio of less than 3.0%; or (iii) a leverage ratio of less than 3.0%. A
"critically undercapitalized" institution is defined as a depository institution
that has a ratio of "tangible equity" to total assets of less than 2.0%.
Tangible equity is defined as core capital plus cumulative perpetual preferred
stock (and related surplus) less all intangibles other than qualifying
supervisory goodwill and certain purchased mortgage servicing rights. The FDIC
may reclassify a well capitalized depository institution as adequately
capitalized and may require an adequately
22
<PAGE>
capitalized or undercapitalized institution to comply with the supervisory
actions applicable to institutions in the next lower capital category (but may
not reclassify a significantly undercapitalized institution as critically
under-capitalized) if it determines, after notice and an opportunity for a
hearing, that the institution is in an unsafe or unsound condition or that the
institution has received and not corrected a less-than-satisfactory rating for
any CAMEL rating category. As of September 30, 1998, the Bank was classified as
"well capitalized" under FDIC regulations.
Safety and Soundness Guidelines. Under FDICIA, as amended by the Riegle
Community Development and Regulatory Improvement Act of 1994 (the "CDRI Act"),
each federal banking agency was required to establish safety and soundness
standards for institutions under its authority. The interagency guidelines
require depository institutions to maintain internal controls and information
systems and internal audit systems that are appropriate for the size, nature and
scope of the institution's business. The guidelines also establish certain basic
standards for loan documentation, credit underwriting, interest rate risk
exposure, and asset growth. The guidelines further provide that depository
institutions should maintain safeguards to prevent the payment of compensation,
fees and benefits that are excessive or that could lead to material financial
loss, and should take into account factors such as comparable compensation
practices at comparable institutions. If the appropriate federal banking agency
determines that a depository institution is not in compliance with the safety
and soundness guidelines, it may require the institution to submit an acceptable
plan to achieve compliance with the guidelines. A depository institution must
submit an acceptable compliance plan to its primary federal regulator within 30
days of receipt of a request for such a plan. Failure to submit or implement a
compliance plan may subject the institution to regulatory sanctions. Management
believes that the Bank already substantially meets all the standards adopted in
the interagency guidelines.
Community Reinvestment Act. The Bank, like other financial institutions, is
subject to the Community Reinvestment Act ("CRA"). The purpose of the CRA is to
encourage financial institutions to help meet the credit needs of their entire
communities, including the needs of low-and moderate-income neighborhoods.
During the Bank's last compliance examination, the Bank received an
"outstanding" rating with respect to CRA compliance. The Bank's rating with
respect to CRA compliance would be a factor to be considered by the Federal
Reserve Board and the FDIC in considering applications submitted by the Bank to
acquire branches or to acquire or combine with other financial institutions and
take other actions and, if such rating was less than "satisfactory," could
result in the denial of such applications.
The federal banking regulatory agencies have issued a revision of the CRA
regulations, which became effective on January 1, 1996, to implement a new
evaluation system that rates institutions based on their actual performance in
meeting community credit needs. Under the regulations, a bank will first be
evaluated and rated under three categories: a lending test, an investment test
and a service test. For each of these three tests, the savings bank will be
given a rating of either "outstanding," "high satisfactory," "low satisfactory,"
"needs to improve," or "substantial non-compliance." A set of criteria for each
rating has been developed and is included in the regulation. If an institution
disagrees with a particular rating, the institution has the burden of rebutting
the presumption by clearly establishing that the quantitative measures do not
accurately present its actual performance, or that demographics, competitive
conditions or economic or legal limitations peculiar to its service area should
be considered. The ratings received under the three tests will be used to
determine the overall composite CRA rating. The composite ratings will be the
same as those that are currently given: "outstanding," "satisfactory," "needs to
improve" or "substantial non-compliance."
Federal Home Loan Bank System. The FHLB System consists of 12 district
FHLBs subject to supervision and regulation by the Federal Housing Finance Board
("FHFB"). The FHLBs provide a central credit facility primarily for member
institutions. As a member of the FHLB of Atlanta, the Bank is required to
acquire and hold shares of capital stock in the FHLB of Atlanta in an amount at
least equal to 1% of the aggregate unpaid principal of its home mortgage loans,
home purchase contracts, and similar obligations at the beginning of each year,
or 1/20 of its advances (borrowings) from the FHLB of Atlanta, whichever is
greater. The Bank was in compliance with this requirement with investment in
FHLB of Atlanta stock at September 30, 1998, of $1.4 million. The FHLB of
Atlanta serves as a reserve or central bank for its member institutions within
its assigned district. It is funded primarily from proceeds derived from the
sale of consolidated obligations of the FHLB System. It offers advances to
members in accordance with policies and procedures established by the FHFB and
the Board of Directors of the FHLB of Atlanta. Long-term advances may only be
made for the purpose of providing funds for residential housing finance.
23
<PAGE>
Reserves. Pursuant to regulations of the Federal Reserve Board, the Bank
must maintain average daily reserves against their transaction accounts. No
reserves are required to be maintained on the first $4.3 million of transaction
accounts, reserves equal to 3% must be maintained on the next $52.0 million of
transaction accounts, plus 10% on the remainder. This percentage is subject to
adjustment by the Federal Reserve Board. Because required reserves must be
maintained in the form of vault cash or in a noninterest bearing account at a
Federal Reserve Bank, the effect of the reserve requirement is to reduce the
amount of the institution's interest-earning assets. As of September 30, 1998,
the Bank met its reserve requirements.
The Bank is also subject to the reserve requirements of North Carolina
commercial banks. North Carolina law requires state non-member banks to
maintain, at all times, a reserve fund in an amount set by the State Commission.
Deposit Insurance. The Bank is required to pay assessments based on a
percentage of its insured deposits to the FDIC for insurance of its deposits by
the SAIF. Under the FDIC's risk-based deposit insurance assessment system, the
assessment rate for an insured depository institution depends on the assessment
risk classification assigned to the institution by the FDIC, which is determined
by the institution's capital level and supervisory evaluations. Based on the
data reported to regulators for the date closest to the last day of the seventh
month preceding the semi-annual assessment period, institutions are assigned to
one of three capital groups -- well capitalized, adequately capitalized or
undercapitalized -- using the same percentage criteria as in the prompt
corrective action regulations. See "-- Prompt Corrective Regulatory Action."
Within each capital group, institutions are assigned to one of three subgroups
on the basis of supervisory evaluations by the institution's primary supervisory
authority and such other information as the FDIC determines to be relevant to
the institution's financial condition and the risk posed to the deposit
insurance fund. Subgroup A consists of financially sound institutions with only
a few minor weaknesses. Subgroup B consists of institutions that demonstrate
weaknesses which, if not corrected, could result in significant deterioration of
the institution and increased risk of loss to the deposit insurance fund.
Subgroup C consists of institutions that pose a substantial probability of loss
to the deposit insurance fund unless effective corrective action is taken. The
assessment rate for SAIF members had ranged from 0.23% of deposits for well
capitalized institutions in Subgroup A to 0.31% of deposits for undercapitalized
institutions in Subgroup C while assessments for over 90% of the Bank Insurance
Fund ("BIF") members had been the statutory minimum of $2,000. Legislation
provided for a one-time assessment of 65.7 basis points of insured deposits as
of March 31, 1995, that fully capitalized the SAIF and had the effect of
reducing future SAIF assessments. Accordingly, although the special assessment
resulted in a one-time charge to the Bank of approximately $946,000 pre-tax,
accrued during the quarter ended September 30, 1996, the recapitalization of the
SAIF had the effect of reducing the Bank's future deposit insurance premiums to
the SAIF. Under the recently enacted legislation, both BIF and SAIF members will
be assessed an amount for Financing Corporation Bond payments. BIF members will
be assessed approximately 1.3 basis points while the SAIF rate will be
approximately 6.4 basis points until January 1, 2000. At that time, BIF and SAIF
members will begin pro rata sharing of the payment at an expected rate of 2.43
basis points.
Although the Bank, as a North Carolina commercial bank, would qualify for
insurance of deposits by the BIF of the FDIC, substantial entrance and exit fees
apply to conversions from SAIF to BIF insurance. Accordingly, following the Bank
Conversion, the Bank remained a member of the SAIF, which insures the deposits
of the Bank to a maximum of $100,000 for each depositor.
Liquidity Requirements. FDIC policy requires that banks maintain an average
daily balance of liquid assets (cash, certain time deposits, bankers'
acceptances and specified United States government, state, or federal agency
obligations) in an amount which it deems adequate to protect safety and
soundness of the bank. The FDIC currently has no specific level which it
requires. Under the FDIC's calculation method, management calculated the Bank's
liquidity ratio as 15.1% of total assets at September 30, 1998, which management
believes is adequate.
North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the Banking Commission to account for the level of liquidity necessary to
assure the safety and soundness of the State banking system. As of September 30,
1998, the Bank's liquidity ratio was in excess of the North Carolina
regulations.
24
<PAGE>
Dividend Restrictions. Under FDIC regulations, the Bank is prohibited from
making any capital distributions if after making the distribution, the Bank
would have: (i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier
1 risk-based capital ratio of less than 4.0%; or (iii) a leverage ratio of less
than 4.0%.
Earnings of the Bank appropriated to bad debt reserves and deducted for
Federal income tax purposes are not available for payment of cash dividends or
other distributions to stockholders without payment of taxes at the then current
tax rate by the Bank on the amount of earnings removed from the pre-1988
reserves for such distributions. The Bank intends to make full use of this
favorable tax treatment and does not contemplate use of any earnings in a manner
which would create federal tax liabilities.
Limits on Loans to One Borrower. The Bank generally is subject to both FDIC
regulations and North Carolina law regarding loans to any one borrower,
including related entities. Under applicable law, with certain limited
exceptions, loans and extensions of credit by a state chartered non-member bank
to a person outstanding at one time and not fully secured by collateral having a
market value at least equal to the amount of the loan or extension of credit
shall not exceed 15% of the unimpaired capital of the bank. Loans and extensions
of credit fully secured by readily marketable collateral having a market value
may comprise shall not exceed 10% of the unimpaired capital fund of the bank.
Under these limits, the Bank's loans to one borrower were limited to $6.3
million at September 30, 1998. At that date, the Bank had no lending
relationships in excess of the loans-to-one-borrower limit. Notwithstanding the
statutory loans-to-one-borrower limitations, the Bank has a self imposed
loans-to-one-borrower limit, which currently is $3.7 million. At September 30,
1998, the Bank's largest lending relationship was a $3.7 million relationship
consisting of four commercial real estate loans. All loans within this
relationship were current and performing in accordance with their terms at
September 30, 1998.
Transactions with Related Parties. Transactions between a state non-member
bank and any affiliate are governed by Sections 23A and 23B of the Federal
Reserve Act. An affiliate of a state non-member bank is any company or entity
which controls, is controlled by or is under common control with the state
non-member bank. In a holding company context, the parent holding company of a
state non-member bank (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution or state non-member bank. Generally, Sections 23A and 23B (i) limit
the extent to which an institution or its subsidiaries may engage in "covered
transactions" with any one affiliate to an amount equal to 10% of such
institution's capital stock and surplus, and contain an aggregate limit on all
such transactions with all affiliates to an amount equal to 20% of such capital
stock and surplus and (ii) require that all such transactions be on terms
substantially the same, or at least as favorable, to the institution or
subsidiary as those provided to a non-affiliate. The term "covered transaction"
includes the making of loans, purchase of assets, issuance of a guarantee and
similar other types of transactions. In addition to the restrictions imposed by
Sections 23A and 23B, no state non-member bank may (i) loan or otherwise extend
credit to an affiliate, except for any affiliate which engages only in
activities which are permissible for bank holding companies, or (ii) purchase or
invest in any stocks, bonds, debentures, notes or similar obligations of any
affiliate, except for affiliates which are subsidiaries of the state non-member
bank.
State non-member banks also are subject to the restrictions contained in
Section 22(h) of the Federal Reserve Act and the Federal Reserve's Regulation O
thereunder on loans to executive officers, directors and principal stockholders.
Under Section 22(h), loans to a director, executive officer and to a greater
than 10% stockholder of a state non-member bank and certain affiliated interests
of such persons, may not exceed, together with all other outstanding loans to
such person and affiliated interests, the institution's loans-to-one-borrower
limit and all loans to such persons may not exceed the institution's unimpaired
capital and unimpaired surplus. Section 22(h) also prohibits loans, above
amounts prescribed by the appropriate federal banking agency, to directors,
executive officers and greater than 10% stockholders of a savings institution,
and their respective affiliates, unless such loan is approved in advance by a
majority of the board of directors of the institution with any "interested"
director not participating in the voting. Regulation O prescribes the loan
amount (which includes all other outstanding loans to such person) as to which
such prior board of director approval is required as being the greater of
$25,000 or 5% of capital and surplus (up to $500,000). Further, Section 22(h)
requires that loans to directors, executive officers and principal stockholders
be made on terms substantially the same as offered in comparable transactions to
other persons. Section 22(h) also generally prohibits a depository institution
from paying the overdrafts of any of its executive officers or directors.
25
<PAGE>
State non-member banks also are subject to the requirements and
restrictions of Section 22(g) of the Federal Reserve Act on loans to executive
officers and the restrictions of 12 U.S.C. ss. 1972 on certain tying
arrangements and extensions of credit by correspondent banks. Section 22(g) of
the Federal Reserve Act requires loans to executive officers of depository
institutions not be made on terms more favorable than those afforded to other
borrowers, requires approval by the board of directors of a depository
institution for extension of credit to executive officers of the institution,
and imposes reporting requirements for and additional restrictions on the type,
amount and terms of credits to such officers. Section 1972 (i) prohibits a
depository institution from extending credit to or offering any other services,
or fixing or varying the consideration for such extension of credit or service,
on the condition that the customer obtain some additional service from the
institution or certain of its affiliates or not obtain services of a competitor
of the institution, subject to certain exceptions, and (ii) prohibits extensions
of credit to executive officers, directors, and greater than 10% stockholders of
a depository institution by any other institution which has a correspondent
banking relationship with the institution, unless such extension of credit is on
substantially the same terms as those prevailing at the time for comparable
transactions with other persons and does not involve more than the normal risk
of repayment or present other unfavorable features.
Additionally, North Carolina statutes set forth restrictions on loans to
executive officers of state-chartered banks, which provide that no bank may
extend credit to any of its executive officers nor a firm or partnership of
which such executive officers is a member, nor a company in which such executive
officer owns a controlling interest, unless the extension of credit is made on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions by the bank with persons who
are not employed by the bank, and provided further that the extension of credit
does not involve more than the normal risk of repayment.
Restrictions on Certain Activities. Under FDICIA, state-chartered
non-member banks with deposits insured by the FDIC are generally prohibited from
acquiring or retaining any equity investment of a type or in an amount that is
not permissible for a national bank. The foregoing limitation, however, does not
prohibit FDIC-insured state banks from acquiring or retaining an equity
investment in a subsidiary in which the bank is a majority owner.
State-chartered banks are also prohibited from engaging as principal in any type
of activity that is not permissible for a national bank and subsidiaries of
state-chartered, FDIC-insured state banks may not engage as principal in any
type of activity that is not permissible for a subsidiary of a national bank
unless in either case the FDIC determines that the activity would pose no
significant risk to the appropriate deposit insurance fund and the bank is, and
continues to be, in compliance with applicable capital standards.
The FDIC has adopted regulations to clarify the foregoing restrictions on
activities of FDIC-insured state-chartered banks and their subsidiaries. Under
the regulations, the term activity refers to the authorized conduct of business
by an insured state bank and includes acquiring or retaining any investment
other than an equity investment. An activity permissible for a national bank
includes any activity expressly authorized for national banks by statute or
recognized as permissible in regulations, official circulars or bulletins or in
any order or written interpretation issued by the Office of the Comptroller of
the Currency ("OCC"). In its regulations, the FDIC indicates that it will not
permit state banks to directly engage in commercial ventures or directly or
indirectly engage in any insurance underwriting activity other than to the
extent such activities are permissible for a national bank or a national bank
subsidiary or except for certain other limited forms of insurance underwriting
permitted under the regulations. Under the regulations, the FDIC permits state
banks that meet applicable minimum capital requirements to engage as principal
in certain activities that are not permissible to national banks including
guaranteeing obligations of others, activities which the Federal Reserve Board
has found by regulation or order to be closely related to banking and certain
securities activities conducted through subsidiaries.
REGULATION OF THE COMPANY
General. The Company, as the sole shareholder of the Bank, is a bank
holding company and is registered with the Federal Reserve Board. Bank holding
companies are subject to comprehensive regulation by the Federal Reserve Board
under the Bank Holding Company Act of 1956, as amended (the "BHCA"), and the
regulations of the Federal Reserve Board. As a bank holding company, the Company
is required to file with the Federal Reserve Board annual reports and such
additional information as the Federal Reserve Board may require, and is subject
to regular examinations
26
<PAGE>
by the Federal Reserve Board. The Federal Reserve Board also has extensive
enforcement authority over bank holding companies, including, among other
things, the ability to assess civil money penalties, to issue cease and desist
or removal orders and to require that a holding company divest subsidiaries
(including its bank subsidiaries). In general, enforcement actions may be
initiated for violations of law and regulations and unsafe or unsound practices.
Under the BHCA, a bank holding company must obtain Federal Reserve Board
approval before: (i) acquiring, directly or indirectly, ownership or control of
any voting shares of another bank or bank holding company if, after such
acquisition, it would own or control more than 5% of such shares (unless it
already owns or controls the majority of such shares); (ii) acquiring all or
substantially all of the assets of another bank or bank holding company; or
(iii) merging or consolidating with another bank holding company, (satisfactory
financial condition, particularly with respect to capital adequacy, and a
satisfactory CRA rating generally are prerequisites to obtaining federal
regulatory approval to make acquisitions).
The BHCA also prohibits a bank holding company, with certain exceptions,
from acquiring direct or indirect ownership or control of more than 5% of the
voting shares of any company which is not a bank or bank holding company, or
from engaging directly or indirectly in activities other than those of banking,
managing or controlling banks, or providing services for its subsidiaries. The
principal exceptions to these prohibitions involve certain non-bank activities
which, by statute or by Federal Reserve Board regulation or order, have been
identified as activities closely related to the business of banking or managing
or controlling banks. The list of activities permitted by the Federal Reserve
Board includes, among other things, operating a savings institution, mortgage
company, finance company, credit card company or factoring company; performing
certain data processing operations; providing certain investment and financial
advice; underwriting and acting as an insurance agent for certain types of
credit-related insurance; leasing property on a full-payout, non-operating
basis; selling money orders, travelers' checks and United States Savings Bonds;
real estate and personal property appraising; providing tax planning and
preparation services; and, subject to certain limitations, providing securities
brokerage services for customers. The Company has no present plans to engage in
any of these activities.
The Federal Reserve Board has adopted guidelines regarding the capital
adequacy of bank holding companies, which require bank holding companies to
maintain specified minimum ratios of capital to total assets and capital to
risk-weighted assets. See " -- Depository Institution Regulation -- Capital
Requirements."
Acquisition of Bank Holding Companies and Banks. Under the BHCA, any
company must obtain approval of the Federal Reserve Board prior to acquiring
control of the Company or the Bank. For purposes of the BHCA, "control" is
defined as ownership of more than 25% of any class of voting securities of the
Company or the Bank, the ability to control the election of a majority of the
directors, or the exercise of a controlling influence over management or
policies of the Company or the Bank. In addition, the Change in Bank Control Act
and the related regulations of the Federal Reserve Board require any person or
persons acting in concert (except for companies required to make application
under the BHCA), to file a written notice with the Federal Reserve Board before
such person or persons may acquire control of the Company or the Bank. The
Change in Bank Control Act defines "control" as the power, directly or
indirectly, to vote 25% or more of any voting securities or to direct the
management or policies of a bank holding company or an insured bank.
Interstate Banking. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (the "Act") was enacted to ease restrictions on
interstate banking. Effective September 29, 1995, the Act allows the Federal
Reserve Board to approve an application of an adequately capitalized and
adequately managed bank holding company to acquire control of, or acquire all or
substantially all of the assets of, a bank located in a state other than such
holding company's home state, without regard to whether the transaction is
prohibited by the laws of any state. The Federal Reserve Board may not approve
the acquisition of bank that has not been in existence for the minimum time
period (not exceeding five years) specified by the statutory law of the host
state. The Act also prohibits the Federal Reserve Board from approving an
application if the applicant (and its depository institution affiliates)
controls or would control more than 10% of the insured deposits in the United
States or 30% or more of the deposits in the target bank's home state or in any
state in which the target bank maintains a branch. The Act does not affect the
authority of states to limit the percentage of total insured deposits in the
state which may be held or controlled by a bank or bank holding company to the
extent such
27
<PAGE>
limitation does not discriminate against out-of-state banks or bank holding
companies. Individual states may also waive the 30% state-wide concentration
limit contained in the Act.
Additionally, the Act authorizes the federal banking agencies to approve
interstate merger transactions without regard to whether such transaction is
prohibited by the law of any state, unless the home state of one of the banks
opts out of the Act by adopting a law after the date of enactment of the Act and
prior to June 1, 1997 that applies equally to all out-of-state banks and
expressly prohibits merger transactions involving out-of-state banks. North
Carolina has enacted legislation permitting interstate banking transactions.
Interstate acquisitions of branches will be permitted only if the law of the
state in which the branch is located permits such acquisitions. Interstate
mergers and branch acquisitions will also be subject to the nationwide and
statewide insured deposit concentration amounts described above.
The Act authorizes the FDIC to approve interstate branching de novo by
state banks only in states which specifically allow for such branching. The
Riegle-Neal Act also requires the appropriate federal banking agencies to
prescribe regulations by June 1, 1997 which prohibit any out-of-state bank from
using the interstate branching authority primarily for the purpose of deposit
production. These regulations must include guidelines to ensure that interstate
branches operated by an out-of-state bank in a host state are reasonably helping
to meet the credit needs of the communities which they serve.
Dividends. The Federal Reserve Board has issued a policy statement on the
payment of cash dividends by bank holding companies, which expresses the Federal
Reserve Board's view that a bank holding company should pay cash dividends only
to the extent that the company's net income for the past year is sufficient to
cover both the cash dividends and a rate of earning retention that is consistent
with the company's capital needs, asset quality and overall financial condition.
The Federal Reserve Board also indicated that it would be inappropriate for a
company experiencing serious financial problems to borrow funds to pay
dividends. Furthermore, under the prompt corrective action regulations adopted
by the Federal Reserve Board pursuant to FDICIA, the Federal Reserve Board may
prohibit a bank holding company from paying any dividends if the holding
company's bank subsidiary is classified as "undercapitalized". See "--
Depository Institution Regulation -- Prompt Corrective Regulatory Action."
Bank holding companies are required to give the Federal Reserve Board prior
written notice of any purchase or redemption of its outstanding equity
securities if the gross consideration for the purchase or redemption, when
combined with the net consideration paid for all such purchases or redemptions
during the preceding 12 months, is equal to 10% or more of the their
consolidated retained earnings. The Federal Reserve Board may disapprove such a
purchase or redemption if it determines that the proposal would constitute an
unsafe or unsound practice or would violate any law, regulation, Federal Reserve
Board order, or any condition imposed by, or written agreement with, the Federal
Reserve Board.
The Federal Reserve Board has adopted guidelines regarding the capital
adequacy of bank holding companies, which require bank holding companies to
maintain specified minimum ratios of capital to total assets and capital to
risk-weighted assets. See " -- Depository Institution Regulation -- Capital
Requirements."
TAXATION - GENERAL
The Bank files a federal income tax return based on a fiscal year ending
September 30.
FEDERAL INCOME TAXATION
The Bank is subject to the provisions of the Internal Revenue Code of 1986,
as amended (the "Internal Revenue Code") in the same general manner as other
corporations. In its form as a savings bank until April 1997, through tax years
beginning before December 31, 1995, institutions such as the Bank which met
certain definitional tests and other conditions prescribed by the Internal
Revenue Code benefitted from certain favorable provisions regarding their
deductions from taxable income for annual additions to their bad debt reserve.
For purposes of the bad debt reserve deduction, loans are separated into
"qualifying real property loans," which generally are loans secured by interests
in
28
<PAGE>
certain real property, and "nonqualifying loans", which are all other loans. The
bad debt reserve deduction with respect to nonqualifying loans must be based on
actual loss experience. The amount of the bad debt reserve deduction with
respect to qualifying real property loans may be based upon actual loss
experience (the "experience method") or a percentage of taxable income
determined without regard to such deduction (the "percentage of taxable income
method"). Under the experience method, the bad debt deduction for an addition to
the reserve for qualifying real property loans was an amount determined under a
formula based generally on the bad debts actually sustained by a savings
institution over a period of years. Under the percentage of taxable income
method, the bad debt reserve deduction for qualifying real property loans was
computed as 8% of a savings institution's taxable income, with certain
adjustments. The Bank generally elected to use the method which has resulted in
the greatest deductions for federal income tax purposes in any given year.
Legislation that became effective for tax years beginning after December
31, 1995 requiring the Bank to recapture into taxable income over a six taxable
year period the portion of the tax loan reserve that exceeds the pre-1988 tax
loan loss reserve. The Bank will no longer be allowed to use the reserve method
for tax loan loss provisions, but would be allowed to use the experience method
of accounting for bad debts. There will be no future effect on net income from
the recapture because the taxes on these bad debts reserves has already been
accrued as a deferred tax liability.
The Bank's federal income tax returns have been audited through the year
ended September 30, 1992.
STATE INCOME TAXATION
Under North Carolina law, the corporate income tax currently is 7.50% of
federal taxable income as computed under the Internal Revenue Code, subject to
certain prescribed adjustments. For the tax years beginning in 1998, 1999 and
2000, this rate will be reduced to 7.25%, 7.00% and 6.90%, respectively. An
annual state franchise tax is imposed at a rate of .15% applied to the greatest
of the institutions (i) capital stock, surplus and undivided profits, (ii)
investment in tangible property in North Carolina or (iii) appraised valuation
of property in North Carolina.
For additional information regarding taxation, see Notes 1 and 11 of Notes
to Consolidated Financial Statements.
29
<PAGE>
ITEM 2. PROPERTIES
- ------------------
The following table sets forth the location and certain additional
information regarding the Bank's offices at September 30, 1998.
<TABLE>
<CAPTION>
Book Value at
Year Owned or September 30, Approximate
Opened Leased 1998 Square Footage
------ -------- ------------- --------------
(Dollars in thousands)
<S> <C> <C> <C> <C>
MAIN OFFICE:
1311 Carolina Avenue
Washington, NC 27889 1986 Owned $ 735 10,200
BRANCH OFFICES:
300 North Market Street
Washington, NC 27889 1959 Owned 236 4,680
301 E. Arlington Blvd.
Greenville, NC 27835 1993 Owned 374 2,600
604 E. Ehringhaus Street
Elizabeth City, NC 27906 1980 Owned 399 2,500
827 Hardee Road
Kinston, NC 28501 1996 Leased 49 2,000
1725 Glenburnie Road
New Bern, NC 28561 1990 Owned 404 2,600
202 Craven Street
New Bern, NC 28560 1995 Leased 65 2,500
300 Sunset Avenue
Rocky Mount, NC 27804 1994 Owned 405 4,948
OPERATIONS CENTER:
239 West Main Street
Washington, NC 27889 1994 Owned 445 7,600
FUTURE BRANCH SITES:
Cypress Landing
Chocowinity, NC Owned 126
Taberna
New Bern, NC Owned 176
</TABLE>
The book value of the Bank's investment in premises and equipment was $3.6
million at September 30, 1998. See Note 6 to Consolidated Financial Statements.
30
<PAGE>
ITEM 3. LEGAL PROCEEDINGS.
- --------------------------
From time to time, the Company and/or the Bank is a party to various legal
proceedings incident to their business. At September 30, 1998, there were no
legal proceedings to which the Company or the Bank was a party, or to which any
of their property was subject, which were expected by management to result in a
material loss to the Company or the Bank. There are no pending regulatory
proceedings to which the Company or the Bank is a party or to which either of
their properties is subject which are currently expected to result in a material
loss.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.
- ----------------------------------------------------------
Not applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS'
- --------------------------------------------------------------------------------
MATTERS
-------
The information contained under the sections captioned "Market Information"
in the Company's Annual Report to Stockholders for the Fiscal Year Ended
September 30, 1998 (the "Annual Report") filed as Exhibit 13 hereto is
incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
- -------------------------------
The information contained in the table captioned "Selected Consolidated
Financial and Other Data" on page 2 in the Annual Report is incorporated herein
by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
- --------------------------------------------------------------------------------
OF OPERATIONS
-------------
The information contained in the section captioned "Management's Discussion
and Analysis of Financial Condition and Results of Operations" on pages 3
through 13 in the Annual Report is incorporated herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
- -------------------------------------------------------------------
The information contained under the sections captioned "Market Risk" on
page 5 in the Annual Report is incorporated herein be reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ---------------------------------------------------
The Consolidated Financial Statements, Notes to Consolidated Financial
Statements, Independent Auditors' Report and Selected Financial Data contained
on pages 14 through 34 in the Annual Report, which are listed under Item 14
herein, are incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
- --------------------------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------
Not applicable.
31
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- -----------------------------------------------------------
The information contained under the sections captioned "Proposal I --
Election of Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's definitive proxy statement for the Company's 1999
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.
ITEM 11. MANAGEMENT REMUNERATION
- --------------------------------
The information contained under the sections captioned "Proposal I --
Election of Directors," "-- Compensation Committee Interlocks and Insider
Participation," "-- Compensation Committee Report on Executive Compensation," "
- -- Comparative Stock Performance Graph," " -- Executive Compensation" and
"--Director Compensation" " in the Proxy Statement is incorporated herein by
reference.
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 "Voting Securities and Security Ownership" in the Proxy
Statement.
(b) Security Ownership of Management. Information required by this item is
incorporated herein by reference to the sections captioned "Voting
Securities and Security Ownership" and "Proposal I -- Election of
Directors" in the Proxy Statement.
(c) Changes in Control. Management of the Company knows of no
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 registrant.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- -------------------------------------------------------
The information required by this item is incorporated herein by reference
to the section captioned "Proposal I -- Election of Directors -- Transactions
with Management" in the Proxy Statement.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
- -------------------------------------------------------------------------
(a) LIST OF DOCUMENTS FILED AS PART OF THIS REPORT
----------------------------------------------
(1) Financial Statements. The following consolidated financial statements
are incorporated by reference from Item 8 hereof (see Exhibit 13):
Independent Auditors' Report
Consolidated Statements of Financial Condition as of September 30, 1998 and
1997
Consolidated Statements of Operations for the Years Ended September 30,
1998, 1997 and 1996
Consolidated Statements of Stockholders Equity for the Years Ended
September 30, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the Years Ended September 30,
1998, 1997 and 1996
Notes to Consolidated Financial Statements
32
<PAGE>
(2) Financial Statement Schedules. All schedules for which provision is
made in the applicable accounting regulations of the Securities and Exchange
Commission are omitted because of the absence of conditions under which they are
required or because the required information is included in the consolidated
financial statements and related notes thereto.
(3) Exhibits. The following is a list of exhibits filed as part of this
Annual Report on Form 10-K and is also the Exhibit Index.
No. Description
--- -----------
3.1 Certificate of Incorporation of NewSouth Bancorp, Inc.
(Incorporated herein by reference from Exhibit 3.1 to the
Company's Registration Statement on Form S-1 (File No.
333-16335))
3.2 Bylaws of NewSouth Bancorp, Inc. (Incorporated herein by
reference from Exhibit 3.2 to the Company's Registration
Statement on Form S-1 (File No. 333-16335))
4 Form of Common Stock Certificate of NewSouth Bancorp, Inc.
(Incorporated herein by reference from Exhibit 1 to the Company's
Registration Statement on Form 8-A))
10.1(a) Employment Agreement between NewSouth Bancorp, Inc. and Thomas A.
Vann (Incorporated herein by reference from Exhibit 10.3(a) to
the Company's Registration Statement on Form S-1 (File No.
333-16335))
10.1(b) Employment Agreement between Home Savings Bank, SSB and Thomas A.
Vann (Incorporated herein by reference from Exhibit 10.3(b) to
the Company's Registration Statement on Form S-1 (File No.
333-16335))
10.2 Change in Control Protective Agreements between Home Savings
Bank, SSB, NewSouth Bancorp, Inc. and Mary R. Boyd, Sherry L.
Correll, Kristie W. Hawkins, Walter P. House and William R.
Outland (Incorporated herein by reference from Exhibit 10.4 to
the Company's Registration Statement on Form S-1 (File No.
333-16335))
10.3 Supplemental Income Agreements as Amended and Restated December
14, 1995 between Home Savings Bank, SSB and Sherry L. Correll,
William R. Outland and Thomas A. Vann and the 1996 Amendment
Thereto (Incorporated herein by reference from Exhibit 10.5 to
the Company's Registration Statement on Form S-1 (File No.
333-16335))
10.4 Supplemental Income Plan Agreements as Amended and Restated
December 14, 1995 between Home Savings Bank, SSB and James F.
Buckman, Walter P. House, Thomas A. Vann and William L. Wall and
the 1996 Amendment Thereto (Incorporated herein by reference from
Exhibit 10.6 to the Company's Registration Statement on Form S-1
(File No. 333-16335))
10.5 Home Savings Bank, SSB Director's Deferred Compensation Plan
Agreements as Amended and Restated December 14, 1995 with Edmund
T. Buckman, Jr., Linley H. Gibbs, Jr., Frederick N. Holscher,
Frederick H. Howdy, Charles E. Parker, Jr., Marshall T. Singleton
and Thomas A. Vann and the 1996 Amendment Thereto (Incorporated
herein by reference from Exhibit 10.7 to the Company's
Registration Statement on Form S-1 (File No. 333-16335))
10.6 Home Savings Bank, SSB Director's Retirement Plan Agreements as
Amended and Restated December 14, 1995 with Edmund T. Buckman,
Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H.
Howdy, Charles E. Parker, Jr. and Thomas A. Vann and the 1996
Amendment Thereto (Incorporated herein by reference from Exhibit
10.8 to the Company's Registration Statement on Form S-1 (File
No. 333-16335))
10.7 Home Savings Bank, SSB Director's Retirement Payment Agreements
as Amended and Restated December 14, 1995 with Edmund T. Buckman,
Jr., Linley H. Gibbs, Jr., Frederick N. Holscher, Frederick H.
Howdy, Charles E. Parker, Jr., and Thomas A. Vann and the 1996
Amendment Thereto (Incorporated herein by reference from Exhibit
10.9 to the Company's Registration Statement on Form S-1 (File
No. 333-16335))
10.8 Home Savings Bank, SSB Directors Retirement Plan Agreement with
Marshall Singleton (Incorporated herein by reference from Exhibit
10.10 to the Company's Registration Statement on Form S-1 (File
No. 333-16335))
33
<PAGE>
13 Annual Report to Stockholders
21 Subsidiaries of the Registrant
23 Consent of PricewaterhouseCoopers, LLP
27 Financial Data Schedule
(b) REPORTS ON FORM 8-K. On July 16, 1998, the Company filed a Current
Report on Form 8-K reporting under Item 5 that the Board of Directors approved a
3-for-2 common stock split in the form of a 50% stock dividend and an increase
in the quarterly cash dividend rate.
On September 24, 1998, the Company filed a Current Report on Form 8-K,
reporting under Item 5 that it had completed the previously announced 5% stock
repurchase program and had adopted a program to repurchase an additional 5% of
its issued and outstanding shares of common stock.
(c) EXHIBITS. The exhibits required by Item 601 of Regulation S-K are
either filed as part of this Annual Report on Form 10-K or incorporated by
reference herein.
(d) FINANCIAL STATEMENTS AND SCHEDULES EXCLUDED FROM ANNUAL REPORT. There
are no other financial statements and financial statement schedules which were
excluded from the Annual Report to Stockholders pursuant to Rule 14a-3(b) which
are required to be included herein.
34
<PAGE>
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.
NEWSOUTH BANCORP, INC.
December 22, 1998
By: /s/ Thomas A. Vann
------------------------------
Thomas A. Vann
President
Pursuant to the requirements of 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.
/s/ Thomas A. Vann December 22, 1998
- --------------------------------------------
Thomas A. Vann
President and Director
(Principal Executive Officer)
/s/ William L. Wall December 22, 1998
- --------------------------------------------
William L. Wall
Executive Vice President, Chief Financial
Officer and Secretary
(Principal Financial and Accounting Officer)
/s/ Edmund T. Buckman, Jr. December 22, 1998
- --------------------------------------------
Edmund T. Buckman, Jr.
Director
/s/ Linley H. Gibbs, Jr. December 22, 1998
- --------------------------------------------
Linley H. Gibbs, Jr.
Director
/s/ Frederick N. Holscher December 22, 1998
- --------------------------------------------
Frederick N. Holscher
Director
/s/ Frederick H. Howdy December 22, 1998
- --------------------------------------------
Frederick H. Howdy
Director
/s/ Charles E. Parker, Jr. December 22, 1998
- --------------------------------------------
Charles E. Parker, Jr.
Director
/s/ Marshall T. Singleton December 22, 1998
- --------------------------------------------
Marshall T. Singleton
Director
NewSouth Bancorp, Inc.
and Subsidiary
Consolidated Financial Statements
Years ended September 30, 1998, 1997 and 1996
<PAGE>
TABLE OF CONTENTS
Letter to Stockholders 1
Selected Consolidated Financial Information and Other Data 2
Management's Discussion and Analysis of Financial Condition
and Results of Operations 3
Report of Independent Accountants 14
Consolidated Statements of Financial Condition 15
Consolidated Statements of Operations 16
Consolidated Statements of Stockholders' Equity 17
Consolidated Statements of Cash Flows 18
Notes to Consolidated Financial Statements 20
Board of Directors 35
Executive Officers 35
NewSouth Bank Office Locations 35
Stockholder Information 36
MISSION STATEMENT
"Our mission is to become the premier community bank in eastern North Carolina.
We will enhance shareholder value by serving the personal and business needs of
our markets, providing superior customer service, investing in the communities
that we serve, and enriching the lives of our employees."
<PAGE>
LETTER TO STOCKHOLDERS
To Our Stockholders:
It is a pleasure to present the results of operations of NewSouth Bancorp and
its subsidiary, NewSouth Bank, for the year ended September 30, 1998. The year
contained many significant events. Record earnings were achieved, the Bank's
loan portfolio increased to record levels, a 50% stock dividend was declared and
the cash dividend was increased. We are pleased with the results achieved during
1998 and are encouraged about the future of the Company.
The financial results for our first full year were gratifying. Net income for
the year was $3.1 million or $0.80 per share, representing a 38% increase over
the $2.3 million earned in 1997. Due to our financial performance, the Board of
Directors declared a 50% stock dividend and increased the cash dividend rate by
5%. To enhance shareholder value and earnings per share, we implemented a stock
repurchase program during 1998, purchasing 218,202 shares as treasury stock. In
September 1998, the Company announced a second program to purchase an additional
5%, or 207,292 shares of its common stock. We believe these purchases are an
effective means of enhancing shareholder value.
The Bank experienced positive growth trends in both loans and deposits
throughout the year. This success resulted in a 13% growth in assets to $281
million at year end 1998 from $249 million at year end 1997. Net loans grew by
14% to $225 million at year end 1998 from $198 million at year end 1997. At the
same time, deposits grew by 17% to $205 million at year end 1998 from $175
million at year end 1997. As we continue our commercial bank transition, and to
support the growth and risk associated with the emphasis placed on commercial
and consumer lending, our loan portfolio is supported by loan loss reserves of
$3.4 million, or 1.5% of total loans outstanding at year end.
We completed the conversion to a new data processing system in 1998 that will
give us access to the very best in technology and enable us to provide our
customers with a variety of new products and services. I want to thank all of
our employees who gave unselfishly of their time and talents to make the
transition to a new data center so successful. We are extremely fortunate to
have such a dedicated and professional staff that is committed to the success of
our Company.
We are pleased to announce that we will be opening our ninth full-service branch
office in Chocowinity by mid-1999. This office will complement our other
Beaufort County branches and will serve as an additional base of operation for
developing customer relationships and meeting the banking needs of our growing
market. Continuing our commitment to provide outstanding service to our
customers, we have recently installed new drive up ATM units in the Elizabeth
City, New Bern and Washington markets. Also, the Bank has put in place the
NewSouth Bank AccessLine, providing customers access to their current account
information 24 hours a day, seven days a week.
Each member of your Board of Directors along with our officers and employees
join me in thanking you for your continued support of NewSouth Bancorp. As
always, your comments or suggestions are welcomed and we look forward to your
continued support.
Sincerely,
/s/ Tom Vann
Tom Vann
President
1
<PAGE>
SELECTED CONSOLIDATED FINANCIAL INFORMATION AND OTHER DATA
<TABLE>
<CAPTION>
September 30,
------------------------------------------------------------
1998 1997 1996 1995 1994
-------- -------- -------- -------- --------
(Dollars in thousands)
Selected Financial Condition Data
- ---------------------------------
<S> <C> <C> <C> <C> <C>
Total assets $281,479 $249,281 $194,139 $177,704 $165,996
Loans receivable, net 224,999 197,785 155,681 144,541 135,679
Cash and investment securities 20,119 18,856 16,684 4,788 5,817
Mortgage-backed securities 27,017 24,818 14,797 22,285 18,535
Deposits 204,635 175,116 171,213 153,457 131,592
Borrowings 11,933 12,621 1,040 4,000 16,500
Stockholders' equity 56,714 57,856 18,347 17,688 15,620
Selected Operations Data
- ------------------------
Interest income $ 21,867 $ 18,515 $ 15,349 $ 14,385 $ 11,811
Interest expense 9,240 8,346 8,105 7,344 5,204
-------- -------- -------- -------- --------
Net interest income 12,627 10,169 7,244 7,041 6,607
Provision for loan losses 310 931 511 20 210
Noninterest income 2,646 1,685 1,833 1,502 1,652
Noninterest expenses 9,940 6,941 7,295 5,660 4,801
-------- -------- -------- -------- --------
Income before income taxes 5,023 3,982 1,271 2,863 3,248
Income taxes 1,900 1,719 451 998 1,011
-------- -------- -------- -------- --------
Net income $ 3,123 $ 2,263 $ 820 $ 1,865 $ 2,237
======== ======== ======== ======== ========
Earnings per share (1)(2) $ .80 $ .35 $ -- $ -- $ --
======== ======== ======== ======== ========
Dividends per share (2) $ .27 $ .13 $ -- $ -- $ --
======== ======== ======== ======== ========
Selected Financial Ratios and Other Data
- ----------------------------------------
Performance Ratios:
Return on average assets 1.19% 1.00% .45% 1.07% 1.28%
Return on average equity 5.40 6.57 4.45 11.17 13.38
Interest rate spread 4.03 4.10 3.72 3.84 4.25
Net interest margin 5.05 4.67 4.12 4.21 4.48
Average earning assets to average
interest-bearing liabilities 127.57 115.00 108.52 108.40 106.58
Noninterest expense to average assets 3.80 3.06 3.97 3.26 3.08
Dividend payout ratio 33.75 37.14 -- -- --
Quality Ratios:
Nonperforming assets to total assets .43% .65% .62% .42% .31%
Nonperforming loans to total loans .36 .64 .66 .47 .25
Loan loss reserves to total loans 1.50 1.64 1.51 1.30 1.46
Loan loss reserves to nonperforming
loans 419.45 257.45 227.37 275.62 583.19
Provision for loan losses to total loans .14 .47 .32 .01 .15
Capital Ratios:
Equity to total assets, end of period 19.95% 23.23% 9.45% 9.95% 9.41%
Average equity to average assets 22.14 15.17 10.05 9.61 9.54
Other Data:
Full service offices 8 8 8 8 6
Loans serviced for others $250,202 $253,647 $253,682 $229,635 $205,141
</TABLE>
- ---------------
(1) Applies to net income of $1,395,900 earned for the period April 8, 1997 to
September 30, 1997.
(2) Adjusted for three-for-two stock split on August 19, 1998.
2
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
Prior to April 7, 1997 NewSouth Bancorp, Inc. (the "Company") had no assets
or liabilities and engaged in no business activities. The Company was formed for
the purpose of issuing common stock and owning 100% of the stock of NewSouth
Bank (the "Bank") and operating through the Bank a commercial banking business.
Subsequent to the stock conversion, the Company has engaged in no significant
activity other than holding the stock of the Bank, therefore, this discussion
relates to the consolidated financial condition and results of operations of the
Company and the Bank.
The business of the Bank consists principally of attracting deposits from
the general public and using them to originate secured and unsecured commercial
and consumer loans, permanent mortgage and construction loans secured by
single-family residences, credit cards and other loans. The Bank's earnings
depend primarily on its net interest income, which is the difference between
interest earned on interest-earning assets and interest paid on interest-bearing
liabilities. The Bank's earnings are also affected by the level of its
noninterest income and expenses.
The operations of the Bank are affected by prevailing economic conditions
as well as policies of federal and state regulatory authorities. The Bank's cost
of funds is influenced by interest rates paid on competing investments, rates
offered on deposits by other financial institutions in the Bank's market area
and by general market interest rates. Lending activities are affected by the
demand for financing of real estate and various types of commercial and consumer
loans, which are influenced by interest rates at which such financing may be
offered.
The Bank's business emphasis is to operate as a well-capitalized,
profitable and independent community oriented financial institution dedicated to
providing quality customer service and meeting the financial needs of the
communities it serves. Management believes the Bank can be more effective in
serving its customers than many larger competitors, because of its ability to
quickly and effectively respond to customer needs and inquiries. The Bank's
ability to provide these services is enhanced by the stability of the Bank's
senior management team.
LIQUIDITY AND CAPITAL RESOURCES
As a state chartered commercial bank, the Bank must meet certain liquidity
requirements established by the North Carolina Office of The Commissioner of
Banks (the "Commissioner"). Savings banks which convert to commercial banks are
required to maintain 15% liquidity pursuant to the conversion guidelines adopted
by the Commissioner. The Bank's liquidity ratio, as computed under these
guidelines, was 15.1% at September 30, 1998 and 15.9% at September 30, 1997.
The Bank's primary sources of funds are deposits, principal and interest
payments on loans, proceeds from loan sales and advances from the Federal Home
Loan Bank of Atlanta (the "FHLB"). While maturities and scheduled amortization
of loans are predictable sources of funds, deposit flows and mortgage
prepayments are greatly influenced by interest rates, economic conditions and
local competition.
The primary investing activity of the Bank is the origination of
commercial, consumer and mortgage loans. During the years ended September 30,
1998 and 1997, the Bank had loan originations of $173.1 million and $143.7
million, respectively. The primary financing activities of the Bank are the
attraction of checking, certificate and savings deposits, and obtaining FHLB
advances.
The Bank's most liquid assets are cash and cash equivalents. The levels of
these assets are dependent on the Bank's operating, financing, lending and
investing activities during any given period. At September 30, 1998 and 1997,
cash and cash equivalents totaled $17.0 million and $15.8 million, respectively.
The Bank has other sources of liquidity if a need for additional funds arises.
During the years ended September 30, 1998 and 1997, the Bank sold and exchanged
real estate loans totaling $54.1 million and $31.7 million, respectively. At
September 30, 1998, the Bank had $9.5 million of FHLB advances, compared to
$11.0 million at September 30, 1997. At September 30, 1998, the Bank had $1.9
million of retail repurchase agreements, compared to $1.6 million at September
30, 1997. Other sources of liquidity include investment and mortgage-backed
securities designated as
3
<PAGE>
available for sale, which totaled $30.1 million at September 30, 1998 and $27.9
million at September 30, 1997.
At September 30, 1998 stockholders' equity was $56.7 million compared to
$57.8 million at September 30, 1997. On April 7, 1997 the Company issued
2,909,500 shares of common stock and received net proceeds of $42.5 million,
including $3.5 million in shares purchased by the Employee Stock Ownership Plan
("ESOP"). On August 19, 1998 the Company had a three-for-two stock split paid in
the form of a 50% stock dividend. At September 30, 1998 the Company had
4,145,842 shares of common stock outstanding, net of 218,202 treasury shares.
Net income for the year ended September 30, 1998 was $3.1 million, compared to
$2.3 million for the year ended September 30, 1997.
As a North Carolina chartered commercial bank and a Federal Deposit
Insurance Corporation (the "FDIC") insured institution, the Bank is required to
meet various capital standards by its state and federal regulatory agencies. The
Bank's stand-alone equity was $42.0 million at September 30, 1998, compared to
$39.9 million at September 30, 1997, which is substantially in excess of all
such regulatory requirements. The Commissioner requires the Bank at all times to
maintain a capital surplus of not less than 50% of common capital stock. The
FDIC requires the Bank to meet a minimum leverage capital requirement of Tier I
capital (consisting of retained earnings and common stockholders' equity, less
any intangible assets) to assets ratio of at least 4% and a total capital to
risk-weighted assets ratio of 8%, of which 4% must be in the form of Tier I
capital. The Bank was in compliance with all capital requirements of both the
Commissioner and the FDIC at September 30, 1998 and September 30, 1997.
ASSET/LIABILITY MANAGEMENT
The Bank strives to achieve consistent net interest income and reduce its
exposure to adverse changes in interest rates by matching the terms to repricing
of its interest-sensitive assets and liabilities. Factors beyond the Bank's
control, such as market interest rates and competition, may also have an impact
on the Bank's interest income and interest expense.
In the absence of any other factors, the overall yield on the Bank's
earning assets generally will increase from existing levels when interest rates
rise over an extended period of time, and conversely interest income will
decrease when interest rates decrease. In general, interest expense will
increase when interest rates rise over an extended period of time, and
conversely interest expense will decrease when interest rates decrease.
Therefore, by controlling the increases and decreases in its interest income and
interest expense which are caused by changes in market interest rates, the Bank
can significantly influence its net interest income.
The President of the Bank reports to the Board of Directors on a regular
basis on interest rate risk and trends, as well as liquidity and capital ratios
and requirements. The Board of Directors reviews the maturities of the Bank's
assets and liabilities and establishes policies and strategies designed to
regulate the Bank's flow of funds and to coordinate the sources, uses and
pricing of such funds. The first priority in structuring and pricing the Bank's
assets and liabilities is to maintain an acceptable interest rate spread while
reducing the net effects of changes in interest rates. The Bank's management is
responsible for administering the policies and determinations of the Board of
Directors with respect to the Bank's asset and liability goals and strategies.
A principal strategy in managing the Bank's interest rate risk has been to
increase interest rate sensitive assets such as commercial business loans and
consumer loans. At September 30, 1998, the Bank had $20.8 million of commercial
business loans and $48.4 million of consumer loans, or 8.6% and 20.0%,
respectively, of the Bank's gross loan portfolio, compared to $16.4 million and
$49.9 million, respectively, at September 30, 1997. At September 30, 1998, the
Bank had $38.4 million of loans held for sale, compared to $25.1 million at
September 30, 1997. Depending on conditions existing at a given time, as part of
its interest rate risk management strategy, the Bank may sell fixed-rate
residential mortgage loans in the secondary market.
In managing its portfolio of investment securities, the Bank has emphasized
the purchase of short-term securities to reduce it's exposure to increases in
interest rates. The Bank had $30.1 million of investment and mortgage-backed
securities classified as available for sale at September 30, 1998, compared to
$27.9 million at September 30, 1997. The Bank is holding these loans, investment
and mortgage-backed securities as available for sale so that they may be sold if
needed for liquidity or asset and liability management purposes.
4
<PAGE>
MARKET RISK
Market risk reflects the risk of economic loss resulting from changes in
market prices and interest rates. The risk of loss can be reflected in
diminished current market values and/or reduced potential net interest income in
future periods. The Bank's market risk arises primarily from interest rate risk
inherent in its lending and deposit taking activities. The Bank does not
maintain a trading account for any class of financial instruments, nor does it
engage in hedging activities or purchase high-risk derivative instruments.
Furthermore, the Bank is not subject to foreign currency exchange risk or
commodity price risk.
Management measures the Bank's interest rate risk by computing estimated
changes in net interest income and the net portfolio value ("NPV") 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. The Bank's exposure to
interest rates is reviewed on a quarterly basis by senior management and the
Board of Directors. Exposure to interest rate risk is measured with the use of
interest rate sensitivity analysis to determine the change in NPV in the event
of hypothetical changes in interest rates, while interest rate sensitivity gap
analysis is used to determine the repricing characteristics of the Bank's assets
and liabilities. If estimated changes to NPV and net interest income are not
within the limits established by the Board, the Board may direct management to
adjust the Bank's asset and liability mix to bring interest rate risk within
Board approved limits.
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 1% to
4% increases and decreases in market interest rates. The Bank's Board of
Directors has adopted an interest rate risk policy which establishes maximum
increases in NPV of 17%, 36%, 56% and 83% and decreases in NPV of 15%, 36%, 61%
and 90% in the event of sudden and sustained 1% to 4% increases or decreases in
market interest rates. Table 1 below presents the Bank's projected change in NPV
for the various rate shock levels at September 30, 1998.
TABLE 1 - PROJECTED CHANGE IN NPV AND NET INTEREST INCOME
Net Portfolio Value Net Interest Income
Change ----------------------------- ------------------------------
in Rates $ Amount $ Change % Change $ Amount $ Change % Change
- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
+ 400 bp $50,867 $(14,939) (22.7)% $ 12,094 $ (19) (.16)%
+ 300 bp 55,000 (10,806) (16.4) 12,134 21 .17
+ 200 bp 59,133 (6,673) (10.1) 12,174 61 .50
+ 100 bp 62,470 (3,336) (5.1) 12,144 31 .25
Base 65,806 -- -- 12,113 -- --
- - 100 bp 67,289 1,483 2.2 11,998 (115) (.95)
- - 200 bp 68,772 2,966 4.5 11,883 (230) (1.90)
- - 300 bp 70,354 4,548 6.9 11,751 (362) (2.99)
- - 400 bp 71,935 6,129 9.3 11,619 (494) (4.08)
Table 1 indicates that at September 30, 1998, in the event of sudden and
sustained increases in market interest rates, the Bank's estimated net interest
income would be expected to increase and NPV would be expected to decrease, and
that in the event of sudden and sustained decreases in market interest rates,
estimated net interest income would be expected to decrease and NPV would be
expected to increase. At September 30, 1998, the Bank's estimated changes in NPV
were within the targets established by the Board of Directors.
Computations of prospective effects of hypothetical interest rate changes
are based on numerous assumptions, including relative levels of market interest
rates, loan prepayments and deposit decay rates, and should not be relied upon
as indicative of actual results. Further, the computations do not contemplate
any actions the Bank may undertake in response to changes in interest rates. The
NPV calculation is based on the net present value of discounted cash flows
utilizing market prepayment assumptions and market rates of interest provided by
surveys performed during each quarterly period, with adjustments made to reflect
the shift in the Treasury yield curve between the survey date and the quarter
end date.
5
<PAGE>
Certain shortcomings are inherent in the method of analysis presented in
Table 1. For example, although certain assets and liabilities may have similar
maturities to repricing, they may react in differing degrees to changes in
market interest rates. 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. Certain
assets such as adjustable-rate loans have features which restrict changes in
interest rates on a short-term basis and over the life of the asset. In
addition, the proportion of adjustable-rate loans in the Bank's portfolio could
decrease in future periods if market interest rates remain at or decrease below
current levels due to refinance activity. Further, in the event of a change in
interest rates, prepayment and early withdrawal levels would likely deviate from
those assumed in the table. Also, the ability of many borrowers to repay their
adjustable-rate debt may decrease in the event of an increase in interest rates.
In addition, the Bank uses interest rate sensitivity gap analysis to
monitor the relationship between the maturity and repricing of its
interest-earning assets and interest-bearing liabilities, while maintaining an
acceptable interest rate spread. Interest rate sensitivity gap is defined as the
difference between the amount of interest-earning assets maturing or repricing
within a specific time period and the amount of interest-bearing liabilities
maturing or repricing within that time period. A gap is considered positive when
the amount of interest-rate-sensitive assets exceeds the amount of
interest-rate-sensitive liabilities, and is considered negative when the amount
of interest-rate-sensitive liabilities exceeds the amount of
interest-rate-sensitive assets. Generally, during a period of rising interest
rates, a negative gap would adversely affect net interest income, while a
positive gap would result in an increase in net interest income. Conversely,
during a period of falling interest rates, a negative gap would result in an
increase in net interest income, while a positive gap would negatively affect
net interest income. The Bank's goal is to maintain a reasonable balance between
exposure to interest rate fluctuations and earnings.
RATE/VOLUME ANALYSIS
Net interest income can also be analyzed in terms of the impact of changing
interest rates on average interest-earning assets and average interest-bearing
liabilities and the changing volume or amount of these assets and liabilities.
Table 2 below represents the extent to which changes in interest rates and
changes in the volume of average interest-earning assets and average
interest-bearing liabilities have affected the Bank's interest income and
interest expense during the periods indicated. For each category of average
interest-earning asset and average interest-bearing liability, information is
provided on changes attributable to: (i) changes in volume (changes in volume
multiplied by old rate); (ii) changes in rate (change in rate multiplied by old
volume); (iii) changes in rate-volume (changes in rate multiplied by the changes
in volume); and (iv) net change (total of the previous columns).
TABLE 2 - RATE/VOLUME ANALYSIS
<TABLE>
<CAPTION>
Year Ended September 30,
-----------------------------------------------------------------------------------------
1998 vs. 1997 1997 vs. 1996
------------------------------------------ -----------------------------------------
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------------------------ -----------------------------------------
Rate/ Rate/
Volume Rate Volume Total Volume Rate Volume Total
------ ---- ------ ----- ------ ---- ------ -----
(In thousands)
Interest income:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Loans receivable $ 2,670 $ 104 $ 17 $ 2,791 $ 2,509 $ 133 $ 24 $ 2,666
Investment securities (54) 47 (8) (15) 3 12 -- 15
Mortgage-backed securities 784 (10) (5) 769 292 (15) (3) 274
Other interest-earning assets (250) 101 (44) (193) 668 (161) (297) 210
------- ------- ------- ------- ------- ------- ------- -------
Total interest-earning assets 3,150 242 (40) 3,352 3,472 (31) (276) 3,165
------- ------- ------- ------- ------- ------- ------- -------
Interest expense:
Deposits 369 610 29 1,008 1,261 (958) (154) 149
FHLB advances (138) 1 (1) (138) 74 (11) (6) 57
Other interest-bearing
liabilities 33 (6) (3) 24 20 8 7 17
------- ------- ------- ------- ------- ------- ------- -------
Total interest-bearing
liabilities 264 605 25 894 1,355 (961) (153) 241
------- ------- ------- ------- ------- ------- ------- -------
Change in net interest income $ 2,886 $ (363) $ (65) $ 2,458 $ 2,117 $ 930 $ (123) $ 2,924
======= ======= ======= ======= ======= ======= ======= =======
</TABLE>
6
<PAGE>
TABLE 3 - YIELD/COST ANALYSIS
<TABLE>
<CAPTION>
Year Ended September 30,
---------------------------------------------------------------------------------------
1998 1997 1996
------------------------- ------------------------- -------------------------
Average Average Average
Average Yield/ Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost Balance Interest Cost
Interest-earning assets:
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Loans receivable (1) $205,587 $18,888 9.19% $176,311 $16,097 9.13% $148,538 $13,431 9.04%
Investment securities 4,410 311 7.05 5,287 326 6.17 5,236 311 5.94
Mortgage-backed securities 31,565 2,290 7.25 20,832 1,521 7.30 16,881 1,247 7.39
Other Interest-earning assets 8,570 378 4.41 15,249 571 3.75 5,349 361 6.75
-------- ------- ---- ------- ------ ---- -------- ------- ----
Total interest-earning assets 250,132 21,867 8.74 217,679 18,515 8.51 176,004 15,350 8.72
------ ---- ------ ---- ------ ----
Non-interest-earning assets 11,278 9,311 7,579
-------- -------- --------
Total assets $261,410 $226,990 $183,583
======== ======== ========
Interest-bearing liabilities:
Deposits $193,061 9,096 4.71 $184,672 8,088 4.38 $159,304 7,939 4.98
FHLB advances 1,071 64 5.98 3,400 202 5.94 2,250 145 6.44
Other interest-bearing liabilities 1,944 80 4.12 1,218 56 4.60 629 21 3.34
------- ------ ---- -------- ------- ---- -------- ------ ----
Total interest-bearing liabilities 196,076 9,240 4.71 189,290 8,346 4.41 162,183 8,105 5.00
----- ---- ------- ---- ----- ----
Non-interest-bearing liabilities 7,445 3,265 2,958
------- ------- --------
Total liabilities 203,521 192,555 165,141
Stockholders' equity 57,889 34,435 18,442
------- ------- -------
Total liabilities and retained income $261,410 $226,990 $183,583
======== ======== ========
Net interest income $12,627 $10,169 $7,245
======= ======= ======
Interest rate spread (2) 4.03% 4.10% 3.72%
==== ==== ====
Net yield on interest-earning assets (3) 5.05% 4.67% 4.12%
==== ====
Ratio of average interest-earning assets
to average interest bearing liabilities 127.57% 115.00% 108.52%
====== ====== ======
</TABLE>
- ---------------
(1) Includes non-performing loans.
(2) Represents the difference between the average yield on interest-earning
assets and the average cost of interest bearing liabilities.
(3) Represents the net interest income divided by average interest-earning
assets.
7
<PAGE>
ANALYSIS OF NET INTEREST INCOME
Net interest income represents the difference between income derived from
interest-earning assets and the interest expense on interest-bearing
liabilities. Net interest income is affected by both the difference between
rates of interest earned on interest-earning assets and rates paid on
interest-bearing liabilities ("interest rate spread") and the relative volume of
interest-earning assets and interest-bearing liabilities.
Table 3 above sets forth certain information relating to the Bank's
statements of financial condition and statements of operations for the three
years ended September 30, 1998, 1997, and 1996 and reflects the yield on average
interest-earning assets and the cost of average interest-bearing liabilities for
the periods indicated. Average balances are derived from month end balances and
the Bank does not believe that the use of month end balances instead of average
daily balances has caused any material difference in the information presented.
RESULTS OF OPERATIONS
Comparison of Financial Condition at September 30, 1998 and 1997
Total assets increased 12.9% to $281.5 million at September 30, 1998, from
$249.3 million at September 30, 1997. Loans receivable (net of loans-in-process,
deferred fees and loan loss reserves) increased by 13.8% to $225.0 million at
September 30, 1998, from $197.8 million at September 30, 1997. Investment
securities and mortgage-backed securities increased by 8.0% to $30.1 million at
September 30, 1998, from $27.9 million at September 30, 1997.
In order to take advantage of generally higher loan yields as well as
shorter terms, the Bank has increased its emphasis on the origination of both
secured and unsecured commercial and consumer loans. Prior to 1994, a majority
of the loans originated by the Bank were mortgage loans secured by single-family
residences. From time to time, the Bank sells selected mortgage loans in the
secondary market in order to reduce interest rate and credit risk, while
retaining servicing to generate additional fee income.
Commercial real estate loans increased 12.0% to $51.5 million at September
30, 1998, from $46.0 million at September 30, 1997. Commercial business loans
increased 26.8% to $20.8 million at September 30, 1998, from $16.4 million at
September 30, 1997, while consumer loans declined 3.0% to $48.4 million at
September 30, 1998 from $49.9 million at September 30, 1997. Residential real
estate mortgage loans increased 17.6% to $120.2 million at September 30, 1998,
from $102.2 million at September 30, 1997. During fiscal 1998, the Bank
originated $95.7 million of residential real estate mortgage loans, compared to
$66.9 million during fiscal 1997. The Bank sold and exchanged $54.1 million of
real estate loans during fiscal 1998, compared to $31.7 million during fiscal
1997. Loans serviced for others was $250.2 million at September 30, 1998,
compared to $253.6 million at September 30, 1997. Commercial real estate,
commercial business and consumer loan originations increased to $77.4 million
during fiscal 1998, from $76.8 million during fiscal 1997, as the Bank continues
to emphasize structuring itself as a commercial banking entity.
Deposits increased by 16.9% to $204.6 million at September 30, 1998, from
$175.1 million at September 30, 1997. Certificates of deposit increased 18.4% to
$155.4 million at September 30, 1998, from $131.2 million at September 30, 1997,
and the Bank continued its efforts of attracting lower cost core deposits, as
checking accounts increased 16.8% to $42.9 million at September 30, 1998, from
$37.5 million at September 30, 1997. Total borrowings were $12.0 million at
September 30, 1998 compared to $12.6 million at September 30, 1997, supporting
the growth in earning assets and banking operations during the period.
Stockholders' equity was $56.7 million at September 30, 1998, compared to
$57.9 million at September 30, 1997. The ratio of equity to total assets at
September 30, 1998 decreased to 19.9% from 23.2% at September 30, 1997. During
the year ended September 30, 1998, the Company declared four quarterly cash
dividends totaling $1.1 million, reflecting a dividend payout ratio of 33.8%.
Future quarterly dividends will be determined at the discretion of the Board of
Directors based upon earnings, the capital and financial condition of the
Company and general economic conditions.
8
<PAGE>
The Company's note receivable from the ESOP declined to $2.7 million at
September 30, 1998, from $3.1 million at September 30, 1997, reflecting the
release of 43,189 shares to ESOP participants. The note is reported as a
reduction of stockholders' equity and requires an annual $349,000 principal
payment plus interest at prime plus one percent. Although the ESOP note is
secured solely by shares of common stock of the Company, the Bank expects to
make discretionary contributions to the ESOP in amounts at least equal to the
required principal and interest payments. At September 30, 1998, 268,709
unallocated shares remain in the ESOP.
During the year ended September 30, 1998, the stockholders of the Company
approved the Management Recognition Plan ("MRP"), established for the benefit of
directors and officers of the Company and the Bank. During the year ended
September 30,1998 the Company acquired 58,020 additional shares of its common
stock for the MRP, through open market purchases totaling $1.2 million,
completing the purchase of 4% of its outstanding shares. In addition, 58,195 of
the shares awarded to MRP participants were vested, totaling $1.3 million. At
September 30, 1998, 116,374 shares totaling $2.3 million are being held in trust
for MRP participants vesting and are reported as a reduction in stockholders'
equity.
Pursuant to a stock repurchase program adopted by the Company during the
year ended September 30, 1998, the Company acquired 218,202 shares of its common
stock through open market purchases, or 5%, totaling $4.9 million. Shares
acquired under the repurchase program are being held as treasury stock, at cost.
Comparison of Operating Results for the Years Ended September 30, 1998 and 1997
Net Income. Net income increased by 38.0% to $3.1 million for the year
ended September 30, 1998, from $2.3 million for the year ended September 30,
1997. The increase in net income is attributable to a 28.8% increase in net
interest income and other income, offset in part by a 43.2% increase in general
and administrative expenses.
Interest Income. Interest income increased by 18.1% to $21.9 million for
fiscal 1998, from $18.5 million for fiscal 1997. The increase in interest income
on loans and investments during 1998 results principally from the increased
volume of average interest-earning assets. Interest on loans increased by 17.3%
to $18.9 million in fiscal 1998, from $16.1 million in fiscal 1997, due
primarily to a $29.3 million increase in the average balance of loans receivable
between fiscal 1998 and 1997, and an increase in the average yield on loans to
9.19% for fiscal 1998 from 9.13% for fiscal 1997. The average yield on total
average interest-earning assets was 8.7% for 1998 compared to an 8.5% for 1997.
Interest Expense. Interest expense for the year ended September 30, 1998
increased by 10.7% to $9.2 million, from $8.3 million for fiscal 1997. This
resulted principally from an increase in the rates paid on average
interest-bearing liabilities. Total deposits increased by 16.9% to $204.6
million at September 30, 1998, from $175.1 million at September 30, 1997. The
average cost of interest-bearing liabilities increased to 4.7% for fiscal 1998,
from 4.4% for 1997. Total average interest-bearing liabilities increased by 3.6%
to $196.1 million for fiscal 1998, from $189.3 million for fiscal 1997.
Net Interest Income. Net interest income increased by 24.2% to $12.6
million for the year ended September 30, 1998, from $10.2 million for the year
ended September 30, 1997. This increase is primarily due to increases in both
the volume and net yield on average interest-earning assets, resulting from
investing the net proceeds of the stock conversion into earning assets for a
full year. Average interest-earning assets increased by 14.9% to $250.1 million
during fiscal 1998, from $217.7 million for 1997. The net yield on
interest-earning assets (net interest income divided by average interest-earning
assets) increased to 5.1% for the year ended September 30, 1998, compared to
4.7% for the year ended September 30, 1997.
Provision for Loan Losses. The Bank maintains an allowance for losses on
loans based upon management's evaluation of risks in the loan portfolio, the
Bank's past loan loss experience, and current and expected future economic
conditions. The Bank provided $310,000 and $931,000 for loan losses during the
years ended September 30, 1998 and 1997, respectively. These provisions were
necessary to support the growth and risks associated with the emphasis placed
upon commercial and consumer lending. The allowance for loan losses was $3.4
million at September 30, 1998 compared to $3.2 million at September 30, 1997,
which the Bank believes is adequate to absorb potential losses in its loan
portfolio. The ratio of the allowance for loan losses to total loans, net of
loans in process and deferred loan fees, was 1.5% at September 30, 1998 compared
to 1.6% at September 30, 1997.
9
<PAGE>
The Bank uses a systematic approach in determining the adequacy of its loan
loss allowance and the necessary provision for loan losses, through a
classification of assets program, whereby the loan portfolio is reviewed
generally and delinquent loans are analyzed individually on a quarterly basis.
Consideration is given to the loan status, payment history, ability to repay,
probability of repayment, and loan-to-value percentages. As a result of this
review and analysis, loans are classified in appropriate categories applicable
to their circumstances. After reviewing current economic conditions, changes in
delinquency status, and actual loan losses incurred by the Bank, management
establishes an appropriate reserve percentage applicable to each category of
assets, and provision for loan losses is recorded when necessary to bring the
allowance to a level consistent with this analysis. The ratio of nonperforming
loans to total loans was 0.4% at September 30, 1998 and 0.6% at September 30,
1997.
Other Income. Other income increased 57.0% to $2.7 million for the year
ended September 30, 1998, from $1.7 million for the year ended September 30,
1997. Other income consists of fees and service charges earned on loans, service
charges on deposit accounts, gains from sales of loans, and other miscellaneous
income. Loan fees and service charges increased to $985,000 for fiscal 1998 from
$752,000 for fiscal 1997, reflecting the growth in the loan portfolio during
1998. Gains from sales of loans and mortgage-backed securities increased to
$796,000 for fiscal 1998 from $124,000 for fiscal 1997, as the volume of loans
and mortgage-backed securities sold during 1998 increased to $45.1 million from
$19.8 million for 1997. Servicing fee income on loans serviced for others
increased to $637,000 for 1998 from $613,000 for 1997.
General and Administrative Expenses. General and administrative expenses
increased 43.2% to $9.9 million for fiscal 1998 from $6.9 million in fiscal
1997. The Company's efficiency ratio (noninterest expenses divided by net
interest income plus noninterest income) increased to 65.1% for fiscal 1998 from
58.6% for fiscal 1997.
The largest single component of these expenses, compensation and fringe
benefits, increased to $7.2 million for fiscal 1998 from $4.6 million for fiscal
1997. During fiscal 1998 the Bank recorded $1.9 million of benefits expense for
the MRP plan, compared to no MRP expense in fiscal 1997. In addition, the Bank
recorded $826,000 in benefits expense for the ESOP in fiscal 1998, compared to
$603,000 in fiscal 1997. This increase is also a result of the growth in
personnel and management required to support the 45.0% growth in assets from
September 30, 1996 to September 30, 1998. Other noninterest expenses including
deposit insurance premiums, premises and equipment, advertising and office
expenses remained relatively constant from period to period.
Income Taxes. The provision for income taxes increased to $1.9 million for
fiscal 1998 from $1.7 million for fiscal 1997. The increase in provision for
income taxes is the result of the increased pretax earnings of $5.0 million for
fiscal 1998 from $4.0 million for fiscal 1997 and the effective income tax rates
then in effect.
Comparison of Financial Condition at September 30, 1997 and 1996
Total assets increased 28.4% to $249.3 million at September 30, 1997 from
$194.1 million at September 30, 1996. Loans receivable (net of loans-in-process,
deferred fees and loan loss reserves) increased by 27.0%, to $197.8 million at
September 30, 1997 from $155.7 million at September 30, 1996. Investment
securities and mortgage-backed securities increased by 21.8%, to $27.9 million
at September 30, 1997 from $22.9 million at September 30, 1996. The increase in
assets was supported by the stock conversion net proceeds. On April 7, 1997 the
Company issued $42.5 million of common stock, which represents the actual net
offering proceeds, including $3.5 million in shares purchased by the ESOP.
Commercial real estate loans increased 47.4% to $46.0 million at September
30, 1997 from $31.2 million at September 30, 1996, commercial business loans
increased 59.2% to $16.4 million at September 30, 1997 from $10.3 million at
September 30, 1996. Consumer loans increased 33.4% to $49.9 million at September
30, 1997 from $37.4 million at September 30, 1996. Residential real estate
mortgage loans increased 7.8% to $102.2 million at September 30, 1997 from $94.8
Million at September 30, 1996. During fiscal 1997, the Bank originated $66.9
million of residential real estate mortgage loans, compared to $76.3 million
during fiscal 1996. The Bank sold and exchanged $31.7 million of real estate
loans during fiscal 1997, compared to $53.0 million during fiscal 1996. Loans
serviced for others was $253.6 million at September 30, 1997, compared to $253.7
million at September 30, 1996. Commercial real estate, commercial business and
consumer loan originations increased 42.8% to $76.8 million during fiscal 1997
from $53.8 million during fiscal 1996.
10
<PAGE>
Deposits increased by 2.3%, to $175.1 million at September 30, 1997 from
$171.2 million at September 30, 1996. During fiscal 1997, approximately $11.8
million of deposits were withdrawn by depositors to purchase shares of the
Company's common stock subscribed for in the stock conversion. While total
deposits experienced a marginal increase during the year ended September 30,
1997, checking accounts increased by $10.2 million, or 37.4%, to $37.5 million
at September 30, 1997 from $27.3 million at September 30, 1996, reflecting the
Bank's efforts to increase lower cost core checking accounts. Total borrowings
increased to $12.6 million at September 30, 1997 from $1.0 million at September
30, 1996, to support the growth in earning assets and banking operations during
the period.
Stockholders' equity increased by $39.5 million, or 215.8%, to $57.8
million at September 30, 1997 from $18.3 million at September 30, 1996,
reflecting the infusion of the net proceeds of the stock conversion and the
consolidated earnings of the Company for the year ended September 30, 1997. At
September 30, 1997, the ratio of equity to total assets increased to 23.2% from
9.5% at September 30, 1996. During the year ended September 30, 1997, the
Company declared two quarterly cash dividends totaling $582,000, reflecting a
dividend payout ratio of 37.1%.
The Company's note receivable from the ESOP was $3.1 million at September
30, 1997 and reported as a reduction of stockholders's equity. During the year
ended September 30, 1997, the Company acquired 77,700 shares of its common stock
for the MRP through open market purchases, totaling $2.1 million. These shares
are being held in trust for future awards and are reported as a reduction in
stockholders' equity. Subsequent to September 30, 1997, the Company completed
purchasing 4% of its outstanding common stock for the MRP.
Comparison of Operating Results for the Years Ended September 30, 1997 and 1996
Net Income. Net income increased by $1.4 million to $2.3 million for the
year ended September 30, 1997 from $820,000 for the year ended September 30,
1996. The principal reason for this increase is the investing of the stock
conversion net proceeds into earning assets, as average interest-earning assets
increased by 23.7% to $217.7 million for fiscal 1997, from $176.0 million for
fiscal 1996.
Interest Income. Interest income increased by 20.9% to $18.5 million for
fiscal 1997, from $15.3 million for fiscal 1996. The increase in interest income
on loans and investments during 1997 is a result of increased volume of average
interest-earning assets. Interest on loans increased by 20.1% to $16.1 million
in fiscal 1997, from $13.4 million in fiscal 1996. This increase was due
primarily to a $27.8 million increase in the average balance of loans
outstanding between fiscal 1997 and 1996, and an increase in the average yield
on loans to 9.13% for fiscal 1997 from 9.04% for fiscal 1996. The average yield
on total average interest-earning assets of $217.7 million was 8.5% for 1997
compared to an 8.7% average yield on $176.0 million of total average
interest-earning assets for 1996.
Interest Expense. Interest expense for fiscal 1997 increased by 3.0% to
$8.3 million, from $8.1 million for fiscal 1996. This resulted principally from
an increase in the volume of average interest-bearing liabilities. Average
deposits increased by 15.9% to $184.7 million for fiscal 1997, from $159.3
million for fiscal 1996. The average cost of interest-bearing liabilities
decreased to 4.4% for 1997 from 5.0% for 1996. Total average interest-bearing
liabilities increased to $189.3 million for fiscal 1997 from $162.2 million for
fiscal 1996.
Net Interest Income. Net interest income increased by 41.7% to $10.2
million for the year ended September 30, 1997, from $7.2 million for the year
ended September 30, 1996.
Provision for Loan Losses. The Bank maintains an allowance for losses on
loans based upon an evaluation of risks in the loan portfolio, past loan loss
experience, and current and expected future economic conditions. The Bank
provided $931,000 and $511,000 for loan losses during the years ended September
30, 1997 and 1996, respectively. The allowance for loan losses was $3.2 million
at September 30, 1997 compared to $2.4 million at September 30, 1996, which the
Bank believes was adequate to absorb potential losses in its loan portfolio. The
ratio of the allowance for loan losses to total loans, net of loans in process
and deferred loan fees, was 1.6% at September 30, 1997 compared to 1.5% at
September 30, 1996. The increased provisions were necessary to support the
growth and risks associated with the Bank's emphasis placed upon commercial and
consumer lending. The ratio of nonperforming loans to total loans was 0.5% at
September 30, 1997 and 0.7% at September 30, 1996.
11
<PAGE>
Other Income. Other income totaled $1.7 million for the year ended
September 30, 1997 and $1.8 million for the year ended September 30, 1996. Other
income consists of fees and service charges earned on loans, service charges on
deposit accounts, gains from sales of loans, and other miscellaneous income.
Loan fees and service charges increased to $752,000 for fiscal 1997 from
$552,000 for fiscal 1996, reflecting the growth in the loan portfolio during
1997. Gains from sales of loans and mortgage-backed securities decreased to
$124,000 for fiscal 1997 from $423,000 for fiscal 1996, as the volume of loans
and mortgage-backed securities sold during 1997 decreased to $19.8 million for
1997 from $57.4 million for 1996. Servicing fee income on loans serviced for
others was $613,000 for 1997 compared to $632,000 for 1996.
General and Administrative Expenses. General and administrative expenses
decreased 5.5% in fiscal 1997 to $6.9 million, from $7.3 million in fiscal 1996.
The Company's efficiency ratio decreased to 58.6% for fiscal 1997, from 80.4%
for fiscal 1996.
The largest single component of these expenses, compensation and fringe
benefits, increased to $4.6 million for fiscal 1997 from $3.6 million for fiscal
1996. This increase is a result of approximately $603,000 in benefits expense
incurred for the ESOP and growth in personnel and management required to support
the 28.4% growth in assets from September 30, 1996 to September 30, 1997.
Federal deposit insurance premiums decreased to $88,000 for the year ended
September 30, 1997 from $1.3 million for the year ended September 30, 1996.
During 1996, the Bank incurred a one-time FDIC assessment of $946,000 to
capitalize the SAIF insurance fund. Pursuant to the Deposit Insurance Funds Act
of 1996, the Bank's deposit insurance premium rate has declined to 6.4 cents per
$100 of deposits for 1997 from 23 cents per $100 of deposits for 1996. This
revised deposit insurance rate structure has enabled the Bank to recognize a
substantial reduction in deposit insurance premiums.
Premises and equipment expense decreased to $377,000 for fiscal 1997 from
$798,000 for fiscal 1996. During the year ended September 30, 1996 the Bank
recognized accelerated depreciation of $225,000 on certain fixed assets with no
future value due to obsolescence or excessive use.
Income Taxes. The provision for income taxes increased to $1.7 million for
fiscal 1997 from $451,000 for fiscal 1996. The increase in provision for income
taxes is the result of the increased pretax earnings to $4.0 million for fiscal
1997 from $1.3 million for fiscal 1996 and the effective income tax rates then
in effect.
IMPACT OF INFLATION AND CHANGING PRICES
The financial statements of the Bank and accompanying footnotes have been
prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars without considering the change in the relative purchasing
power of money over time and due to inflation. The impact of inflation is
reflected in the increased cost of the Bank's operations. Unlike most industrial
companies, nearly all the assets and liabilities of the Bank are monetary. As a
result, interest rates have a greater impact on the Bank's performance than do
the effects of general levels of inflation. Interest rates do not necessarily
move in the same direction or to the same extent as the price of goods and
services.
YEAR 2000
A great deal of information has been disseminated about the global computer
crash that may occur in the year 2000. Many computer programs that can only
distinguish the final two digits of the year entered (a common programming
practice in earlier years) are expected to read entries for the year 2000 as the
year 1900 and compute payment, interest or delinquency based on the wrong date
or are expected to be unable to compute payment, interest or delinquency. Rapid
and accurate data processing is essential to the operations of the Bank, most
other financial institutions and many other companies.
In compliance with regulatory guidelines, the Bank has formed a Year 2000
("Y2K") committee to review the effects the century change may have on all
current systems and to assess the potential risks associated with the Y2K issue.
A formal Y2K strategic plan and contingency plan have been developed to address
the necessary steps to insure that problems and disruptions related to the Y2K
issue are minimized. An inventory of all systems, both
12
<PAGE>
computer and non-computer related, was completed in the process. Potential
weaknesses were then documented and prioritized as to their effect on critical
business functions. All of the material data processing functions of the Bank
that could be impacted by the Y2K issue are provided by a national third party
service bureau, Bisys, Inc. Bisys has dedicated tremendous resources in assuring
its systems are Y2K compliant and in developing a comprehensive testing and
verification program. The Bisys client test facility is providing the Bank with
end-to-end testing capabilities of all its hardware, software and related
interfaces.
The recently released remediated version of the Bisys client test facility
has undergone extensive beta testing. All Bank user departments are currently
involved in an extensive Y2K testing program to assure validation of the
changes. Bisys has advised us that our testing through their client test
facility is expected to reveal any potential problems well in advance of the
impending year 2000 deadline. Additional testing is also scheduled to take place
with all other external mission critical information systems and relationships
with which the Bank exchanges data or information. It is believed that this
readiness will increase the likelihood of uninterrupted operations of the Bank.
In addressing the Y2K issue, the Bank has used its current internal
staffing with little reliance on outside resources. The Bank's major vendor, the
Bisys service bureau, has provided remediated software at no expense to the
Bank. No major system is expected to be replaced in the coming years. As a
result, Y2K related expenses were less than $5,000 in fiscal year 1998 and
expenses for fiscal 1999 are estimated at less than $25,000. These expenses are
in the areas of customer awareness and additional software testing. The Bank
believes the cost of addressing the Y2K issue will have no material impact on
its results of operations, liquidity, capital resources, or uncertainty that
would cause its reported financial condition not to be necessarily indicative of
future operating results or financial condition.
FORWARD LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 states that the
disclosure of forward looking information is desirable for investors and
encourages such disclosure by providing a safe harbor for forward looking
statements by corporate management. This Annual Report, including the Letter to
Stockholders and Management's Discussion and Analysis of Financial Condition and
Results of Operations, contains forward looking statements that involve risk and
uncertainty. In order to comply with the terms of the safe harbor, the Company
notes that a variety of risk factors could cause its actual results and
experience to differ materially from the anticipated results or other
expectations expressed in the Company's forward looking statements. The risks
and uncertainties that may affect the operations, performance, development,
growth projections and results of the Company's business include, but are not
limited to, economic growth, interest rate movements, timely development of
technology enhancements for products, services and operating systems, the impact
of competitive products, services and pricing, customer requirements, regulatory
changes and similar matters. Readers of this report are cautioned not to place
undue reliance on forward looking statements that are subject to influence by
these risk factors and unanticipated events. Accordingly, actual results may
differ materially from management's expectations.
13
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
November 5, 1998
To the Board of Directors
NewSouth Bancorp, Inc.
Washington, North Carolina
In our opinion, the accompanying consolidated statements of financial condition
and the related consolidated statements of operations, stockholders' equity and
cash flows present fairly, in all material respects, the financial position of
NewSouth Bancorp, Inc. and Subsidiary at September 30, 1998 and 1997 and the
results of their operations and their cash flows for each of the three years in
the period ended September 30, 1998, in conformity with generally accepted
accounting principles. 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 of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatements. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
14
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
SEPTEMBER 30, 1998 AND 1997
- -------------------------------------------------------------------------------------------------
ASSETS 1998 1997
<S> <C> <C>
Cash and due from banks $ 5,243,853 $ 3,027,271
Interest-bearing deposits in financial institutions 11,767,988 12,744,980
Investment securities - available for sale 3,107,545 3,083,422
Mortgage-backed securities - available for sale 27,016,679 24,818,412
Loans receivable, net:
Held for sale 38,406,628 25,055,845
Held for investment 186,592,403 172,729,060
Premises and equipment, net 3,558,836 2,818,167
Deferred income taxes 569,604 821,863
Real estate owned 411,938 357,503
Federal Home Loan Bank of Atlanta stock, at cost
which approximates market 1,363,800 1,287,500
Accrued interest receivable 1,935,490 1,847,346
Prepaid expenses and other assets 1,504,689 689,828
------------- -------------
Total assets $ 281,479,453 $ 249,281,197
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand $ 42,873,230 $ 37,500,216
Savings 6,397,856 6,455,357
Large denomination certificates of deposit 25,587,798 17,097,175
Other time 129,776,201 114,063,040
------------- -------------
Total deposits 204,635,085 175,115,788
Borrowed money 11,932,919 12,621,120
Accrued interest payable 62,707 91,915
Income taxes payable -- 457,498
Advance payments by borrowers for property taxes and insurance 451,860 182,731
Other liabilities 7,682,912 2,956,558
------------- -------------
Total liabilities 224,765,483 191,425,610
Commitments and contingencies (Notes 10 and 14)
Common stock, $.01 par value, 8,000,000 shares authorized,
4,364,044 shares issued and outstanding 43,640 29,095
Additional paid-in capital 43,801,987 42,654,054
Retained earnings, substantially restricted 22,091,243 20,041,635
Treasury stock at cost, 218,202 shares (4,895,754) --
Unearned ESOP shares, 268,709 and 311,898 shares (2,687,093) (3,118,984)
Deferred stock awards (2,126,299) (2,050,531)
Unrealized gain on available for sale securities, net 486,246 300,318
------------- -------------
Total stockholders' equity 56,713,970 57,855,587
------------- -------------
Total liabilities and stockholders' equity $ 281,479,453 $ 249,281,197
============= =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
15
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
- --------------------------------------------------------------------------------------------------
1998 1997 1996
Interest income:
<S> <C> <C> <C>
Interest and fees on loans $18,888,253 $16,096,914 $13,430,797
Interest and dividends on investments and deposits 2,978,655 2,418,451 1,918,876
----------- ----------- -----------
Total interest income 21,866,908 18,515,365 15,349,673
----------- ----------- -----------
Interest expense:
Interest on deposits 9,096,290 8,088,144 7,939,014
Interest on borrowings 143,342 258,084 166,438
----------- ----------- -----------
Total interest expense 9,239,632 8,346,228 8,105,452
----------- ----------- -----------
Net interest income before provision for loan losses 12,627,276 10,169,137 7,244,221
Provision for loan losses 310,000 931,078 511,000
----------- ----------- -----------
Net interest income 12,317,276 9,238,059 6,733,221
----------- ----------- -----------
Other income:
Loan fees and service charges 985,439 752,470 552,169
Loan servicing fees 637,480 613,353 631,866
Gain on sale of real estate, net 28,478 32,190 33,628
Gain on sale of mortgage loans and mortgage-backed
securities 796,004 124,066 423,113
Other income 198,647 162,893 191,768
----------- ----------- -----------
Total other income 2,646,048 1,684,972 1,832,544
----------- ----------- -----------
General and administrative expenses:
Compensation and fringe benefits 7,239,911 4,603,764 3,569,144
Federal insurance premiums 113,646 88,165 353,585
Insurance fund special assessment -- -- 946,020
Premises and equipment 356,550 377,468 798,119
Advertising 134,978 181,016 102,762
Payroll and other taxes 417,140 311,290 286,949
Other 1,677,841 1,379,348 1,238,180
----------- ----------- -----------
Total general and administrative expenses 9,940,066 6,941,051 7,294,759
----------- ----------- -----------
Income before income taxes 5,023,258 3,981,980 1,271,006
Income taxes 1,899,900 1,719,350 450,517
----------- ----------- -----------
Net income $ 3,123,358 $ 2,262,630 $ 820,489
=========== =========== ===========
Net income per common share:
Basic $ .80 .35(1)
=========== ===========
Assuming dilution $ .80 .35(1)
=========== ===========
</TABLE>
(1) Calculated from date of conversion, see Note 2
The accompanying notes are an integral part of these consolidated financial
statements.
16
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
- ------------------------------------------------------------------------------------------------------------
RETAINED
ADDITIONAL EARNINGS,
Common Paid-in Substantially Treasury
Stock Capital Restricted Stock
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
BALANCE AT SEPTEMBER 30, 1995 $ -- $ -- $ 17,485,547 $ --
Change in unrealized gains on securities
available-for sale, net of taxes -- -- -- --
Net income -- -- 820,489 --
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1996 -- -- 18,306,036 --
Issuance of shares of common stock 29,095 42,423,041 -- (3,491,400)
Net income -- -- 2,262,630 --
Change in unrealized gains on securities
available-for-sale, net of taxes -- -- -- --
Acquisition of shares for MRP -- -- -- --
Dividends ($.13 per share) -- -- (527,031) --
Release of ESOP shares -- 231,013 -- 372,416
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1997 29,095 42,654,054 20,041,635 --
Three for two stock split effected in the
form of a 50% stock dividend 14,545 -- (14,545) --
Net income -- -- 3,123,358 --
Fractional shares paid -- -- (4,652) --
Change in unrealized gains on securities
available-for-sale, net of taxes -- -- -- --
Acquisition of shares for MRP -- -- -- --
Change in market value of deferred stock -- 753,959 -- --
MRP amortization -- -- -- --
Acquisition of treasury shares -- -- -- (4,895,754)
Dividends ($.27 per share) -- -- (1,054,553) --
Release of ESOP shares -- 393,974 -- 431,891
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1998 $ 43,640 $ 43,801,987 $ 22,091,243 $ (4,895,754)
============ ============ ============ ============
<CAPTION>
UNREALIZED
GAIN ON
AVAILABLE
UNEARNED DEFERRED FOR SALE
ESOP Stock Securities,
Shares Awards Net Total
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
BALANCE AT SEPTEMBER 30, 1995 $ -- $ -- $ 202,522 $ 17,688,069
Change in unrealized gains on securities
available-for sale, net of taxes -- -- (161,987) (161,987)
Net income -- -- -- 820,489
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1996 -- -- 40,535 18,346,571
Issuance of shares of common stock -- -- 38,960,736
Net income -- -- -- 2,262,630
Change in unrealized gains on securities
available-for-sale, net of taxes -- -- 259,783 259,783
Acquisition of shares for MRP -- (2,050,531) -- (2,050,531)
Dividends ($.13 per share) -- -- -- (527,031)
Release of ESOP shares -- -- 603,429
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1997 (3,118,984) (2,050,531) 300,318 57,855,587
Three for two stock split effected in the
form of a 50% stock dividend -- -- -- --
Net income -- -- -- 3,123,358
Fractional shares paid -- -- -- (4,652)
Change in unrealized gains on securities
available-for-sale, net of taxes -- -- 185,928 185,928
Acquisition of shares for MRP -- (1,224,768) -- (1,224,768)
Change in market value of deferred stock -- (753,959) -- --
MRP amortization -- 1,902,959 -- 1,902,959
Acquisition of treasury shares -- -- -- (4,895,754)
Dividends ($.27 per share) -- -- -- (1,054,553)
Release of ESOP shares -- -- 825,865
------------ ------------ ------------ ------------
BALANCE, SEPTEMBER 30, 1998 $ (2,687,093) $ (2,126,299) $ 486,246 $ 56,713,970
============ ============ ============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
17
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
- ------------------------------------------------------------------------------------------------------------
1998 1997 1996
Operating activities:
<S> <C> <C> <C>
Net income $ 3,123,358 $ 2,262,630 $ 820,489
Adjustments to reconcile net income to net cash
used in operating activities:
Provision for loan losses 310,000 931,078 511,000
Depreciation 172,844 147,927 449,104
ESOP compensation 825,865 603,429 --
MRP compensation 1,902,959 -- --
Accretion of discounts on securities 372 24,263 19,918
Provision for (benefit of) deferred income taxes 132,438 (765,372) (440,704)
Gain on disposal of premises and equipment and
real estate acquired in settlement of loans (34,259) (33,506) (36,293)
Gain on sale of mortgage loans and mortgage-
backed securities (796,004) (139,405) (423,113)
Originations of loans held for sale, net (66,892,933) (35,004,100) (55,047,196)
Proceeds from sale of loans held for sale 36,106,871 13,190,353 51,656,899
Other operating activities 3,327,998 (50,297) 562,728
------------ ------------ ------------
Net cash used in operating activities (21,820,491) (18,833,000) (1,927,168)
------------ ------------ ------------
Investing activities:
Proceeds from maturities of securities available for -- 7,000,000 --
sale
Purchases of investment securities -- (2,000,000) (6,043,438)
Proceeds from principal repayments and sales of
mortgage-backed securities available-for-sale 16,314,270 8,914,741 8,832,521
Loan originations, net of principal repayments of
loans held for investment (14,631,404) (40,566,654) (9,827,513)
Proceeds from maturities of securities held-to-maturity -- -- 1,000,000
Proceeds from disposal of premises and equipment
and real estate acquired in settlement of loans 441,237 815,117 238,564
Purchases of FHLB stock (76,300) -- --
Purchases of premises and equipment (916,865) (66,057) (351,588)
------------ ------------ ------------
Net cash provided by (used in) investing
activities 1,130,938 (25,902,853) (6,151,454)
------------ ------------ ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
18
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
YEARS ENDED SEPTEMBER 30, 1998, 1997 AND 1996
- ------------------------------------------------------------------------------------------------------
1998 1997 1996
Financing activities:
<S> <C> <C> <C>
Net increase in deposit accounts 29,519,297 3,902,502 17,756,258
Proceeds from FHLB borrowings 46,000,000 49,000,000 24,000,000
Repayments of FHLB borrowings (47,500,000) (38,000,000) (28,000,000)
Net proceeds from issuance of stock -- 38,960,736 --
Purchase of treasury shares (4,895,754) -- --
MRP funding (1,224,768) (2,050,531) --
Cash paid for fractional shares (4,652) -- --
Cash dividends paid (1,045,908) (264,574) --
Net change in escrow accounts 269,129 (198,118) 73,647
Net change in repurchase agreements 811,799 581,512 1,039,608
------------ ------------ ------------
Net cash provided by financing activities 21,929,143 51,931,527 14,869,513
------------ ------------ ------------
Increase in cash and cash equivalents 1,239,590 7,195,674 6,790,891
Cash and cash equivalents, beginning of year 15,772,251 8,576,577 1,785,686
------------ ------------ ------------
Cash and cash equivalents, end of year $ 17,011,841 $ 15,772,251 $ 8,576,577
============ ============ ============
Supplemental disclosures:
Real estate acquired in settlement of loans $ 458,061 $ 960,221 $ 296,690
Exchange of loans for mortgage-backed securities $ 17,958,559 $ 18,524,209 $ 1,545,859
Transfers to securities available-for-sale $ -- $ -- $ 16,140,485
Cash paid for interest $ 9,268,840 $ 8,322,252 $ 8,100,128
Cash paid for income taxes $ 2,637,000 $ 1,673,000 $ 1,327,315
Dividends declared, not paid $ 271,102 $ 262,457 $ --
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
19
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NEWSOUTH BANCORP, INC. AND SUBSIDIARY
- --------------------------------------------------------------------------------
1. BASIS OF PRESENTATION AND ACCOUNTING POLICIES
ORGANIZATION AND NATURE OF OPERATIONS
NewSouth Bancorp, Inc. (the "Company") is a bank holding company incorporated in
October, 1996 under the laws of the State of Delaware. NewSouth Bank (the
"Bank"), the wholly-owned subsidiary of the Company, is organized and
incorporated under the laws of the state of North Carolina. The Bank is
regulated by the Federal Deposit Insurance Corporation and the North Carolina
Office of The Commissioner of Banks.
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, the Bank. All significant intercompany balances and
transactions have been eliminated in consolidation.
The accounting and reporting policies of the Company and the Bank follow
generally accepted accounting principles and general practices within the
financial services industry as summarized below.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include demand and time deposits (with remaining
maturities of ninety days or less at time of purchase) at other financial
institutions and federal funds sold. Generally, federal funds are purchased and
sold for one-day periods.
INVESTMENTS AND MORTGAGE-BACKED SECURITIES
Investments in certain securities are classified into three categories and
accounted for as follows: (1) debt securities that the entity has the positive
intent and the ability to hold to maturity are classified as held-to-maturity
and reported at amortized cost; (2) debt and equity securities that are bought
and held principally for the purpose of selling them in the near term are
classified as trading securities and reported at fair value, with unrealized
gains and losses included in earnings; (3) debt and equity securities not
classified as either held-to-maturity securities 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 as a separate
component of equity. As of September 30, 1998, the Bank has classified all
investments as available-for-sale.
Premiums and discounts on debt securities are recognized in interest income on
the level interest yield method over the period to maturity.
Mortgage-backed securities represent participating interests in pools of
long-term first mortgage loans. Premiums and discounts are amortized using the
interest method over the remaining period to contractual maturity, adjusted for
anticipated prepayments.
Gains and losses on the sale of securities are determined by using the specific
identification method.
LOANS RECEIVABLE AND ALLOWANCE FOR LOAN LOSSES
Loans receivable held for investment are stated at the amount of unpaid
principal, reduced by an allowance for loan losses and net deferred origination
fees. Interest on loans is accrued based on the principal amount outstanding and
is recognized on a level yield method. The accrual of interest is discontinued,
and accrued but unpaid interest is reversed when, in management's judgment, it
is determined that the collectibility of interest, but not necessarily
principal, is doubtful. Generally, this occurs when payment is delinquent in
excess of ninety days.
Loan origination fees, as well certain direct loan origination costs, are
deferred. Such costs and fees are recognized as an adjustment to yield over the
contractual lives of the related loans utilizing the interest method.
Commitment fees to originate or purchase loans are deferred, and if the
commitment is exercised, recognized over the life of the loan as an adjustment
of yield. If the commitment expires unexercised, commitment fees are recognized
in income upon expiration of the commitment. Fees for originating loans for
other financial institutions are recognized as loan fee income.
A loan is considered impaired, based on current information and events, if it is
probable that the Bank will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement. Uncollateralized loans are measured for impairment based on the
present value of expected future cash flows discounted at the
20
<PAGE>
historical effective interest rate, while all collateral-dependent loans are
measured for impairment based on the fair value of the collateral. At September
30, 1998 and 1997 and during the years then ended there were no loans material
to the consolidated financial statements which were defined as impaired.
The Bank uses several factors in determining if a loan is impaired. The internal
asset classification procedures include a thorough review of significant loans
and lending relationships and include the accumulation of related data. This
data includes loan payment status, borrowers' financial data and borrowers'
operating factors such as cash flows, operating income or loss, etc.
The allowance for loan losses is increased by charges to income and decreased by
charge-offs (net of recoveries). Management's periodic evaluation of the
adequacy of the allowance is based on the Bank's past loan loss experience,
known and inherent risks in the portfolio, adverse situations that may affect
the borrower's ability to repay, the estimated value of any underlying
collateral, and current economic conditions. While management believes that it
has established the allowance in accordance with generally accepted accounting
principles and has taken into account the views of its regulators and the
current economic environment, there can be no assurance that in the future the
Bank's regulators or its economic environment will not require further increases
in the allowance.
LOANS HELD FOR SALE
Loans originated and intended for sale are carried at the lower of cost or
aggregate estimated market value. Net unrealized losses are recognized in a
valuation allowance by charges to income. Gains and losses on sales of whole or
participating interests in real estate loans are recognized at the time of sale
and are determined by the difference between net sales proceeds and the Bank's
basis of the loans sold, adjusted for the recognition of any servicing assets
retained.
INCOME RECOGNITION ON IMPAIRED AND NONACCRUAL LOANS
Loans, including impaired loans, are generally classified as nonaccrual if they
are past due as to maturity or payment of principal or interest for a period of
more than 90 days, unless such loans are well-secured and in the process of
collection. If a loan or a portion of a loan is classified as doubtful or is
partially charged off, the loan is generally classified as nonaccrual. Loans
that are on a current payment status or past due less than 90 days may also be
classified as nonaccrual if repayment in full of principal and/or interest is in
doubt.
Loans may be returned to accrual status when all principal and interest amounts
contractually due (including arrearages) are reasonably assured of repayment
within an acceptable period of time, and there is a sustained period of
repayment performance (generally a minimum of six months) by the borrower, in
accordance with the contractual terms of interest and principal.
While a loan is classified as nonaccrual and the future collectibility of the
recorded loan balance is doubtful, collections of interest and principal are
generally applied as a reduction to principal outstanding, except in the case of
loans with scheduled amortization where the payment is generally applied to the
oldest payment due. When the future collectibility of the recorded loan balance
is expected, interest income may be recognized on a cash basis limited to that
which would have been recognized on the recorded loan balance at the contractual
interest rate. Receipts in excess of that amount are recorded as recoveries to
the allowance for loan losses until prior charge-offs have been fully recovered.
PREMISES AND EQUIPMENT
Premises and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed by the straight-line
and accelerated methods based on estimated service lives of assets. Useful lives
range from 10 to 40 years for substantially all premises and from 3 to 20 years
for equipment and fixtures.
REAL ESTATE OWNED
Assets acquired through loan foreclosure are recorded as real estate owned
("REO") at the lower of the estimated fair value of the property less estimated
costs to sell at the date of foreclosure or the carrying amount of the loan plus
unpaid accrued interest. The carrying amount is subsequently reduced by
additional allowances which are charged to earnings if the estimated fair value
declines below its initial value plus any capitalized costs. Costs related to
the improvement of the property are capitalized, whereas costs related to
holding the property are expensed.
INVESTMENT IN FEDERAL HOME LOAN BANK STOCK
The Bank is required to invest in stock of the Federal Home Loan Bank of Atlanta
(FHLB) in the amount of 1% of its outstanding home loans or 5% of its
outstanding advances from the FHLB, whichever is greater. At September 30, 1998
and 1997, respectively the Bank owned 13,638 and 12,875 shares of the FHLB's
$100 par value capital stock.
21
<PAGE>
INCOME TAXES
Deferred tax asset and liability balances are determined by application to
temporary differences of the tax rate expected to be in effect when taxes will
become payable or receivable. Temporary differences are differences between the
tax basis of assets and liabilities and their reported amounts in the financial
statements that will result in taxable or deductible amounts in future years.
The effect on deferred taxes of a change in tax rates is recognized in income in
the period that includes the enactment date.
STOCK SPLIT
On July 16, 1998 the Company declared at three-for-two stock split, in the form
of a 50% stock dividend, payable August 19, 1998 to stockholders of record July
31, 1998. Stockholders received one additional share of common stock for every
two shares held on the record date. All prior period share and per share data
have been adjusted for the split.
RECLASSIFICATIONS
Certain items included in the 1997 financial statements have been reclassified
to conform to the 1998 presentation. These reclassifications have no effect on
the net income or stockholders' equity previously reported.
NEW ACCOUNTING PRONOUNCEMENTS
The Company adopted SFAS No. 130, "Reporting Comprehensive Income" on October 1,
1998. SFAS No. 130 establishes standards for reporting and displaying
comprehensive income and its components in a full set of general-purpose
financial statements.
The Company adopted SFAS No. 131, "Disclosure About Segments of an Enterprise
and Related Information" on October 1, 1998. SFAS No. 131 specifies revised
guidelines for determining an entity's operating segments and the type and level
of financial information to be disclosed. The adoption of SFAS No. 131 is not
expected to have a material effect on the Company's financial statement.
The Company will adopt the provisions of Financial Accounting Standards No. 132,
"Employers Disclosures about Pensions and Other Postretirement benefits",
effective for fiscal years beginning after December 15, 1997. This Statement
revises employees' disclosures about pension and other postretirement benefit
plans. It does not change the measurement or recognition of those plans. The
adoption of SFAS No. 132 is not expected to have a material effect on the
Company's financial statement.
The Company will adopt the provisions of SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities" effective with the fiscal quarter beginning
July 1, 1999. This Statement establishes accounting and reporting standards for
derivative instruments and for hedging activities. It requires that derivatives
be recognized as either assets or liabilities in the statement of financial
position and be measured at fair value. The accounting for changes in the fair
value of a derivative depends on the intended use of the derivative and whether
or not the derivative is designated as a hedging instrument. SFAS No. 133 is not
expected to have a material effect on the Company's financial statements.
Statement of Financial Accounting Standards No. 134, "Accounting for
Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans
Held for Sale by a Mortgage Banking Enterprise", was issued in October 1998.
This Statement amends existing classification and accounting treatment of
mortgage-backed securities, retained after mortgage loans held for sale are
securitized, for entities engaged in mortgage baking activities. These
securities previously were classified and accounted for as trading and now may
be classified as held-to-maturity or available-for-sale, also. This Statement is
effective for the first fiscal quarter beginning after December 15, 1998. SFAS
No. 134 is not expected to have material effect on the Company's financial
statements.
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.
22
<PAGE>
2. CONVERSION TO COMMERCIAL BANK
NewSouth Bancorp, Inc. was incorporated in October, 1996 under the laws for the
State of Delaware for the purpose of becoming the holding company for Home
Savings Bank, SSB. On April 7, 1997, Home Savings Bank, SSB converted from a
North Carolina-chartered mutual savings bank to a North Carolina-chartered stock
savings bank to be known as Home Savings Bank, Inc., SSB, ("Converted Bank"), in
connection with an initial public offering of common stock. Immediately
following completion of the stock conversion, the Converted Bank converted from
a North Carolina-chartered stock savings bank to a North Carolina commercial
bank known as "NewSouth Bank." In connection with the conversion, the Company
issued 4,364,250 shares of $.01 par value per share common stock, including
349,140 issued to the Employee Stock Ownership Plan ("ESOP"), for $10 per share.
The sale of common stock generated proceeds of $38,960,736, net of conversion
costs of $1,190,364 and ESOP shares of $3,491,400.
At the time of the conversion, the Bank established a liquidation account in an
amount equal to the Bank's net worth, or approximately $19,200,000, for the
benefit of eligible account holders at that time. The liquidation account will
be reduced annually to the extent that eligible account holders have reduced
their eligible deposits, shall cease upon the closing of the accounts, and shall
never be increased. In the event of the liquidation of the Bank, all remaining
eligible deposit account holders shall be entitled, after all payments to
creditors, to a distribution from the liquidation account before any
distribution to stockholders. Dividends paid by the Company cannot be paid from
the liquidation account.
3. INVESTMENT SECURITIES
Investment securities at September 30, 1998 and 1997 are classified as available
for sale according to management's intent and summarized as follows:
Gross Unrealized Estimated
Amortized --------------------- Market
Cost Gains Losses Value
----------- -------- ------- -----------
1998:
U. S. Treasury notes $ -- $ -- $ -- $ --
=========== ======== ======= ===========
1997:
U.S. Treasury notes $ 3,000,897 $ 82,525 $ -- $ 3,083,422
=========== ======== ======= ===========
U.S. Treasury notes at September 30, 1998 with amortized cost of $3,000,526 and
estimated market value of $3,107,545 are contractually scheduled to mature after
one through five years.
4. MORTGAGE-BACKED SECURITIES
Mortgage-backed securities at September 30, 1998 and 1997 are classified as
available for sale according to management's intent and summarized as follows:
<TABLE>
<CAPTION>
Gross Unrealized Estimated
Amortized -------------------- Market
Cost Gains Losses Value
----------- --------- -------- -----------
<S> <C> <C> <C> <C>
1998:
FHLMC participation certificates,
maturing from years 2003 to 2028 $26,323,899 $ 692,780 $ -- $27,016,679
=========== ========= ======== ===========
1997:
FHLMC participation certificates,
maturing from years 2006 to 2022 $24,406,887 $ 463,942 $ 52,417 $24,818,412
=========== ========= ======== ===========
</TABLE>
23
<PAGE>
Mortgage-backed securities at September 30, 1998 are contractually scheduled to
mature as follows:
Estimated
Amortized Market
Cost Value
----------- -----------
Due after five years through ten years $ 4,757,078 $ 4,858,150
Due after ten years 21,566,821 22,158,529
----------- -----------
$26,323,899 $27,016,679
=========== ===========
Expected maturities may differ from contractual maturities because borrowers
have the right to call or prepay obligations with or without call or prepayment
penalties.
Mortgage-backed securities with a carrying value of $9,016,982, $6,607,924 and
$5,566,420 were sold during the years ended September 30, 1998, 1997, and 1996,
respectively. Gross realized gains on the sales of mortgage-backed securities
were $272,724, $688 and $146,723 during 1998, 1997 and 1996, respectively. Gross
realized losses on sales of mortgage-backed securities were $0, $15,339 and $0
during 1998, 1997 and 1996, respectively.
Mortgage-backed securities with a carrying value of approximately $3,619,011 and
$1,594,000 were pledged as collateral for deposits from public entities at
September 30, 1998 and 1997, respectively.
5. LOANS RECEIVABLE
Loans receivable at September 30, 1998 and 1997 are summarized as follows:
1998 1997
------------- -------------
Mortgage loans $ 120,211,101 $ 102,154,361
Consumer loans 48,385,965 49,889,347
Commercial loans 73,303,016 62,438,748
------------- -------------
Total 241,900,082 214,482,456
Less:
Loans in process (12,930,301) (12,716,819)
Allowance for loan losses (3,364,588) (3,249,352)
Deferred loan fees (606,162) (731,380)
------------- -------------
Loans receivable, net $ 224,999,031 $ 197,784,905
============= =============
The Bank has pledged its eligible real estate loans to collateralize actual or
potential borrowings from the Federal Home Loan Bank of Atlanta (See Note 10).
During 1998, 1997 and 1996, the Bank exchanged loans with outstanding principal
balances of $17,958,559, $18,524,209 and $1,545,859, respectively, with the
Federal Home Loan Mortgage Corporation ("FHLMC") for mortgage-backed securities
of equal value.
The Bank originates mortgage loans for portfolio investment or sale in the
secondary market. During the period of origination, mortgage loans are
designated as either held for sale or investment purposes. Transfers of loans
held for sale to the investment portfolio are recorded at the lower of cost or
market value on the transfer date. Loans receivable held for sale at September
30, 1998 and 1997, are fixed rate mortgage loans with an estimated market value
of approximately $ 38,400,000 and $25,100,000, respectively.
Net gains on sales of loans receivable held for sale amounted to $523,280,
$138,717 and $276,390 during the years ended September 30, 1998, 1997 and 1996,
respectively.
24
<PAGE>
The changes in the allowance for loan losses for the years ended September 30,
1998, 1997 and 1996 are as follows:
1998 1997 1996
Balance at beginning of year $ 3,249,352 $ 2,351,309 $ 1,876,954
Provisions for loan losses 310,000 931,078 511,000
Loans charged off (202,543) (71,904) (62,559)
Recoveries 7,779 38,869 25,914
----------- ----------- -----------
Balance at end of year $ 3,364,588 $ 3,249,352 $ 2,351,309
=========== =========== ===========
The following is a summary of the principal balances of loans on nonaccrual
status and loans past due ninety days or more:
1998 1997
Loans contractually past due 90 days or more
and/or on nonaccrual status:
Residential $ 728,856 $1,214,189
Consumer and commercial 73,544 48,233
---------- ----------
$ 802,400 $1,262,422
========== ==========
During the years ended September 30, 1998, 1997 and 1996, interest income of
approximately $18,000, $48,000 and $44,000, respectively, was not recorded
related to loans accounted for on a nonaccrual basis.
6. PREMISES AND EQUIPMENT
Premises and equipment at September 30, 1998 and 1997 consist of the following:
1998 1997
Land $1,081,952 $ 935,560
Office buildings 2,499,579 2,488,976
Furniture, fixtures and equipment 1,706,207 1,067,858
Vehicles 249,748 225,041
---------- ----------
5,537,486 4,717,435
Less accumulated depreciation 1,978,650 1,899,268
---------- ----------
Total $3,558,836 $2,818,167
========== ==========
7. EMPLOYEE BENEFIT PLANS
The Company participates in a multiemployer defined benefit pension plan which
covers substantially all employees. Expenses of the plan for the years ended
September 30, 1998, 1997 and 1996 were $168,500, $96,000 and $137,000,
respectively.
The Company participates in a multiemployer defined contribution plan which
covers substantially all employees. Under the plan, employees may contribute
from 1% to 15% of compensation, subject to an annual maximum as determined by
the Internal Revenue Code. The Company makes matching contributions of 50% of
employees' contributions up to 6% of the employees' salaries. The plan provides
that employees' contributions are 100% vested at all times and the Bank's
contributions vest 25% for each year of service. The expenses related to the
Company's contributions to these plans for the years ended September 30, 1998,
1997 and 1996 were $76,386, $52,253 and $46,171, respectively.
25
<PAGE>
Directors and certain officers participate in deferred compensation plans. These
plans generally provide for fixed payments beginning at retirement. These
payments are earned over service periods of up to ten years, and can include
provisions for deferral of current payments. The expense related to these plans
during the years ended September 30, 1998, 1997 and 1996 aggregated $562,478,
$515,435 and $463,250, respectively. The plans generally include provisions for
forfeitures of unvested portions of payments, and vesting in the event of death
or disability.
On April 8, 1998, the Company's Stockholders approved a Management Recognition
Plan ("MRP") for directors and key employees. The Company is authorized to fund
the acquisition and award of up to 174,570 shares (4% of shares issued in the
stock conversion) to be awarded by a committee of the Board of Directors. The
Company completed the acquisition of MRP shares during fiscal 1998. On April 8,
1998, 174,570 shares (market value of $4,029,258 and aggregate cost of
$3,275,299) were awarded to certain officers and employees. The vesting schedule
provides that 33-1/3% of the shares shall be earned and become non-forfeitable
on April 30, 1998, 1999 and 2000.
The shares issued to the MRP plan have been recorded as outstanding shares, and
the unvested portion has been recorded as unearned compensation through a contra
equity account. The consolidated statement of operations for the year ended
September 30, 1998 include compensation expense of $1,902,959 relating to the
scheduled vesting of MRP shares.
8. EMPLOYEE STOCK OWNERSHIP PLAN
The Company's Board of Directors adopted an Employee Stock Ownership Plan
("ESOP"), effective October 1, 1996. Employees of the Company and its
subsidiaries who have attained age 21 and completed one year of service are
eligible to participate in the ESOP, provided that any employee who was employed
full-time on the closing date of the Stock Conversion automatically became a
participant on October 1, 1996. The ESOP is to be funded by contributions made
by the Company or the Bank in cash or shares of Common Stock. Allocations to
participants' accounts occur annually on September 30. Shares are committed to
be released for financial statement purposes when the Bank makes scheduled
payments on the ESOP note payable and will be allocated to employees for
services rendered in the current accounting period. Employees vest in their
allocated ESOP shares over three years. The number of shares legally released
and allocated is based on the ratio of the actual principal payments amount to
the remaining total principal payments for the ESOP note payable. The Bank
expects to contribute sufficient funds to the ESOP to repay the note payable
over a ten-year period, plus such other amounts as the Company's Board of
Directors may determine in its discretion.
Initially, the ESOP acquired 349,140 shares of the Company's common stock
financed by $3,491,400 in borrowings by the ESOP from the Company. This loan is
secured by the shares of Common Stock purchased and earnings thereon. At
September 30, 1998 and 1997, 80,431 and 37,242 shares respectively have been
allocated to participants' accounts and 268,709 and 311,898 shares, with an
estimated market value of $5,844,420 and $6,237,960, remain unallocated. All
allocated shares are considered outstanding for earning per share purposes,
while the unallocated shares are not included in the calculation.
The principal balance of the ESOP loan was $2,687,093 and $3,118,984 at
September 30, 1998 and 1997, respectively. The Bank is using the dividends
declared on shares held by the ESOP to reduce the outstanding debt. Dividends on
allocated shares are treated as a reduction of retained earnings. Dividends on
unallocated shares are treated only as debt service, and there is no reduction
of retained earnings. Compensation expense related to the ESOP is based on the
average fair market value of shares during the period since the prior allocation
date through the dates shares are committed to be released. The financial
statements for the years ended September 30, 1998 and 1997, include compensation
expense of $825,865 and $603,429, respectively, related to the ESOP.
9. STOCK OPTION PLAN
On April 8, 1998, the Shareholders of the Company approved the NewSouth Bancorp,
Inc. 1997 stock option plan. The purpose of this Plan is to advance the
interests of the Company through providing selected key employees and Directors
of the Bank and the Company with the opportunity to purchase shares. The Plan
reserves 436,425 shares for grant within ten years of the effective date. The
option price is required to be 100% of the stock's fair market value as defined,
with an exception for any shareholder with more than a 10% ownership interest in
the Company. The exercise price is required to be 110% of the stock's fair
market value for these options holders. Options vesting is determined on the
date of the grant. Options have a 10 year life, however, there are additional
limitation's for shareholders with more than a 10% ownership interest in the
Company. The Plan also has a change of control provision under which all shares
immediately vest if a change of control, as defined, occurs.
26
<PAGE>
During the year ended September 30, 1998, 398,303 options were granted at market
value on the date of award, (233,603 to a group of 13 officers and 164,700 to a
group of six directors). The weighted average grant price was $23.08 No options
were exercised during the year ended September 30, 1998. No options expired or
were forfeited during the year ended September 30, 1998. On November 19, 1998,
the Board of Directors approved a plan to recall the outstanding stock options
and regrant the same number of options at an exercise price of $18.25 per share.
The Company has adopted SFAS No. 123, "Accounting for Stock Based Compensation".
As permitted by SFAS No. 123, the Company has chosen to apply APB Opinion No.
25, "Accounting for Stock Issued to Employees" and related interpretations.
Accordingly, no compensation cost has been recognized for options granted under
the Option Plan. Had compensation cost for the Company's Option Plan been
determined based on the fair value at the grant dates for awards under the
Option Plan consistent with the method of SFAS No. 123, the Plan's net income
and net income per share would have been reduced to the pro forma amounts
indicated below. The Company did not grant any options during the years ended
September 30, 1997 or 1996, therefore, there are no pro forma amounts for those
periods.
For the Year Ended
September 30, 1998
----------------------------
as
Reported Pro Forma
------------ ------------
Net income $ 3,123,358 $ 1,829,801
Earnings per common share - basic $ .80 $ .47
Earnings per common share - assuming dilution $ .80 $ .47
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions used for grants in 1998: dividend growth rate of 0%, expected
volatility of 6.1%; risk-free interest rates of 5.3%; and expected lives of 7
years. The weighted average fair value of options granted in 1998 is $5.59.
The following table summarizes additional information about the Option Plan at
September 30, 1998:
Number Remaining Number
Outstanding Contractual Exercisable
Exercise Price At 9/30/98 Life At 9/30/98
-------------- ---------- ------- -------
$23.08 395,303 9 years 344,303
$22.63 3,000 9 years 1,000
10. BORROWED MONEY
Borrowed money represents advances from the Federal Home Loan Bank of Atlanta
and repurchase agreements. Advances from the Federal Home Loan Bank had a
weighed average rate of 6.00% and 6.17% and totaled, $9,500,000 and $11,000,000
at September 30, 1998 and 1997, respectively.
At September 30, 1998 and 1997, repurchase agreements outstanding had a rate of
3.33% and 4.67% and totaled $2,432,919 and $1,621,120, respectively.
Repurchase agreements are collateralized by U.S. government agency obligations
with a principal balance of $3,000,000. The Company has pledged all of its stock
in the Federal Home Loan Bank of Atlanta and certain loans secured by one to
four family residential mortgages as collateral for actual or potential
borrowings from the FHLB. At September 30, 1998, the Company had an additional
$15,500,000 of credit available with the Federal Home Loan Bank of Atlanta.
27
<PAGE>
11. INCOME TAXES
The components of income taxes for the years ended September 30, 1998, 1997 and
1996 are as follows:
1998 1997 1996
Current:
Federal $1,422,845 $ 1,908,576 $ 766,558
State 344,617 576,146 124,663
---------- ----------- ---------
Total current 1,767,462 2,484,722 891,221
---------- ----------- ---------
Deferred:
Federal 115,458 (617,976) (360,903)
State 16,980 (147,396) (79,801)
---------- ----------- ---------
Total deferred 132,438 (765,372) (440,704)
---------- ----------- ---------
Total $1,899,900 $ 1,719,350 $ 450,517
========== =========== =========
Reconciliations of expected income tax at the statutory Federal rate of 34% with
income tax expense for the years ended September 30, 1998, 1997 and 1996 are as
follows:
<TABLE>
<CAPTION>
1998 1997 1996
<S> <C> <C> <C>
Expected income tax expense $ 1,707,908 $1,353,873 $ 432,142
State income taxes net of federal income tax 239,220 147,000 26,671
Non-deductible ESOP, other expenses and
other adjustments (47,228) 218,477 (8,296)
----------- ---------- ---------
$ 1,899,900 $1,719,350 $ 450,517
=========== ========== =========
</TABLE>
The components of the net deferred income tax liability and asset are as
follows:
1998 1997
Deferred income tax assets:
Deferred directors' fees $ 365,384 $ 346,328
Bad debt reserve 931,514 782,302
Deferred employee benefits 483,382 363,925
Other 108,765 26,382
---------- ----------
1,889,045 1,518,937
---------- ----------
Deferred income tax liabilities:
Loans mark-to-market adjustment 665,254 235,757
Depreciation and amortization 134,905 91,306
Unrealized gains on securities available-for-sale 313,553 193,732
Deferred loan origination fees and costs 106,379 76,929
FHLB stock 99,350 99,350
---------- ----------
1,319,441 697,074
---------- ----------
Net deferred income tax asset $ 569,604 $ 821,863
========== ==========
28
<PAGE>
Retained income at September 30, 1998, includes approximately $1,850,000 for
which no deferred income tax liability has been recognized. This amount
represents an allocation of income to bad debt deductions for income tax
purposes only. Reductions of the amount so allocated for purposes other than tax
bad debt losses or adjustments arising from carryback of net operating losses
would create income for tax purposes only, which would be subject to the then
current corporate income tax rate.
During 1996, Congress enacted certain tax legislation that exempted thrift
institutions from being taxed on pre-1987 bad debt reserves. The Bank will be
recapturing a portion of its post-1987 bad debt reserve created by using the
percentage of taxable income method. The Bank has previously recorded deferred
tax liabilities related to these excess reserves. Additionally, the Bank is now
required to use the experience method.
12. REGULATORY CAPITAL REQUIREMENTS
Dividend payments made by the Company are subject to regulatory restrictions
under Federal Reserve Board policy as well as to limitations under applicable
provisions of Delaware corporate law. The Federal Reserve Board may prohibit a
bank holding company from paying any dividends if the holding company's bank
subsidiary is classified as "undercapitalized". Under Delaware law, dividends
may be paid out of surplus or, if there is no surplus, out of net profits for
the fiscal year in which the dividend is declared and for the preceding fiscal
year. Furthermore, under FDIC regulations, the Bank is prohibited from making
any capital distributions if after making the distribution, the Bank would have:
(i) a total risk-based capital ratio of less than 8.0%; (ii) a Tier 1 risk-based
capital ratio of less than 4.0%; or (iii) a leverage ratios of less than 4.0%.
The Bank is subject to various regulatory capital requirements administered by
the federal and state banking 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. Quantitative measures
established by regulation to ensure capital adequacy require the Bank to
maintain minimum amounts and ratios, as set forth in the table below. Management
believes, as of September 30, 1998, that the Bank meets all capital adequacy
requirements to which it is subject.
As of September 30, 1998, the most recent notification from the FDIC categorized
the Bank as well capitalized under the regulatory framework for prompt
corrective action. To be categorized as well capitalized the Bank must maintain
minimum amounts and ratios, as set forth in the table below. There are no
conditions or events since that notification that management believes have
changed the Bank's category.
The Company's actual capital amounts and ratios as of September 30, 1998 and
1997 are also presented in the table below (dollars in thousands).
<TABLE>
<CAPTION>
To Be Well Capitalized
For Capital Under Prompt
Actual Adequacy Purpose Action Provisions
--------------- -------------- ---------------
Amount Ratio Amount Ratio Amount Ratio
------ ----- ------ ----- ------ -----
1998:
<S> <C> <C> <C> <C> <C> <C>
Total Capital (to Risk Weighted Assets) $58,169 28.9% $16,125 8.0% $20,156 10.0%
Tier I Capital (to Risk Weighted Assets) 55,650 27.6% 8,063 4.0% 12,094 6.0%
Tier I Capital (to Average Assets) 55,650 20.2% 11,066 4.0% 13,758 5.0%
1997:
Total Capital (to Risk Weighted Assets) $59,684 34.8% $13,719 8.0% $17,149 10.0%
Tier I Capital (to Risk Weighted Assets) 57,527 33.6% 6,859 4.0% 10,289 6.0%
Tier I Capital (to Average Assets) 57,527 23.8% 9,679 4.0% 12,099 5.0%
</TABLE>
13. EARNING PER SHARE
The Company adopted SFAS No. 128 "Earnings Per Share" on October 1, 1997. As
required, all prior period earnings per share have been restated to conform with
the provisions of the statement.
29
<PAGE>
The following table provides a reconciliation of income available to common
stockholders and the average number of shares outstanding (less unearned ESOP
shares) for the years ended September 31, 1998 and 1997. As the Company
converted from mutual form during fiscal 1997, there are no reported earnings
per share for fiscal 1996.
1998 1997
Net income (numerator) $3,123,358 $1,395,900(1)
========== ==========
Shares for basic EPS (denominator) 3,876,813 3,961,933(1)
Dilutive effect of stock options -- --
---------- ----------
Adjusted shares for diluted EPS 3,876,813 3,961,933
========== ==========
(1) Calculated from date of conversion, April 7, 1997.
14. MORTGAGE BANKING ACTIVITIES
Mortgage loans serviced for others are not included in the accompanying
consolidated statements of financial condition. The unpaid principal balances of
mortgage loans serviced for others was $250,202,000 and $253,647,000 at
September 30, 1998 and 1997, respectively. Servicing loans for others generally
consists of collecting mortgage payments, maintaining escrow accounts,
disbursing payment to investors and foreclosure processing. Loan servicing
income is recorded on the accrual basis and includes servicing fees from
investors and certain charges collected from borrowers, such as late payment
fees.
The Company accounts for its mortgage banking transactions in accordance with
SFAS No. 125 "Accounting for Transfers and Servicing of Financial Assets and
Extinguishements of Liabilities". At September 30, 1998 and 1997, mortgage
servicing rights reported in the consolidated statements of financial condition,
net of amortization, were $184,433 and $57,525, respectively.
Impairments of servicing assets are evaluated through an assessment of the fair
value of those assets using a disaggregated, discounted cash-flows method under
which the assets are disaggregated into various stratum, based on predominant
risk characteristics. The net carrying value of each stratum, based on
predominant risk characteristics, is compared to its discounted estimated future
net cash flows to determine whether adjustments should be made to carrying
values or amortization schedules. Impairment of a servicing asset is recognized
through a valuation allowance and a charge to current-period earnings if it is
considered to be temporary, or, through a direct write-down of the asset and a
charge to current-period earnings if it is considered other than temporary. The
predominant risk characteristics of the underlying loans that are used to
satisfy the servicing assets and liabilities for measurement purposes generally
include the (1) loan origination date, (2) loan rate, (3) loan type and size and
(4) loan maturity date.
15. FINANCIAL INSTRUMENT WITH OFF-BALANCE SHEET RISK AND SIGNIFICANT GROUP
CONCENTRATION OF CREDIT RISK
The Company is a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers and
to reduce its own exposure to fluctuations in interest rates. These financial
instruments include commitments to extend credit and involve, to varying
degrees, elements of credit and interest rate risk in excess of the amount
recognized in the balance sheet.
The Company's exposure to credit loss in the event of non-performance by the
other party to the financial instrument for commitments to extend credit is
represented by the contractual amount of those instruments. The Company uses the
same credit policies in making commitments and conditional obligations as it
does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. The Company evaluates each customer's creditworthiness
on a case-by-case basis. The amount of collateral obtained, if deemed necessary
by the Company upon extension of credit, is based on management's credit
evaluation of the borrower.
30
<PAGE>
A summary of the contractual amounts of the Company's exposure to off-balance
sheet risk as of September 30, 1998 and 1997 is as follows:
<TABLE>
<CAPTION>
1998 1997
Commitments to extend credit:
<S> <C> <C>
Commitments to originate loans $14,887,234 $13,070,715
Undrawn balances on lines of credit and undrawn
balances on credit reserves (overdraft protection) 18,626,163 19,889,495
----------- -----------
$33,513,397 $32,960,210
=========== ===========
</TABLE>
Included in the commitments to originate loans as of September 30, 1998 and 1997
are fixed interest rate loan commitments of $5,821,488 and $6,722,340,
respectively. The shorter duration of interest-sensitive liabilities, to the
extent they are used to fund these fixed-rate loans, indicates that the Company
is exposed to interest rate risk because, in a rising rate environment,
liabilities will be repricing faster at higher interest rates, thereby reducing
the market value of fixed-rate long-term assets and net interest income.
The Company's lending is concentrated primarily in Beaufort, Craven, Nash,
Lenoir, Pasquotank, Pitt and surrounding counties in North Carolina. Credit has
been extended to certain of the Company's customers through multiple lending
transactions.
Since many of the commitments are expected to expire without being drawn upon,
amounts reported do not necessarily represent future cash requirements.
16. PARENT COMPANY FINANCIAL INFORMATION
The Company's principal asset is its investment in the Bank. Condensed financial
statements of the parent company as of September 30, 1998 and 1997 and for the
two years ended September 30, 1998 are as follows:
<TABLE>
<CAPTION>
1998 1997
------------ ------------
CONDENSED BALANCE SHEET
<S> <C> <C>
Cash $ 959,617 $ 23,383
Due from subsidiary 13,485,534 18,220,854
Investment in wholly-owned subsidiary 41,960,610 39,941,603
Other assets 579,311 --
------------ ------------
Total assets $ 56,985,072 $ 58,185,840
============ ============
Deferred income taxes $ -- $ 57,800
Other liabilities 271,102 272,453
Shareholders' equity 56,713,970 57,855,587
------------ ------------
Total liabilities and shareholders' equity $ 56,985,072 $ 58,185,840
============ ============
CONDENSED STATEMENT OF INCOME
Interest income, net $ 291,950 $ 159,006
Other income 3,007,978 1,570,050
Miscellaneous expenses 176,570 333,156
------------ ------------
Net income $ 3,123,358 $ 1,395,900
============ ============
</TABLE>
31
<PAGE>
<TABLE>
<CAPTION>
CONDENSED STATEMENT OF CASH FLOWS
Operating activities:
<S> <C> <C>
Net income $ 3,123,358 $ 1,395,900
Adjustments to reconcile net income to net cash
provided by operating activities:
Equity in undistributed earnings of subsidiary (3,007,978) (1,570,050)
Deferred income taxes (57,800) 57,800
ESOP compensation 825,865 603,429
MRP compensation 1,902,959 --
Other operating activities (589,308) 1,870,996
------------ ------------
Net cash provided by operating activities 2,197,096 2,358,075
------------ ------------
Investing activities:
Investment in, and advances to, subsidiary -- (38,980,323)
Repayments of advances to subsidiary 5,910,220 --
------------ ------------
Net cash used by investing activities 5,910,220 (38,980,323)
------------ ------------
Financing activities:
Net proceeds from issuance of stock -- 38,960,736
MRP funding (1,224,768) (2,050,531)
Purchase of treasury shares (4,895,754) --
Cash paid for fractional shares (4,652) --
Dividends paid (1,045,908) (264,574)
------------ ------------
Net cash provided by provided by (used in )
financing activities (7,171,082) 36,645,631
------------ ------------
Net increase in cash 936,234 23,383
Cash at beginning of the year 23,383 --
------------ ------------
Cash at the end of year $ 959,617 $ 23,383
============ ============
</TABLE>
17. QUARTERLY FINANCIAL DATA (UNAUDITED)
Summarized unaudited quarterly financial data for the years ended September 30,
1998 and 1997 is as follows (in thousands):
Fourth Third Second First
------ ------ ------ ------
1998:
Interest income $5,694 $5,603 $5,330 $5,240
Interest expense 2,417 2,357 2,262 2,204
Provision for loan losses 100 110 -- 100
Noninterest income 647 678 732 589
Noninterest expense 2,524 2,564 2,558 2,294
Income tax expense 483 467 476 474
------ ------ ------ ------
Net income $ 817 $ 783 $ 766 $ 757
====== ====== ====== ======
Net income per common share:
Basic and assuming dilution $ .21 $ .20 $ .20 $ .19
====== ====== ====== ======
32
<PAGE>
Fourth Third Second First
------ ------ ------ ------
1997:
Interest income $5,166 $4,911 $4,356 $4,083
Interest expense 2,149 1,986 2,124 2,087
Provision for loan losses 184 541 100 107
Noninterest income 459 485 366 370
Noninterest expense 1,961 1,643 1,864 1,468
Income tax expense 614 547 249 310
------ ------ ------ ------
Net income $ 717 $ 679 $ 385 $ 481
====== ====== ====== ======
Net income per common share
Basic and assuming dilution $ .18 $ .17 N/A N/A
====== ====== ====== ======
18. FAIR VALUES OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, "Disclosures about Fair
Value of Financial Instruments" (SFAS No. 107), requires the disclosure of
estimated fair values for financial instruments. Quoted market prices, if
available, are utilized as an estimate of the fair value of financial
instruments. Because no quoted market prices exist for a significant part of the
Company financial instruments, the fair value of such instruments has been
derived based on management's assumptions with respect to future economic
conditions, the amount and timing of future cash flows and estimated discount
rates with respect to future economic conditions, the amount and timing of
future cash flows and estimated discount rates. Different assumptions could
significantly affect these estimates. Accordingly, the net realizable value
could be materially different from the estimates presented below. In addition,
the estimates are only indicative of individual financial instruments' values
and should not be considered an indication of the fair value of the Company
taken as a whole.
Fair values have been estimated using data which management considers as the
best available, and estimation methodologies deemed suitable for the pertinent
category of financial instrument. The estimation methodologies, resulting fair
values, and recorded carrying amounts at September 30, 1998 and 1997, were as
follows:
Cash and cash equivalents are by definition short-term and do not prevent any
unanticipated credit issues. Therefore, the carrying amount is a reasonable
estimate of fair value. The estimated fair values of investment securities and
mortgage backed securities are provided in Notes 3 and 4 to the financial
statements. These are based on quoted market prices, when available. If a quoted
market price is not available, fair value is estimated using quoted market
prices for similar securities.
The fair value of the net loan portfolio has been estimated using the present
value of expected cash flows, discounted at an interest rate adjusted for
servicing costs and giving consideration to estimated prepayment risk and credit
loss factors, as follows:
<TABLE>
<CAPTION>
1998 1997
Estimated Carrying Estimated Carrying
Fair Value Amount Fair Value Amount
-------------- ------------- -------------- -------------
<S> <C> <C> <C> <C>
1 - 4 family mortgages $ 107,101,833 $ 105,059,149 $ 92,301,373 $ 90,080,092
Consumer 47,905,877 48,414,917 48,442,139 48,942,499
Non-residential 71,524,965 71,524,965 58,762,314 58,762,314
-------------- ------------- -------------- -------------
$ 226,532,675 $ 224,999,031 $ 199,505,826 $ 197,784,905
============== ============= ============== =============
</TABLE>
33
<PAGE>
The fair value of deposit liabilities with no stated maturities has been
estimated to equal the carrying amount (the amount payable on demand), totaling
$50,271,086 and $43,955,573 at September 30 1998 and 1997, respectively. The
fair value estimates for these products do not reflect the benefits that the
Bank receives from the low-cost, long-term funding they provide. These benefits
are considered significant.
The fair value of certificates of deposits and advances from the Federal Home
Loan Bank is estimated by discounting the future cash flows using the current
rates offered for similar deposits and advances with the same remaining
maturities. The carrying value and estimated fair values of certificates of
deposit and Federal Home Loan Bank advances at September 30, 1998 and 1997 are
as follows:
1998 1997
------------ ------------
Certificates of deposits:
Carrying amount $155,363,999 $131,160,215
Estimated fair value $156,426,259 $131,780,748
Advances for Federal Home Loan Bank:
Carrying amount $ 9,500,000 $ 11,000,000
Estimated fair value $ 9,500,000 $ 11,000,595
The carrying amount of repurchase agreements approximates the fair value. The
interest rate on these agreements is a floating rate based on the Federal funds
daily rate.
There is no material difference between the carrying amount and estimated fair
value of off-balance sheet items totaling $33,513,397 in 1998 and $32,962,010 in
1997, which are primarily comprised of unfunded loan commitments.
The Company's remaining assets and liabilities are not considered financial
instruments.
34
<PAGE>
<TABLE>
<CAPTION>
BOARD OF DIRECTORS
<S> <C> <C>
DR. FREDERICK H. HOWDY LINLEY H. GIBBS, JR. EDMUND T. BUCKMAN, JR.
CHAIRMAN VICE CHAIRMAN Retired
President Retired Washington, NC
Drs. Freshwater and Howdy, P.A. Washington, NC
Washington, NC
FREDERICK N. HOLSCHER CHARLES E. PARKER, JR. MARSHALL T. SINGLETON
Partner Vice President Co-Owner
Rodman, Holscher, Francisco & Robinson Insurance Agency B. E. Singleton & Sons
Peck, P.A. New Bern, NC Washington, NC
Washington, NC
THOMAS A. VANN
President
NewSouth Bank
Washington, NC
EXECUTIVE OFFICERS
THOMAS A. VANN JACK L. ASHLEY JOHN B. BURGESS
President Executive Vice President Executive Vice President
Branch Administration and Credit Administration
Operations
WILLIAM L. WALL JOSEPH C. DUNN MARY R. BOYD
Executive Vice President Senior Vice President Vice President
Chief Financial Officer and Commercial Lending Loan Servicing
Secretary
SHERRY L. CORRELL KRISTIE W. HAWKINS WALTER P. HOUSE
Vice President Treasurer Vice President
Deposit Administration Controller Mortgage Operations
WILLIAM R. OUTLAND
Vice President
Consumer Lending
NEWSOUTH BANK OFFICE LOCATIONS
CORPORATE OFFICE KINSTON WASHINGTON
1311 Carolina Avenue 827 Hardee Road 1311 Carolina Avenue
Washington, NC 27889 252-522-9466 252-946-4178
252-946-4178
NEW BERN 300 North Market Street
FULL-SERVICE BRANCH OFFICES 202 Craven Street 252-946-4178
252-636-2997
ELIZABETH CITY Operations Center
604 East Ehringhaus Street 1725 Glenburnie Road 239 West Main Street
252-335-0848 252-636-2997 252-946-4178
GREENVILLE ROCKY MOUNT
301 East Arlington Blvd. 300 Sunset Avenue
252-321-2600 252-972-9661
</TABLE>
35
<PAGE>
STOCKHOLDER INFORMATION
CORPORATE HEADQUARTERS
NewSouth Bancorp, Inc. Telephone: 252-946-4178
1311 Carolina Avenue Fax: 252-946-3873
Washington, NC 27889
STOCK LISTING INFORMATION
The Company's common stock trades on the Nasdaq Stock Market under the symbol
NSBC.
STOCK PRICE INFORMATION
The following table sets forth the high and low trade price information and
dividends declared per share for the periods indicated. The Company's common
stock began trading on April 8, 1997.
Quarter Ended High Low Dividends Declared
------------- ---- --- ------------------
June 30, 1997 (1) $16.667 $13.333 $.067
September 30, 1997 (1) 20.75 16.167 .067
December 31, 1997 (1) 22.417 19.25 .067
March 31, 1998 (1) 23.167 19.333 .067
June 30, 1998 (1) 23.667 21.333 .067
September 30, 1998 (1) 23.333 21.25 .07
---------------
(1) Adjusted for three-for-two stock split on August 19, 1998.
REGISTRAR AND TRANSFER AGENT
Inquiries regarding stock transfer, registration, lost certificates or changes
in name and address should be directed to the stock registrar and transfer
agent:
Registrar and Transfer Company
10 Commerce Drive
Cranford, New Jersey 07016
(800) 866-1340
FORM 10-K
The Company's annual report on Form 10-K, filed with the Securities and Exchange
Commission, is available to shareholders without charge by writing: William L.
Wall, Chief Financial Officer, NewSouth Bancorp, Inc., P. O. Box 2047,
Washington, NC 27889.
INVESTOR INFORMATION
Shareholders, investors, and analysts interested in additional information may
contact William L. Wall, Chief Financial Officer, NewSouth Bancorp, Inc.
ANNUAL MEETING
The Annual Meeting of shareholders of NewSouth Bancorp, Inc. will be held
Thursday, February 18, 1999 at 1:00 p.m. at the main office of NewSouth Bank,
1311 Carolina Avenue, Washington, North Carolina.
<TABLE>
<CAPTION>
<S> <C> <C>
GENERAL COUNSEL SPECIAL COUNSEL INDEPENDENT ACCOUNTANTS
Rodman, Holscher, Francisco & Housley, Kantarian & Bronstein, P.C. PricewaterhouseCoopers LLP
Peck, P.A. Suite 700 Suite 2300
320 North Market Street 1220 19th Street, N.W. 150 Fayetteville Street Mall
Washington, NC 27889 Washington, DC 20036 Raleigh, NC 27601
</TABLE>
36
EXHIBIT 21
SUBSIDIARIES OF THE REGISTRANT
State or Other
Jurisdiction of Percentage
Incorporation Ownership
------------- ---------
Parent
- ------
NewSouth Bancorp, Inc. Delaware 100%
Subsidiary
- ----------
NewSouth Bank North Carolina 100%
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statement of
NewSouth Bancorp, Inc. on Form S-8 (File No. 333-49759) of our report dated
November 5, 1998 on our audits of the consolidated financial statements of
NewSouth Bancorp, Inc. as of September 30, 1998 and 1997, and for each of the
three years in the period ended September 30, 1998, which report has been
incorporated by reference in NewSouth Bancorp, Inc.'s Annual Report on Form 10-K
filed with the Securities and Exchange Commission pursuant to the Securities
Exchange Act of 1934.
/s/ PricewaterhouseCoopers LLP
PRICEWATERHOUSECOOPERS LLP
Raleigh, North Carolina
December 23, 1998
<TABLE> <S> <C>
<ARTICLE> 9
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-START> OCT-01-1997
<PERIOD-END> SEP-30-1998
<CASH> 5,243,853
<INT-BEARING-DEPOSITS> 11,767,988
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 30,124,224
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 228,363,619
<ALLOWANCE> 3,364,588
<TOTAL-ASSETS> 281,479,453
<DEPOSITS> 204,635,085
<SHORT-TERM> 11,932,919
<LIABILITIES-OTHER> 8,197,479
<LONG-TERM> 0
0
0
<COMMON> 43,640
<OTHER-SE> 56,670,330
<TOTAL-LIABILITIES-AND-EQUITY> 281,479,453
<INTEREST-LOAN> 18,888,253
<INTEREST-INVEST> 2,978,655
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 21,866,908
<INTEREST-DEPOSIT> 9,096,290
<INTEREST-EXPENSE> 9,239,632
<INTEREST-INCOME-NET> 12,627,276
<LOAN-LOSSES> 310,000
<SECURITIES-GAINS> 272,724
<EXPENSE-OTHER> 9,940,066
<INCOME-PRETAX> 5,023,258
<INCOME-PRE-EXTRAORDINARY> 5,023,258
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 5,023,258
<EPS-PRIMARY> 0.80
<EPS-DILUTED> 0.80
<YIELD-ACTUAL> 5.05
<LOANS-NON> 802,400
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 18,201
<ALLOWANCE-OPEN> 3,249,352
<CHARGE-OFFS> 202,543
<RECOVERIES> 7,779
<ALLOWANCE-CLOSE> 3,364,588
<ALLOWANCE-DOMESTIC> 3,364,588
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
