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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 or 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
(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, 1999
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
1ST STATE BANCORP, INC.
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(Exact name of registrant as specified in its charter)
Virginia 56-2130744
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(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)
445 S. Main Street, Burlington, North Carolina 27215
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (336) 227-8861
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 _
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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, 1999, the aggregate market value of the 2,188,720 shares of
Common Stock of the registrant issued and outstanding held by non-affiliates on
such date was approximately $43.8 million based on the closing sale price of
$20.00 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, 1999: 3,163,125.
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, 1999. (Parts I, II and IV)
2. Portions of Proxy Statement for 2000 Annual Meeting of Stockholders.
(Part III)
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PART I
Item 1. Business
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General
References in this document to the "Bank," "we," "us," and "our" refer to
1st State Bank. Where appropriate, "us" or "our" refers collectively to 1st
State Bancorp, Inc. and 1st State Bank. References in this document to the
"Company" refer to 1st State Bancorp, Inc. As a result, portions of this
discussion as of dates and for periods prior to April 23, 1999 relate to the
financial condition and results of operations of 1st State Bank.
1st State Bancorp, Inc. We organized 1st State Bancorp in November 1998 to
be the holding company for 1st State Bank, following its conversion from mutual
to stock form (the "Stock Conversion"), and then as a bank holding company of
1st State Bank following its conversion from a North Carolina-chartered savings
bank to a North Carolina commercial bank (the "Bank Conversion"). 1st State
Bancorp is primarily engaged in the business of directing, planning and
coordinating the business activities of 1st State Bank. In the future, 1st State
Bancorp may conduct operations or acquire or organize other operating
subsidiaries, including other financial institutions, though we have no current
plans in this regard. Currently, 1st State Bancorp does not maintain offices
separate from those of 1st State Bank nor employ any persons other than its
officers who are not separately compensated for their service.
1st State Bank. Founded in 1914, 1st State Bank is a community and customer
oriented North Carolina-chartered commercial bank headquartered in Burlington,
North Carolina. We have six full service offices located in north central North
Carolina on the Interstate 85 corridor between the Piedmont Triad and Research
Triangle. We conduct most of our business in Alamance County, North Carolina.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of the interest we
pay on deposits and borrowed funds. We also earn income from miscellaneous fees
related to our loans and deposits, mortgage banking income and commissions from
sales of annuities and mutual funds.
Market Area
We conduct most of our business in Alamance County in north central North
Carolina, located on the Interstate 85 corridor between the Piedmont Triad and
Research Triangle. Historically, the Alamance County economy has been heavily
dependent on the textile industry. During the past 20 years, the economy has
diversified to some extent, with increasing employment in the areas of
insurance, banking, manufacturing and services. Major employers in the area
include LabCorp, Burlington Industries, Alamance County Schools, Glenraven Mills
and Alamance Health Services. Nevertheless, the economy in Alamance County
continues to be heavily dependent on the textile industry.
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Lending Activities
Loan Portfolio Composition. At September 30, 1999, our gross loan portfolio
totaled $206.2 million and represented 61.9% of total assets. The following
table sets forth information relating to the composition of our loan portfolio
by type of loan at the dates indicated. At September 30, 1999, we had no
concentrations of loans exceeding 10% of gross loans other than as disclosed
below. Excluded from this table are mortgage loans held for sale, which are
presented separately on our consolidated balance sheets and in "Selected
Consolidated Financial Information and Other Data" in the Annual Report.
<TABLE>
<CAPTION>
At September 30,
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1999 1998 1997 1996 1995
---------------- ---------------- ---------------- ---------------- ----------------
Amount % Amount % Amount % Amount % Amount %
------ --- ------ --- -------- --- ------ --- -------- ---
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Real estate loans:
Single-family residential.... $ 90,883 44.06% $100,891 48.84% $108,400 53.76% $100,247 55.70% $ 98,660 55.78%
Commercial................... 40,816 19.79 38,763 18.76 34,333 17.02 35,302 19.62 35,774 20.23
Home equity.................. 18,888 9.16 16,877 8.17 18,141 8.99 15,872 8.82 16,409 9.28
Construction................. 16,496 8.00 18,572 8.99 12,582 6.24 7,838 4.36 7,084 4.01
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate........ 167,083 81.01 175,103 84.76 173,456 86.01 159,259 88.50 157,927 89.30
Commercial..................... 32,502 15.76 25,190 12.19 22,870 11.34 16,989 9.44 15,072 8.52
Consumer....................... 6,658 3.23 6,310 3.05 5,354 2.65 3,706 2.06 3,847 2.18
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
206,243 100.00% 206,603 100.00% 201,680 100.00% 179,954 100.00% 176,846 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
Less:
Loans in process............. (7,289) (6,446) (1,660) (3,515) (3,457)
Deferred fees and discounts.. (208) (147) (144) (94) (73)
Allowance for loan losses.... (3,454) (3,228) (2,754) (2,496) (2,223)
-------- -------- -------- -------- --------
Total...................... $195,292 $196,782 $197,122 $173,849 $171,093
======== ======== ======== ======== ========
</TABLE>
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Loan Maturity Schedule. The following table sets forth certain information
at September 30, 1999 regarding the dollar amount of loans maturing in our
portfolio based on their contractual terms to maturity, including scheduled
repayments of principal. Demand loans, loans having no stated schedule of
repayments, such as lines of credit, 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 our
repayment experience to differ from that shown below.
<TABLE>
<CAPTION>
Due During Through Due After
the Year Ending 5 Years After 5 Years After
September 30, 2000 September 30, 1999 September 30, 1999 Total
------------------ ------------------ ------------------ --------
(In thousands)
<S> <C> <C> <C> <C>
Real estate loans:
Single-family..... $ 2,858 $ 10,320 $ 77,705 $ 90,883
Commercial........ 3,744 15,008 22,064 40,816
Home equity....... 415 495 17,978 18,888
Construction...... 5,144 4,038 25 9,207
Commercial.......... 16,094 13,503 2,905 32,502
Consumer............ 1,772 4,517 369 6,658
---------- ----------- ----------- -----------
Total........ $ 30,027 $ 47,881 $ 121,046 $ 198,954
========== =========== =========== ===========
</TABLE>
The following table sets forth at September 30, 1999, the dollar amount of
all loans due one year or more after September 30, 1999 which have predetermined
interest rates and have floating or adjustable interest rates.
<TABLE>
<CAPTION>
Predetermined Floating or
Rate Adjustable Rates Total
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(In thousands)
<S> <C> <C> <C>
Real estate loans:
Single-family residential.. $ 53,519 $ 34,506 $ 88,025
Commercial................. 10,845 26,227 37,072
Home equity................ 6,282 12,191 18,473
Construction............... -- 4,063 4,063
Commercial................... 3,134 13,274 16,408
Consumer..................... 4,759 127 4,886
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Total.................... $ 78,539 $ 90,388 $ 168,927
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</TABLE>
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Scheduled contractual principal repayments of loans do not reflect the
actual life of the loans. 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 us the right to declare a loan immediately due
and payable in the event that, among other things, 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. We generally have authority to
originate and purchase loans secured by real estate located throughout the
United States. Consistent with our emphasis on being a community-oriented
financial institution, we concentrate our lending activities in Alamance County.
The following table sets forth certain information with respect to our loan
origination, purchase and sale activity for the periods indicated.
<TABLE>
<CAPTION>
Year Ended September 30,
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1999 1998 1997
-------- -------- -------
(In thousands)
<S> <C> <C> <C>
Loans originated:
Real estate loans:
Single-family residential.. $ 54,309 $ 44,118 $27,731
Commercial................. 9,358 9,437 5,446
Home equity................ 12,088 7,351 6,340
Construction............... 12,039 19,158 17,082
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Total real estate loans... 87,794 80,064 56,599
Commercial................... 19,291 18,982 15,835
Consumer..................... 6,744 6,361 6,801
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Total loans originated.. $113,829 $105,407 $79,235
======== ======== =======
Loans purchased:
Real estate loans............ $ 270 $ 135 $ 96
Other loans.................. 36 18 --
-------- -------- -------
Total loans purchased..... $ 306 $ 153 $ 96
======== ======== =======
Loans sold: (1)................ $ 39,803 $ 27,635 $ 9,166
======== ======== =======
</TABLE>
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(1) All loans sold were whole loans.
We obtain our loan originations from a number of sources, including
referrals from depositors, borrowers and realtors, repeat customers, advertising
and calling officers, as well as walk-in customers. We also advertise in local
media and participate in various community organizations and events. Real estate
loans are originated by our loan officers. All of our loan officers are salaried
and are eligible to receive commissions for loans originated. We accept loan
applications at our offices and do not originate loans on an indirect basis such
as through arrangements with automobile dealers. In all cases, we have final
approval of the application. Historically, we have purchased limited quantities
of loans. During the years ended September 30, 1999, 1998 and 1997, virtually
all loans purchased were small participation interests in multi-family
residential real estate loans to finance low income housing.
In recent years, and particularly during the years ended September 30, 1999
and 1998, we have sold an increasing amount of fixed-rate, single-family
mortgage loans that we originated. During the years ended September 30, 1999,
1998 and 1997, we sold $39.8 million, $27.6 million and $9.2 million,
respectively, of such loans. Typically, in the current low interest rate
environment, we have been selling fixed-rate, single-family mortgage loans with
terms
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of 15 years or more except in cases where the interest rate is sufficient to
compensate us for the risk of retaining a long-term, fixed-rate loan in our
portfolio. Most loans have been sold to private purchasers with servicing
released. In addition, we sell a smaller amount of loans in the secondary market
to the Federal Home Loan Mortgage Corporation. We retain servicing on loans sold
to the Federal Home Loan Mortgage Corporation.
Loan Underwriting Policies. We have established written, non-discriminatory
underwriting standards and loan origination procedures. We obtain detailed loan
applications to determine the borrower's ability to repay, and verify the more
significant items on these applications through the use of credit reports,
financial statements and confirmations. Individual officers have been granted
authority by the board of directors to approve mortgage, consumer and commercial
loans up to varying specified dollar amounts, depending upon the type of loan. A
loan committee consisting of our President, Executive Vice President, Chief
Financial Officer, senior credit officer and head of mortgage lending has
authority to approve any loan in an amount exceeding individual lending
authorities where our total loans to that borrower would not exceed $350,000.
Our executive committee, which consists of the Chairman of the Board, the
President, two additional board members that serve on a permanent basis and one
board member selected on a rotating basis that serves for a three-month period,
has authority to approve any loan where our total loans to that borrower would
not exceed $1.0 million. Loans above that amount may not be made unless approved
by the full board of directors. These authorities are based on aggregate
borrowings of an individual or entity. On a monthly basis, the Executive
Committee reviews the actions taken by the loan committee and the full board of
directors reviews the actions taken by the Executive Committee.
Applications for single-family real estate loans are underwritten and
closed in accordance with the standards of Federal Home Loan Mortgage
Corporation. Generally, upon receipt of a loan application from a prospective
borrower, we order a credit report and verifications 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, we
usually obtain an appraisal of the real estate from an appraiser approved by us
and licensed by the State of North Carolina. Except when we become aware of a
particular risk of environmental contamination, we generally do not obtain a
formal environmental report on real estate at the time a loan is made.
Our policy is 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.
On single-family residential mortgage loans, we make a loan commitment of
between 30 and 60 days for each loan approved. If the borrower desires a longer
commitment, we may extend the commitment for good cause. We guarantee the
interest rate for the commitment period.
We are permitted to lend up to 95% of the lesser of the appraised value or
the purchase price of the real property securing a mortgage loan. However, if
the amount of a residential loan originated or refinanced exceeds 80% of the
appraised value, our 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% of the appraised value of the property. We 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. We generally limit 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%. We limit the loan-to-value ratio on multi-family residential real
estate loans to 80%.
Under applicable law, with certain limited exceptions, loans and extensions
of credit by a financial institution 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 net worth plus the
general loan loss reserve. Loans and extensions of credit fully secured by
readily marketable collateral may comprise an additional 10% of net worth.
Applicable law additionally authorizes financial institutions to make loans to
one borrower, for any purpose:
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. in an amount not to exceed $500,000;
. in an amount not to exceed the lesser of $30,000,000 or 30% of net
worth to develop residential housing, provided (a) the purchase price
of each single-family dwelling in the development does not exceed
$500,000 and (b) the aggregate amount of loans made under this
authority does not exceed 150% of net worth; or
. loans to finance the sale of real property in satisfaction of debts
previously contracted in good faith, not to exceed 50% of net worth.
Under these limits, our loans to one borrower were limited to $7.7 million
at September 30, 1999. At that date, we had no lending relationships in excess
of the loans-to-one-borrower limit. At September 30, 1999, our ten largest
lending relationships ranged in size from $2.1 million to $4.6 million.
Single-Family Residential Real Estate Lending. We historically have been
and continue to be an originator of single-family, residential real estate loans
in our market area. At September 30, 1999, single-family, residential mortgage
loans, excluding home equity loans, totaled $90.9 million, or 44.1%, of our
gross loan portfolio.
We originate fixed-rate mortgage loans at competitive interest rates. At
September 30, 1999, $59.2 million, or 28.7%, of our gross loan portfolio was
comprised of fixed-rate, single-family mortgage loans. Generally, in the
currently low interest rate environment, we have been retaining fixed-rate
mortgages with maturities of ten years or less while fixed-rate loans with
longer maturities are being sold in the secondary market.
We also offer adjustable-rate residential mortgage loans. The adjustable-
rate loans we currently offer 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 three or five years in accordance with a
designated index, plus a stipulated margin. The primary index we utilize is the
weekly average yield on the one year 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"). The maximum
adjustment on the bulk of our loans is 2% per adjustment period with a maximum
aggregate adjustment of 6% over the life of the loan. We offer adjustable-rate
mortgage loans that provide for initial rates of interest slightly below the
rates that would prevail when the index used for repricing is applied, i.e.,
"teaser" rates. All of our 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, 1999, $31.7 million, or 34.9%, of our single-family residential
mortgage loans were adjustable-rate loans.
The retention of adjustable-rate loans in our portfolio helps reduce our
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 us to increase the
sensitivity of our 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, yields on our adjustable-rate loans may not fully
adjust to compensate for increases in our cost of funds.
Commercial Real Estate Lending. Our commercial real estate loan portfolio
includes loans secured by small office buildings, commercial and industrial
buildings and small apartment buildings. These loans generally range in size
from $100,000 to $3.3 million. At September 30, 1999, our commercial real estate
loans totaled $40.8 million, which amounted to 19.8%, of our gross loan
portfolio. We originate commercial real estate loans for terms of up to 15
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years and with interest rates that adjust daily based on our prime rate plus a
negotiated margin typically up to 1% or that carry predetermined rates fixed for
one, three or five years.
Commercial real estate lending entails significant additional risks as
compared with single-family residential property lending. 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,
apartment building 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, we generally originate loans
secured by collateral located in our market area or to borrowers with which we
have prior experience or who are otherwise known to us. It has been our policy
to obtain annual financial statements of the business of the borrower or the
project for which commercial real estate loans are made. In addition, in the
case of commercial mortgage loans made to a partnership or a corporation, we
seek, whenever possible, to obtain personal guarantees and annual financial
statements of the principals of the partnership or corporation.
Home Equity Loans. At September 30, 1999, we had approximately $18.9
million in home equity line of credit loans, representing approximately 9.2% of
our gross loan portfolio. Our home equity lines of credit generally have
adjustable interest rates tied to our prime interest rate plus a margin,
although we currently are offering a program where the interest rate on home
equity loans will be fixed for one or two years. Home equity lines of credit
must be repaid in 15 years or less and require monthly interest payments. Home
equity lines of credit generally are secured by subordinate liens against
residential real property. We require that fire and extended coverage casualty
insurance and, if appropriate, flood insurance, be maintained in an amount at
least sufficient to cover the loan. Home equity loans generally are limited so
that the amount of such loans, along with any senior indebtedness, does not
exceed 80% of the value of the real estate security.
Construction Lending. We offer residential and commercial construction
loans, with a significant portion of such loans originated to date being for the
construction of owner-occupied, single-family dwellings in our 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. In addition, on occasion, we make acquisition and
development loans to local developers to acquire and develop land for sale to
builders who will construct single-family residences. At September 30, 1999,
$16.5 million, or 8.0%, of our gross loan portfolio consisted of construction
loans.
Generally, we originate loans to owner/occupants for the construction of
owner-occupied, single-family residential properties in connection with the
permanent loan on the property, and these loans have a construction term of six
to 12 months. Loans are offered on an adjustable-rate basis. Interest rates on
residential construction loans made to the owner/occupant have interest rates
during the construction period equal to our prime rate. Upon completion of
construction, the loan is converted into a one-year adjustable-rate loan, and
the owner may lock in a fixed-rate loan at any time during the one-year period.
We make construction loans to builders on either a pre-sold or speculative
basis. However, we limit the number of outstanding loans on unsold homes under
construction to individual builders, with the amount dependent on the financial
strength of the builder, the present exposure of the builder, the location of
the property and prior sales of homes in the development. At September 30, 1999,
speculative construction loans amounted to $3.0 million. At September 30, 1999,
the largest amount of construction loans outstanding to one builder was
$500,000, all of which was for speculative construction. Interest rates on
residential construction loans to builders are typically set at our prime rate
plus a margin typically up to 1% and adjust with changes in the prime rate, and
are made for terms of up to 24 months.
Interest rates on commercial construction loans are based on the prime rate
plus a negotiated margin typically up to 1%, and adjust with changes in our
prime rate, and are made for terms of up to 24 months, with construction terms
generally not exceeding 12 months.
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We make acquisition and development loans at a rate that adjusts daily,
based on our prime rate plus a negotiated margin, for terms of up to three
years. Interest only is paid during the term of the loan, and the principal
balance of the loan is paid down as developed lots are sold to builders. At
September 30, 1999, $6.3 million of our gross loan portfolio consisted of
acquisition and development loans. We had ten such loans. All acquisition and
development loans were performing in accordance with their terms at such date.
Prior to making a commitment to fund a construction loan, we require an
appraisal of the property by appraisers approved by our board of directors. We
also review and inspect each project at the commencement of construction and
periodically during the term of the construction loan. We may charge a
construction fee and/or an inspection fee on construction loans. Advances are
made on a percentage of completed basis.
We consider construction financing generally 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 our requirements of putting up additional funds to
cover extra costs or change orders, then we 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 collateral may not have
sufficient value to assure full repayment. We have sought to minimize this risk
by limiting construction lending to borrowers based in Alamance County and who
satisfy all credit requirements and whose loans satisfy all other underwriting
standards which would apply to our permanent mortgage loan financing for the
subject property. On loans to builders, we work only with selected builders with
whom we have experience and carefully monitor the creditworthiness of the
builders.
Commercial Lending. We originate commercial loans to small and medium sized
businesses in our market area. Our commercial borrowers are generally small
businesses engaged in manufacturing, distribution or retailing, or professionals
in healthcare, accounting and law. Commercial loans generally are 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 loans are sometimes granted on an unsecured basis.
Commercial 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 our prime rate plus a margin typically up to 2%.
Generally, we make commercial loans in amounts ranging between $50,000 and $1.0
million. At September 30, 1999, commercial loans totaled $32.5 million, or
15.8%, of our gross loan portfolio.
We underwrite commercial 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 we seek to structure such loans to have more than one
source of repayment. The borrower is required to provide us with sufficient
information to allow us to make our 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, we require that borrowers and guarantors provide
updated financial information at least annually throughout the term of the loan.
Our commercial loans may be structured as term loans or as lines of credit.
Commercial term loans are generally made to finance the purchase of assets and
have maturities of five years or less. Commercial lines of credit are typically
made for the purpose of providing working capital and are usually reviewed on an
annual basis but may be called on demand. We also offer standby letters of
credit for commercial borrowers. Standby letters of credit are written for a
maximum term of one year.
Commercial loans are often larger and may involve greater risk than other
types of lending. Because payments on commercial loans are often dependent on
successful operation of the business involved, repayment of such loans may
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be subject to a greater extent to adverse conditions in the economy. We seek to
minimize these risks through our 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, we limit this type of lending to our market area and to borrowers
with which we have prior experience or who are otherwise well known to us.
Consumer Lending. In recent years, we have gradually increased our
portfolio of consumer loans. Our consumer loans include automobile loans,
savings account loans, unsecured lines of credit and miscellaneous other
consumer loans, including unsecured loans. At September 30, 1999, our consumer
loans totaled $6.7 million, or 3.2%, of our gross loan portfolio.
We generally underwrite automobile loans in amounts up to 80% 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. We require that the vehicles
be insured and that we be listed as loss payee on the insurance policy.
We make savings account loans for up to 90% of the depositor's savings
account balance. The interest rate is normally 2.5% above the annual percentage
yield paid on the savings account. The account must be pledged as collateral to
secure the loan. Interest generally is paid on a monthly basis.
Consumer lending affords us 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 lines of credit, 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 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, we consider the borrower's credit history, an analysis of the borrower's
income and ability to repay the loan, and the value of the collateral.
Loan Fees and Servicing. We receive fees in connection with late payments
and for miscellaneous services related to our loans and deposits. We also charge
fees in connection with loan originations. These fees can consist of
origination, discount, application, construction and/or commitment fees,
depending on the type of loan. We generally do not service loans for others
except for mortgage loans we originate and sell with servicing retained.
Mortgage servicing rights were not material for any of the periods presented.
Nonperforming Loans and Other Problem Assets. We continually monitor our
loan portfolio to anticipate and address potential and actual delinquencies.
When a borrower fails to make a payment on a loan, we take 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, we will contact the
borrower after the loan has been delinquent 15 days. If payment is not promptly
received, we contact the borrower again, and we try to formulate an affirmative
plan to cure the delinquency. Generally, after any loan is delinquent 45 days or
more, we send a default letter to the borrower. If the default is not cured
after 30 days, we commence formal legal proceedings to collect amounts owed.
Generally we charge off or reserve through an allowance account interest on
loans, including impaired loans, that are contractually 90 days or more past
due. The allowance is established by a charge to interest income equal to all
interest previously accrued. In certain circumstances, interest on loans that
are contractually 90 days or more past due is not charged off or reserved
through an allowance account when we believe that the loan is both well secured
and
10
<PAGE>
in the process of collection. If amounts are received on loans for which the
accrual of interest has been discontinued, we decide whether payments received
should be recorded as a reduction of the principal balance or as interest income
depending on our analysis of the collectibility of principal. The loan is
returned to accrual status when we believe the borrower has demonstrated the
ability to make periodic interest and principal payments on a timely basis.
We classify real estate acquired as a result of foreclosure as real estate
acquired in settlement of loans 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. Subsequent costs directly related to development
and improvement of property are capitalized, whereas costs related to holding
property are expensed. We charge any required write-down of the loan to its fair
value less estimated selling costs upon foreclosure against the allowance for
loan losses. See Note 1 of Notes to Consolidated Financial Statements.
The following table sets forth information with respect to our
nonperforming assets at the dates indicated. At the dates shown, we had no
restructured loans within the meaning of Statement of Financial Accounting
Standards No. 114, as amended.
<TABLE>
<CAPTION>
At September 30,
----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Loans accounted for on a nonaccrual basis (1).... $ 366 $ 263 $ 259 $ 288 $ 3,661
======== ======== ======== ======== ========
Accruing loans which are contractually past due
90 days or more................................ $ -- $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
Total nonperforming loans.................... $ 366 $ 263 $ 259 $ 288 $ 3,661
======== ======== ======== ======== ========
Total loans...................................... $198,747 $200,010 $199,876 $176,345 $173,316
======== ======== ======== ======== ========
Percentage of total loans........................ 0.18% 0.13% 0.13% 0.16% 2.11%
======== ======== ======== ======== ========
Other nonperforming assets (2)................... $ -- $ -- $ -- $ 1 $ 1
======== ======== ======== ======== ========
Loans modified in troubled debt restructuring.... $ -- $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
</TABLE>
____________________
(1) Payments received on a nonaccrual loan are either applied to the
outstanding principal balance or recorded as interest income, depending on
management's assessment of the collectibility of the loan.
(2) Other nonperforming assets consist of property acquired through foreclosure
or repossession.
During the years ended September 30, 1999, 1998 and 1997, gross interest
income of $27,000, $10,000 and $27,000, respectively, would have been recorded
on loans accounted for on a nonaccrual basis if the loans had been current
throughout the year. Interest on such loans included in income during the years
ended September 30, 1999, 1998 and 1997 amounted to $13,000, $15,000 and
$16,000, respectively.
At September 30, 1999 there were no loans which are not currently
classified as nonaccrual, 90 days past due or restructured but where known
information about possible credit problems of borrowers causes 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 nonaccrual, 90 days past
due or restructured. See " -- Classified Assets" for information regarding
classified assets.
At September 30, 1999, an analysis of our portfolio did not reveal any
impaired loans that needed to be classified under Statement of Financial
Accounting Standards No. 114.
At September 30, 1999, we had $366,000 of nonaccrual loans, which consisted
of five single-family mortgage loans, three commercial loans and four consumer
loans. At September 30, 1999, we did not have any real estate owned.
11
<PAGE>
Classified Assets. Regulations require that we classify our 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 financial institution to establish general
allowances for loan losses. If an asset or portion thereof is classified loss, a
financial institution must either establish a specific allowance for loss in the
amount of the portion of the asset classified loss, or charge off such amount.
1st State Bank regularly reviews its assets to determine whether any assets
require classification or re-classification. At September 30, 1999, we had
$700,000 in classified assets consisting of $698,000 in assets classified as
substandard, $2,000 in assets classified as doubtful and no assets classified as
loss.
In addition to regulatory classifications, we also classify as special
mention or watch assets that are currently performing in accordance with their
contractual terms but may be classified or nonperforming assets in the future.
At September 30, 1999 we have identified approximately $4.7 million in assets
classified as special mention.
Allowance for Loan Losses. Our policy is to establish reserves for
estimated losses on delinquent loans when we determine that losses are expected
to be incurred on such loans. We maintain the allowance for losses on loans at a
level we believe to be adequate to absorb potential losses in the portfolio. Our
determination of the adequacy of the allowance is based on an evaluation of the
portfolio, past loss experience, current 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 we believe we use the best information available to make
determinations with respect to the allowance for losses and believe 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. We anticipate that our allowance for
loan losses will increase in the future as we implement the board of directors'
strategy of continuing existing lines of business while gradually expanding
commercial and consumer lending, which loans generally entail greater risks than
single-family residential mortgage loans.
During 1999 we decreased our provision for loan losses to account for the
slower loan growth and the mix in our loan portfolio. During 1999 and 1998, we
increased commercial and consumer loans. At September 30, 1999, 1998 and 1997,
commercial loans comprised 15.8%, 12.2% and 11.3%, respectively, of total loans,
and consumer loans comprised 3.2%, 3.1% and 2.7%, respectively, of total loans.
These loans carry a higher inherent credit risk than single family residential
mortgage loans.
During 1999 we experienced a decrease in asset based loans, construction
loans and acquisition and development loans. These loan types carry a higher
incremental risk of loss than other loans. Net loan chargeoffs for 1999 were
$19,000 and year-end nonperforming loans were $366,000. The allowance for loan
losses was $3.5 million at September 30, 1999, an increase of $227,000 over
September 30, 1998. The ratio of the allowance for loan losses to loans was
1.74% at September 30, 1999 and 1.61% at September 30, 1998.
Banking regulatory agencies, including the FDIC, have adopted a policy
statement regarding maintenance of an adequate allowance for loan and lease
losses and an effective loan review system. This policy includes an arithmetic
formula for checking the reasonableness of an institution's allowance for loan
loss estimate compared to the average loss experience of the industry as a
whole. Examiners will review an institution's allowance for loan losses and
compare it against the sum of:
12
<PAGE>
. 50% of the portfolio that is classified doubtful;
. 15% of the portfolio that is classified as substandard; and
. for the portions of the portfolio that have not been classified,
including those loans designated as special mention, estimated credit
losses over the upcoming 12 months given the facts and circumstances
as of the evaluation date.
This amount is considered neither a "floor" nor a "safe harbor" of the level of
allowance for loan losses an institution should maintain, but examiners will
view a shortfall relative to the amount as an indication that they should review
management's policy on allocating these allowances to determine whether it is
reasonable based on all relevant factors.
We have our own allowance for loan loss model which is similar to the FDIC
model. Our model indicated that the allowance for loan losses was adequate at
September 30, 1999.
The following table sets forth an analysis of our allowance for loan losses
for the periods indicated.
<TABLE>
<CAPTION>
Year Ended September 30,
-----------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- ----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Balance at beginning of period............. $ 3,228 $ 2,754 $ 2,496 $ 2,223 $ 1,767
-------- -------- -------- -------- ---------
Loans charged off.......................... 23 4 7 13 5
-------- -------- -------- -------- ---------
Recoveries................................. 4 1 4 5 7
-------- -------- -------- -------- ---------
Net loans charged off...................... 19 3 3 8 (2)
-------- -------- -------- -------- ---------
Provision for loan losses.................. 245 477 261 281 454
-------- -------- -------- -------- ---------
Balance at end of period................... $ 3,454 $ 3,228 $ 2,754 $ 2,496 $ 2,223
======== ======== ======== ======== =========
Average loans outstanding.................. $198,603 $199,203 $186,413 $171,148 $ 165,347
======== ======== ======== ======== =========
Ratio of net loans charged off to average
loans outstanding during the period...... 0.0096% 0.0015% 0.0016% 0.0047% (0.0012)%
======== ======== ======== ======== =========
</TABLE>
13
<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,
------------------------------------------------------------------------------------
1999 1998 1997 1996
-------------------- -------------------- ------------------- -------------------
Percent of Percent of Percent of Percent of
Loans in Loans in Loans in Loans in
Category to Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Real estate mortgage:
Single-family residential $ 559 44.06% $ 400 48.84% $ 376 53.76% $ 387 55.70%
Commercial................ 934 19.79 898 18.76 854 17.02 882 19.62
Home equity............... 244 9.16 319 8.17 318 8.99 303 8.82
Construction.............. 275 8.00 458 8.99 380 6.24 232 4.36
Commercial................. 1,273 15.76 815 12.19 540 11.34 450 9.44
Consumer................... 169 3.23 338 3.05 286 2.65 242 2.06
------ ------ ------ ------ ------ ------ ------ ------
Total allowance for
loan losses.............. $3,454 100.00% $3,228 100.00% $2,754 100.00% $2,496 100.00%
====== ====== ====== ====== ====== ====== ====== ======
<CAPTION>
At September 30,
--------------------
1995
--------------------
Percent of
Loans in
Category to
Amount Total Loans
------ -----------
(Dollars in thousands)
<S> <C> <C>
Real estate mortgage:
Single-family residential $ 326 55.78%
Commercial................ 788 20.23
Home equity............... 272 9.28
Construction.............. 235 4.01
Commercial................. 374 8.52
Consumer................... 228 2.18
------ ------
Total allowance for
loan losses.............. $2,223 100.00%
====== ======
</TABLE>
14
<PAGE>
Investment Activities
General. Interest income from investment securities generally provides our
second largest source of income after interest on loans. Our board of directors
has authorized investment in U.S. Government and agency securities, state
government obligations, municipal securities, obligations of the FHLB, mortgage-
backed securities issued by Federal National Mortgage Association, the
Government National Mortgage Association and Federal Home Loan Mortgage
Corporation. Our objective is to use these investments to reduce interest rate
risk, enhance yields on assets and provide liquidity. At September 30, 1999, the
amortized cost of our investment securities portfolio amounted to $95.5 million,
which included $87.2 million of U.S. Government and agency securities, $3.0
million of short-term money market instruments, $1.2 million of mortgage-backed
securities and $68,000 of collateralized mortgage obligations ("CMO's"). In
addition, at September 30, 1999, we had a $4.0 million investment in two mutual
funds that invest in U.S. Government and agency securities and mortgage-backed
securities. At that date, we had an unrealized loss of $123,000, net of deferred
taxes, with respect to our investment securities classified as available for
sale.
The board of directors has established an investment policy that sets forth
investment and aggregate investment limitations and credit quality parameters of
each class of investment security. Securities purchases are subject to the
oversight of our Executive Committee. The President has authority to make
specific investment decisions within the parameters determined by the board of
directors.
Pursuant to Statement of Financial Accounting Standards No. 115, we had
securities with an aggregate cost of $11.2 million and an approximate fair value
of $11.0 million at September 30, 1999 as available for sale. The impact on our
financial statements was an after-tax decrease in shareholders' equity of
approximately $123,000 as of September 30, 1999. The net unrealized losses at
September 30, 1999 in our portfolio of investment securities and mortgage-backed
securities were due to increases in interest rates after we bought the
securities. Upon acquisition, we classify securities as to our intent.
Securities designated as "held to maturity" are those assets which we have the
ability and intent to hold to maturity. The held to maturity investment
portfolio is not used for speculative purposes and is carried at amortized cost.
Securities designated as "available for sale" are those assets which we may not
hold to maturity and thus are carried at fair value with unrealized gains or
losses, net of tax effect, recognized in shareholders' equity.
We periodically evaluate investment securities for other than temporary
declines in value and record any losses through an adjustment to earnings.
During the year ended September 30, 1999, we did not recognize any losses.
At September 30, 1999, we had $6.0 million of U.S. Government and agency
securities classified as available for sale, which carry unrealized after-tax
losses of $133,000, and $81.2 million of U.S. Government and agency securities
classified as held to maturity. We attempt to maintain a high degree of
liquidity in our investment securities portfolio by choosing those that are
readily marketable. As of September 30, 1999, the estimated weighted average
life of our U.S. Government and agency securities was approximately 4.5 years,
and the average yield on our portfolio of U.S. Government and agency securities
was 6.04%. In addition, at September 30, 1999, we had $1.3 million of FHLB of
Atlanta stock.
Mortgage-Backed and Related Securities. Included in our portfolio of
investment securities are mortgage-backed and mortgage-related securities.
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 intermediaries may include quasi-governmental agencies such as Federal Home
Loan Mortgage Corporation, Federal National Mortgage Association and Government
National Mortgage Association which guarantee the payment of principal and
interest to investors. Mortgage-backed securities generally increase the quality
of our assets by virtue of the guarantees that back them, are more liquid than
individual mortgage loans and may be used to collateralize borrowings or other
obligations.
15
<PAGE>
The Federal Home Loan Mortgage Corporation is a public corporation
chartered by the U.S. Government and owned by the 12 FHLBs and federally insured
savings institutions. The Federal Home Loan Mortgage Corporation issues
participation certificates backed principally by conventional mortgage loans.
The Federal Home Loan Mortgage Corporation guarantees the timely payment of
interest and the ultimate return of principal on participation certificates. The
Federal National Mortgage Association is a private corporation chartered by the
U.S. Congress with a mandate to establish a secondary market for mortgage loans.
The Federal National Mortgage Association guarantees the timely payment of
principal and interest on Federal National Mortgage Association securities.
Federal Home Loan Mortgage Corporation and Federal National Mortgage Association
securities are not backed by the full faith and credit of the United States, but
because the Federal Home Loan Mortgage Corporation and the Federal National
Mortgage Association are U.S. Government-sponsored enterprises, these securities
are considered to be among the highest quality investments with minimal credit
risks.
The Government National Mortgage Association is a government agency within
the Department of Housing and Urban Development which is intended to help
finance government-assisted housing programs. Government National Mortgage
Association securities are backed by FHA-insured and VA-guaranteed loans, and
the timely payment of principal and interest on Government National Mortgage
Association securities is guaranteed by the Government National Mortgage
Association and backed by the full faith and credit of the U.S. Government.
Because the Federal Home Loan Mortgage Corporation, the Federal National
Mortgage Association and the Government National Mortgage Association were
established to provide support for low- and middle-income housing, there are
limits to the maximum size of loans that qualify for these programs. The limit
for Federal National Mortgage Association and Federal Home Loan Mortgage
Corporation currently is $240,000.
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, whether 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 in the event that we determined to utilize borrowings
as a source of funds. Mortgage-backed securities issued or guaranteed by the
Federal National Mortgage Association or the Federal Home Loan Mortgage
Corporation generally 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 -- Depository Institution Regulation -- Capital Requirements" as to
how we assign a risk weight to assets under the risk-based capital regulations.
Our mortgage-backed and related securities portfolio consists primarily of
seasoned fixed-rate, mortgage-backed and related securities. We make these
investments in order to manage cash flow, diversify assets, obtain yield and to
satisfy certain requirements for favorable tax treatment.
At September 30, 1999, the weighted average contractual maturity of our
mortgage-backed securities, all of which carried fixed rates, was approximately
4.7 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
16
<PAGE>
the mortgage-backed security, and we review these assumptions 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.
At September 30, 1999, mortgage-backed securities with an amortized cost of
$1.2 million and a carrying value of $1.3 million were held as available for
sale. No mortgage-backed securities were classified as held to maturity.
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 shareholders'
equity, net of applicable income taxes. See Notes 1 and 3 of the Notes to
Consolidated Financial Statements for a description of our accounting policies.
At September 30, 1999, our mortgage-backed securities had a weighted average
yield of 8.3%.
Mortgage-related securities, which include CMOs, are typically issued by a
special purpose entity, which may be organized in a variety of legal forms, such
as a trust, a corporation or a partnership. The entity aggregates pools of pass-
through securities, which are used to collateralize the mortgage-related
securities. Once combined, the cash flows can be divided into "tranches" or
"classes" of individual securities, thereby creating more predictable average
lives for each security than the underlying pass-through pools. Accordingly,
under this security structure, all principal paydowns from the various mortgage
pools are allocated to a mortgage-related securities' class or classes
structured to have priority until it has been paid off. These securities
generally have fixed interest rates, and, as a result, changes in interest rates
generally would affect the market value and possibly the prepayment rates of
such securities.
Some mortgage-related securities instruments are like traditional debt
instruments due to their stated principal amounts and traditionally defined
interest rate terms. Purchasers of certain other mortgage-related securities
instruments are entitled to the excess, if any, of the issuer's cash flows.
These mortgage-related securities instruments may include instruments designated
as residual interest and are riskier in that they could result in the loss of a
portion of the original investment. Cash flows from residual interests are very
sensitive to prepayments and, thus, contain a high degree of interest rate risk.
We do not purchase residual interests in mortgage-related securities.
At September 30, 1999, we had within our investment securities portfolio
CMOs with an amortized cost of $68,000, representing less than 0.02% of total
assets. Our CMOs had a weighted average yield of 5.9% at September 30, 1999.
17
<PAGE>
The following table sets forth the carrying value of our investment
securities portfolio at the dates indicated.
<TABLE>
<CAPTION>
At September 30,
-------------------------
1999 1998 1997
------- ------- -------
(In thousands)
<S> <C> <C> <C>
Securities available for sale:
U.S. government and agency securities..... $ 5,867 $ 4,043 $ 4,012
Federal Home Loan Mortgage Corporation.... 477 662 1,564
Government National Mortgage Association.. 833 1,147 1,754
Federal National Mortgage Association..... -- -- 29
Marketable equity securities (1).......... 3,859 4,006 3,961
------- ------- -------
Total................................. $11,036 $ 9,858 $11,320
======= ======= =======
Securities held to maturity:
U.S. government and agency securities..... $81,160 $30,087 $23,338
Other..................................... 3,000 -- --
CMOs...................................... 68 108 144
------- ------- -------
Total.................................. $84,228 $30,195 $23,482
======= ======= =======
</TABLE>
_____________
(1) Consists of an investment in two mutual funds.
18
<PAGE>
The following table sets forth the scheduled maturities, carrying values,
amortized cost and average yields for our investment securities and mortgage-
backed securities portfolio at September 30, 1999.
<TABLE>
<CAPTION>
One Year or Less One to Five Years Five to Ten Years More than Ten Years
----------------- ----------------- ------------------ -------------------
Carrying Average Carrying Average Carrying Average Carrying Average
Value Yield Value Yield Value Yield Value Yield
-------- ------- -------- ------- --------- ------- --------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Securities available for sale:
U.S. government and agency
securities............. $ 1,001 5.64% $ 4,866 5.99% $ -- --% $ -- --
Mortgage-backed
securities............. 335 7.64 509 8.36 253 8.82 213 8.62
Marketable equity
securities (1)......... -- -- 1,981 4.89 1,878 6.89 -- --
------- ------- ------- -------
Total.................. $ 1,336 6.14 $ 7,356 5.86 $ 2,131 7.12 $ 213 8.62
======= ======= ======= =======
Securities held to maturity:
U.S. government and agency
securities............. $11,996 5.34 $40,421 6.04 $28,743 6.34 $ -- --
Other................... 3,000 4.98 -- -- -- -- $ -- --
CMOs.................... 36 6.05 32 5.74 -- -- -- --
------- ------- ------- -------
Total.................. $15,032 5.27 $40,453 6.04 $28,743 6.34 $ -- --
======= ======= ======= =======
<CAPTION>
Total Investment Portfolio
-----------------------------
Carrying Market Average
Value Value Yield
-------- ------- -------
<S> <C> <C> <C>
Securities available for sale:
U.S. government and agency
securities............. $ 5,867 $ 5,867 5.93%
Mortgage-backed
securities............. 1,310 1,310 8.31
Marketable equity
securities (1)......... 3,859 3,859 5.86
-------- -------
Total.................. $ 11,036 $11,036 6.19
======== =======
Securities held to maturity:
U.S. government and agency
securities............. $ 81,160 $79,473 6.04
Other................... 3,000 3,000 4.98
CMOs.................... 68 68 5.90
-------- -------
Total.................. $ 84,228 $82,541 6.00
======== =======
</TABLE>
_______________
(1) Consists of an investment in two mutual funds.
19
<PAGE>
Deposit Activity and Other Sources of Funds
General. Deposits are our primary source of funds for lending, investment
activities and general operational purposes. In addition to deposits, we derive
funds from loan principal and interest repayments, maturities of investment
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. We have access to FHLB of Atlanta advances.
Deposits. We attract deposits principally from within Alamance County by
offering a variety of deposit instruments, including checking accounts, money
market accounts, passbook and statement 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 our deposit
accounts are established by us on a periodic basis. We review our deposit
pricing on a weekly basis. In determining the characteristics of our deposit
accounts, we consider the rates offered by competing institutions, lending and
liquidity requirements, growth goals and applicable regulations. We believe we
price our deposits comparably to rates offered by our competitors. We do not
accept brokered deposits.
We compete for deposits with other institutions in our market area by
offering competitively priced deposit instruments that are tailored to the needs
of our customers. Additionally, we seek to meet customers' needs by providing
convenient customer service to the community, efficient staff and convenient
hours of service. Substantially all of our depositors are North Carolina
residents. To provide additional convenience, we participate in the STAR and
CIRRUS Automatic Teller Machine networks at locations throughout the world,
through which customers can gain access to their accounts at any time. To better
serve our customers, we have installed automatic teller machines at five office
locations.
20
<PAGE>
Our savings deposits at September 30, 1999 consisted of the various types
of savings programs described below.
<TABLE>
<CAPTION>
Weighted
Average
Interest Minimum Minimum Balance (in Percentage of
Rate Term Category Amount Thousands) Total Deposits
- ------- ------ -------- -------- ----------- --------------
<S> <C> <C> <C> <C> <C>
-- None Non-interest-bearing checking accounts $ 100 $ 8,220 3.51%
1.84% None NOW accounts 300 26,093 11.15
2.36 None Savings Accounts 100 27,276 11.65
3.62 None Money Market Accounts 1,000 14,770 6.31
Certificates of Deposit
-----------------------
4.07 3 months Fixed-term, fixed-rate 500 203 0.09
4.49 6 months Fixed-term, fixed-rate 500 6,262 2.67
4.38 7 months (1) Fixed-term, fixed-rate 5,000 49,381 21.10
4.41 9 months Fixed-term, fixed-rate 500 1,338 0.57
4.48 10 months Fixed-term, fixed-rate 5,000 6,309 2.70
4.60 12 months Fixed-term, fixed-rate 500 29,052 12.41
4.83 18 months Floating rate individual retirement account 50 967 0.41
4.81 18 months Fixed-term, fixed-rate 500 3,298 1.41
4.78 20 months Fixed-term, fixed-rate 500 30 0.01
5.02 24 months Fixed-term, fixed-rate 500 7,445 3.18
5.74 30 months Fixed-term, fixed-rate 500 17,930 7.66
5.32 36 months Fixed-term, fixed-rate 500 3,274 1.40
5.41 48 months Fixed-term, fixed-rate 500 4,192 1.79
5.41 60 months Fixed-term, fixed-rate 500 15,944 6.81
5.30 7 to 365 days Fixed-term, fixed-rate 100,000 12,111 5.17
-------- ------
$234,095 100.00%
======== ======
</TABLE>
________________
(1) These certificates of deposit do not carry a penalty for early withdrawal.
As a result, we believe that should interest rates increase materially after
September 30, 1999, borrowers may withdraw funds invested in these
certificates prior to maturity, causing our cost of funds to increase.
21
<PAGE>
The following table sets forth the distribution of our deposit accounts at
the dates indicated and the change in dollar amount of deposits in the various
types of accounts we offer between the dates indicated.
<TABLE>
<CAPTION>
Balance at Balance at Balance at
September 30, % of Increase September 30, % of Increase September 30, % of
1999 Deposits (Decrease) 1998 Deposits (Decrease) 1997 Deposits
------------- -------- ---------- ------------- -------- ---------- ------------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Noninterest-bearing demand.. $ 8,220 3.51% $ (404) $ 8,624 3.66% $ 2,078 $ 6,546 2.85%
Interest-bearing checking... 26,093 11.15 1,013 25,080 10.64 930 24,150 10.53
Money market accounts....... 14,770 6.31 1,532 13,238 5.62 2,120 11,118 4.85
Passbook and savings........ 27,276 11.65 (815) 28,091 11.92 391 27,700 12.08
Certificates of deposit..... 157,736 67.38 (2,925) 160,661 68.16 834 159,827 69.69
-------- ------- -------- -------- ------ -------- -------- ------
$234,095 100.00% $ (1,599) $235,694 100.00% $ 6,353 $229,341 100.00%
======== ======= ======== ======== ====== ======== ======== ======
</TABLE>
22
<PAGE>
The following table sets forth the average balances and average interest
rates based on daily balances for various types of deposits at the dates
indicated for each category of deposits presented.
<TABLE>
<CAPTION>
Year Ended September 30,
-----------------------------------------------------------------
1999 1998 1997
-------------------- ------------------- ------------------
Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Noninterest-bearing demand.............. $ 9,282 --% $ 6,417 --% $ 4,972 --%
Interest-bearing checking............... 27,026 1.86 24,987 2.21 23,975 2.23
Money market accounts................... 14,306 3.47 12,277 3.82 10,638 3.42
Passbook and savings.................... 35,220 2.47 28,017 2.85 28,650 2.85
Certificates of deposit................. 153,811 4.99 159,053 5.36 152,231 5.27
-------- -------- --------
Total............................... $239,645 3.98 $230,751 4.48 $220,466 4.42
======== ======== ========
</TABLE>
The following table sets forth our time deposits classified by rates at the
dates indicated.
<TABLE>
<CAPTION>
At September 30,
-------------------------------
1999 1998 1997
---- ---- ----
(In thousands)
<S> <C> <C> <C>
2 - 3.99%......................... $ 116 $ -- $ 220
4 - 5.99%......................... 154,076 149,064 147,667
6 - 7.99%......................... 3,443 11,496 11,843
8 - 9.99%......................... 101 101 97
-------- -------- --------
$157,736 $160,661 $159,827
======== ======== ========
</TABLE>
The following table sets forth the amount and maturities of our time
deposits at September 30, 1999.
<TABLE>
<CAPTION>
Amount Due
----------------------------------------
Less Than After
Rate One Year 1-2 Years 2-3 Years 3 Years Total
- ---- -------- --------- --------- ------- -----
(In thousands)
<S> <C> <C> <C> <C> <C>
2.00 - 3.99%..... $ 116 $ -- $ -- $ -- $ 116
4.00 - 5.99%..... 127,677 15,045 4,324 7,030 154,076
6.00 - 7.99%..... 2,888 385 164 6 3,443
8.00 - 9.99%..... -- -- -- 101 101
-------- -------- ------- -------- --------
$130,681 $ 15,430 $ 4,488 $ 7,137 $157,736
======== ======== ======= ======== ========
</TABLE>
23
<PAGE>
The following table indicates the amount of our certificates of deposit of
$100,000 or more by time remaining until maturity as of September 30, 1999. At
that date, such deposits represented 16.0% of total deposits and had a weighted
average rate of 4.99%.
<TABLE>
<CAPTION>
Certificates
Maturity Period of Deposit
--------------- ----------
(In thousands)
<S> <C>
Three months or less........... $16,953
Over three through six months.. 9,779
Over six through 12 months..... 7,986
Over 12 months................. 2,665
-------
Total....................... $37,383
=======
</TABLE>
We estimate that more than $24.0 million of certificates of deposit in
amounts of $100,000 or more maturing within one year of September 30, 1999 were
held by our retail and commercial customers, while the remainder of such
deposits were from schools, municipalities and other public entities and were
obtained through competitive rate bidding. We believe certificates of deposits
held by our retail and commercial customers are more likely to be renewed upon
maturity than certificates of deposit obtained through competitive bidding.
The following table sets forth our savings activities for the periods
indicated.
<TABLE>
<CAPTION>
Year Ended September 30,
-----------------------------------------
1999 1998 1997
---- ---- ----
(In thousands)
<S> <C> <C> <C>
Net increase (decrease) before interest credited.. $(10,124) $(3,026) $10,693
Interest credited................................. 8,525 9,379 8,941
-------- ------- -------
Net (decrease) increase in deposits........... $ (1,599) $ 6,353 $19,634
======== ======= =======
</TABLE>
Borrowings. Savings deposits historically have been the primary source of
funds for our lending, investments and general operating activities. We are
authorized, however, to use advances from the FHLB of Atlanta to supplement our
supply of lendable funds and to meet deposit withdrawal requirements. The FHLB
of Atlanta functions as a central reserve bank providing credit for member
financial institutions. As a member of the FHLB System, we are required to own
stock in the FHLB of Atlanta and are authorized to apply for advances. Advances
are obtained pursuant to several different programs, each of which has its own
interest rate and range of maturities. We have a Blanket Agreement for advances
with the FHLB under which we may borrow up to 16% of assets subject to normal
collateral and underwriting requirements. Advances from the FHLB of Atlanta are
secured by our stock in the FHLB of Atlanta and other eligible assets.
In February 1998, we obtained $20.0 million in fixed-rate FHLB of Atlanta
advances. These advances were structured with maturities estimated to coincide
with the expected repricing of $20.0 million of loans. Through this strategy, we
were able to establish a positive interest rate spread on the $20.0 million of
assets and FHLB of Atlanta advances.
24
<PAGE>
The following table sets forth certain information regarding our short-term
borrowings at the dates and for the periods indicated:
<TABLE>
<CAPTION>
At or For the
Year Ended September 30,
-------------------------------
1999 1998 1997
---- ---- ----
(Dollars in thousands)
<S> <C> <C> <C>
Amounts outstanding at end of period:
FHLB advances........................... $22,000 $20,000 $1,000
Weighted average rate paid on:
FHLB advances........................... 5.42% 5.39% 5.57%
</TABLE>
<TABLE>
<CAPTION>
For the Year
Ended September 30,
---------------------------
1999 1998 1997
----- ---- -----
(In thousands)
<S> <C> <C> <C>
Maximum amount of borrowings outstanding
at any month end
FHLB advances............................ $22,000 $21,000 $1,000
</TABLE>
<TABLE>
<CAPTION>
For the Year
Ended September 30,
--------------------------
1999 1998 1997
---- ---- -----
(Dollars in thousands)
<S> <C> <C> <C>
Average amounts outstanding:
FHLB advances................................. $20,044 $13,559 $1,000
Approximate weighted average rate paid on: (1)
FHLB advances................................. 5.47% 5.46% 5.60%
</TABLE>
- -------------------------
(1) Based on month-end balances.
Subsidiary Activities
In prior years, we had one subsidiary, First Capital Services, Inc., a
North Carolina corporation ("First Capital"), that engaged in sales of
annuities, mutual funds and insurance products on an agency basis. In September
1997, that corporation transferred its assets and liabilities to a newly formed
North Carolina limited liability company, First Capital Services Company, LLC
(the "LLC"), and the corporation was dissolved. 1st State Bank is the sole
member of the LLC, and since the transfer of assets and liabilities, the LLC has
conducted the activities previously conducted by First Capital. We earned
$326,000, $262,000 and $232,000 on a pre-tax basis from the activities of the
LLC and First Capital during the years ended September 30, 1999, 1998 and 1997,
respectively.
Competition
We face strong competition in originating real estate, commercial business
and consumer loans and in attracting deposits. We compete for real estate and
other loans principally on the basis of interest rates, the types of loans we
originate, the deposit products we offer and the quality of services we provide
to our customers. We also compete by offering products which are tailored to
the local community. Our competition in originating real estate loans comes
primarily from savings institutions, commercial banks, 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 continuing reduction of restrictions on the interstate operations of
financial institutions.
25
<PAGE>
We attract our deposits through our branch offices primarily from the local
communities. Consequently, competition for deposits is principally from savings
institutions, commercial banks, credit unions and brokers in our primary market
area. We compete for deposits and loans by offering what we believe to be a
variety of deposit accounts at competitive rates, convenient business hours, a
commitment to outstanding customer service and a well-trained staff. We believe
we have developed strong relationships with local realtors and the community in
general.
We consider our primary market area for gathering deposits and originating
loans to be Alamance County in north central North Carolina, which is the county
in which our offices are located. Based on data provided by a private marketing
firm, we estimate that at June 30, 1998, we had 15.0% of deposits held by all
banks and savings institutions in our market area.
Employees
As of September 30, 1999, we had 71 full-time and 13 part-time employees,
none of whom were represented by a collective bargaining agreement. We believe
that our relationship with our employees is good.
Depository Institution Regulation
General. We are a North Carolina-chartered commercial bank and a member of
the FHLB of Atlanta, and our deposits are insured by the FDIC through the
Savings Association Insurance Fund of the FDIC. 1st State Bank is subject to
supervision, examination and regulation by the North Carolina Banking Commission
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. We are also subject to the
FDIC's authority to conduct special examinations. 1st State Bank is required to
file reports with the North Carolina Banking Commission and the FDIC concerning
its activities and financial condition and is required to obtain regulatory
approvals prior to entering into certain transactions, including mergers with,
or acquisitions of, other depository institutions.
As a federally insured depository institution, 1st State Bank is subject to
various regulations promulgated by the Federal Reserve Board, including
Regulation B (Equal Credit Opportunity), Regulation D (Reserve Requirements),
Regulation 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 us establishes a
comprehensive framework for our operations and is intended primarily for the
protection of the FDIC and our depositors. Changes in the regulatory framework
could have a material effect on us and our operations.
Recently Enacted Legislative and Regulatory Changes. On November 12, 1999,
President Clinton signed legislation which could have a far-reaching impact on
the financial services industry. The Gramm-Leach-Bliley ("G-L-B") Act
authorizes affiliations between banking, securities and insurance firms and
authorizes bank holding companies and national banks to engage in a variety of
new financial activities. Among the new activities that will be permitted to
bank holding companies are securities and insurance brokerage, securities
underwriting, insurance underwriting and merchant banking. The Federal Reserve
Board, in consultation with the Department of Treasury, may approve additional
financial activities. National bank subsidiaries will be permitted to engage in
similar financial activities but only on an agency basis unless they are one of
the 50 largest banks in the country. National bank subsidiaries will be
prohibited from insurance underwriting, real estate development and merchant
banking. The G-L-B Act, however, prohibits future acquisitions of existing
unitary savings and loan holding companies by firms that are engaged in
commercial activities and prohibits the formation of new unitary holding
companies.
The G-L-B Act imposes new requirements on financial institutions with
respect to customer privacy. The G-L-B Act generally prohibits disclosure of
customer information to non-affiliated third parties unless the customer has
been given the opportunity to object and has not objected to such disclosure.
Financial institutions are further
26
<PAGE>
required to disclose their privacy policies to customers annually. Financial
institutions, however, will be required to comply with state law if it is more
protective of customer privacy than the G-L-B Act. The G-L-B Act directs the
federal banking agencies, the National Credit Union Administration, the
Secretary of the Treasury, the Securities and Exchange Commission and the
Federal Trade Commission, after consultation with the National Association of
Insurance Commissioners, to promulgate implementing regulations within six
months of enactment. The privacy provisions will become effective six months
thereafter.
The G-L-B Act contains significant revisions to the Federal Home Loan Bank
System. The G-L-B Act imposes new capital requirements on the Federal Home Loan
Banks and authorizes them to issue two classes of stock with differing dividend
rates and redemption requirements. The G-L-B Act expands the permissible uses
of Federal Home Loan Bank advances by community financial institutions (under
$500 million in assets) to include funding loans to small businesses, small
farms and small agri-businesses.
The G-L-B Act contains a variety of other provisions including a
prohibition against ATM surcharges unless the customer has first been provided
notice of the imposition and amount of the fee. The G-L-B Act reduces the
frequency of Community Reinvestment Act examinations for smaller institutions
and imposes certain reporting requirements on depository institutions that make
payments to non-governmental entities in connection with the Community
Reinvestment Act. The G-L-B Act eliminates the SAIF special reserve and
authorizes a federal savings association that converts to a national or state
bank charter to continue to use the term "federal" in its name and to retain any
interstate branches.
The Company is unable to predict the impact of the G-L-B Act on its
operations at this time. Although the G-L-B Act reduces the range of companies
with which the Company may affiliate, it may facilitate affiliations with
companies in the financial services industry.
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%. 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 Savings Association Insurance Fund of the FDIC-insured,
state-chartered bank, we must also deduct from Tier 1 capital an amount equal to
our 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% 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 Tier 1 capital to total
asset of not less than 4%. 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.
27
<PAGE>
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% of which at least 4% 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, certain other capital instruments and up to 45% of
unrealized gains on equity securities. The includable 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 Federal Reserve Board and the
FDIC, have revised their risk-based capital requirements to ensure that such
requirements provide for explicit consideration of interest rate risk. Under
the rule, a bank's interest rate risk exposure would be quantified using either
the measurement system set forth in the rule or the bank's internal model for
measuring such exposure, if such model is determined to be adequate by the
bank's examiner. 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 rule to hold additional capital
equal to the dollar amount of the excess. We believe that the interest rate
risk component does not have a material effect on our capital. Further, 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 non-
traditional activities in determining the adequacy of its capital. We have not
been advised that we will be required to maintain any additional capital under
this regulation. The interest rate risk component does not apply to bank
holding companies on a consolidated basis.
In addition to FDIC regulatory capital requirements, the North Carolina
Commissioner of Banks requires us to have adequate capitalization which is
determined based upon each bank's particular set of circumstances. We are
subject to the North Carolina Bank 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.
At September 30, 1999, we complied with each of the capital requirements of
the FDIC and the North Carolina Banking Commission.
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, known as an "undercapitalized institution," may be:
. subject to increased monitoring by the appropriate federal banking
regulator;
. required to submit an acceptable capital restoration plan within 45
days;
. subject to asset growth limits; and
. required to obtain prior regulatory approval for acquisitions,
branching and new lines of businesses.
28
<PAGE>
A "significantly undercapitalized" institution may be subject to statutory
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.
Federal banking regulators have adopted regulations implementing the prompt
corrective action provisions of FDICIA. Under these regulations, the federal
banking regulators generally will measure a depository institution's capital
adequacy on the basis of:
. the institution's total risk-based capital ratio;
. Tier 1 risk-based capital ratio; and
. leverage ratio.
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:
. a total risk-based capital ratio of 10% or greater;
. a Tier 1 risk-based capital ratio of 6% or greater; and
. a leverage ratio of 5% or greater.
An "adequately capitalized" depository institution is an institution that does
not meet the definition of well capitalized and has:
. a total risk-based capital ratio of 8% or greater;
. a Tier 1 risk-based capital ratio of 4% or greater; and
. a leverage ratio of 4% or greater, or 3% or greater if the depository
institution has a composite 1 CAMELS rating.
An "undercapitalized institution" is a depository institution that has:
. a total risk-based capital ratio less than 8%; or
. a Tier 1 risk-based capital ratio of less than 4%; or
. a leverage ratio of less than 4%, or less than 3% if the institution
has a composite 1 CAMELS rating.
A "significantly undercapitalized" institution is defined as a depository
institution that has:
. a total risk-based capital ratio of less than 6%; or
29
<PAGE>
. a Tier 1 risk-based capital ratio of less than 3%; or
. a leverage ratio of less than 3%.
A "critically undercapitalized" institution is defined as a depository
institution that has a ratio of "tangible equity" to total assets of less than
2%. 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 appropriate federal banking agency may reclassify a well capitalized
depository institution as adequately capitalized and may require an adequately
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 CAMELS rating category. At September 30, 1999, we were 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 1st State Bank meets all the standards adopted in the interagency
guidelines.
Community Reinvestment Act. 1st State 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 our last compliance examination, we received a
"satisfactory" rating for CRA compliance. Our CRA rating would be a factor
considered by the Federal Reserve Board and the FDIC in considering applications
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 implemented an 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 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."
30
<PAGE>
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, we are 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 home mortgage loans, home
purchase contracts, and similar obligations at the beginning of each year, or
1/20 of advances from the FHLB of Atlanta, whichever is greater. We were in
compliance with this requirement with investment in FHLB of Atlanta stock at
September 30, 1999 of $1.3 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. At September 30, 1999, we had $22 million in
advances outstanding from the FHLB of Atlanta.
Reserves. Under Federal Reserve Board regulations, we must maintain
average daily reserves against transaction accounts. Reserves equal to 3% must
be maintained on transaction accounts of between $5.0 million and $44.3 million,
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 non-interest 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, 1999, we met our
reserve requirements.
We are 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 regulation of the
North Carolina Banking Commission. As of September 30, 1999, we met our reserve
requirements.
Deposit Insurance. We are required to pay assessments based on a
percentage of insured deposits to the FDIC for insurance of our deposits by the
Savings Association Insurance Fund of the FDIC. 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" for definitions and percentage criteria for
the capital group categories. 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 ranges from
zero for well capitalized institutions in Subgroup A to 0.27% of deposits for
undercapitalized institutions in Subgroup C. Both Bank Insurance Fund of the
FDIC and Savings Association Insurance Fund of the FDIC members are assessed an
amount for the Financing Corporation Bond payments. Bank Insurance Fund of the
FDIC members are assessed approximately 1.3 basis points while the Savings
Association Insurance Fund of the FDIC rate is approximately 6.4 basis points
until January 1, 2000. At that time, Bank Insurance Fund of the FDIC and
Savings Association Insurance Fund of the FDIC members will begin pro rata
sharing of the payment at an expected rate of 2.43 basis points.
Although 1st State Bank, as a North Carolina commercial bank, would qualify
for insurance of deposits by the Bank Insurance Fund of the FDIC, substantial
entrance and exit fees apply to conversions from Savings Association Insurance
Fund of the FDIC to Bank Insurance Fund of the FDIC insurance. Accordingly, we
remain a member of the Savings Association Insurance Fund of the FDIC, which
insures our deposits to a maximum of $100,000 for each depositor.
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<PAGE>
Liquidity Requirements. FDIC policy requires that banks maintain an
average daily balance of liquid assets in an amount which it deems adequate to
protect safety and soundness of the bank. Liquid assets include cash, certain
time deposits, bankers' acceptances and specified United States government,
state, or federal agency obligations. The FDIC currently has no specific level
which it requires.
North Carolina banks must maintain a reserve fund in an amount and/or ratio
set by the North Carolina Banking Commission to account for the level of
liquidity necessary to assure the safety and soundness of the State banking
system. At September 30, 1999, our liquidity ratio exceeded the North Carolina
regulations.
Dividend Restrictions. Under FDIC regulations, we are prohibited from
making any capital distributions if after making the distribution, we would
have:
. a total risk-based capital ratio of less than 8%;
. a Tier 1 risk-based capital ratio of less than 4%; or
. a leverage ratio of less than 4%.
Our earnings 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 on the amount of earnings removed from the pre-1988 reserves for such
distributions. We intend to make full use of this favorable tax treatment and
do not contemplate use of any earnings in a manner which would create federal
tax liabilities.
We may not pay dividends on our capital stock if our regulatory capital
would thereby be reduced below the amount then required for the liquidation
account established for the benefit of certain depositors at the time of the
conversion.
1st State Bancorp is subject to limitations on dividends imposed by the
Federal Reserve Board.
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 1st State Bancorp, and any companies which are
controlled by the 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 Board'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
32
<PAGE>
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 financial 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.
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. (S)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 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
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<PAGE>
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 1st State Bancorp, Inc.
General. 1st State Bancorp, as the sole shareholder of 1st State Bank, is
a bank holding company and is registered as such 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, 1st State Bancorp 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 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. 1st State Bancorp is also required
to file certain reports with, and comply with the rules and regulations of the
Securities and Exchange Commission under the federal securities laws.
Under the BHCA, a bank holding company must obtain Federal Reserve Board
approval before:
. 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;
. acquiring all or substantially all of the assets of another bank or
bank holding company; or
. 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;
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<PAGE>
. 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.
Presently, we have no plans to engage in any of these activities.
Under the BHCA, any company must obtain approval of the Federal Reserve
Board prior to acquiring control of 1st State Bancorp or 1st State Bank. For
purposes of the BHCA, "control" is defined as ownership of more than 25% of any
class of voting securities of 1st State Bancorp or 1st State 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 1st State Bancorp or 1st
State 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 to file a written notice with the Federal Reserve Board before such
person or persons may acquire control of 1st State Bancorp or 1st State 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.
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.
Interstate Banking. The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 (the "Riegle-Neal 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 a bank that has not been in existence for a minimum of five
years, regardless of a longer minimum period specified by the statutory law of
the host state. The Riegle-Neal Act also prohibits the Federal Reserve Board
from approving an application if the applicant and its depository institution
affiliates control 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 Riegle-Neal 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 limitation does not discriminate against out-of-state
banks or bank holding companies. Individual states may also waive the 30%
statewide concentration limit contained in the Riegle-Neal Act.
Additionally, the federal banking agencies are authorized 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 Riegle-Neal Act by adopting a law, which applies equally to all
out-of-state banks and expressly prohibits merger transactions involving out-of-
state banks, after the date of enactment of the Riegle-Neal Act and prior to
June 1, 1997. 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 Riegle-Neal Act authorizes the FDIC to approve interstate branching de
novo by state banks only in states which specifically allow for such branching.
Pursuant to the Riegle-Neal Act, the appropriate federal banking agencies have
adopted regulations which prohibit any out-of-state bank from using the
interstate branching authority primarily for the purpose of deposit production.
These regulations include guidelines to ensure that interstate branches operated
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<PAGE>
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". For a definition
of "undercapitalized" institution, 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. Bank holding companies whose capital ratios exceed the
thresholds for "well-capitalized" banks on a consolidated basis are exempt from
the foregoing requirement if they were rated composite 1 or 2 in their most
recent inspection and are not the subject of any unresolved supervisory issues.
TAXATION
General
1st State Bancorp files a federal income tax return based on a calendar
year. 1st State Bank files its tax returns based on a calendar year ending
September 30. They file separate returns.
Federal Income Taxation
Financial institutions such as 1st State Bank are subject to the provisions
of the Internal Revenue Code in the same general manner as other corporations.
Through tax years beginning before December 31, 1995, institutions such as 1st
State 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 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. We generally elected to use the method which has
resulted in the greatest deductions for federal income tax purposes in any given
year.
Legislation that is effective for tax years beginning after December 31,
1995 requires institutions 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
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<PAGE>
loss reserve. As a result of changes in the law, institutions were required to
change to either the reserve method or the specific charge-off method that
applied to banks.
We are not required to provide a deferred tax liability for the tax effect
of additions to the tax bad debt reserve through 1987, the base year. Retained
income at September 30, 1998 includes approximately $4.2 million for which no
provision for federal income tax has been made. These amounts represent
allocations of income to bad debt deductions for tax purposes only. Reduction
of such amounts for purposes other than tax bad debt losses could create income
for tax purposes in certain remote instances, which would be subject to the then
current corporate income tax rate.
Our federal income tax returns have not been audited since 1993.
For additional information on our policies regarding tax and accounting
matters, see our consolidated financial statements and related notes, which you
can find beginning on page F-1 of this document.
State Income Taxation
Under North Carolina law, the corporate income tax currently is 7.25% of
federal taxable income as computed under the Internal Revenue Code, subject to
certain prescribed adjustments. This rate will be reduced to 7.00% for 1999 and
6.9% for 2000 and thereafter. In addition, for tax years beginning in 1991,
1992, 1993 and 1994, corporate taxpayers were required to pay a surtax equal to
4%, 3%, 2% and 1%, respectively, of the state income tax otherwise payable. An
annual state franchise tax is imposed at a rate of .15% applied to the greatest
of the institution's (i) capital stock, surplus and undivided profits, (ii)
investment in tangible property in North Carolina, or (iii) appraised valuation
of property in North Carolina.
For additional information regarding taxation, see Notes 1 and 11 of the
Notes to the Consolidated Financial Statements, which you can find beginning on
page F-1 of this document.
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Item 2. Properties
- -------------------
The following table sets forth the location and certain additional
information regarding our offices at September 30, 1999.
<TABLE>
<CAPTION>
Book Value at Deposits at
Year Owned or September 30, Approximate September 30,
Opened Leased 1999 (1) Square Footage 1999
------ ------ ------------- -------------- -------------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Main Office:
445 S. Main Street 1988 Owned $3,750 33,700 $92,497
Burlington, NC 27215
Branch Offices:
2294 N. Church Street 1984 Leased (2) 271 2,600 23,631
Burlington, NC 27215
503 Huffman Mill Road 1982 Owned 346 2,600 40,679
Burlington, NC 27215
102 S. 5th Street 1973 Owned 53 2,000 27,576
Mebane, NC 27302
211 N. Main Street 1974 Owned 130 2,700 35,677
Graham, NC 27253
3466 S. Church Street 1996 Owned 1,429 4,000 14,035
Burlington, NC 27215
</TABLE>
__________
(1) Land and building only.
(2) Land is leased. Lease expires on July 5, 2009, with options to extend for
three five-year periods.
The book value of our investment in premises and equipment was $7.3 million
at September 30, 1999. See Note 7 of Notes to Consolidated Financial Statements
elsewhere in this document.
Item 3. Legal Proceedings.
- -------------------------
From time to time, we are a party to various legal proceedings incident to
its business. There currently are no legal proceedings to which we are a party,
or to which any of our property was subject, which were expected to result in a
material loss. There are no pending regulatory proceedings to which we are a
party or to which any of our properties is subject which are 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
- -------
38
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The information contained under the sections captioned "Market Information"
in the Company's Annual Report to Stockholders for the Fiscal Year Ended
September 30, 1999 (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 3 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 5
through 20 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 10 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 21 through 52 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.
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 2000
Annual Meeting of Stockholders (the "Proxy Statement") is incorporated herein by
reference.
Item 11. Executive Compensation
- -------------------------------
The information contained under the sections captioned "Proposal I --
Election of Directors -- Executive 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.
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<PAGE>
(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 Balance Sheets as of September 30, 1999 and 1998
Consolidated Statements of Income for the Years Ended September 30, 1999,
1998 and 1997
Consolidated Statements of Stockholders' Equity and Comprehensive Income
for the Years Ended September 30, 1999, 1998 and 1997
Consolidated Statements of Cash Flows for the Years Ended September 30,
1998, 1997 and 1996
Notes to Consolidated Financial Statements
(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 Articles of Incorporation of 1st State Bancorp, Inc. (Incorporated
herein by reference from Exhibit 3.1 to the Company's Registration
Statement on Form S-1 (File No. 333-68091))
3.2 Bylaws of 1st State Bancorp, Inc. (Incorporated herein by reference
from Exhibit 3.2 to the Company's Registration Statement on Form S-1
(File No. 333-68091))
4 Form of Common Stock Certificate of 1st State Bancorp, Inc.
(Incorporated herein by reference from Exhibit 4 to the Company's
Registration Statement on Form 8-A))
10.1 Proposed 1st State Bancorp, Inc. 1999 Stock Option and Incentive Plan
(Incorporated herein by reference from Exhibit 10.1 to the Company's
Registration Statement on Form S-1 (File No. 333-68091))
10.2 Proposed 1st State Bancorp, Inc. Management Recognition Plan
(Incorporated herein by reference from Exhibit 10.2 to the Company's
Registration Statement on Form S-1 (File No. 333-68091))
10.3 Employment Agreements by and between 1st State Bank and James C.
McGill, A. Christine Baker and Fairfax C. Reynolds (Incorporated
herein by reference from Exhibit 10.3 to the Company's Registration
Statement on Form S-1 (File No. 333-68091))
40
<PAGE>
10.4 Form of Guaranty Agreement by and between 1st State Bancorp, Inc. and
James C. McGill, A. Christine Baker and Fairfax C. Reynolds
(Incorporated herein by reference from Exhibit 10.4 to the Company's
Registration Statement on Form S-1 (File No. 333-68091))
10.5 1st State Bank Deferred Compensation Plan (Incorporated herein by
reference from Exhibit 10.5 to the Company's Registration Statement on
Form S-1 (File No. 333-68091))
13 Annual Report to Stockholders
21 Subsidiaries of the Registrant
23 Consent of KPMG LLP
27 Financial Data Schedule
(b) Reports on Form 8-K. None.
-------------------
(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.
41
<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.
1ST STATE BANCORP, INC.
December 23, 1999
By: /s/ James C. McGill
--------------------------
James C. McGill
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/ James C. McGill December 23, 1999
- ---------------------------------
James C. McGill
President, Chief Executive Officer and Director
(Principal Executive Officer)
/s/ A. Christine Baker December 23, 1999
- ---------------------------------
A. Christine Baker
Executive Vice President, Chief Financial
Officer, Secretary and Treasurer
(Principal Financial and Accounting Officer)
/s/ Richard C. Keziah December 23, 1999
- ---------------------------------
Richard C. Keziah
Chairman of the Board
/s/ James A. Barnwell, Jr. December 23, 1999
- ---------------------------------
James A. Barnwell, Jr.
Director
/s/ Bernie C. Bean December 23, 1999
- ---------------------------------
Bernie C. Bean
Director
/s/ James G. McClure December 23, 1999
- ---------------------------------
James G. McClure
Director
/s/ T. Scott Quakenbush December 23, 1999
- --------------------------------
T. Scott Quakenbush
Director
<PAGE>
/s/ Richard H. Shirley December 23, 1999
- ------------------------------
Richard H. Shirley
Director
/s/ Virgil L. Stadler December 23, 1999
- ------------------------------
Virgil L. Stadler
Director
<PAGE>
EXHIBIT 13
1st STATE BANCORP, INC.
[LOGO]
1999 ANNUAL REPORT
<PAGE>
1st STATE BANCORP, INC.
==============================================================================
1st State Bancorp, Inc. serves as the holding company for its wholly owned
subsidiary, 1st State Bank. 1st State Bancorp is primarily engaged in the
business of directing, planning and coordinating the business activities of 1st
State Bank. In the future, 1st State Bancorp may conduct operations or acquire
or organize other operating subsidiaries, including other financial
institutions, though we have no current plans in this regard. Currently, 1st
State Bancorp does not maintain offices separate from those of 1st State Bank
nor employ any persons other than its officers who are not separately
compensated for their service.
Founded in 1914, 1st State Bank is a community and customer oriented North
Carolina-chartered commercial bank headquartered in Burlington, North Carolina.
We operate six full service offices located in north central North Carolina on
the Interstate 85 corridor between the Piedmont Triad and Research Triangle. We
conduct most of our business in Alamance County, North Carolina.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income, which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of the interest we
pay on deposits and borrowed funds. We also earn income from miscellaneous fees
related to our loans and deposits, mortgage banking income and commissions from
sales of annuities and mutual funds.
MARKET INFORMATION
==============================================================================
1st State Bancorp's common stock began trading under the symbol "FSBC" on
the Nasdaq National Market System on April 26, 1999. There are currently
3,163,125 shares of common stock outstanding and approximately 1,170 holders of
record of the common stock. Following are the high and low bid prices, by fiscal
quarter, as reported on the Nasdaq National Market System during the periods
indicated, as well as dividends declared on the common stock during each
quarter.
High Low Dividends Per Share
---- --- -------------------
Fiscal 1999
-----------
Third quarter............ $19.625 $19.000 $0.08
Fourth quarter........... 19.750 19.188 0.08
The stated high and low bid prices reflect inter-dealer prices, without
retail mark-up, mark-down or commission, and may not represent actual
transactions.
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, 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 prompt corrective action regulations.
TABLE OF CONTENTS
<TABLE>
===========================================================================================================
<S> <C>
1st State Bancorp, Inc.................................................................. (i)
Market Information...................................................................... (i)
Letter to Stockholders.................................................................. 1
Selected Consolidated Financial and Other Data.......................................... 3
Management's Discussion and Analysis of Financial Condition and Results of Operations... 5
Consolidated Financial Statements....................................................... 21
Corporate Information................................................................... Inside Back Cover
</TABLE>
(i)
<PAGE>
Much has been written lately about the upcoming year 2000 and its potential
impact on computer systems. It has been acknowledged generally that the banking
industry is year 2000 compliant. We have taken all the actions we feel are
prudent to ensure uninterrupted service to our customers into the next century.
We are continuing to monitor third party vendors, refine our contingency plans
and assure our customers of our state of readiness.
We believe that the greatest strength of our Company is our people and
their ability to meet the needs of our market. Unlike most bank employees, our
people are empowered with the authority to make decisions. This structure is
true for both loans and deposit products. We are committed to maintaining the
flexibility needed to serve our commercial and consumer customers in the
Alamance County area. The stability and accessability of our employees
differentiates us from other financial institutions. We will continue to provide
the training necessary for our people to better serve our customers.
Your Board of Directors approved a quarterly dividend policy in June 1999.
Cash dividends of $0.08 per share were paid to shareholders in August and
November. It is the Board's stated intention to pay regular quarterly cash
dividends to allow stockholders to directly participate in the Company's
success.
On behalf of staff, officers and directors, thank you for being a
stockholder of 1st State Bancorp, Inc. We believe the Company has a bright
future. We look forward to continuing to serve our customers and to enhance
stockholder value through growth, profitability improvement and capital
management.
Very truly yours,
/s/ James C. McGill
James C. McGill
President
2
<PAGE>
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
==============================================================================
Selected Financial Condition Data
<TABLE>
<CAPTION>
At September 30,
--------------------------------------------------
1999 1998 1997 1996 1995
------- -------- -------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C>
Total assets......................................... $332,926 $288,223 $258,509 $235,138 $222,916
Loans receivable..................................... 195,292 196,782 197,122 173,849 171,093
Loans held for sale, at lower of cost or fair value.. 12,143 7,540 684 2,377 --
Cash and cash equivalents............................ 15,657 31,077 14,990 9,754 7,550
Investment securities:
Available for sale................................. 11,036 9,858 11,320 16,024 16,307
Held to maturity................................... 84,228 30,195 23,482 21,685 17,649
Deposit accounts..................................... 234,095 235,694 229,341 209,707 200,769
Advances from Federal Home Loan Bank................. 22,000 20,000 1,000 1,000 --
Stockholders' equity................................. 71,615 25,966 23,277 20,629 19,151
</TABLE>
Selected Operating Data
<TABLE>
<CAPTION>
Year Ended September 30,
-------------------------------------------------
1999 1998 1997 1996 1995
-------- -------- -------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C>
Total interest income................................ $ 21,474 $ 20,708 $ 19,061 $ 17,395 $ 16,146
Total interest expense............................... 10,640 11,071 9,799 9,453 8,584
-------- -------- -------- -------- --------
Net interest income.................................. 10,834 9,637 9,262 7,942 7,562
Provision for loan losses............................ 245 477 261 281 454
-------- -------- -------- -------- --------
Net interest income after provision
for loan losses..................................... 10,589 9,160 9,001 7,661 7,108
Other income......................................... 1,654 1,497 1,468 1,179 1,600
Operating expenses................................... 9,818 6,774 6,473 6,403 5,006
-------- -------- -------- -------- --------
Income before income taxes........................... 2,425 3,883 3,996 2,437 3,702
Income taxes......................................... 870 1,362 1,447 841 1,378
-------- -------- -------- -------- --------
Net income........................................... $ 1,555 $ 2,521 $ 2,549 $ 1,596 $ 2,324
======== ======== ======== ======== ========
</TABLE>
3
<PAGE>
SELECTED FINANCIAL RATIOS AND OTHER DATA
<TABLE>
<CAPTION>
At or for the
Year Ended September 30,
---------------------------------------------------
1999 1998 1997 1996 1995
------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C>
Performance Ratios:
Return on average assets (net income divided
by average total assets)............................ 0.50% 0.92% 1.03% 0.70% 1.07%
Return on average equity (net income
divided by average equity).......................... 3.30 10.20 11.34 7.92 12.94
Interest rate spread (combined weighted average
interest rate earned less combined weighted
average interest rate cost)......................... 3.11 3.45 3.70 3.41 3.43
Net interest margin (net interest income divided by
average interest-earning assets).................... 3.71 3.77 4.00 3.68 3.68
Ratio of average interest-earning assets
to average interest-bearing liabilities............. 116.58 107.42 106.99 106.25 105.61
Ratio of operating expenses to average total
assets (1).......................................... 2.18 2.48 2.62 2.80 2.30
Asset Quality Ratios:
Nonperforming assets to total assets
at end of period.................................... 0.11 0.09 0.10 0.12 1.64
Nonperforming loans to total loans
at end of period.................................... 0.18 0.13 0.13 0.16 2.11
Allowance for loan losses to total
loans at end of period.............................. 1.74 1.61 1.38 1.42 1.28
Allowance for loan losses to nonperforming
loans at end of period.............................. 943.82 1,227.38 1,063.32 866.67 60.72
Provision for loan losses to total loans............... 0.12 0.24 0.13 0.16 0.26
Net charge-offs to average loans outstanding........... 0.01 -- -- -- --
Capital Ratios:
Shareholders' equity to total assets at end of period.. 21.51 9.01 9.00 8.77 8.59
Average equity to average assets....................... 15.09 9.05 9.10 8.80 8.25
</TABLE>
________________
(1) Excludes $3.0 million contribution to fund 1st State Bank Foundation, Inc.
in 1999.
4
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
==============================================================================
References in this document to the "Bank," "we," "us," and "our" refer to
1st State Bank. Where appropriate, "us" or "our" refers collectively to 1st
State Bancorp, Inc. and 1st State Bank. References in this document to "the
Company" refer to 1st State Bancorp, Inc.
General
1st State Bancorp, Inc. was formed in November 1998 and became the holding
company for 1st State Bank on April 23, 1999. As a result, portions of this
discussion (as of dates and for periods prior to April 23, 1999) relate to the
financial condition and results of operations of 1st State Bank.
Our business consists principally of attracting deposits from the general
public and investing these funds in loans secured by single-family residential
and commercial real estate, secured and unsecured commercial loans and consumer
loans. Our profitability depends primarily on our net interest income which is
the difference between the income we receive on our loan and investment
securities portfolios and our cost of funds, which consists of interest paid on
deposits and borrowed funds. Net interest income also is affected by the
relative amounts of interest-earning assets and interest-bearing liabilities.
When interest-earning assets approximate or exceed interest-bearing liabilities,
any positive interest rate spread will generate net interest income. Our
profitability also is affected by the level of other income and operating
expenses. Other income consists of miscellaneous fees related to our loans and
deposits, mortgage banking income and commissions from sales of annuities and
mutual funds. Operating expenses consist of compensation and benefits, occupancy
related expenses, federal deposit insurance premiums, data processing,
advertising and other expenses.
Our operations are influenced significantly by local economic conditions
and by policies of financial institution regulatory authorities. Our cost of
funds is influenced by interest rates on competing investments and by rates
offered on similar investments by competing financial institutions in our market
area, as well as general market interest rates. Lending activities are affected
by the demand for financing of real estate and other types of loans, which in
turn is affected by the interest rates at which such financing may be offered.
Our business emphasis has been to operate as a well-capitalized, profitable
and independent community-oriented financial institution dedicated to providing
quality customer service. We are committed to meeting the financial needs of the
communities in which we operate. We believe that we can be more effective in
servicing our customers than many of our nonlocal competitors because of our
ability to quickly and effectively provide senior management responses to
customer needs and inquiries. Our ability to provide these services is enhanced
by the stability of our senior management team.
Beginning in the late 1980's, we have sought to gradually increase the
percentage of our assets invested in commercial real estate loans, commercial
loans and consumer loans, which have higher interest rates and shorter terms and
adjust more frequently to changes in interest rates than single-family
residential mortgage loans. At September 30, 1999, commercial real estate,
commercial and consumer loans totaled $40.8 million, $32.5 million and $6.7
million, respectively, which represented 19.8%, 15.8% and 3.2%, respectively, of
gross loans. At September 30, 1999, $90.9 million, or 44.1% of gross loans,
consisted of residential real estate mortgage loans.
5
<PAGE>
Forward-Looking Statements
When used in this Annual Report, the words or phrases "will likely result,"
"are expected to," "will continue," "is anticipated," "estimate," "project" or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995. Such
statements are subject to certain risks and uncertainties including changes in
economic conditions in our market area, changes in policies by regulatory
agencies, fluctuations in interest rates, demand for loans in our market area,
competition and information provided by third-party vendors that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. We wish to caution readers not to place undue reliance
on any such forward-looking statements, which speak only as of the date made. We
wish to advise readers that the factors listed above could affect our financial
performance and could cause our actual results for future periods to differ
materially from any opinions or statements expressed with respect to future
periods in any current statements.
We do not undertake, and specifically disclaims any obligation, to publicly
release the result of any revisions which may be made to any forward-looking
statements to reflect events or circumstances after the date of such statements
or to reflect the occurrence of anticipated or unanticipated events.
Year 2000 Readiness Disclosure
The following information constitutes "Year 2000 Readiness Disclosure"
under the Year 2000 Information and Readiness Disclosure Act.
Our operations, like those of most financial institutions, are
substantially dependent upon computer systems for our lending and deposit
activities. We are addressing the potential problems associated with the
possibility that the computers which control our data processing activities,
facilities and networks may not be programmed to read four-digit dates and, upon
the arrival of the year 2000, may recognize the two-digit code "00" as the year
1900 rather than 2000. This could cause systems to fail to function or generate
erroneous information.
We formed a Year 2000 Committee early in 1998 with senior representatives
from every functional area of our Bank. At the direction of the Board, this
Committee is leading our efforts to ensure that we are ready for the Year 2000.
Our board of directors has approved 1st State Bancorp, Inc.'s five phase Year
2000 Plan that was developed in accordance with the guidelines set forth by the
Federal Financial Institutions Examination Council.
The first phase, awareness, was intended to provide on-going information to
our employees, directors and customers of the impact of the Year 2000 issue. We
have conducted Year 2000 training for all directors and employees.
The second phase, assessment, required us to review all systems that we
believe to be potential risks in order to minimize any Year 2000 operating
difficulties. This review included all major computer and non-computer based
systems, such as vaults, security systems and telephone systems and resulted in
us identifying one vendor (Open Solutions, Inc.) and one system (The Complete
Banking System) as mission critical.
In April 1998, we converted to a new computer system for processing all
loan, deposit and general ledger transactions. In conjunction with this
conversion, we purchased and installed new hardware and software throughout 1st
State Bank. The hardware and software purchased are Year 2000 compliant or have
been made compliant with minor modifications or upgrades. The combined cost of
this hardware and software was $1.2 million, which was capitalized during the
year ended September 30, 1998 in accordance with our capitalization policy. The
assessment phase is complete, although it is updated periodically as necessary.
We have contacted all of our significant commercial borrowers and have
determined that they are progressing appropriately with their efforts on Year
2000 issues. We do not believe this poses a significant risk to us at this time.
6
<PAGE>
In addition, we take into consideration a commercial loan applicant's Year
2000 preparedness and will reject any application where the applicant's Year
2000 preparedness could hinder its ability to repay the loan.
The third phase, renovation, includes making the necessary enhancements to
ensure that our systems are Year 2000 compliant as well as obtaining
certification from our vendors that their systems are Year 2000 compliant. As
noted above, the hardware and software purchased as part of our system
conversion is Year 2000 compliant. We have contacted significant third parties
with whom we interface to complete customer transactions. These vendors have
advised us that they have completed the renovation phase of their mission
critical processes, and that their validation processes are either complete, or
substantially complete.
The fourth phase, validation, involves developing a testing strategy by
establishing priorities based on the risks that a data processing failure may
have on mission critical operations. Hardware used to operate mission critical
processes has been successfully tested. In addition, we have received
representations from our mission critical third party vendor that they are Year
2000 compliant. Testing of mission critical software applications and external
testing with significant third parties has been completed.
The fifth and final phase, implementation, began in the second quarter of
calendar 1999 and will be completed in the first quarter of calendar 2000. In
accordance with regulatory guidelines at September 30, 1999, we have developed a
business resumption contingency plan and designed a method of plan validation.
We have validated this plan.
We estimate that the total future cost of Year 2000 compliance, excluding
internal staffing costs, will not be significant. Year 2000 expenses were
$8,000 for the year ended September 30, 1999 which included the cost of an
independent consultant that was retained to assist us in evaluating our Year
2000 Plan and assist us in testing. We believe that our policies, plans and
actions are in compliance with regulatory guidelines and milestone dates.
Our customers may also experience Year 2000 problems, which could adversely
affect their ability to comply with their obligations to us. We have assessed
all significant commercial loan customers to determine their Year 2000
readiness. Although Year 2000 readiness varies among our customers, we do not
expect that Year 2000 problems will have such a serious impact on our customers
as to cause them to suffer material adverse financial consequences.
We believe that the potential effects on our internal operations from Year
2000 issues can and will be addressed prior to the Year 2000. However, as
unforeseen circumstances arise, the Year 2000 issue could disrupt our normal
business operations. The most reasonably likely worst case Year 2000 scenarios
foreseeable at this time would include our not being able to systematically
process, in some combination, various types of customer transactions. This could
affect our ability to accept deposits or process withdrawals, originate new
loans or accept loan payments in the automated manner we currently utilize.
Depending upon how long this scenario lasted, this could have a material adverse
effect on our operations. Our contingency plan addresses alternative methods to
enable us to continue to offer basic services to our customers. The costs of our
Year 2000 project and our benchmark dates are based on our best estimates, which
are based on a number of assumptions including future events. We cannot
guarantee that these estimates will be achieved at the cost disclosed or within
the time frames indicated.
Liquidity and Capital Resources
1st State Bancorp has no business other than that of 1st State Bank and
investing its assets. We believe that our current assets, consisting of invested
cash and short-term investments, earnings on those assets and principal and
interest payments on 1st State Bancorp's loan to the employee stock ownership
plan, together with dividends that may be paid from 1st State Bank to 1st State
Bancorp, will provide sufficient funds for its initial operations and liquidity
needs; however, it is possible that 1st State Bancorp may need additional funds
in the future. We cannot assure you, however, that 1st State Bancorp's sources
of funds will be sufficient to satisfy its liquidity needs in the future. 1st
State
7
<PAGE>
Bank is subject to certain regulatory limitations on the payment of dividends to
1st State Bancorp. For a discussion of these regulatory dividend limitations,
see "Market Information."
At September 30, 1999, we had stockholders' equity of $71.6 million, as
compared to $26.0 million at September 30, 1998. We reported net income for the
year ended September 30, 1999 of $1.6 million, as compared to $2.5 million and
$2.5 million for the years ended September 30, 1998 and 1997, respectively. At
September 30, 1999 and 1998, we had a Tier 1 risk-based capital to risk-weighted
assets ratio of 36.6% and 14.5%, respectively. At September 30, 1999, we had
Tier 1 leverage capital, Tier 1 risk-based capital, and total risk-based capital
of $71.5 million, $71.5 million and $74.0 million, respectively. At September
30, 1999, we exceeded all regulatory minimum capital requirements.
Our primary sources of funds are deposits, principal and interest payments
on loans, proceeds from the sale of loans, and to a lesser extent, advances from
the FHLB of Atlanta. While maturities and scheduled amortization of loans are
predictable sources of funds, deposit flows and mortgage prepayments are greatly
influenced by general interest rates, economic conditions and local competition.
Our primary investing activities have been the origination of loans and the
purchase of investment securities. During the years ended September 30, 1999,
1998 and 1997, we had $113.8 million, $105.4 million and $79.2 million,
respectively, of loan originations. During the years ended September 30, 1999,
1998 and 1997, we purchased investment securities in the amounts of $77.7
million, $34.6 million and $7.0 million, respectively. Our primary financing
activities are the attraction of savings deposits and, during the year ended
September 30, 1999, obtaining FHLB advances.
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 the 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 33.3% of total
assets at September 30, 1999, 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, 1999, the Bank's liquidity ratio was in excess of the North Carolina
regulations.
Our most liquid assets are cash and cash equivalents. The levels of these
assets are dependent on our operating, financing, lending and investing
activities during any given period. At September 30, 1999 and 1998, cash and
cash equivalents totaled $15.7 million and $31.1 million, respectively. We have
other sources of liquidity should we need additional funds. During the years
ended September 30, 1999, 1998 and 1997, we sold loans totaling $40.4 million,
$27.8 million and $9.2 million, respectively. Additional sources of funds
include FHLB of Atlanta advances. During the year ended September 30, 1998, we
obtained $20 million of FHLB of Atlanta advances with maturities matched to the
repricing of a comparable amount of loans to reduce our exposure to potentially
rising interest rates. For more information regarding this strategy, see " --
Asset/Liability Management." At September 30, 1999, we had $22.0 million of FHLB
of Atlanta advances outstanding, compared to $20.0 million at September 30,
1998. Other sources of liquidity include loans and investment securities
designated as available for sale, which totaled $12.1 million and $11.0 million,
respectively, at September 30, 1999.
We anticipate that we will have sufficient funds available to meet our
current commitments. At September 30, 1999, we had $6.4 million in commitments
to originate new loans, $43.9 million in unfunded commitments to extend credit
under existing equity line and commercial lines of credit and $469,000 in
standby letters of credit. At September 30, 1999, certificates of deposit which
are scheduled to mature within one year totaled $130.7 million. We believe that
a significant portion of such deposits will remain with us.
8
<PAGE>
Asset/Liability Management
Net interest income, the primary component of our net income, is derived
from the difference or "spread" between the yield on interest-earning assets and
the cost of interest-bearing liabilities. We strive to achieve consistent net
interest income and to reduce our exposure to changes in interest rates by
matching the terms to repricing of our interest-sensitive assets and
liabilities. The matching of our assets and liabilities may be analyzed by
examining the extent to which our assets and liabilities are interest rate
sensitive and by monitoring the expected effects of interest rate changes on our
net interest income. Factors beyond our control, such as market interest rates
and competition, may also have an impact on our interest income and interest
expense.
In the absence of any other factors, the overall yield or return associated
with our 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 brought about by changes in market interest rates, we
can significantly influence our net interest income.
Our President reports to our 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 our assets and
liabilities and establishes policies and strategies designed to regulate our
flow of funds and to coordinate the sources, uses and pricing of such funds. The
first priority in structuring and pricing our assets and liabilities is to
maintain an acceptable interest rate spread while reducing the net effects of
changes in interest rates. Our management is responsible for administering the
policies and determinations of the board of directors with respect to our asset
and liability goals and strategies.
Our principal strategy in managing our interest rate risk has been to
increase interest rate sensitive assets such as commercial loans and consumer
loans. At September 30, 1999, we had $32.5 million of commercial loans and $6.7
million of consumer loans, which amounted to 15.8% and 3.2%, respectively, of
our gross loan portfolio, as compared to $25.2 million of commercial loans and
$6.3 million of consumer loans, respectively, at September 30, 1998, which
amounted to 12.2% and 3.1%, respectively, of our gross loan portfolio at that
date. In addition, in managing our portfolio of investment securities in recent
periods we emphasized the purchase of short-term securities so as to reduce our
exposure to increases in interest rates. In addition, at September 30, 1999, we
had $12.1 million of loans held for sale, and, pursuant to Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities", we had investment securities with an aggregate
amortized cost of $11.2 million and an aggregate fair value of $11.0 million as
available for sale. We are holding these loans and investment securities as
available for sale so that they may be sold if needed for liquidity or asset and
liability management purposes.
We also have shortened the average repricing period of our assets by
retaining in our portfolio single-family residential mortgage loans only in
cases where the loan carries an adjustable rate or the loan has an interest rate
that is sufficient to compensate us for the risk of maintaining long-term,
fixed-rate loans in our portfolio. During the past two years, we have sold a
significant portion of our fixed-rate, single-family residential mortgage loans
with terms of 15 years or more we have originated, and at September 30, 1999,
most of our single-family residential mortgage loans classified as held for
investment were originated at least three years previously when market interest
rates were higher. At September 30, 1999, we held approximately $31.7 million of
adjustable-rate residential mortgage loans, which represented approximately
15.4% of our gross loan portfolio. Depending on conditions existing at any given
time, as part of our interest rate risk management strategy, we may sell newly
originated fixed-rate residential mortgage loans with original maturities of 15
years or more in the secondary market.
In addition, in early 1998, as market interest rates were falling and our
yields on newly originated loans were decreasing, we became increasingly
concerned that if interest rates were to increase significantly from the low
rates then prevailing our cost of funds could be expected to increase while we
would continue to earn the same low yield on our
9
<PAGE>
fixed-rate loans. To reduce our interest rate risk, in February 1998, we
obtained $20.0 million in fixed-rate FHLB of Atlanta advances. These advances
were structured with maturities estimated to coincide with the expected
repricing of approximately $20.0 million of our loans. Through this strategy, we
were able to establish a positive interest rate spread on the $20.0 million of
assets and FHLB of Atlanta advances. The strategy of obtaining FHLB advances
with maturities matched to a comparably sized portfolio of interest-earning
assets has helped us to significantly reduce our interest rate risk in times of
rising interest rates with respect to that portion of our assets and
liabilities.
Market Risk
Market risk reflects the risk of economic loss resulting from adverse
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.
Our market risk arises primarily from interest rate risk inherent in our
lending and deposit-taking activities. We do not maintain a trading account for
any class of financial instrument nor do we engage in hedging activities or
purchase high-risk derivative instruments. Furthermore, we are not subject to
foreign currency exchange rate risk or commodity price risk.
We measure our interest rate risk by computing estimated changes in net
interest income and the net portfolio value of cash flows from assets,
liabilities and off-balance sheet items in the event of a range of assumed
changes in market interest rates. These computations estimate the effect on our
net interest income and net portfolio value of sudden and sustained 1% to 3%
increases and decreases in market interest rates. Our board of directors has
adopted an interest rate risk policy which establishes maximum decreases in our
estimated net interest income of 15%, 20% and 25% in the event of 1%, 2% and 3%
increases and decreases in the market interest rates, respectively. Limits have
also been established for changes in net portfolio value of decreases of 15%,
25% and 50% in the event of 1%, 2% and 3% increases in market interest rates,
respectively, and decreases of 10%, 15% and 20% in the event of 1%, 2% and 3%
decreases in market interest rates, respectively. The following table presents
the projected change in net interest income and net portfolio value for the
various rate shock levels at September 30, 1999.
<TABLE>
<CAPTION>
Net Portfolio Value Net Interest Income
Change ----------------------------- ------------------------------
in Rates $ Amount $ Change % Change $ Amount $ Change % Change
- -------- -------- -------- --------- --------- -------- ---------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
+ 300 bp $75,739 $(7,381) (8.88)% $13,281 $ 2,049 18.24%
+ 200 bp 78,314 (4,806) (5.78) 12,668 1,436 12.78
+ 100 bp 80,803 (2,317) (2.79) 11,993 761 6.78
Static 83,120 0 0 11,232 0 0
- - 100 bp 84,221 1,101 1.32 10,404 (828) (7.37)
- - 200 bp 82,971 (149) (0.18) 9,489 (1,743) (15.52)
- - 300 bp 80,971 (2,149) (2.59) 8,539 (2,693) (23.98)
</TABLE>
The above table indicates that at September 30, 1999, in the event of
sudden and sustained increases in prevailing market interest rates, we would
expect our estimated net interest income to increase and our net portfolio value
to decrease, and that in the event of sudden and sustained decreases in
prevailing market interest rates, we would expect our estimated net interest
income and net portfolio value to decrease, except that we would expect our net
portfolio value to increase in the event of a sudden and sustained decrease in
interest rates of 100 basis points. Our board of directors reviews our net
interest income and net portfolio value position quarterly, and, if estimated
changes in net interest income and net portfolio value are not within the
targets established by the board, the board may direct management to adjust the
asset and liability mix to bring interest rate risk within board approved
targets. At September 30, 1999, our estimated changes in net interest income and
net portfolio value were within the targets established by the board of
directors.
10
<PAGE>
Computations of prospective effects of hypothetical interest rate changes,
such as the above computations, are based on numerous assumptions, including
relative levels of market interest rates, loan prepayments and deposit decay,
and should not be relied upon as indicative of actual results. Further, the
computations do not contemplate any actions we may undertake in response to
changes in interest rates.
Certain shortcomings are inherent in the method of analysis presented in
the above table. For example, although certain assets and liabilities may have
similar maturities or periods 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. Additionally, 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
our 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 significantly from those assumed in the table. Also,
borrowers may have difficulty in repaying their adjustable-rate debt if interest
rates increase.
11
<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 the difference between the rates
of interest earned on interest-earning assets and the rates paid on interest-
bearing liabilities, known as "interest rate spread," and the relative volume of
interest-earning assets and interest-bearing liabilities.
The following table sets forth certain information relating to our
consolidated statements of income for the years ended September 30, 1999, 1998
and 1997 and reflects the average yield on assets and average cost of
liabilities at the date and for the periods indicated. We derived yields and
costs by dividing income or expense by the average balance of assets and
liabilities, respectively, for the periods shown. Average balances are derived
from daily balances.
<TABLE>
<CAPTION>
Year Ended September 30,
-------------------------------------------------------------------------------
At September 30,
1999 1999 1998 1997
------------------- ---------------------------- --------------------------- --------------------
Average Average
Yield/ Average Yield/ Average Yield/ Average
Balance Cost Balance Interest Cost Balance Interest Cost Balance Interest
--------- ------- -------- -------- -------- -------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Assets:
Loans receivable (1)..... $207,435 7.93% $198,603 $16,113 8.11% $199,203 $17,185 8.63% $186,413 $16,167
Investment securities (2) 96,524 6.04 68,182 4,160 6.10 35,938 2,320 6.46 39,101 2,557
Interest-bearing
overnight deposits...... 7,246 5.50 25,139 1,201 4.78 20,409 1,203 5.89 6,116 337
-------- -------- ------- -------- ------- -------- -------
Total interest-earning
assets................ 311,205 7.24 291,924 21,474 7.36 255,550 20,708 8.10 231,630 19,061
------- ------- -------
Non-interest-earning assets 21,721 20,290 17,499 15,362
-------- -------- -------- --------
Total assets........... $332,926 $312,214 $273,049 $246,992
======== ======== ======== ========
Liabilities and net worth:
Deposits................. $225,876 4.12 $230,363 $ 9,540 4.14 $224,334 10,331 4.61 $215,494 9,743
FHLB advances............ 22,000 5.42 20,044 1,100 5.49 13,559 740 5.46 1,000 56
-------- -------- ------- -------- ------- -------- -------
Total interest-bearing
liabilities........... 247,876 4.24 250,407 10,640 4.25 237,893 11,071 4.65 216,494 9,799
------ ------- ------ ------- ------ -------
Non-interest-bearing
liabilities............... 13,435 14,696 10,436 8,026
-------- -------- -------- --------
Total liabilities...... 261,311 265,103 248,329 224,520
Net worth.................. 71,615 47,111 24,720 22,472
-------- -------- -------- --------
Total liabilities and
net worth............. $332,926 $312,214 $273,049 $246,992
======== ======== ======== ========
Net interest income........ $10,834 $ 9,637 $ 9,262
======= ======= =======
Interest rate spread....... 3.00% 3.11% 3.45%
====== ====== ======
Net interest margin (3).... 3.71% 3.77%
====== ======
Ratio of average
interest-earning assets
to average interest-bearing
liabilities............. 125.55% 116.58% 107.42%
====== ====== ======
<CAPTION>
<S>
Year Ended September 30
-----------------------
1997
-------
Assets: Average
Yield/
Cost
-------
Loans receivable (1).............. 8.67%
Investment securities (2)......... 6.54
Interest-bearing
overnight deposits............... 5.51
Total interest-earning
assets......................... 8.23
Non-interest-earning assets.........
Total assets....................
Liabilities and net worth:
Deposits.......................... 4.52
FHLB advances..................... 5.60
Total interest-bearing
liabilities.................... 4.53
------
Non-interest-bearing
liabilities........................
Total liabilities...............
Net worth...........................
Total liabilities and
net worth......................
Net interest income.................
Interest rate spread................ 3.70%
======
Net interest margin (3)............. 4.00%
======
Ratio of average interest-earning
assets to average interest-bearing
liabilities...................... 106.99%
======
</TABLE>
_________________
(1) Includes nonaccrual loans and loans held for sale, net of discounts and
allowance for loan losses.
(2) Includes FHLB of Atlanta Stock.
(3) Represents net interest income divided by the average balance of interest-
earning assets.
12
<PAGE>
Rate/Volume Analysis
The table below sets forth certain information regarding changes in our
interest income and interest expense for the periods indicated. For each
category of interest-earning asset and interest-bearing liability, we have
provided information on changes attributable to:
. changes in volume, which are changes in volume multiplied by old rate
. changes in rates, which are changes in rate multiplied by old volume
. changes in rate-volume, which are changes in rate multiplied by the
changes in volume and
. total change, which is the sum of the previous columns.
<TABLE>
<CAPTION>
Year Ended September 30,
--------------------------------------------------------------------------
1999 vs. 1998 1998 vs. 1997
------------------------------------ -------------------------------
Increase (Decrease) Increase (Decrease)
Due to Due to
------------------------------------ -------------------------------
Rate/ Rate/
Volume Rate Volume Total Volume Rate Volume Total
------- -------- ------- -------- ------- ------ ------- -----
(In thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Interest income:
Loans receivable (1)............. $ (52) $(1,023) $ 3 $(1,072) $1,109 $ (85) $ (6) $1,018
Investment securities (2)........ 2,081 (127) (114) 1,840 (207) (33) 3 (237)
Other interest-earning assets.... 279 (228) (53) (2) 788 23 55 866
------ ------- ----- ------- ------ ----- ---- ------
Total interest-earning assets.. 2,308 (1,378) (164) 766 1,690 (95) 52 1,647
------ ------- ----- ------- ------ ----- ---- ------
Interest expense:
Deposits......................... 278 (1,041) (28) (791) 400 181 7 588
FHLB advances.................... 354 4 2 360 703 (1) (18) 684
------ ------- ----- ------- ------ ----- ---- ------
Total interest-bearing
liabilities............... 632 (1,037) (26) (431) 1,103 180 (11) 1,272
------ ------- ----- ------- ------ ----- ---- ------
Change in net interest income...... $1,676 $ (341) $(138) $ 1,197 $ 587 $(275) $ 63 $ 375
====== ======= ===== ======= ====== ===== ==== ======
</TABLE>
- ---------------
(1) Includes nonaccrual loans and loans held for sale net of discounts, fees
and allowance for loan losses.
(2) Includes FHLB of Atlanta stock.
Comparison of Financial Condition at September 30, 1999 and 1998
Total assets increased by $44.7 million or 15.5%, from $288.2 million at
September 30, 1998 to $332.9 million at September 30, 1999. The increase in
assets was due primarily to the proceeds from the public stock offering which
was completed on April 23, 1999. The growth in total assets exceeded the
Company's loan growth for the year ended September 30, 1999; therefore, the
level of investments increased by $55.2 million or 137.7%, from $40.1 million at
September 30, 1998 to $95.3 million at September 30, 1999. Increases in the
Company's investment portfolio depend largely on loan demand. The relatively low
level of interest rates during the year ended September 30, 1999 caused the
Company to sell most of its fixed rate mortgage production and prompted
customers to refinance their mortgage loans which increased the Company's
mortgage prepayments. Cash and cash equivalents decreased $15.4 million or 49.5%
from $31.1 million at September 30, 1998 to $15.7 million at September 30, 1999
as we shifted excess overnight funds into investments to earn increased interest
income. Loans held for sale increased $4.6 million or 61.3% from $7.5 million at
September 30, 1998 to $12.1 million at September 30, 1999. These loans will be
sold to fund future loan demand.
13
<PAGE>
Comparison of Operating Results for the Years Ended September 30, 1999 and 1998
Net Income. We had $1.6 million of net income for the year ended September
30, 1999, compared to $2.5 million of net income for the year ended September
30, 1998, representing a decrease of $967,000, or 38.3%. During the year ended
September 30, 1999, increases in net interest income and other income were
offset by increases in operating expenses. Included in operating expenses for
the year ended September 30, 1999 was the $3.0 million contribution to fund the
charitable foundation.
Net Interest Income. Net interest income was $10.8 million for the year
ended September 30, 1999, as compared to $9.6 million for the year ended
September 30, 1998, representing an increase of $1.2 million, or 12.5%. During
the year ended September 30, 1999, we were able to increase our net interest
income by increasing our levels of interest-earning assets and interest-bearing
liabilities. The average balance of interest-earning assets increased by $36.3
million, or 14.2%, from $255.6 million for the year ended September 30, 1998 to
$291.9 million for the year ended September 30, 1999 primarily due to increases
in the average balances of investment securities and interest-bearing overnight
deposits. In addition, the average balance of interest-bearing liabilities
increased by $12.5 million, or 5.3%, from $237.9 million for the year ended
September 30, 1998 to $250.4 million for the year ended September 30, 1999
primarily due to increases in the average balance of deposits and FHLB advances.
The effect of the increases in the average balances of assets and liabilities
was offset in part by a decrease in our interest rate spread from 3.45% for the
year ended September 30, 1998 to 3.11% for the year ended September 30, 1999.
During the quarter ended December 31, 1998 the Federal Reserve lowered interest
rates three times, and the prime interest rate decreased from 8.50% on September
29, 1998 to 7.75% on November 18, 1998. The Federal Reserve boosted rates twice
during the quarter ended September 30, 1999. The average prime rate for the year
ended September 30, 1999 was 7.88%, a decrease of 0.62% from 8.50%, the average
for the year ended September 30, 1998. These lower interest rates decreased the
yields which we earned on loans, investments and interest-bearing deposits
during the year ended September 30, 1999. We were able to lower our cost of
funds by decreasing the rates of interest paid on our deposits to partially
offset this decrease.
Interest Income. Total interest income was $21.5 million for the year ended
September 30, 1999, as compared to $20.7 million for the year ended September
30, 1998, representing an increase of $765,000, or 3.7%. This increase was
attributable to the $36.3 million, or 14.2% increase in the average balance of
interest-earning assets during the year and, offset in part by a 74 basis point
decrease in the average yield on interest-earning assets.
Interest on loans receivable decreased by $1.1 million, or 6.4%, from $17.2
million for the year ended September 30, 1998 to $16.1 million for the year
ended September 30, 1999. The average yield on loans receivable decreased 52
basis points during the year ended September 30, 1999. The decrease was due
primarily to a 0.62% decrease in the average prime rate from 8.50% for the year
ended September 30, 1998 to 7.88% for the year ended September 30, 1999. The
average balance of loans receivable for the year September 30, 1998 decreased by
$600,000, or 0.3%, from $199.2 million to $198.6 million for the year ended
September 30, 1999 despite increases in loan originations. In response to lower
market interest rates, we sold a higher percentage of single family residential
loans and many of our mortgage loan customers refinanced their existing mortgage
loans.
Interest on investment securities increased by $1.9 million, or 82.6%, from
$2.3 million for the year ended September 30, 1998 to $4.2 million for the year
ended September 30, 1999. The increase was attributable to a $32.3 million, or
90.0%, increase in the average balance of investment securities from $35.9
million for the year ended September 30, 1998 to $68.2 million for the year
ended September 30, 1999. Offsetting the increased average balances of
investment securities was a 36 basis point decrease in the average yield on
investment securities due to falling market interest rates during the first half
of the year ended September 30, 1999. As rates declined, a higher than normal
level of our investment securities were called by the issuers and we were faced
with lower reinvestment rates.
Interest on interest-bearing overnight deposits was $1.2 million for each
of the years ended September 30, 1999 and 1998. The average balance of interest-
bearing deposits increased $4.7 million, or 23.0%, from $20.4 million for
14
<PAGE>
the year ended September 30, 1998 to $25.1 million for the year ended September
30, 1999. The volume increase was offset by a decrease of 111 basis points in
the yield on other interest-earning assets.
Interest Expense. Total interest expense was $10.6 million for the year
ended September 30, 1999, as compared with $11.1 million for the year ended
September 30, 1998, representing a decrease of $432,000, or 3.9%. Such decrease
was due primarily to a 40 basis point decrease in the average cost of funds
which was partially offset by a $12.5 million, or 5.3%, increase in average
interest-bearing liabilities from $237.9 million for the year ended September
30, 1998 to $250.4 million for the year ended September 30, 1999.
Interest on deposits decreased by $791,000, or 7.7%, from $10.3 million for
the year ended September 30, 1998 to $9.5 million for the year ended September
30, 1999. The decrease was attributable to a 47 basis point decrease in the
average cost of deposits. As market interest rates decreased we lowered the
interest rates on our deposit products. Offsetting the decreased cost of funds
was an increase in average deposits of $6.1 million, or 27%, from $224.3 million
for the year ended September 30, 1998 to $230.4 million for the year ended
September 30, 1999.
Interest expense on borrowings increased $360,000, or 48.6%, from $740,000
for the year ended September 30, 1998 to $1.1 million for the year ended
September 30, 1999. The increase was primarily due to a $6.4 million, or 47.1%,
increase in average borrowings from $13.6 million for the year ended September
30, 1998 to $20.0 million for the year ended September 30, 1999. We borrowed $20
million from the FHLB Atlanta in February 1998. The long-term advance was
outstanding for all of the year ended September 30,1999 which accounts for the
majority of the increase in the average balance.
Provision for Loan Losses. We charge provisions for loan losses to earnings
to maintain the total allowance for loan losses at a level we consider adequate
to provide for probable loan losses, based on prior loss experience, volume and
type of lending we conduct, industry standards and past due loans in our loan
portfolio. Our policies require the review of assets on a regular basis, and we
appropriately classify loans as well as other assets if warranted. We believe we
use the best information available to make a determination with respect to the
allowance for loan losses, recognizing that future adjustments may be necessary
depending upon a change in economic conditions. We provided $245,000 and
$477,000 for loan losses during the years ended September 30, 1999 and 1998,
respectively. The decreased provision during the year ended September 30, 1999
reflects slower loan growth and a change in the mix of our commercial,
construction, and commercial real estate loans compared to the prior year. At
September 30, 1999, construction loans and asset based loans were $16.5 million
and $8.6 million, respectively, which amounted to 8.0% and 4.2%, respectively,
of the gross loan portfolio. Comparatively, at September 30, 1998, construction
loans and asset based loans were $18.6 million and $9.4 million, respectively,
which amounted to 9.0% and 4.5%, respectively, of the gross loan portfolio.
The allowance for loan losses was $3.5 million at September 30, 1999, as
compared to $3.2 million at September 30, 1998. The ratio of the allowance for
loan losses to total loans, net of loans in process and deferred loan fees was
1.74% and 1.61% at September 30, 1999 and 1998, respectively. We are continuing
to see signs that our local economy may be softening. We are continuing to make
loans to smaller businesses, churches and non-profit organizations. We believe
that these borrowers are more vulnerable to changes in the economy than larger,
more diversified companies whose revenues are supported by customers in a
variety of locations. We continue to see the negative impact of the NAFTA
legislation on the textile industry and borrowers employed by local textile
companies. The textile industry currently provides 10,000 jobs in Alamance
County. Finally, we continue to see increased consumer debt levels and rising
consumer bankruptcy rates nationally and in North Carolina. These factors have
had a negative effect on our consumer and mortgage loan portfolios during 1999.
Collectively, these factors prompted us to increase the allowance for loan
losses during 1999.
Other Income. Total other income increased by $156,000, or 10.43%, from
$1.5 million for the year ended September 30, 1998 to $1.7 million for the year
ended September 30, 1999. Of such increase, $64,000 was attributable to
increased commissions from sales of annuities and mutual funds. Our sales of
annuities and mutual funds were $11.6
15
<PAGE>
million and $10.1 million for the years ended September 30, 1999 and 1998,
respectively. During the year ended September 30, 1999, mortgage banking income,
net decreased by $112,000. As interest rates increased during the second half of
the year, we recorded a $328,397 lower of cost or market adjustment on the loans
held for sale. At September 30, 1999, we had loans held for sale with a carrying
value of $12.1 million. During the years ended September 30, 1999 and 1998, we
recognized net losses of $198,000 and $119,000 on the sale of $40.4 million and
$27.8 million of mortgage loans, respectively. Of these loans sold, the Bank
retained the servicing rights on $7.8 million and $4.1 million, respectively. We
received fees to compensate us for releasing the servicing rights on the
remaining loans sold. These fees, which amounted to $850,000 and $351,000 for
the years ended September 30, 1999 and 1998, respectively, more than offset the
aforementioned losses recognized on the sale of these loans. Customer service
fees on loan and deposit accounts decreased by $26,000, or 4.6%, from $566,000
for the year ended September 30, 1998 to $540,000 for the year ended September
30, 1999. During the year ended September 30, 1998 we recognized net securities
losses of $246,000 from an other than temporary decline in the value of an
investment in marketable equity securities. The fair value of the marketable
equity securities depends largely on changes in interest rates as the underlying
securities are debt securities. At September 30, 1999, we had an unrealized loss
of $134,000 on our marketable equity securities. These unrealized losses were
the result of increased interest rates and are not considered an other than
temporary decline in value. However, future changes in interest rates could
cause additional declines in values that are other than temporary.
Operating Expenses. Total operating expenses increased by $3.0 million, or
44.1%, from $6.8 million for the year ended September 30, 1998 to $9.8 million
for the year ended September 30, 1999. Included in the $9.8 million of operating
expenses for the year ended September 30, 1999 is the $3.0 million contribution
to establish the 1st State Bank Foundation, Inc. Excluding this one-time
nonrecurring expense, operating expenses would have been $6.8 million which was
$43,000, or 0.6%, over the prior year. Compensation and related benefits
decreased by $155,000, or 3.4%, from $4.6 million for the year ended September
30, 1998 to $4.5 million for the year ended September 30, 1999. Deferred
compensation expense decreased $697,000, or 70.7%, from $987,000 for the year
ended September 30, 1999 to $289,000 for the year ended September 30, 1998 due
to a decrease in expense attributable to the implementation and vesting of a
Deferred Compensation Plan for directors and executive officers. Partially
offsetting this decrease were increased benefit expenses of $286,000 from the
implementation of the ESOP. Salaries and wages, including incentives and
bonuses, increased $371,000, or 12.3%, from $3.0 million for the year ended
September 30, 1998 to $3.4 million for the year ended September 30, 1999.
Occupancy and equipment expense decreased $86,000 or 8.2%, from $1.0 million for
the year ended September 30, 1998 to $959,000 for the year ended September 30,
1999. We converted to an inhouse data processing system during April 1998. The
higher expense in 1998 included a writedown of $85,000 for obsolete equipment
which was replaced in the computer conversion. Other expenses increased $348,000
from $870,000 for the year ended September 30, 1999 to $1.2 million for the year
ended September 30, 1999. This increase was primarily due to added expenses from
being a public company including increased audit fees, legal fees, office
supplies, marketing expenses and stockholders relations expense.
Income Taxes. Our income tax expense was $870,000 and $1.4 million for the
years ended September 30, 1999 and 1998, respectively. Our effective tax rate
was 35.9% for the year ended September 30, 1999 and 35.1% for the year ended
September 30, 1998. In 1999, we did not recognize any state tax benefit on the
charitable contribution to fund the Foundation because North Carolina tax law
does not provide for the carryforward of charitable contributions. This
increased our effective tax rate for 1999.
Comparison of Operating Results for the Years Ended September 30, 1998 and 1997
Net Income. We had $2.5 million of net income for each of the years ended
September 30, 1998 and 1997. During the year ended September 30, 1998, increases
in net interest income and other income were offset by increases in the
provision for loan losses and operating expenses.
Net Interest Income. Net interest income was $9.6 million for the year
ended September 30, 1998, as compared to $9.3 million for the year ended
September 30, 1997, representing an increase of $375,000, or 4.1%. During
16
<PAGE>
the year ended September 30, 1998, we were able to increase our net interest
income by leveraging our capital and increasing our levels of interest-earning
assets and interest-bearing liabilities. The average balance of interest-earning
assets increased by $23.9 million, or 10.3%, from $231.6 million for the year
ended September 30, 1997 to $255.6 million for the year ended September 30, 1998
primarily due to increases in the average balances of loans receivable and
interest-bearing overnight deposits. In addition, the average balance of
interest-bearing liabilities increased by $21.4 million, or 9.9%, from $216.5
million for the year ended September 30, 1997 to $237.9 million for the year
ended September 30, 1998 primarily due to increases in the average balances of
deposits and FHLB advances. The effect of the increases in the average balances
of assets and liabilities was offset in part by a decrease in our interest rate
spread from 3.70% for the year ended September 30, 1997 to 3.45% for year ended
September 30, 1998. In February 1998, we obtained $20.0 million in fixed-rate
FHLB of Atlanta advances. These advances were structured with maturities
estimated to coincide with the expected repricing of approximately $20.0 million
of our loans. Through this strategy, we were able to establish a positive
interest rate spread on the $20.0 million of assets and FHLB of Atlanta
advances. The proceeds of advances increased our cash and cash equivalents
pending deployment of the proceeds into loans. Interest rates declined between
the time we obtained the advances and September 30, 1998, with the result that
our cost of funds were negatively affected because the advances had a higher
rate of interest than other sources of funds while cash and cash equivalents had
a lower yield than our other interest-earning assets. As a result, we earned a
lesser interest rate spread than we would have otherwise earned had we not
obtained the advances. However, the strategy of obtaining FHLB advances with
maturities matched to a comparably sized portfolio of interest-earning assets
has helped us to significantly reduce our interest rate risk in times of rising
interest rates with respect to that portion of our assets and liabilities.
See "--Asset/Liability Management" for our strategies in managing our interest
rate spread. However, during the year ended September 30, 1998, we continued our
efforts to increase the yield on interest-earning assets by increasing
originations of loans that are based on the prime rate, such as commercial loans
and home equity lines of credit, and to lower our cost of funds by successfully
attracting lower cost deposits such as checking accounts and money market
accounts.
Interest Income. Total interest income was $20.7 million for the year ended
September 30, 1998, as compared to $19.1 million for the year ended September
30, 1997, representing an increase of $1.6 million, or 8.6%. Such increase was
due primarily to a $23.9 million, or 10.3%, increase in the average balance of
the interest-earning assets during such year which was offset in part by a 13
basis point decrease in the average yield on interest-earning assets.
Interest on loans receivable increased by $1.0 million, or 6.3%, from $16.2
million for the year ended September 30, 1997 to $17.2 million of the year ended
September 30, 1998. The increase was due primarily to an increase of $12.8
million, or 6.9%, in the average balance of loans receivable from $186.4 million
for the year ended September 30, 1997 to $199.2 million for the year ended
September 30, 1998, reflecting increased single-family residential mortgage loan
and commercial loan originations. The increase in the average balance of loans
receivable more than offset a 4 basis point decrease in the average yield on
loans receivable due to falling market interest rates during the year ended
September 30, 1998. Offsetting the decreased yield attributable to declining
market interest rates were our increased originations of commercial loans and
construction loans, which carry interest rates based on the prime rate, enabling
us to earn a higher yield on interest-earning assets, as commercial loans
generally earn higher interest rates than single-family residential mortgage
loans, although those loans entail greater credit risk.
Interest on investment securities decreased by $237,000, or 9.3%, from $2.6
million for the year ended September 30, 1997 to $2.3 million for the year ended
September 30, 1998. The decrease was attributable to a $3.2 million, or 8.1%,
decrease in the average balance of investment securities from $39.1 million for
the year ended September 30, 1997 to $35.9 million for the year ended September
30, 1998, combined with an 8 basis point decrease in the average yield on
investment securities. As market interest rates fell during the year ended
September 30, 1998, a higher than normal level of our investment securities were
called by the issuers.
Interest on interest-bearing overnight deposits increased by $867,000 from
$336,000 for the year ended September 30, 1997 to $1.2 million for the year
ended September 30, 1998. The increase was due primarily to a $14.3 million
increase in the average balance of other interest-earning assets from $6.1
million for the year ended September
17
<PAGE>
30, 1997 to $20.4 million for the year ended September 30, 1998, as a result of
the temporary investment of the proceedings from the $20.0 million of FHLB of
Atlanta advances obtained in February 1998, as well as to a 38 basis point
increase in the yield on other interest-earning assets.
Interest Expense. During the years ended September 30, 1998 and 1997,
interest expense consisted primarily of interest on deposit accounts. Interest
on deposit accounts increased by $588,000, or 6.0%, from $9.7 million for the
year ended September 30, 1997 to $10.3 million for the year ended September 30,
1998. The increase was due to an $8.8 million, or 4.1%, increase in the average
balance of deposits from $215.5 million for the year ended September 30, 1997 to
$224.3 million for the year ended September 30, 1998. In addition, there was a 9
basis point increase in the average cost of deposits. The increase in the
average cost of deposits reflected our decision to increase our deposit rates to
match competition in our market. In addition, during the year ended September
30, 1998, we had interest expense of $740,000 on our increased balance of FHLB
of Atlanta advances, as compared to $56,000 of interest expense during the year
ended September 30, 1997.
Provisions for Loan Losses. We provided $477,000 and $261,000 for loan
losses during the years ended September 1998 and 1997, respectively. The
allowance for loan losses was $3.2 million at September 30, 1998, as compared to
$2.8 million at September 30, 1997. The ratio for the allowance for loan losses
to total loans, net of loans in process and deferred loan fees, was 1.61% and
1.38% at September 30, 1998 and 1997, respectively. The increased provision
during the year ended September 30, 1998 reflects the increased risk in our loan
portfolio attributable to the higher percentage of loans invested in commercial
loans, commercial real estate loans and construction loans. At September 30,
1998, commercial loans, commercial real estate loans and construction loans
totaled $25.2 million, $38.8 million and $18.6 million, respectively, which
amounted to 12.2%, 18.8% and 9.0%, respectively, of the gross loan portfolio.
Comparatively, at September 30, 1997, commercial loans, commercial real estate
loans and construction loans totaled $22.9 million, $34.3 million and $12.6
million, respectively, which amounted to 11.3%, 17.0% and 6.2%, respectively, of
the gross loan portfolio. Single-family real estate loans totaled $100.9 million
and $108.4 million at September 30, 1998 and 1997, respectively, which
represented 48.8% and 53.8%, respectively, of the gross loan portfolio at such
dates. Furthermore, we continued to originate asset-based loans, which are loans
where repayment is based largely on the liquidation of assets such as inventory
and accounts receivable. These loans carry an even higher incremental risk of
loss, as their repayment is often dependent on the financial performance of the
persons that owe money to our borrower. At September 30, 1998 and 1997, we had
$9.4 million and $8.1 million, respectively, of loans that we considered to be
asset-based loans.
In addition, changes in the economy during fiscal year 1998 have altered
the credit risk profile of some of our customers and as a result, we increased
our provision to reflect this additional credit risk. We believe that our local
economy may be nearing the end of a business cycle, which affects all of our
borrowers through a softening economy. We have been further affected by this
trend in that in recent years we have increased lending to smaller businesses,
churches and non-profit organizations, and we have increased the origination of
asset-based loans. We consider these borrowers to be more vulnerable to changes
in the economy than larger, more diversified companies whose revenues are
supported by customers in a variety of locations. The NAFTA legislation passed
by Congress also appears to be having a negative impact on the textile industry
of Alamance County, affecting or potentially affecting borrowers in the textile
industry and borrowers employed by local textile companies. Finally, we believe
increased consumer debt levels and rising consumer bankruptcy rates nationally
and in North Carolina have had a negative effect on our consumer and mortgage
loan portfolios during 1998. Collectively, these factors prompted us to increase
the allowance for loan losses during 1998.
Other Income. Total other income was $1.5 million for the years ended
September 30, 1998 and 1997. During the year ended September 30, 1998, mortgage
banking income, net increased by $256,000. As interest rates decreased during
the year, we decided to sell a greater volume of new residential mortgage loan
originations to reduce our exposure to interest rate risk. For most of these
transactions, we incurred a loss on the sale of the loan. During the years ended
September 30, 1998 and 1997, we recognized net losses on the sale of mortgage
loans of $119,000 and $16,000, respectively. These losses were offset by other
sources of income from mortgage banking transactions. For example,
18
<PAGE>
in many cases, we elected to sell the rights to service the loan, resulting in
the collection of an additional premium to release the servicing rights. These
premiums, which amounted to $351,000 and $121,000 for the years ended September
30, 1998 and 1997, respectively, more than offset the aforementioned marketing
losses on the sale of the loans during these periods. In addition, during the
year ended September 30, 1998, commissions from sales of annuities and mutual
funds increased by $38,000 as customers shifted retirement funds into non-
insured investments. Also, customer service fees on loan and deposit accounts
increased by $66,000, or 13.1%, from $500,000 for the year ended September 30,
1997 to $566,000 for the year ended September 30, 1998 as a result of increased
levels of deposit and loan accounts. Offsetting these increases was a $269,000
securities loss during the year ended September 30, 1998 from an other than
temporary decline in the value of marketable equity securities. During the mid
1980s, we made an investment in a mutual fund classified as a marketable equity
security which invests in mortgage-backed securities and U.S. Government and
agency securities. This investment is classified as available for sale, and in
prior years we have reflected a net unrealized loss on investment securities on
our consolidated balance sheets attributable to the then current unrealized loss
associated with this mutual fund investment. During the year ended September 30,
1998, we determined that the value of the investment in marketable equity
securities would not recover in the foreseeable future and we recognized an
expense attributable to the other than temporary decline in fair value. The fair
value of marketable equity securities depends largely on changes in interest
rates as the underlying securities are debt securities. Future changes in
interest rates could cause additional declines in value that are other than
temporary.
Operating Expenses. Total operating expenses increased by $302,000, or
4.7%, from $6.5 million for the year ended September 30, 1997 to $6.8 million
for the year ended September 30, 1998. Compensation and related benefits
increased by $267,000, or 6.2%, from $4.3 million for the year ended September
30, 1997 to $4.6 million for the year ended September 30, 1998, due to an
increase in expense attributable to normal salary increases and increases in the
number of employees. During the year ended September 30, 1998 and 1997, we
incurred $987,000 and $1.1 million, respectively, in compensation and related
expenses attributable to the implementation and vesting of a Deferred
Compensation Plan for directors and executive officers. Occupancy and equipment
expenses increased by $105,000, or 11.1%, from $940,000 for the year ended
September 30, 1997 to $1.0 million for the year ended September 30, 1998 due to
an $85,000 write-down of obsolete equipment. Deposit insurance premiums
increased by $38,000, or 36.9%, from $104,000 for the year ended September 30,
1997 to $142,000 for the year ended September 30, 1998 due to increased levels
of deposits.
Income Taxes. Our income tax expense was $1.4 million for each of the years
ended September 30, 1998 and 1997. Our effective tax rate was 35.1% for the year
ended September 30, 1998 and 36.2% for the year ended September 30, 1997.
Impact of Inflation and Changing Prices
Our financial statements and the accompanying notes 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 our operations. As a result, interest rates have a greater
impact on our 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 prices of goods and services.
Accounting Matters
Accounting for Derivative Instruments and Hedging Activities. In June 1998,
the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 133 ("SFAS 133"). SFAS 133 establishes accounting and
reporting standards for derivative instruments and for hedging activities.
Statement of Financial Accounting Standards No. 137, "Accounting for Derivative
Instruments and Hedging Activities-Deferral of the Effective Date of FASB
Statement No. 133 - an amendment of FASB No. 133" delayed the effective date of
this statement for one year. This Statement is effective for all fiscal quarters
of fiscal years beginning after June 15, 2000. The Company
19
<PAGE>
plans to adopt SFAS 133 in fiscal year 2000 without any impact on its
consolidated financial statements as the Company does not have any derivative
financial instruments and is not involved in any hedging activities.
Accounting for Mortgage-Backed Securities Retained after the Securitization
of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise. In October
1998, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 134 ("SFAS 134"). SFAS 134 establishes accounting and
reporting standards for certain mortgage banking activities. It also conforms
the subsequent accounting for securities retained after the securitization of
other types of assets. This statement is effective for financial statements for
fiscal year beginning after December 15, 1998. The Company adopted SFAS 134 in
fiscal year 1999 without any impact on its consolidated financial statements.
20
<PAGE>
Independent Auditors' Report
The Board of Directors
1st State Bancorp, Inc.
Burlington, North Carolina
We have audited the accompanying consolidated balance sheets of 1st State
Bancorp, Inc. and subsidiary as of September 30, 1999 and 1998 and the related
consolidated statements of income, stockholders' equity and comprehensive income
and cash flows for each of the years in the three-year period ended September
30, 1999. These consolidated financial statements are the responsibility of the
Bank's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of 1st State Bancorp,
Inc. and subsidiary at September 30, 1999 and 1998, and the results of their
operations and their cash flows for each of the years in the three-year period
ended September 30, 1999, in conformity with generally accepted accounting
principles.
/s/ KPMG LLP
October 29, 1999
Raleigh, North Carolina
21
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Consolidated Balance Sheets
September 30, 1999 and 1998
<TABLE>
<CAPTION>
1999 1998
------------ -----------
<S> <C> <C>
Assets
Cash and cash equivalents $ 15,657,202 31,077,054
Investment securities (note 3):
Held to maturity (fair value of $82,541,457 and $30,415,447
at September 30, 1999 and 1998, respectively) 84,228,343 30,195,094
Available for sale (cost of $11,241,966 and $9,705,529 at
September 30, 1999 and 1998, respectively) 11,035,966 9,857,780
Loans held for sale, at lower of cost or fair value 12,143,063 7,539,919
Loans receivable (net of allowance for loan losses of $3,454,373 and $3,227,775
at September 30, 1999 and 1998, respectively)
(notes 4, 5 and 9) 195,292,344 196,782,275
Federal Home Loan Bank stock, at cost (notes 6 and 9) 1,259,600 1,346,500
Premises and equipment (note 7) 7,282,361 7,513,347
Accrued interest receivable 2,652,134 1,807,588
Other assets (note 11) 3,374,915 2,103,659
------------ -----------
Total assets $332,925,928 288,223,216
============ ===========
Liabilities and Net Worth
Liabilities:
Deposit accounts (note 8) $234,094,735 235,693,715
Advances from Federal Home Loan Bank (note 9) 22,000,000 20,000,000
Advance payments by borrowers for property taxes and insurance 232,973 299,939
Other liabilities (notes 11 and 12) 4,983,039 6,263,957
------------ -----------
Total liabilities 261,310,747 262,257,611
------------ -----------
Stockholders' equity (notes 10 and 12):
Preferred stock, $0.01 par value, 1,000,000 shares authorized;
none issued -- --
Common stock, $0.01 par value, 7,000,000 shares authorized;
3,163,125 shares issued and outstanding in 1999 31,631 --
Additional paid in capital 49,216,648 --
Unearned ESOP shares (4,469,611) --
Deferred compensation 2,373,485 --
Treasury stock for deferred compensation (2,373,485) --
Retained income - substantially restricted 26,959,913 25,872,605
Accumulated other comprehensive income (loss) - net unrealized
gain (loss) on investment securities available for sale (123,400) 93,000
------------ -----------
Total stockholders' equity 71,615,181 25,965,605
------------ -----------
Total liabilities and stockholders' equity $332,925,928 288,223,216
============ ===========
</TABLE>
See accompanying notes to consolidated financial statements.
22
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Consolidated Statements of Income
For the Years Ended September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
1999 1998 1997
----------- ---------- ----------
<S> <C> <C> <C>
Interest income:
Interest and fees on loans $16,112,667 17,184,941 16,167,269
Interest and dividends on investments 4,159,750 2,319,980 2,557,133
Overnight deposits 1,201,191 1,203,594 336,426
----------- ---------- ----------
Total interest income 21,473,608 20,708,515 19,060,828
----------- ---------- ----------
Interest expense:
Deposit accounts (note 8) 9,539,532 10,330,999 9,743,038
FHLB advances (note 9) 1,100,361 740,439 55,910
----------- ---------- ----------
Total interest expense 10,639,893 11,071,438 9,798,948
----------- ---------- ----------
Net interest income 10,833,715 9,637,077 9,261,880
Provision for loan losses (note 5) (245,000) (477,017) (261,288)
----------- ---------- ----------
Net interest income after provision
for loan losses 10,588,715 9,160,060 9,000,592
----------- ---------- ----------
Other income:
Loan servicing fees (note 4) 98,687 103,280 108,517
Customer service fees 540,070 565,693 500,216
Commission from sales of annuities and mutual funds 500,321 436,568 399,058
Real estate operations, net 5,000 (1,734) 19,808
Mortgage banking income, net 324,513 436,401 180,809
Securities losses, net (note 3) -- (246,259) --
Other 185,074 203,581 259,343
----------- ---------- ----------
Total other income 1,653,665 1,497,530 1,467,751
----------- ---------- ----------
Operating expenses:
Compensation and related benefits (note 12) 4,456,710 4,612,183 4,344,800
Occupancy and equipment (note 13) 958,608 1,044,147 939,544
Deposit insurance premiums 144,300 142,015 103,707
Other expenses 1,217,975 869,734 933,851
Contributions (note 2) 3,040,096 106,249 150,767
----------- ---------- ----------
Total operating expenses 9,817,689 6,774,328 6,472,669
----------- ---------- ----------
Income before income taxes 2,424,691 3,883,262 3,995,674
Income taxes (note 11) 870,000 1,362,000 1,447,100
----------- ---------- ----------
Net income $ 1,554,691 2,521,262 2,548,574
=========== ========== ==========
Net income (loss) per share - basic $ (0.10) -- --
=========== ========== ==========
Net income (loss) per share - diluted $ (0.10) -- --
=========== ========== ==========
</TABLE>
See accompanying notes to consolidated financial statements.
23
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Consolidated Statements of Stockholders' Equity and Comprehensive Income
For the Years Ended September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
Unearned
Common Additional ESOP Deferred
Stock Paid-in Capital Shares Compensation
----------------- ----------------- ----------------- --------------
<S> <C> <C> <C> <C>
Balance at September 30, 1996 $ -- -- -- --
Comprehensive income:
Net income -- -- -- --
Other comprehensive income-unrealized gain
on securities available-for-sale net
of income taxes of $64,000. -- -- -- --
Total comprehensive income
----------- ------------- ------------- -------------
Balance at September 30, 1997 -- -- -- --
Comprehensive income:
Net income -- -- -- --
Other comprehensive income-unrealized gain
on securities available-for-sale net
of income taxes of $107,000. -- -- -- --
Total comprehensive income
------------ ------------- ------------- ------------
Balance at September 30, 1998 -- -- -- --
Comprehensive income:
Net income -- -- -- --
Other comprehensive income-unrealized loss
on securities available-for-sale net
of income taxes of $142,600. -- -- -- --
Total comprehensive income
Net proceeds from issuance of common stock 31,631 49,215,725 -- --
Common Stock acquired by ESOP -- -- (4,898,639) --
Release of ESOP shares -- 923 429,028 --
Deferred compensation (note 12) -- -- -- 2,373,485
Treasury stock held for deferred
compensation (note 12) -- -- -- --
Cash dividends declared -- -- -- --
Cash dividends on unallocated ESOP shares -- -- -- --
------------ ------------- ------------- ------------
Balance at September 30, 1999 $ 31,631 49,216,648 (4,469,611) 2,373,485
============ ============= ============= ============
<CAPTION>
Treasury
Stock Accumulated
for Other Total
Deferred Retained Comprehensive Stockholder's
Compensation Income Income (loss) Equity
----------------- ----------------- --------------------- -------------
<S> <C> <C> <C> <C>
Balance at September 30, 1996 -- 20,802,769 (174,000) 20,628,769
Comprehensive income:
Net income -- 2,548,574 -- 2,548,574
Other comprehensive income-unrealized gain
on securities available-for-sale net
of income taxes of $64,000. -- -- 100,000 100,000
-----------
Total comprehensive income 2,648,574
------------ ------------- ----------- -----------
Balance at September 30, 1997 -- 23,351,343 (74,000) 23,277,343
Comprehensive income:
Net income -- 2,521,262
Other comprehensive income-unrealized gain -- 2,521,262
on securities available-for-sale net
of income taxes of $107,000. -- -- 167,000 167,000
-----------
Total comprehensive income 2,688,262
------------ ------------- ------------ -----------
Balance at September 30, 1998 -- 25,872,605 93,000 25,965,605
Comprehensive income:
Net income -- 1,554,691 -- 1,554,691
Other comprehensive income-unrealized loss
on securities available-for-sale net
of income taxes of $142,600. -- -- (216,400) (216,400)
-----------
Total comprehensive income 1,338,291
Net proceeds from issuance of common stock -- -- -- 49,247,356
Common Stock acquired by ESOP -- -- -- (4,898,639)
Release of ESOP shares -- -- -- 429,951
Deferred compensation (note 12) -- -- -- 2,373,485
Treasury stock held for deferred
compensation (note 12) (2,373,485) -- -- (2,373,485)
Cash dividends declared -- (506,100) -- (506,100)
Cash dividends on unallocated ESOP shares -- 38,717 -- 38,717
------------- --------------- -------------- -----------
Balance at September 30, 1999 (2,373,485) 26,959,913 (123,400) 71,615,181
============= =============== ============== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
24
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows
Years ended September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
1999 1998 1997
------------ ------------ -----------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $ 1,554,691 2,521,262 2,548,574
Adjustments to reconcile net income to net cash
provided (used) in operating activities:
Provision for loan losses 245,000 477,017 261,288
Depreciation 463,416 424,997 270,572
Deferred income tax expense (benefit) (1,138,000) (601,000) 139,000
Amortization of premiums and discounts, net (33,437) 24,419 (37,116)
Contribution of common shares to the
Foundation 3,000,000 -- --
Release of ESOP shares 429,951 -- --
Loan origination fees and unearned discounts
deferred, net of current amortization 61,389 2,221 104,658
Net loss on loans available for sale 603,844 118,633 15,520
Gain on sale of other real estate -- -- (21,288)
Securities losses, net -- 246,259 --
Proceeds from loans held for sale 39,802,903 27,635,212 9,165,706
Originations of loans held for sale (45,009,891) (34,609,326) (9,765,263)
Decrease (increase) in other assets 8,594 (307,657) 586,726
Increase in accrued interest receivable (844,546) (250,760) (133,747)
Increase (decrease) in other liabilities (1,515,495) 1,760,298 1,042,830
------------ ------------ -----------
Net cash provided (used)
in operating activities (2,371,581) (2,558,425) 4,177,460
------------ ------------ -----------
Cash flows from investing activities:
Proceeds from sale of FHLB stock 86,900 -- --
Purchase of FHLB stock -- (65,300) (35,500)
Purchases of investment securities held to
maturity (73,705,248) (32,614,244) (6,998,750)
Purchases of investment securities available for
sale (4,000,000) (2,002,500) --
Proceeds from sales of investment securities
available for sale -- 2,879,973 --
Proceeds from maturities of investment
securities available for sale 2,463,564 588,144 4,000,000
Proceeds from maturities of investment
securities held to maturity 19,705,436 25,900,000 6,107,200
Net increase in loans receivable 1,183,537 (139,715) (21,361,303)
Proceeds from disposal of real estate acquired in
settlement of loans -- -- 22,289
Purchases of premises and equipment (232,430) (1,166,544) (355,006)
------------ ------------ -----------
Net cash used in investing activities (54,498,241) (6,620,186) (18,621,070)
============ ============ ===========
</TABLE>
(Continued)
25
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Consolidated Statements of Cash Flows - Continued
Years ended September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
1999 1998 1997
----------- ---------- ------------
<S> <C> <C> <C>
Cash flows from financing activities:
Net increase (decrease) in deposits $(1,598,980) 6,353,112 19,633,862
Increase (decrease) in advance payments by
borrowers for property taxes and insurance (66,966) (87,860) 45,819
Advances from Federal Home Loan Bank 2,000,000 20,000,000 --
Repayments of advances from Federal Home
Loan Bank -- (1,000,000) --
Net proceeds from sale of common stock 46,247,361 -- --
Purchase of stock for ESOP (4,898,639) -- --
Dividends paid on common stock (232,806) -- --
----------- ---------- ------------
Net cash provided by financing
activities 41,449,970 25,265,252 19,679,681
----------- ---------- ------------
Net increase (decrease) in cash
and cash equivalents (15,419,852) 16,086,641 5,236,071
Cash and cash equivalents at beginning of year 31,077,054 14,990,413 9,754,342
----------- ---------- ------------
Cash and cash equivalents at end of year $15,657,202 31,077,054 14,990,413
=========== ========== ============
Payments are shown below for the following:
Interest $10,583,093 10,947,338 9,777,417
=========== ========== ============
Income taxes $ 1,586,748 2,301,000 866,300
=========== ========== ============
Noncash activities:
Deferred compensation to be settled in
Company's stock $ 2,373,485 -- --
=========== ========== ============
Cash dividends declared but not paid $ 234,577 -- --
=========== ========== ============
Cash dividends on unallocated ESOP shares $ 38,717 -- --
=========== ========== ============
Unrealized gains (losses) on available for
sale securities $ (359,000) 274,000 164,000
=========== ========== ============
Transfer from loans held for sale to loans
receivable $ -- -- 2,277,071
=========== ========== ============
</TABLE>
See accompanying notes to consolidated financial statements.
26
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(1) Significant Accounting Policies
(a) Organization and Description of Business
1st State Bancorp, Inc. (the "Company" or the "Parent") is a bank
holding company formed in connection with the April 1999
conversion (the "Conversion") of 1st State Bank, SSB from a North
Carolina-chartered mutual savings bank to a North Carolina-
chartered commercial bank, which now operates as a wholly owned
subsidiary of the Parent under the name of 1st State Bank (the
"Bank"). The Bank has one wholly owned subsidiary, First Capital
Services Company, LLC ("First Capital"). The Bank is primarily
engaged in the business of obtaining deposits and providing
mortgage, commercial and consumer loans to the general public.
First Capital is engaged primarily in the sale of annuities,
mutual funds and insurance products on an agency basis. The
principal activity of the Parent is ownership of the Bank.
(b) Basis of Presentation
The consolidated financial statements include the accounts of the
Parent, the Bank and the Bank's subsidiary, First Capital. All
significant intercompany transactions and balances are eliminated
in consolidation.
(c) Use of Estimates
The preparation of the consolidated financial statements in
conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect reported
amounts of assets and liabilities at the date of the financial
statements and the amounts of income and expenses during the
reporting period. Actual results could differ from those
estimates.
(d) Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents
include cash and interest-bearing overnight deposits with the
Federal Home Loan Bank ("FHLB") of Atlanta. At September 30, 1999
and 1998, interest-bearing overnight deposits were $7,246,167 and
$25,558,925, respectively.
(e) Investment Securities
Investment securities that the Company has the positive intent
and ability to hold to maturity are classified as held to
maturity and are reported at amortized cost. Investment
securities held for current resale are classified as trading
securities and are reported at fair value, with unrealized gains
and losses included in earnings. Investment securities not
classified either as securities held to maturity or trading
securities are classified as available for sale and reported at
fair value,
27 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
with net unrealized gains and losses net of related taxes
excluded from earnings and reported as accumulated other
comprehensive income (loss) within stockholders' equity. The
classification of investment securities as held to maturity,
trading or available for sale is determined at the date of
purchase.
Realized gains and losses from sales of investment securities are
determined based upon the specific identification method.
Premiums and discounts are amortized as an adjustment to yield
over the remaining lives of the securities using the level-yield
method.
Management periodically evaluates investment securities for other
than temporary declines in value and records any losses through
an adjustment to earnings.
(f) Loans Held For Sale
Loans held for sale are carried at the lower of cost or fair
value in the aggregate as determined by outstanding commitments
from investors or current investor yield requirements. Gains and
losses on loan sales are determined by the difference between the
selling price and the carrying value of the loans sold.
(g) Loans Receivable
Interest on loans, including impaired loans, that are
contractually ninety days or more past due is generally either
charged off or reserved through an allowance account. The
allowance is established by a charge to interest income equal to
all interest previously accrued. In certain circumstances,
interest on loans that are contractually ninety days or more past
due is not charged off or reserved through an allowance account
when management determines that the loan is both well secured and
in the process of collection. If amounts are received on loans
for which the accrual of interest has been discontinued, a
determination is made as to whether payments received should be
recorded as a reduction of the principal balance or as interest
income depending on management's judgment as to the
collectibility of principal. The loan is returned to accrual
status when, in management's judgment, the borrower has
demonstrated the ability to make periodic interest and principal
payments on a timely basis.
(h) Loan Origination Fees and Related Costs
Loan origination fees and certain direct loan origination costs
are deferred, and the net fee or cost is recognized as an
adjustment of the loan yield using the level-yield method over
the contractual life of the related loans.
28 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(i) Allowance for Loan Losses
The allowance for loan losses is established through provisions
for loan losses charged against income. Loans deemed to be
uncollectible are charged against the allowance for loan losses,
and subsequent recoveries, if any, are credited to the allowance.
Management's evaluation of the adequacy of the allowance is based
on a review of individual loans, historical loan loss experience,
the value and adequacy of collateral, and economic conditions in
the Company's market area. This evaluation is inherently
subjective as it requires material estimates, including the
amounts and timing of future cash flows expected to be received
on impaired loans that may be susceptible to significant change.
Various regulatory agencies, as an integral part of their
examination process, periodically review the Company's allowance
for loan losses. Such agencies may require the Company to
recognize changes to the allowance based on their judgments about
information available to them at the time of their examinations.
For all specifically reviewed loans for which it is probable that
the Company will be unable to collect all amounts due according
to the terms of the loan agreement, the Company determines
impairment by computing a fair value either based on discounted
cash flows using the loans' initial interest rate or the fair
value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogenous loans that are
collectively evaluated for impairment (such as residential
mortgage and consumer installment loans) are excluded from
specific impairment evaluation, and their allowance for loan
losses is calculated in accordance with the allowance for loan
losses policy described above.
(j) Real Estate Acquired in Settlement of Loans
Real estate acquired in settlement of loans by foreclosure or
deed in lieu of foreclosure is initially recorded at the lower of
cost (unpaid loan balance plus costs of obtaining title and
possession) or fair value less estimated costs to sell at the
time of acquisition. Subsequent costs directly related to
development and improvement of property are capitalized, whereas
costs relating to holding the property are expensed.
When the carrying value of real estate exceeds its fair value,
less cost to sell, an allowance for loss on real estate is
established and a provision for loss on real estate is charged to
other expenses. At September 30, 1999 and 1998, the Company had
no real estate acquired in settlement of loans.
29 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(k) Premises and Equipment
Premises and equipment are carried at cost less accumulated
depreciation. Depreciation is computed generally by the straight-
line method over the estimated useful lives of the related
assets. Estimated lives are 15 to 50 years for buildings and 3 to
15 years for furniture, fixtures and equipment.
(l) Income Taxes
Deferred income taxes are recognized for the future tax
consequences attributed to differences between the financial
statement carrying amounts of existing assets and liabilities and
their respective tax bases. Deferred tax assets and liabilities
are measured using enacted tax rates in effect for the year in
which the temporary differences are expected to be recovered or
settled. Deferred tax assets are reduced by a valuation allowance
if it is more likely than not that the tax benefits will not be
realized. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized as an adjustment to the income
tax expense in the period that includes the enactment date.
(m) Employee Stock Ownership Plan
The Company has an employee stock ownership plan (the"ESOP")
which covers substantially all of it employees. The ESOP
purchased shares of the Company's common stock after the
Conversion using funds from a loan by the Company to the ESOP.
The shares purchased by the ESOP are held in a suspense account
as collateral for loan, and are released from the suspense
account and allocated to participants as scheduled principal and
interest payments are made. The Company makes an annual
contribution to the ESOP in an amount sufficient to make the
scheduled principal and interest payments on the loan. The
Company records a charge to its income statement in an amount
equal to the fair value of the shares that are committed to be
released from the suspense account each period in accordance with
the terms of the ESOP and the related ESOP loan agreement.
(n) Earnings Per Share
Earnings per share computations have been made only for the
periods subsequent to the Conversion. Since the Company has no
potential dilutive common stock, there is no difference in the
computations of basic and diluted earnings per share. For
purposes of computing basic and diluted earnings per share,
weighted average shares outstanding excludes unallocated shares
that have not been committed to be released. The deferred
compensation obligation discussed in note 12 that is funded with
shares of the Company's common stock has no net impact on the
Company's earnings per share computations.
30 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The components of the earnings per share computation for 1999 are
as follows:
<TABLE>
<S> <C>
Net income (loss) for the period following the Conversion $ (303,630)
==================
Weighted average common shares outstanding 3,163,125
Less: Unallocated ESOP shares (237,149)
Weighted average shares outstanding for earnings per -----------------
share computation 2,925,976
==================
</TABLE>
(o) Comprehensive Income
On October 1, 1998, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 130, Reporting Comprehensive
Income. SFAS No. 130 establishes standards for reporting and
presentation of comprehensive income and its components in a full
set of financial statements. Comprehensive income consists of net
income and other comprehensive income and is presented in the
statements of stockholders' equity and comprehensive income. SFAS
No. 130 requires only additional disclosures in the consolidated
financial statements; it does not affect the Company's financial
position or results of operations. Prior year financial
statements have been reclassified to conform to the requirements
of SFAS No. 130.
The Company's other comprehensive income for the years ended
September 30, 1999, 1998 and 1997 and accumulated other
comprehensive income as of September 30, 1999 and 1998 are
comprised solely of unrealized gains and losses on investments in
available for sale securities. Other comprehensive income for the
years ended September 30, 1999, 1998 and 1997 follows:
<TABLE>
<CAPTION>
1999 1998 1997
-------------- --------------- ---------------
<S> <C> <C> <C>
Unrealized holding gains (losses) arising
during period, net of tax $ (216,400) 253,372 100,000
Less: reclassification adjustment for
realized gains (losses), net of tax -- (86,372) --
-------------- --------------- ---------------
Unrealized gains (losses) on securities, net
of applicable income taxes $ (216,400) 167,000 100,000
============== =============== ===============
</TABLE>
(p) Disclosures Regarding Segments
The Company adopted SFAS No. 131, Disclosures about Segments of
an Enterprise and Related Information, in 1999. SFAS No. 131
establishes standards for the way that public businesses report
information about operating segments in annual financial
statements and requires that those enterprises report selected
information about operating segments in interim financial reports
issued to shareholders. It also establishes standards for related
disclosures about products and services, geographic areas and
other major customers. The Company adopted SFAS No. 131
31 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
without any impact on the consolidated financial statements as
the chief operating decision-maker reviews the results of
operations of the Company and its subsidiaries as a single
enterprise.
(q) Reclassifications
Certain amounts in the 1998 and 1997 consolidated financial
statements have been reclassified to conform with the
presentation adopted in 1999. Such reclassifications did not
change net income or net worth as previously reported.
(2) Conversion to stock Form of Ownership
On August 11, 1998, the Board of Directors of the Bank adopted the Plan
of Conversion (the "Plan"). Immediately upon completion of the
Conversion, 1st State Bank converted from a state chartered mutual
savings bank to a state chartered stock savings bank and subsequently
converted from a state chartered stock savings bank to a state chartered
commercial bank and became the wholly-owned subsidiary of 1st State
Bancorp, Inc. The Company was incorporated in November 1998 as a Virginia
corporation to serve as the Bank's holding company, and prior to April
23, 1999 had no operations and insignificant assets and liabilities. In
addition, pursuant to the Plan of Conversion, the Company sold 2,975,625
shares of its $.01 par value common stock for $16.00 per share. Gross
proceeds of the offering totaled $47,610,000, and expenses associated
with the Conversion totaled approximately $1,362,644.
In addition, pursuant to the Plan, the Company established 1st State Bank
Foundation, Inc. (the "Foundation"). In connection with the Conversion,
187,500 additional shares of common stock of the Company (valued at
$3,000,000) were issued and donated to the Foundation. The Foundation is
dedicated to charitable and educational purposes within the Bank's market
area.
32 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(3) INVESTMENT SECURITIES
Investment securities consist of the following:
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
-------------- ------------- ------------- -------------
<S> <C> <C> <C> <C>
September 30, 1999
Held to maturity:
U.S. Government and
agency securities $ 81,160,388 30,439 (1,717,664) 79,473,163
Other 3,000,000 -- -- 3,000,000
Collateralized mortgage
obligations 67,955 339 -- 68,294
-------------- ------------- ------------ -------------
Total $ 84,228,343 30,778 (1,717,664) 82,541,457
============== ============= ============ =============
Available for sale:
U.S. Government and
agency securities $ 5,999,724 6,711 (139,427) 5,867,008
Marketable equity securities 3,993,081 -- (133,716) 3,859,365
FHLMC mortgage-backed
securities 460,425 17,259 (475) 477,209
GNMA mortgage-backed
securities 788,736 43,648 -- 832,384
-------------- ------------- ------------ -------------
Total $ 11,241,966 67,618 (273,618) 11,035,966
============== ============= ============ =============
</TABLE>
33 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
-------------- ------------- ------------ -----------
<S> <C> <C> <C> <C>
September 30, 1998
Held to maturity:
U.S. Government and
agency securities $ 30,087,456 219,742 -- 30,307,198
Collateralized mortgage
obligations 107,638 611 -- 108,249
-------------- ------------- ------------ -----------
Total $ 30,195,094 220,353 -- 30,415,447
============== ============= ============ ===========
Available for sale:
U.S. Government and
agency securities $ 4,001,142 42,363 (232) 4,043,273
Marketable equity securities 3,993,081 13,120 -- 4,006,201
FHLMC mortgage-backed
securities 648,029 13,550 -- 661,579
GNMA mortgage-backed
securities 1,063,277 83,450 -- 1,146,727
-------------- ------------- ------------ -----------
Total $ 9,705,529 152,483 (232) 9,857,780
============== ============= ============ ===========
</TABLE>
Following is a summary of investments in debt securities by maturity at
September 30, 1999. Marketable equity securities, mortgage-backed securities and
collateralized mortgage obligations do not have single maturity dates and are
not included below.
<TABLE>
<CAPTION>
Amortized Fair
Cost Value
------------- ------------
<S> <C> <C>
Held to maturity:
Within one year $ 14,996,672 14,961,666
After one but within five years 40,420,971 39,728,017
After five but within ten years 28,742,745 27,783,480
------------- ------------
Total $ 84,160,388 82,473,163
============= ============
Available for sale:
Within one year $ 1,000,087 1,000,546
After one but within five years 4,999,637 4,866,462
------------- ------------
Total $ 5,999,724 5,867,008
============= ============
</TABLE>
34 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
There were no sales of securities during 1999. During the year ended
September 30, 1998, the Company recognized gross gains on the sale of
investment securities available for sale of approximately $23,000. The
Company also recognized a loss of approximately $269,259 on the write-down
of marketable equity securities for an other than temporary decline in
value during the year ended September 30, 1998.
At September 30, 1999, U.S. Government securities with an amortized cost of
approximately $11,700,000 were pledged as collateral for certain deposit
accounts.
(4) Loans Receivable
Loans receivable are summarized as follows:
<TABLE>
<CAPTION>
September 30,
1999 1998
--------------------- --------------------
<S> <C> <C>
Real estate loans:
One-to-four family residential $ 90,883,341 100,891,490
Commercial real estate and other properties 40,815,741 38,763,299
Home equity and property improvement 18,887,854 16,877,066
Construction loans 16,496,553 18,571,550
-------------------- -------------------
Total real estate loans 167,083,489 175,103,405
-------------------- -------------------
Other loans:
Commercial 32,501,539 25,189,613
Consumer 6,658,253 6,309,951
-------------------- -------------------
Total other loans 39,159,792 31,499,564
-------------------- -------------------
Less:
Loans in process (7,288,580) (6,446,324)
Net deferred loan origination fees (207,984) (146,595)
-------------------- -------------------
Net loans receivable before allowance for loan losses 198,746,717 200,010,050
Allowance for loan losses (3,454,373) (3,227,775)
-------------------- -------------------
Loans receivable, net $ 195,292,344 196,782,275
==================== ===================
</TABLE>
At September 30, 1999 and 1998 and during the years then ended there are no
loans considered to be impaired.
35 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The Company grants residential, construction, commercial real estate, home
equity and other loans to customers primarily throughout its market area of
Alamance County which includes the cities of Burlington, Mebane and Graham.
As reflected in the summary of loans receivable at September 30, 1999, the
largest component of the Company's loan portfolio consists of lower-risk,
one-to-four family residential loans. The higher risk components of the loan
portfolio consist of real estate construction loans, commercial real estate
loans and commercial loans for which repayment is dependent on the current
real estate market and general economic conditions. The consumer portfolio
generally consists of smaller loans to individuals in the Company's primary
market area and can also be affected by general economic conditions.
The Company's nonaccrual loans amounted to approximately $366,000 and
$263,000 at September 30, 1999 and 1998, respectively. If the Company's
nonaccrual loans had been current in accordance with their original terms,
gross interest income of approximately $27,000, $10,100 and $27,300 would
have been recorded for the years ended September 30, 1999, 1998 and 1997,
respectively. Interest income on these loans included in net income was
approximately $12,800, $15,000 and $15,700 for 1999, 1998 and 1997,
respectively.
Loans serviced for others at September 30, 1999 and 1998 were approximately
$35,000,000 and $37,000,000, respectively. Mortgage servicing rights were
not material for any of the periods presented.
The Company grants residential, construction, commercial and consumer loans
to its officers, directors, and employees for the financing of their personal
residences and for other personal purposes. The Company also offers
commercial loans to companies affiliated with directors. These loans are made
in the ordinary course of business and, in management's opinion, are made on
substantially the same terms, including interest rates and collateral,
prevailing at the time for comparable transactions with other persons and
companies. Management does not believe these loans involve more than the
normal risk of collectibility or present other unfavorable features.
The following is a summary of the activity of loans outstanding to certain
executive officers, directors and their affiliates for the year ended
September 30:
<TABLE>
<CAPTION>
1999 1998
------------- -------------
<S> <C> <C>
Balance at September 30 $ 7,519,705 7,495,243
New loans 2,217,826 1,412,420
Repayments (1,522,720) (1,387,958)
-------------- ------------
Balance at September 30 $ 8,214,811 7,519,705
============== ============
</TABLE>
36
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The Company is a party to financial instruments with off-balance sheet risk
including commitments to extend credit under existing lines of credit and
commitments to sell loans. These instruments involve, to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized
in the consolidated balance sheets.
Off-balance sheet financial instruments whose contract amount represents
credit and interest rate risk are summarized as follows:
<TABLE>
<CAPTION>
September 30,
1999 1998
---------------- ----------------
<S> <C> <C>
Commitments to originate new loans $ 6,389,428 6,650,700
Commitments to originate new loans held for sale -- 833,411
Unfunded commitments to extend credit under existing equity
line and commercial lines of credit 43,915,380 40,444,057
Commercial letters of credit 468,750 505,000
Commitments to sell loans held for sale 486,985 1,863,591
</TABLE>
Commitments to originate new loans or 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. Since many of the
commitments are expected to expire without being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. 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.
Commitments to sell loans held for sale are agreements to sell loans to a
third party at an agreed upon price. At September 30, 1999, the aggregate
fair value of these commitments exceeded the book value of the loans to be
sold.
37 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(5) Allowance for Loan Losses
The following is a summary of the activity in the allowance for loan
losses:
<TABLE>
<CAPTION>
Years ended September 30,
1999 1998 1997
---------------- --------------- -----------------
<S> <C> <C> <C>
Balance at beginning of year $ 3,227,775 2,753,793 2,495,677
Provision for loan losses 245,000 477,017 261,288
Charge-offs (22,661) (3,731) (7,548)
Recoveries 4,259 696 4,376
---------------- --------------- -----------------
Net charge-offs (18,402) (3,035) (3,172)
---------------- --------------- -----------------
Balance at end of year $ 3,454,373 3,227,775 2,753,793
================ =============== =================
</TABLE>
(6) Investment in FHLB Stock
As a member of the FHLB of Atlanta, the Company is required to maintain an
investment in the stock of the FHLB. This stock is carried at cost since it
has no quoted fair value. See also note 9.
(7) Premises and Equipment
Premises and equipment consist of the following:
<TABLE>
<CAPTION>
September 30,
1999 1998
---------------- ----------------
<S> <C> <C>
Land $ 2,231,450 2,231,450
Building and improvements 5,193,991 5,166,911
Furniture and equipment 4,171,003 3,987,664
---------------- ----------------
11,596,444 11,386,025
Less accumulated depreciation (4,314,083) (3,872,678)
---------------- ----------------
Total $ 7,282,361 7,513,347
================ ================
</TABLE>
(Continued)
38
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(8) Deposit Accounts
A comparative summary of deposit accounts follows:
<TABLE>
<CAPTION>
September 30, 1999
---------------------------------------
Weighted
Balance Average Rate
----------------- -------------------
<S> <C> <C>
Transactions accounts:
Noninterest bearing accounts $ 8,219,412 --%
Interest bearing accounts:
Checking accounts 26,093,482 1.84%
Money market accounts 14,770,004 3.62%
Passbook and statement savings accounts 27,276,136 2.36%
Certificates of deposit 157,735,701 4.85%
----------------- -------------------
Total $ 234,094,735 3.98%
================= ===================
<CAPTION>
September 30, 1998
---------------------------------------
Weighted
Balance Average Rate
----------------- -------------------
<S> <C> <C>
Transactions accounts:
Noninterest bearing accounts $ 8,623,397 --%
Interest bearing accounts:
Checking accounts 25,080,180 2.29%
Money market accounts 13,238,368 3.93%
Passbook and statement savings accounts 28,091,013 2.84%
Certificates of deposit 160,660,757 5.28%
----------------- -------------------
Total $ 235,693,715 4.40%
================= ===================
</TABLE>
Time deposits with balances of $100,000 or greater totaled approximately
$37,400,000 and $29,700,000 at September 30, 1999 and 1998, respectively.
(Continued)
39
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
At September 30, 1999, the scheduled maturities of certificate accounts
were as follows:
<TABLE>
<S> <C>
Year ending:
2000 $ 130,681,176
2001 15,429,830
2002 4,487,983
2003 4,461,142
2004 2,675,570
----------------
Total $ 157,735,701
================
</TABLE>
Interest expense on deposit accounts is summarized below:
<TABLE>
<CAPTION>
Years ended September 30,
1999 1998 1997
---------------- -------------- ------------
<S> <C> <C> <C>
Interest-bearing transaction accounts $ 998,748 1,004,155 898,330
Passbook and statement savings accounts 869,549 797,752 815,816
Certificates of deposit accounts 7,671,235 8,529,092 8,028,892
---------------- -------------- ------------
Total $ 9,539,532 10,330,999 9,743,038
================ ============== ============
</TABLE>
(9) Advances From Federal Home Loan Bank Of Atlanta
Advances from the FHLB of Atlanta at September 30, 1999 and 1998 totaled
$22,000,000 and $20,000,000, respectively, at a weighted average interest
rate of 5.42% and 5.39%, respectively. The $20,000,000 advance will mature
on February 13, 2008 and is callable on February 13, 2003. The $2,000,000
advance is a variable rate daily advance which will mature on September 25,
2000. At September 30, 1999, the Bank had additional credit availability
from the FHLB of $48,500,000.
At September 30, 1999 and 1998, the Company had pledged all of its stock in
the FHLB (see note 6) and entered into a security agreement with a blanket
floating lien pledging all of its real estate loans to secure potential
borrowings. Under an agreement with the FHLB, the Company must have
unencumbered collateral with principal balances, when discounted at 75% of
the unpaid principal, at least equal to 100% of the Company's FHLB
advances.
(Continued)
40
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(10) Regulatory Capital and Other Matters
(a) Capital Adequacy
The Company is regulated by the Board of Governors of the Federal
Reserve Board ("FRB") and is subject to securities registration and
public reporting regulations of the Securities and Exchange
Commission.
The Bank is regulated by the Federal Deposit Insurance Corporation
("FDIC") and the North Carolina Commissioner of Banks
("Commissioner"). The Bank must comply with the capital requirements
of the FDIC and the Commissioner. The FDIC requires the Bank to
maintain minimum ratios of Tier I capital to risk-weighted assets and
total capital to risk-weighted assets of 4% and 8%, respectively. To
be "well capitalized," the FDIC requires ratios of Tier I capital to
risk-weighted assets and total capital to risk-weighted assets of 6%
and 10%, respectively. Tier I capital consists of total stockholders'
equity calculated in accordance with generally accepted accounting
principles less certain adjustments, and Total Capital is comprised of
Tier I capital plus certain adjustments, the only one of which is
applicable to the Company is the allowance for loan losses, subject to
certain limitations. Risk-weighted assets reflect the Bank's on- and
off-balance sheet exposures after such exposures have been adjusted
for their relative risk levels using formulas set forth in FDIC
regulations. The Bank is also subject to a leverage capital
requirement, which calls for a minimum ratio of Tier I capital (as
defined above) to quarterly average total assets of 3%, and a ratio of
5% to be "well capitalized."
As summarized below, at September 30, 1999 and 1998, the Bank was in
compliance with all of the aforementioned capital requirements. At
September 30, 1999, the FDIC categorized the Bank as "well
capitalized" under the regulatory framework for prompt corrective
action.
41 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
As of September 30:
Minimum Ratios
----------------------------------
To Be "Well
Capital Amount Ratio For Capital Capitalized" for
------------------ ------------------ Adequacy Prompt Corrective
1999 1998 1999 1998 Purposes Action Purposes
-------- -------- ------ ------ -------- -----------------
(in thousands)
<S> <C> <C> <C> <C> <C> <C>
Tier I Capital (to risk-
weighted assets) $ 71,535 25,873 36.58% 14.53% 4.00% 6.00%
Total Capital
(to risk-weighted
assets) 73,992 28,112 37.83% 15.78% 8.00% 10.00%
Leverage - Tier I capital
(to average assets) 71,535 25,873 22.09% 9.13% 4.00% 5.00%
Total Capital - (to
fourth quarter
average assets) 73,992 28,112 22.85% 9.92% 3.00% 5.00%
</TABLE>
(b) Liquidation Account
At the time of Conversion, the Bank established a liquidation account in
an amount equal to its September 30, 1998 net worth for the benefit of
eligible account holders who continue to maintain their accounts at the
Bank after the Conversion. The liquidation account will be reduced
annually to the extent eligible account holders have reduced their
qualifying deposits. Subsequent increases will not restore an eligible
account holder's interest in the liquidation account. In the event of a
complete liquidation of the Bank, all remaining eligible account holders
would be entitled, after all payments to creditors, to a distribution
from the liquidation account before any distribution to stockholders.
Dividends cannot be paid from this liquidation account.
(c) Dividends
Subject to applicable law, the Board of Directors of the Bank and the
Company may each provide for the payment of dividends. Subject to
regulations of the Commissioner and the FDIC, the Bank may not declare
or pay a cash dividend on any of its common stock if its equity would
thereby be reduced below either the aggregate amount then required for
the liquidation account or the minimum regulatory capital requirements
imposed by regulations. In addition, regulators of the Bank may prohibit
the payment of dividends by the Bank to the Company if they determine
such payment will constitute an unsafe or unsound practice. The Company
has similar dividend limitations imposed by the FRB such that it is
unable to declare a dividend that would reduce its capital below
regulatory capital limitations or constitute an unsafe or unsound
practice.
42 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(11) Income Taxes
Components of income tax expense (benefit) consist of the following:
<TABLE>
<CAPTION>
Year Ended September 30,
1999 1998 1997
----------- --------- ---------
<S> <C> <C> <C>
Current:
Federal $ 1,840,000 1,804,000 1,221,100
State 168,000 159,000 87,000
----------- --------- ---------
2,008,000 1,963,000 1,308,100
----------- --------- ---------
Deferred:
Federal (1,076,000) (486,000) 139,000
State (62,000) (115,000) --
----------- --------- ---------
(1,138,000) (601,000) 139,000
----------- --------- ---------
Total $ 870,000 1,362,000 1,447,100
=========== ========= =========
</TABLE>
Other assets include current income taxes receivable of $243,000 and
$251,000 at September 30, 1999 and 1998, respectively.
A reconciliation of reported income tax expense for the years ended
September 30 1999 and 1998, to the amount of the income tax expense
computed by multiplying income before income taxes by the statutory federal
income tax rate of 34% follows:
<TABLE>
<CAPTION>
1999 1998 1997
---------- --------- ---------
<S> <C> <C> <C>
Income tax expense at statutory rate $ 824,000 1,320,000 1,359,000
Increase in income taxes resulting from:
State income taxes, net of federal benefit 70,000 29,000 57,000
Other (24,000) 13,000 31,100
---------- --------- ---------
Income tax expense $ 870,000 1,362,000 1,447,100
========== ========= =========
</TABLE>
43 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The significant components of deferred tax assets (liabilities) which are
included in other assets, at September 30, 1999 and 1998, respectively, are:
<TABLE>
<CAPTION>
1999 1998
----------- ---------
<S> <C> <C>
Deferred tax assets:
Allowance for loan losses $ 1,272,000 1,160,000
Deferred compensation 994,000 817,000
Other than temporary declines in value of investment
securities available for sale 104,000 105,000
Unrealized losses on investments securities available for sale 82,600 --
Accrued ESOP expense 167,000 --
Carryforward of charitable contributions 767,000 --
Other 1,000 4,000
----------- ---------
Total gross deferred tax assets 3,387,600 2,086,000
----------- ---------
Less valuation allowance -- --
----------- ---------
Deferred tax assets net of valuation allowance 3,387,600 2,086,000
----------- ---------
Deferred tax liabilities:
Depreciable basis of fixed assets (434,000) (378,000)
Tax basis of FHLB stock (180,000) (192,000)
Net loan fees (205,000) (191,000)
Unrealized gains on investment securities available for sale -- (59,000)
Other (42,000) (19,000)
----------- ---------
Total gross deferred tax liabilities (861,000) (839,000)
----------- ---------
Net deferred tax asset $ 2,526,600 1,247,000
=========== =========
</TABLE>
There is no valuation allowance for deferred tax assets as it is management's
belief that realization of the deferred tax assets is more likely than not
based upon the Company's history of taxable income and estimates of future
taxable income.
The Company is permitted under the Internal Revenue Code to deduct an annual
addition to a reserve for bad debts in determining taxable income, subject to
certain limitations. This addition differs significantly from the provisions
for losses for financial reporting purposes. Under generally accepted
accounting principles, the Company is not required to provide a deferred tax
liability for the tax effect of additions to the tax bad debt reserve through
1987, the base year. Retained income at September 30, 1999, includes
approximately $4,188,000 for which no provision for federal income tax has
been made. These amounts represent allocations of income to bad debt
deductions for tax purposes only. Reductions of such amounts for purposes
other than tax bad debt losses could create income for tax
44 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
purposes in certain remote instances, which would be subject to the then
current corporate income tax rate.
(12) Employee Benefit Plans
(a) 401(k) Plan
The Bank sponsors a 401(k) plan that covers all eligible employees.
The Bank matches 100% of employee contributions, with the Bank's
contribution limited to 3% of each employee's salary. Matching
contributions are funded when accrued. Matching expense totaled
approximately $49,000 in 1999, $45,000 in 1998, and $50,000 in 1997.
(b) Money Purchase Pension Plan
The Bank previously had a defined contribution money purchase pension
plan covering substantially all of its employees. The Bank's policy
was to fund retirement costs as accrued. Contributions to the plan
were determined based upon specified percentages of annual salaries.
In conjunction with the Conversion, the defined contribution
retirement plan was terminated effective as of September 30, 1998 and
balances were distributed to participants. There was no gain or loss
upon the termination of the plan. There was no retirement expense
during 1999. Retirement expense totaled approximately $146,000 in 1998
and $157,000 in 1997.
(c) Directors' and Executive Officers' Deferred Compensation Plan
Directors and certain executive officers participate in a deferred
compensation plan which was approved by the Board of Directors on
September 24, 1997. This plan generally provides for fixed payments
beginning after the participant retires. The plan provided for past
service credits on September 24, 1997 for prior years' service up to
nine years. Annual credits are made on September 30 provided that
annual credits shall not be made for the benefit of non-employee
directors after 12 years of service credits. Each participant is fully
vested in his account balance under the plan. In future years,
directors may elect to defer directors' fees and executive officers
may defer 25% of their salary and 100% of bonus compensation.
Prior to the Conversion, amounts deferred by each participant
accumulated interest at a rate equal to the highest rate of interest
paid on the Bank's one-year certificates of deposit. In connection
with the Conversion, participants in the Plan were given the
opportunity to prospectively elect to have their deferred compensation
balance earn a rate of return equal to the total return on the
Company's common stock. All participants elected this option
concurrent with the Conversion, so the Company purchased common stock
in the Conversion on behalf of these participants to fund this
obligation.
45 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The common stock purchased by the Company for this deferred
compensation obligation is maintained in a rabbi trust (the "Trust")
on behalf of the participants. The assets of the Trust are subject to
the claims of general creditors of the Company. Dividends payable on
the common shares held by the Trust will be reinvested in additional
shares of common stock of the Company. Since the deferred compensation
plan does not provide for diversification of the Trust's assets and
can only be settled with a fixed number of shares of the Company's
common stock, the deferred compensation obligation is classified as a
component of stockholders' equity and the common stock held by the
Trust is classified as treasury stock. Subsequent changes in the fair
value of the common stock are not reflected in earnings or
stockholders' equity of the Company.
The expense related to these plans for the years ended September 30,
1999, 1998 and 1997 was $289,381, $986,663 and $1,085,000,
respectively, and it is included in compensation expense.
(d) ESOP
The ESOP is a noncontributory retirement plan adopted by the Company
effective October 1, 1998 which covers all eligible employees. The
ESOP purchased 253,050 shares of common stock with the proceeds of a
loan from the Company in the amount of $4,898,639. The Bank makes
annual cash contributions to the ESOP in an amount sufficient for the
ESOP to make scheduled payments on the note payable to the Company.
The note payable has a term of 11 years, bears interest at prime and
requires annual payments. The note is secured by the stock purchased
by the ESOP and is not guaranteed by the Bank.
As the note is repaid, shares are released from collateral based on
the proportion of the payment in relation to total payments required
to be made on the loan. The shares released are allocated to
participants based upon compensation on September 30. Benefits under
the ESOP vest 20% per year beginning with the third year of service.
Up to five years of service has been credited for employment before
October 1, 1998.
Compensation expense is determined by multiplying the per share market
price of the Company's stock at the time the shares are committed to
be released by the number of shares to be released. The Company
recognized $429,954 in compensation expense related to the ESOP for
the year ended September 30, 1999.
The cost of the shares not yet committed to be released from
collateral is shown as a reduction of stockholders' equity.
Uncommitted shares are not considered as outstanding shares for
computation of earnings per share. Dividends on unallocated ESOP
shares are reflected as a reduction in the note payable and not as a
reduction in retained earnings.
At September 30, 1999, a total of 22,162 shares have been committed to
be released and there were 230,888 of unallocated ESOP shares with a
market value of approximately $4,500,000.
46 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(13) Leasing Arrangements
Rental expense was approximately $29,500 and $33,000 for the years ended
September 30, 1999 and 1998, respectively. All leases are accounted for as
operating leases. Minimum annual rents under noncancelable operating leases
with remaining terms in excess of one year at September 30, 1999 are as
follows:
<TABLE>
<CAPTION>
Office
Properties
----------
Year ending September 30:
<S> <C>
2000 $ 17,250
2001 18,000
2002 18,000
2003 18,000
2004 18,000
Thereafter 109,500
----------
Total $ 198,750
==========
</TABLE>
(14) Fair Value of Financial Instruments
SFAS No. 107, "Disclosures about Fair Value of Financial Instruments,"
requires a company to disclose the fair value of its financial instruments,
whether or not recognized in the balance sheet, where it is practical to
estimate that value.
The fair value estimates are made at a specific point in time based on
relevant market information about the financial instrument. These estimates
do not reflect any premium or discount that could result from offering for
sale at one time the Company's entire holding of a particular financial
instrument. In cases where quoted market prices are not available, fair
value estimates are based on judgments regarding current economic
conditions, risk characteristics of various financial instruments, and
other factors. These estimates are subjective in nature and involve
uncertainties and matters of significant judgment and, therefore, cannot be
determined with precision. Changes in assumptions could significantly
affect the estimates. In addition, the tax ramifications related to the
realization of the unrealized gains and losses can have a significant
effect on fair value estimates and have not been considered in the
estimates. Finally, the fair value estimates presented herein are based on
pertinent information available to management as of September 30, 1999 and
1998, respectively. Such amounts have not been comprehensively revalued for
purposes of these financial statements since those dates and, therefore,
current estimates of fair value may differ significantly from the amounts
presented herein.
47 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments:
(a) Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash and cash
equivalents approximate those assets' fair values.
(b) Investment Securities
Fair values were based on quoted market prices, where available. If
quoted market prices were not available, fair values were based on
quoted market prices of comparable instruments.
(c) Loans Receivable
The carrying values of variable-rate loans and other loans with short-
term characteristics were considered to approximate the fair values. For
other loans, the fair values were calculated using discounted cash flow
analyses, using interest rates currently being offered for loans with
similar terms and credit quality.
(d) Deposit Accounts
The fair value of deposits with no stated maturity, such as noninterest-
bearing accounts, interest-bearing checking accounts, money market
accounts, passbook and statement savings, was, by definition, equal to
the amount payable on demand as of September 30, 1999 and 1998,
respectively. The fair value of certificates of deposit was estimated
using discounted cash flow analyses, using interest rates currently
offered for deposits of similar remaining maturities.
(e) Advances From the FHLB
The fair value of advances from the FHLB was estimated using discounted
cash flow analyses, using interest rates currently offered for advances
of similar remaining maturities.
48 (Continued)
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
The estimated fair values of financial instruments are as follows:
<TABLE>
<CAPTION>
September 30, 1999
--------------------------------
Carrying Estimated
Value Fair Value
------------ ------------
<S> <C> <C>
Financial Assets:
Cash and cash equivalents $ 15,657,202 15,657,202
Investment securities 95,264,309 93,577,423
Loans held for sale 12,143,063 12,143,063
Loans receivable, net of allowance for loan losses 195,292,344 192,897,862
Federal Home Loan Bank stock 1,259,600 1,259,600
============ ============
Financial Liabilities:
Deposit accounts $234,094,735 234,128,858
Advances from the Federal Home Loan Bank 22,000,000 19,881,707
============ ============
</TABLE>
<TABLE>
<CAPTION>
September 30, 1998
--------------------------------
Carrying Estimated
Value Fair Value
------------ ------------
<S> <C> <C>
Financial Assets:
Cash and cash equivalents $ 31,077,054 31,077,054
Investment securities 40,052,874 40,273,227
Loans held for sale 7,539,919 8,192,660
Loans receivable, net of allowance for loan losses 196,782,275 201,783,429
Federal Home Loan Bank stock 1,346,500 1,346,500
============ ============
Financial Liabilities:
Deposit accounts $235,693,715 235,904,989
Advances from the Federal Home Loan Bank 20,000,000 21,038,755
============ ============
</TABLE>
At September 30, 1999 and 1998, the Company had outstanding commitments to
originate new loans and to extend credit. These off-balance sheet financial
instruments were exercisable at the market rate prevailing at the date the
underlying transaction will be completed and, therefore, they were deemed to
have no current fair market value.
SFAS No. 107 excludes certain financial instruments and all non-financial
instruments from its disclosure requirements. The disclosures do not include
premises and equipment and certain intangible assets, such as customer
relationships. Accordingly, the aggregate fair value amounts presented above do
not represent the underlying value of the Company.
(Continued)
49
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(15) Parent Company Financial Data
Condensed financial information for 1st State Bancorp, Inc. is as follows:
<TABLE>
<CAPTION>
Condensed Balance Sheet
1999
------------
<S> <C>
Assets:
Cash and cash equivalents $ 4,280,586
Investment securities:
Held to maturity (fair value of $14,961,666) 14,996,672
Due from bank subsidiary 4,898,639
Investment in bank subsidiary 47,662,082
Accrued interest receivable 200,811
Other 22,474
------------
Total assets $ 72,061,264
============
Liabilities and stockholders' equity:
Accrued taxes and other liabilities $ 446,083
Stockholders' equity 71,615,181
------------
Total liabilities and stockholders' equity $ 72,061,264
============
Condensed Statement of Income
Interest on loan from bank subsidiary $ 161,118
Interest on investment securities 271,056
Interest on overnight deposits 142,776
------------
Total income 574,950
Operating expenses 36,467
------------
Income before income taxes 538,483
Income tax expense 195,000
------------
Income before equity in undistributed net income of subsidiary 343,483
Equity in undistributed net income of bank subsidiary 1,211,208
------------
Net income $ 1,554,691
============
</TABLE>
(Continued)
50
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
<TABLE>
<CAPTION>
Condensed Statement of Cash Flows
1999
--------------
<S> <C>
Cash flows from operating activities:
Net income $ 1,554,691
Adjustments to reconcile net income to net cash
provided by operating activities:
Undistributed earnings of bank subsidiary (1,211,208)
Contribution to charitable Foundation 3,000,000
Amortization of premiums and discounts, net (32,306)
Increase in accrued interest receivable (200,811)
Increase in other assets (22,474)
Increase in other liabilities 211,506
--------------
Net cash provided by operating activities 3,299,398
Cash flows from investing activities:
Purchases of held-to-maturity investment securities (16,964,366)
Maturities of held-to-maturity investment securities 2,000,000
--------------
Net cash used by investing activities (14,964,366)
Cash flows from financing activities:
Net proceeds from issuance of common stock 46,247,361
Purchase of common stock for ESOP (4,898,639)
Capital contribution to 1st State Bank (25,170,362)
Cash dividends paid on common stock (232,806)
--------------
Net cash provided by financing activities 15,945,554
--------------
Net increase in cash and cash equivalents 4,280,586
Cash and cash equivalents at beginning of year --
Cash and cash equivalents at end of year $ 4,280,586
==============
Supplemental disclosure of cash flow information:
Cash paid during the year for income taxes $ 20,000
==============
Supplemental disclosure of noncash transactions:
Cash dividends declared but not paid $ 234,577
==============
Cash dividends on unallocated ESOP shares $ 38,717
==============
</TABLE>
(Continued)
51
<PAGE>
1ST STATE BANCORP, INC. AND SUBSIDIARY
Notes to Consolidated Financial Statements
September 30, 1999, 1998 and 1997
(16) Quarterly Financial Data (Unaudited)
Summarized unaudited quarterly financial data for the year ended September
30, 1999 is as follows:
<TABLE>
<CAPTION>
First Second Third Fourth
Quarter Quarter Quarter Quarter
--------- --------- ----------- ---------
<S> <C> <C> <C> <C>
Operating Summary:
Interest income $5,123,743 5,189,499 5,468,573 5,691,793
Interest expense 2,845,606 2,708,531 2,556,327 2,529,429
Net interest income 2,278,137 2,480,968 2,912,246 3,162,364
Provision for loan losses 60,000 60,000 60,000 65,000
Net interest income after provision
for loan losses 2,218,137 2,420,968 2,852,246 3,097,364
Other income 665,231 376,416 183,667 428,351
Other expense 1,718,600 1,477,913 4,834,615 1,786,561
Income before income tax expense 1,164,768 1,319,471 (1,798,702) 1,739,154
Income taxes 414,000 453,000 (621,000) 624,000
Net income 750,768 866,471 (1,177,702) 1,115,154
Per share data:
Earnings/(loss) - basic and diluted -- -- (0.48) 0.38
</TABLE>
Summarized unaudited quarterly financial data for the year ended
September 30, 1998 is as follows:
<TABLE>
<CAPTION>
First Second Third Fourth
Quarter Quarter Quarter Quarter
---------- --------- --------- ---------
<S> <C> <C> <C> <C>
Operating Summary:
Interest income $4,982,718 5,037,061 5,206,681 5,482,055
Interest expense 2,620,305 2,709,895 2,857,615 2,883,623
Net interest income 2,362,413 2,327,166 2,349,066 2,598,432
Provision for loan losses 60,000 60,000 60,000 297,017
Net interest income after provision
for loan losses 2,302,413 2,267,166 2,289,066 2,301,415
Other income 391,338 485,867 402,957 217,368
Other expense 1,496,703 1,465,804 1,514,838 2,296,983
Income before income tax expense 1,197,048 1,287,229 1,177,185 221,800
Income taxes 439,000 465,000 417,000 41,000
Net income 758,048 822,229 760,185 180,800
</TABLE>
52
<PAGE>
BOARD OF DIRECTORS
<TABLE>
<S> <C> <C>
James C. McGill Richard C. Keziah Richard H. Shirley
President and Chief Executive Officer of President of Monarch Hoisery Mills, Inc. President of Dick Shirley Chevrolet, Inc.
1st State Bancorp, Inc. and 1st State
Bank James G. McClure Virgil L. Stadler
President of Green & McClure, a retail Vice President of Stadler Country
James A. Barnwell, Jr. furniture store Hams, Inc.
President of Huffman Oil Co., Inc.
T. Scott Quakenbush
Bernie C. Bean Retired
Retired
</TABLE>
1ST STATE BANK OFFICERS
<TABLE>
<S> <C> <C>
James C. McGill A. Christine Baker Fairfax C. Reynolds
President and Chief Executive Officer Executive Vice President, Secretary and Executive Vice President
Treasurer
Frank Gavigan Dan Hansell Theresa L. Joyce
Senior Vice President Manager, First Capital Services, LLC Vice President
Robert W. Malburg, Jr. William E. Swing, Jr. R. Hoyle Vickrey
Vice President Vice President Vice President
Gail M. Barnette L. Michael Dunning Mona S. Gunn
Assistant Vice President Assistant Vice President Assistant Vice President
Julie F. Miller H. Dean Rainey Sherry M. Stewart
Assistant Vice President Assistant Vice President Assistant Vice President
Patty G. Blaetz Myra P. Cathey Michelle N. Isley
Commercial Credit Officer Bank Operations and Security Officer Consumer Credit Officer
Diane P. Jeffries Glenda S. Madren Sharon S. Oakley
Branch Officer Assistant Secretary Branch Officer
</TABLE>
OFFICE LOCATIONS
<TABLE>
<S> <C> <C>
455 S. Main Street 2294 N. Church Street 503 Huffman Mills Road
Burlington, North Carolina 27215 Burlington, North Carolina 27215 Burlington, North Carolina 27215
102 S. 5th Street 211 N. Main Street 3466 S. Church Street
Mebane, North Carolina 27302 Graham, North Carolina 27253 Burlington, North Carolina 27215
</TABLE>
CORPORATE INFORMATION
<TABLE>
<S> <C> <C>
Auditors Transfer Agent and Registrar Annual Report on Form 10-K
KPMG LLP Registrar & Transfer Company
150 Fayetteville Street Mall 10 Commerce Drive A copy of 1st State Bancorp, Inc.'s Annual
Suite 1200 Cranford, New Jersey 07016 Report on Form 10-K for the fiscal year
Raleigh, North Carolina 27601 ended September 30, 1999 as filed with the
Securities and Exchange Commission, will be
General Counsel Annual Meeting furnished without charge to stockholders as
Wishart Harris Henninger & The 2000 Annual Meeting of Stockholders will be of the record date for the 2000 Annual
Pittman, PA be held on January 25, 2000 at 5:30 p.m. at 1st Meeting upon written request to Corporate
3120 South Church Street State Bank's main office located at 445 S. Main Secretary 1st State Bancorp, Inc., 445 S.
Burlington, North Carolina 27215 Street, Burlington, North Carolina 27215 Main Street, Burlington, North Carolina
27215
Special Counsel
Housley Kantarian & Bronstein, P.C.
1220 19th Street, N.W., Suite 700
Washington, D.C. 20036
</TABLE>
<PAGE>
EXHIBIT 21
Subsidiaries of the Registrant
State or Other
Jurisdiction of Percentage
Incorporation Ownership
-------------- ----------
Parent
- ------
1st State Bancorp, Inc. Virginia N/A
Subsidiary (1)
- ----------
1st State Bank North Carolina 100%
Subsidiaries of 1st State Bank (1)
- ------------------------------
First Capital Services Company, LLC North Carolina 100%
- --------------------
(1) The assets, liabilities and operations of the subsidiaries are included in
the consolidated financial statements contained in the Annual Report to
Stockholders attached hereto as an exhibit.
<PAGE>
Exhibit 23
The Board of Directors
1st State Bancorp, Inc.:
We consent to incorporation by reference in the registration statement (No.
33-72787) on Form S-8 of 1st State Bancorp, Inc. of our report dated October 29,
1999, relating to the consolidated balance sheets of 1st State Bancorp, Inc. and
subsidiary as of September 30, 1999 and 1998, and the related consolidated
statements of income, stockholders' equity and comprehensive income, and cash
flows for each of the years in the three-year period ended September 30, 1999,
which report appears in the September 30, 1999, annual report on Form 10-K of
1st State Bancorp, Inc.
/s/ KPMG LLP
KPMG LLP
Raleigh, North Carolina
December 21, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 9
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> SEP-30-1999
<PERIOD-END> SEP-30-1999
<CASH> 8,411,035
<INT-BEARING-DEPOSITS> 7,246,167
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 11,035,966
<INVESTMENTS-CARRYING> 84,228,343
<INVESTMENTS-MARKET> 82,541,457
<LOANS> 210,889,780
<ALLOWANCE> 3,454,373
<TOTAL-ASSETS> 332,925,928
<DEPOSITS> 234,094,735
<SHORT-TERM> 2,000,000
<LIABILITIES-OTHER> 5,216,012
<LONG-TERM> 20,000,000
0
0
<COMMON> 44,778,668
<OTHER-SE> 26,836,513
<TOTAL-LIABILITIES-AND-EQUITY> 332,925,928
<INTEREST-LOAN> 16,112,667
<INTEREST-INVEST> 4,159,750
<INTEREST-OTHER> 1,201,191
<INTEREST-TOTAL> 21,473,608
<INTEREST-DEPOSIT> 9,539,532
<INTEREST-EXPENSE> 10,639,893
<INTEREST-INCOME-NET> 10,833,715
<LOAN-LOSSES> 245,000
<SECURITIES-GAINS> 0
<EXPENSE-OTHER> 9,817,689
<INCOME-PRETAX> 2,424,691
<INCOME-PRE-EXTRAORDINARY> 1,554,691
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,554,691
<EPS-BASIC> (0.10)
<EPS-DILUTED> (0.10)
<YIELD-ACTUAL> 3.71
<LOANS-NON> 366,000
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 3,227,775
<CHARGE-OFFS> 22,661
<RECOVERIES> 4,259
<ALLOWANCE-CLOSE> 3,454,373
<ALLOWANCE-DOMESTIC> 3,454,373
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
