SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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, 2000
OR
[ ] TRANSITIONAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
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Commission File No. 0-25859
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 19, 2000, the aggregate market value of the 1,908,677 shares
of Common Stock of the registrant issued and outstanding held by non-affiliates
on such date was approximately $35.1 million based on the closing sale price of
$18.375 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 19, 2000:
3,289,607
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, 2000. (Parts I, II and IV)
2. Portions of Proxy Statement for 2001 Annual Meeting of Stockholders.
(Part III)
<PAGE>
PART I
ITEM 1. BUSINESS
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GENERAL
1st State Bancorp, Inc. (the "Company") acquired all the outstanding
stock of 1st State Bank, Burlington, North Carolina (the "Bank"), in connection
with the Bank's conversion from mutual to stock form on April 23, 2000. Prior to
that time, the Company did not own assets or conduct operations. 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 seven full service offices located in north
central North Carolina on the Interstate 85 corridor between the Piedmont Triad
and Research Triangle Park. 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, Glen Raven
Mills and Alamance Health Services. Nevertheless, the economy in Alamance County
continues to be heavily dependent on the textile industry.
2
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LENDING ACTIVITIES
Loan Portfolio Composition. At September 30, 2000, our gross loan
portfolio totaled $237.5 million and represented 66.8% 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, 2000, 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,
-------------------------------------------------------------------
2000 1999 1998
------------------- ------------------- -------------------
Amount % Amount % Amount %
------ ----- ------ ----- ------ -----
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Real estate loans:
Single-family residential............... $ 97,989 41.27% $ 90,883 44.06% $ 100,891 48.84%
Commercial.............................. 46,525 19.59 40,816 19.79 38,763 18.76
Home equity............................. 21,225 8.94 18,888 9.16 16,877 8.17
Construction............................ 21,991 9.26 16,496 8.00 18,572 8.99
--------- ------ --------- ------ --------- ------
Total real estate................... 187,730 79.06 167,083 81.01 175,103 84.76
Commercial................................ 42,949 18.09 32,502 15.76 25,190 12.19
Consumer.................................. 6,782 2.85 6,658 3.23 6,310 3.05
--------- ------ --------- ------ --------- ------
237,461 100.00% 206,243 100.00% 206,603 100.00%
--------- ====== --------- ====== --------- ======
Less:
Loans in process........................ (9,972) (7,289) (6,446)
Deferred fees and discounts............. (358) (208) (147)
Allowance for loan losses............... (3,536) (3,454) (3,228)
--------- --------- ---------
Total................................. $ 223,595 $ 195,292 $ 196,782
========= ========= =========
<CAPTION>
At September 30,
--------------------------------------
1997 1996
---------------- -----------------
Amount % Amount %
------ ----- ------ -----
<S> <C> <C> <C> <C>
Real estate loans:
Single-family residential............... $108,400 53.76% $100,247 55.70%
Commercial.............................. 34,333 17.02 35,302 19.62
Home equity............................. 18,141 8.99 15,872 8.82
Construction............................ 12,582 6.24 7,838 4.36
-------- ------ -------- ------
Total real estate................... 173,456 86.01 159,259 88.50
Commercial................................ 22,870 11.34 16,989 9.44
Consumer.................................. 5,354 2.65 3,706 2.06
-------- ------ -------- ------
201,680 100.00% 179,954 100.00%
-------- ====== -------- ======
Less:
Loans in process........................ (1,660) (3,515)
Deferred fees and discounts............. (144) (94)
Allowance for loan losses............... (2,754) (2,496)
-------- --------
Total................................. $197,122 $173,849
======== ========
</TABLE>
3
<PAGE>
Loan Maturity Schedule. The following table sets forth certain
information at September 30, 2000 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 After 1
Due During Through Due After
the Year Ending 5 Years After 5 Years After
September 30, 2001 September 30, 2000 September 30, 2000 Total
------------------ ------------------ ------------------ -----
(In thousands)
<S> <C> <C> <C> <C>
Real estate loans:
Single-family..................... $ 2,164 $ 10,106 $ 85,719 $ 97,989
Commercial........................ 3,827 20,550 22,148 46,525
Home equity....................... 198 1,877 19,150 21,225
Construction...................... 9,696 2,312 11 12,019
Commercial.......................... 20,162 18,035 4,752 42,949
Consumer............................ 1,986 4,418 378 6,782
----------- ----------- ----------- ----------
Total....................... $ 38,033 $ 57,298 $ 132,158 $ 227,489
=========== =========== =========== ==========
</TABLE>
The following table sets forth at September 30, 2000, the dollar amount
of all loans due one year or more after September 30, 2000 which have
predetermined interest rates and have floating or adjustable interest rates.
<TABLE>
<CAPTION>
Predetermined Floating or
Rate Adjustable Rates Total
------------- ---------------- ---------
(In thousands)
<S> <C> <C> <C>
Real estate loans:
Single-family residential........................ $ 63,900 $ 31,925 $ 95,825
Commercial....................................... 14,377 28,321 42,698
Home equity...................................... 34 20,993 21,027
Construction..................................... -- 2,323 2,323
Commercial......................................... 4,323 18,464 22,787
Consumer .......................................... 4,758 38 4,796
----------- ---------- ----------
Total.......................................... $ 87,392 $ 102,064 $ 189,456
=========== ========== ==========
</TABLE>
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.
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<PAGE>
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,
------------------------------------------------
2000 1999 1998
------ ------ ------
(In thousands)
<S> <C> <C> <C>
Loans originated:
Real estate loans:
Single-family residential................................. $ 24,124 $ 54,309 $ 44,118
Commercial................................................ 8,105 9,358 9,437
Home equity............................................... 8,738 12,088 7,351
Construction.............................................. 12,383 12,039 19,158
---------- --------- ---------
Total real estate loans.................................. 56,350 87,794 80,064
Commercial.................................................. 28,257 19,291 18,982
Consumer.................................................... 6,457 6,744 6,361
---------- --------- ---------
Total loans originated................................. $ 91,064 $ 113,829 $ 105,407
========== ========= =========
Loans purchased:
Real estate loans........................................... $ 80 $ 270 $ 135
Other loans................................................. 6 36 18
---------- --------- ---------
Total loans purchased.................................... $ 86 $ 306 $ 153
========== ========= =========
Loans sold: (1)............................................... $ 19,001 $ 40,407 $ 27,754
========== ========= =========
<FN>
------------------
(1) All loans sold were whole loans.
</FN>
</TABLE>
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, 2000, 1999 and 1998, 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,
2000 and 1999, we have sold an increasing amount of fixed-rate, single-family
mortgage loans that we originated. During the years ended September 30, 2000,
1999 and 1998, we sold $19.0 million, $40.4 million and $27.8 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 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
5
<PAGE>
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:
o in an amount not to exceed $500,000;
o 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
o 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 $8.3
million at September 30, 2000. At that date, we had no lending relationships in
excess of the loans-to-one-borrower limit. At September 30, 2000, our ten
largest lending relationships ranged in size from $3.4 million to $6.5 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, 2000, single-family, residential
mortgage loans, excluding home equity loans, totaled $98.0 million, or 41.3% of
our gross loan portfolio.
6
<PAGE>
We originate fixed-rate mortgage loans at competitive interest rates.
At September 30, 2000, $64.4 million, or 27.1%, of our gross loan portfolio was
comprised of fixed-rate, single-family mortgage loans. Generally, in the current
interest rate environment, we have been retaining fixed-rate mortgages with
maturities of ten years or less while fixed-rate loans with longer maturities
may be retained in the portfolio or 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, 2000, $33.6 million, or 34.3%, 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, 2000, our commercial
real estate loans totaled $46.5 million, which amounted to 19.6%, of our gross
loan portfolio. We originate commercial real estate loans for terms of up to 15
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, 2000, we had approximately $21.2
million in home equity line of credit loans, representing approximately 8.9% 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.
7
<PAGE>
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, 2000,
$22.0 million, or 9.3%, 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, 2000, speculative construction loans amounted to $9.4 million. At
September 30, 2000, the largest exposure to one borrower for speculative
construction was $2.5 million. This credit facility will finance the
construction of residential condominium units in a fifty acre planned unit
development in Burlington, North Carolina. 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.
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, 2000, $7.0 million of our gross loan portfolio consisted of
acquisition and development loans. We had 13 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
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<PAGE>
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, 2000, commercial loans totaled $42.9 million, or 18.1%, 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 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, 2000, our consumer
loans totaled $6.8 million, or 2.9%, 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.
9
<PAGE>
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 for uncollected
interest account, interest on loans, including impaired loans, that are
contractually 90 days or more past due. The allowance for uncollected interest
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 for
uncollected interest account when we believe 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, 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, less costs
to sell the property, or the carrying amount of the loan. Subsequent costs
directly related to development and improvement of property are capitalized,
whereas costs related to holding the 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,
-----------------------------------------------------------
2000 1999 1998 1997 1996
-------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Loans accounted for on a nonaccrual
basis (1)................................ $ 2,893 $ 366 $ 263 $ 259 $ 288
======== ======== ======== ======== ========
Accruing loans which are contractually past
due 90 days or more....................... $ -- $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
Total nonperforming loans................ $ 2,893 $ 366 $ 263 $ 259 $ 288
======== ======== ======== ======== ========
Total loans.................................. $227,131 $198,747 $200,010 $199,876 $176,345
======== ======== ======== ======== ========
Percentage of total loans.................... 1.27% 0.18% 0.13% 0.13% 0.16%
======== ======== ======== ======== ========
Other nonperforming assets (2)............... $ -- $ -- $ -- $ -- $ 1
======== ======== ======== ======== ========
Loans modified in troubled debt
restructuring.............................. $ -- $ -- $ -- $ -- $ --
======== ======== ======== ======== ========
<FN>
______________
(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.
</FN>
</TABLE>
10
<PAGE>
During the years ended September 30, 2000, 1999 and 1998, gross interest
income of $265,000, $27,000, and $10,000, 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, 2000, 1999 and 1998 amounted to $58,000, $13,000 and
$15,000, respectively.
At September 30, 2000 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, 2000, we had $2.9 million of nonaccrual loans, which
consisted of ten single-family mortgage loans, two commercial real estate loans
and six consumer loans. At September 30, 2000, we did not have any real estate
owned.
At September 30, 2000, we had impaired loans with two unrelated borrowers
of $2.6 million which are on nonaccrual status. The related reserve for loan
losses on the impaired loans totaled $245,000. The average carrying value of
impaired loans was $1.7 million for the year ended September 30, 2000. These
loans are secured by commercial real estate properties in Alamance County.
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, 2000, we had $3.4
million in classified assets consisting of $3.4 million in assets classified as
substandard, no 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, 2000 we have identified approximately $1.7 million in assets
classified as special mention.
Allowance for Loan Losses. We maintain the allowance for losses on loans at
a level we believe to be adequate to absorb probable 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.
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
11
<PAGE>
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. The provision for loan losses was $240,000, charge-offs were
$164,000 and recoveries were $6,000 for the year ended September 30, 2000
compared with a provision of $245,000, charge-offs of $23,000 and recoveries of
$4,000 for the year ended September 30, 1999. Nonperforming loans at September
30, 2000 and 1999 were $2.9 million and $366,000, respectively. The increase in
non-performing loans resulted from two unrelated, unique credits which are not
necessarily indicative of the credit quality of the entire portfolio. There was
no significant impact on the provision as a result of these two credits as we
had already anticipated the loans' performance in setting the allowance for loan
losses in the previous year.
The allowance for loan losses was $3.5 million at September 30, 2000
and September 30, 1999 which we think is adequate to absorb probable losses in
the loan portfolio. The ratio of the allowance for the loan losses to total
loans, net of loans in process and deferred loan fees was 1.56% and 1.74% at
September 30, 2000 and 1999, respectively. In fiscal 1999, the Company was
concerned about the impact of the local economy on the credit risk of its
borrowers. While there are still concerns over recent economic conditions in the
local, state and national economy, including the impact of rising interest rates
on borrowers, management concluded that this impact may not be as great as once
expected. This was the primary factor contributing to the decrease in the
percentage of the allowance for loan losses to loans during fiscal 2000. While
management uses the best information available to make evaluations, future
adjustments to the allowance may be necessary based on changes in economic and
other conditions. Additionally, 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 recognition of adjustments to the
allowance for loan losses based on their judgments of information available to
them at the time of their examinations.
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 generally review an institution's allowance for loan
losses and compare it against the sum of:
o 50% of the portfolio that is classified doubtful;
o 15% of the portfolio that is classified as substandard; and
o 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, 2000.
12
<PAGE>
The following table sets forth an analysis of our allowance for loan
losses for the periods indicated.
<TABLE>
<CAPTION>
Year Ended September 30,
-------------------------------------------------------------------
2000 1999 1998 1997 1996
-------- -------- -------- -------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
Balance at beginning of period............... $ 3,454 $ 3,228 $ 2,754 $ 2,496 $ 2,223
---------- --------- --------- --------- ----------
Loans charged off............................ 164 23 4 7 13
---------- --------- --------- --------- ----------
Recoveries................................... 6 4 1 4 5
---------- --------- --------- --------- ----------
Net loans charged off........................ 158 19 3 3 8
---------- --------- --------- --------- ----------
Provision for loan losses.................... 240 245 477 261 281
---------- --------- --------- --------- ----------
Balance at end of period..................... $ 3,536 $ 3,454 $ 3,228 $ 2,754 $ 2,496
========== ========= ========= ========= ==========
Average loans outstanding.................... $ 219,381 $ 198,603 $ 199,203 $ 186,413 $ 171,148
========== ========= ========= ========= ==========
Ratio of net loans charged off to average
loans outstanding during the period........ 0.0720% 0.0096% 0.0015% 0.0016% 0.0047%
========= ======== ======== ======== ==========
</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,
-------------------------------------------------------------------------
2000 1999 1998
--------------------- -------------------- -------------------
Percent of Percent of Percent of
Loans in Loans in Loans in
Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans
------ ----------- ------ ------------ ------ -----------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
Real estate mortgage:
Single-family residential............. $ 320 41.27% $ 559 44.06% $ 400 48.84%
Commercial............................ 1,084 19.59 934 19.79 898 18.76
Home equity........................... 179 8.94 244 9.16 319 8.17
Construction.......................... 213 9.26 275 8.00 458 8.99
Commercial.............................. 1,616 18.09 1,273 15.76 815 12.19
Consumer................................ 124 2.85 169 3.23 338 3.05
--------- ------ --------- ------ -------- ------
Total allowance for loan losses..... $ 3,536 100.00% $ 3,454 100.00% $ 3,228 100.00%
========= ====== ========= ====== ======== ======
<CAPTION>
At September 30,
-----------------------------------------------
1997 1996
--------------------- --------------------
Percent of Percent of
Loans in Loans in
Category to Category to
Amount Total Loans Amount Total Loans
------ ----------- ------ ------------
(Dollars in thousands)
<S> <C> <C> <C> <C>
Real estate mortgage:
Single-family residential............. $ 376 53.76% $ 387 55.70%
Commercial............................ 854 17.02 882 19.62
Home equity........................... 318 8.99 303 8.82
Construction.......................... 380 6.24 232 4.36
Commercial.............................. 540 11.34 450 9.44
Consumer................................ 286 2.65 242 2.06
-------- ------ --------- ------
Total allowance for loan losses..... $ 2,754 100.00% $ 2,496 100.00%
======== ====== ========= ======
</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, 2000, the
amortized cost of our investment securities portfolio amounted to $77.2 million,
which included $72.2 million of U.S. Government and agency securities, $1.0
million of mortgage-backed securities and $53,000 of collateralized mortgage
obligations ("CMO's"). In addition, at September 30, 2000, 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 $164,000, 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 $10.0 million and an approximate fair value
of $9.8 million at September 30, 2000 classified as available for sale. The
impact on our financial statements was an after-tax decrease in shareholders'
equity of approximately $164,000 as of September 30, 2000. The net unrealized
losses at September 30, 2000 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 years ended September 30, 2000 and 1999, we did not recognize any
losses. Management is closely monitoring its investments in marketable equity
securities, which consist of two mutual funds, for signs of other than temporary
impairment of value. While management concluded that the unrealized losses
totalling $152,000 at September 30, 2000 were not deemed to be other than
temporary, continuing declines in the fair values of these investments could
result in a charge to earnings in fiscal 2001.
At September 30, 2000, we had $5.0 million of U.S. Government and
agency securities classified as available for sale, which carry unrealized
after-tax losses of $98,000, and $67.2 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 securities
that are readily marketable. As of September 30, 2000, the estimated weighted
average life of our U.S. Government and agency securities was approximately 4.2
years, and the average yield on our portfolio of U.S. Government and agency
securities was 6.14%. In addition, at September 30, 2000, we had $1.7 million of
FHLB of Atlanta stock.
Mortgage-Backed Securities. Included in our portfolio of investment
securities are mortgage-backed 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 $275,000.
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 securities portfolio consists primarily of seasoned
fixed-rate, mortgage-backed 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, 2000, the weighted average contractual maturity of our
mortgage-backed securities, all of which carried fixed rates, was approximately
7.3 years. The actual maturity of a mortgage-backed security varies, depending
on when the mortgagors prepay or repay the underlying mortgages. Prepayments of
the underlying mortgages may shorten the life of the investment, thereby
adversely affecting its yield to maturity and the related market value of the
mortgage-backed security. The yield is based upon the interest income and the
amortization of the premium or accretion of the discount related to the
mortgage-backed security. Premiums and discounts on mortgage-backed securities
are amortized or accreted over the estimated term of the securities using a
level yield method. The prepayment assumptions used to determine the
amortization period for premiums and discounts can significantly affect the
yield of the mortgage-backed security, and 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
16
<PAGE>
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, 2000, mortgage-backed securities with an amortized
cost of $1.0 million and a carrying value of $1.1 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, 2000, our mortgage-backed securities had a weighted average
yield of 8.47%.
The following table sets forth the carrying value of our investment
securities portfolio at the dates indicated.
<TABLE>
<CAPTION>
At September 30,
---------------------------------------------
2000 1999 1998
------ ------ -------
(In thousands)
<S> <C> <C> <C>
Securities available for sale:
U.S. government and agency securities...................... $ 4,841 $ 5,867 $ 4,043
Federal Home Loan Mortgage Corporation..................... 319 477 662
Government National Mortgage Association................... 751 833 1,147
Marketable equity securities (1)........................... 3,841 3,859 4,006
--------- ---------- ---------
Total.................................................. $ 9,752 $ 11,036 $ 9,858
========= ========== =========
Securities held to maturity:
U.S. government and agency securities...................... $ 65,119 $ 81,160 $ 30,087
Other...................................................... -- 3,000 --
CMOs....................................................... 54 68 108
--------- ---------- ---------
Total................................................... $ 65,173 $ 84,228 $ 30,195
========= ========== =========
<FN>
-----------
(1) Consists of an investment in two mutual funds.
</FN>
</TABLE>
17
<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, 2000.
<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.................. $ 999 6.43% $ 1,930 5.74% $ 1,912 5.99% $ -- -- %
Mortgage-backed securities..... -- -- 20 4.46 74 9.75 977 8.45
Marketable equity securities (1) -- -- -- -- -- -- 3,841 5.83
--------- ---------- --------- ---------
Total....................... $ 999 6.43 $ 1,950 5.73 $ 1,986 6.13 $ 4,818 6.36
========= ========== ========= =========
Securities held to maturity:
U.S. government and agency
securities.................. $ 2,493 6.46 $ 46,692 6.05 $ 17,994 6.38 $ -- --
CMOs.............................. -- -- -- -- -- -- 53 7.43
--------- ---------- --------- ---------
Total..................... $ 2,493 6.46 $ 46,692 6.05 $ 17,994 6.38 $ 53 7.43
========= ========== ========= =========
<CAPTION>
Total Investment Portfolio
------------------------------
Carrying Market Average
Value Value Yield
-------- ------ -------
<S> <C> <C> <C>
Securities available for sale:
U.S. government and agency
securities.................. $ 4,841 $ 4,841 5.98%
Mortgage-backed securities..... 1,071 1,071 8.47
Marketable equity securities (1) 3,841 3,841 5.83
------- --------
Total....................... $ 9,753 $ 9,753 6.19
======= ========
Securities held to maturity:
U.S. government and agency
securities.................. $67,179 $ 65,119 6.15
CMOs.............................. 53 54 7.43
------- --------
Total..................... $67,232 $ 65,173 6.15
======= ========
<FN>
___________
(1) Consists of investments in two mutual funds.
</FN>
</TABLE>
18
<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 six office
locations.
19
<PAGE>
Our deposits at September 30, 2000 consisted of the various types of
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 $ 100 $ 11,891 4.67%
accounts
1.80 None NOW accounts 300 29,223 11.49
4.51 None Savings Accounts 100 19,072 7.50
2.36 None Money Market Accounts 1,000 25,930 10.19
Certificates of Deposit
-----------------------
5.17 3 months Fixed-term, fixed-rate 500 263 0.10
5.71 6 months Fixed-term, fixed-rate 500 5,919 2.33
5.30 7 months (1) Fixed-term, fixed-rate 5,000 38,122 14.98
5.47 9 months Fixed-term, fixed-rate 500 1,033 0.41
5.26 10 months Fixed-term, fixed-rate 5,000 3,309 1.30
5.63 12 months Fixed-term, fixed-rate 500 20,770 8.16
6.40 15 months Fixed-term, fixed-rate 5,000 36,557 14.38
5.23 18 months Floating rate individual retirement 50 877 0.34
account
5.38 18 months Fixed-term, fixed-rate 500 2,473 0.97
5.18 20 months Fixed-term, fixed-rate 500 32 0.01
5.28 24 months Fixed-term, fixed-rate 500 6,744 2.65
5.56 30 months Fixed-term, fixed-rate 500 8,813 3.46
5.46 36 months Fixed-term, fixed-rate 500 2,895 1.14
5.57 48 months Fixed-term, fixed-rate 500 3,726 1.46
5.52 60 months Fixed-term, fixed-rate 500 15,050 5.92
6.64 7 to 365 days Fixed-term, fixed-rate 100,000 21,706 8.54
---------- ------
$ 254,405 100.00%
========== ======
<FN>
_________
(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, 2000, borrowers may withdraw funds
invested in these certificates prior to maturity, causing our cost of
funds to increase.
</FN>
</TABLE>
20
<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 % of Increase September % of Increase September % of
30, 2000 Deposits (Decrease) 30, 1999 Deposits (Decrease) 30, 1998 Deposits
---------- -------- ---------- ---------- -------- ---------- ---------- --------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Noninterest-bearing demand..........$ 11,891 4.67% $ 3,671 $ 8,219 3.51% $ (404) $ 8,624 3.66%
Interest-bearing checking........... 29,223 11.49 3,130 26,094 11.15 1,013 25,080 10.64
Money market accounts............... 19,072 7.50 4,302 14,770 6.31 1,532 13,238 5.62
Passbook and savings................ 25,930 10.19 (1,346) 27,276 11.65 (815) 28,091 11.92
Certificates of deposit............. 168,289 66.15 10,553 157,736 67.38 (2,925) 160,661 68.16
--------- ------ ---------- ---------- ------ ------- --------- ------
$ 254,405 100.00% $ 20,310 $ 234,095 100.00% $(1,599) $ 235,694 100.00%
========= ====== ========== ========== ====== ======= ========= ======
</TABLE>
21
<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,
-----------------------------------------------------------------------
2000 1999 1998
------------------- ------------------ -------------------
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.............. $ 9,040 0.00% $ 9,282 0.00% $ 6,417 0.00%
Interest-bearing checking............... 28,268 1.73 27,026 1.86 24,987 2.21
Money market accounts................... 15,470 4.11 14,306 3.47 12,277 3.82
Passbook and savings.................... 26,654 2.37 35,220 2.47 28,017 2.85
Certificates of deposit................. 159,773 5.26 153,811 4.99 159,053 5.36
--------- -------- ---------
Total............................... $ 239,205 4.25 $239,645 3.98 $ 230,751 4.48
========= ======== =========
</TABLE>
The following table sets forth our time deposits classified by rates at
the dates indicated.
<TABLE>
<CAPTION>
At September 30,
----------------------------------------------
2000 1999 1998
----- ------ -------
(In thousands)
<S> <C> <C> <C>
2 - 3.99%................................................... $ -- $ 116 $ --
4 - 5.99%................................................... 105,266 154,076 149,064
6 - 7.99%................................................... 62,900 3,443 11,496
8 - 9.99%................................................... 123 101 101
--------- ---------- ---------
$ 168,289 $ 157,736 $ 160,661
========= ========== =========
</TABLE>
The following table sets forth the amount and maturities of our time deposits at
September 30, 2000.
<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%................... $ -- $ -- $ -- $ -- $ --
4.00 - 5.99%................... 85,698 10,014 5,904 3,650 105,266
6.00 - 7.99%................... 47,515 11,117 1,481 2,787 62,900
8.00 - 9.99%................... -- -- 123 -- 123
--------- ---------- ---------- ---------- ----------
$ 133,213 $ 21,131 $ 7,508 $ 6,437 $ 168,289
========= ========== ========== ========== ==========
</TABLE>
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, 2000.
At that date, such deposits represented 19.0% of total deposits and had a
weighted average rate of 6.20%.
Certificates
Maturity Period of Deposit
---------------- -----------
(In thousands)
Three months or less....................... $ 29,368
Over three through six months.............. 6,286
Over six through 12 months................. 8,209
Over 12 months............................. 4,370
----------
Total................................ $ 48,233
==========
22
<PAGE>
We estimate that more than $19.0 million of certificates of deposit in
amounts of $100,000 or more maturing within one year of September 30, 2000 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,
----------------------------------------------
2000 1999 1998
----- ------ -------
(In thousands)
<S> <C> <C> <C>
Net increase (decrease) before interest credited.............. $ 11,831 $(10,124) $ (3,026)
Interest credited............................................. 8,479 8,525 9,379
--------- -------- ---------
Net (decrease) increase in deposits....................... $ 20,310 $ (1,599) $ 6,353
========= ======== =========
</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.
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,
-------------------------------------
2000 1999 1998
------ ------ ------
(Dollars in thousands)
<S> <C> <C> <C>
Amounts outstanding at end of period:
FHLB advances............................................. $ 20,000 $ 22,000 $ 20,000
Weighted average rate paid on:
FHLB advances............................................. 5.55% 5.42% 5.39%
</TABLE>
<TABLE>
<CAPTION>
For the Year
Ended September 30,
-------------------------------------
2000 1999 1998
----- ------ ------
(In thousands)
<S> <C> <C> <C>
Maximum amount of borrowings outstanding at any month end:
FHLB advances............................................. $ 33,000 $ 22,000 $ 21,000
</TABLE>
23
<PAGE>
<TABLE>
<CAPTION>
For the Year
Ended September 30,
------------------------------------
2000 1999 1998
------ ------ ------
(Dollars in thousands)
<S> <C> <C> <C>
Average amounts outstanding:
FHLB advances............................................. $ 25,467 $ 20,044 $ 13,559
Approximate weighted average rate paid on: (1)
FHLB advances............................................. 5.65% 5.49% 5.46%
<FN>
________
(1) Based on month-end balances.
</FN>
</TABLE>
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
$399,000, $326,000 and $262,000 on a pre-tax basis from the activities of the
LLC and First Capital during the years ended September 30, 2000, 1999 and 1998,
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.
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, 1999, we had 14.4% of
deposits held by all banks and savings institutions in our market area.
EMPLOYEES
As of September 30, 2000, we had 75 full-time and 16 part-time
employees, none of whom were represented by a collective bargaining agreement.
We believe that our relationship with our employees is good.
24
<PAGE>
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.
Financial Modernization Legislation. 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 Secretary of the Treasury, may approve additional
financial activities. The G-L-B Act, however, prohibits future acquisitions of
existing unitary savings and loan holding companies, like the Company, by firms
which are engaged in commercial activities and limits the permissible activities
of unitary holding companies formed after May 4, 1999.
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 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 became
effective in November 2000, with full compliance required by July 1, 2001.
The G-L-B Act contains significant revisions to the FHLB System. The
G-L-B Act imposes new capital requirements on the FHLBs and authorizes them to
issue two classes of stock with differing dividend rates and redemption
requirements. The G-L-B Act deletes the current requirement that the FHLBs
annually contribute $300 million to pay interest on certain government
obligations in favor of a 20% of net earnings formula. The G-L-B Act expands the
permissible uses of FHLB 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 makes membership in the FHLB
voluntary for federal savings associations.
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.
25
<PAGE>
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 may acquire control of the Company, 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
assets 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.
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.
26
<PAGE>
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, 2000, we complied with each of the capital
requirements of the FDIC and the North Carolina Banking Commission.
Prompt Corrective Regulatory Action. Under FDICIA, the federal banking
regulators are required to take prompt corrective action if an insured
depository institution fails to satisfy certain minimum capital requirements,
including a leverage limit, a risk-based capital requirement, and any other
measure deemed appropriate by the federal banking regulators for measuring the
capital adequacy of an insured depository institution. All institutions,
regardless of their capital levels, are restricted from making any capital
distribution or paying any management fees if the institution would thereafter
fail to satisfy the minimum levels for any of its capital requirements. An
institution that fails to meet the minimum level for any relevant capital
measure (an "undercapitalized institution") may be: (i) subject to increased
monitoring by the appropriate federal banking regulator; (ii) required to submit
an acceptable capital restoration plan within 45 days; (iii) subject to asset
growth limits; and (iv) required to obtain prior regulatory approval for
acquisitions, branching and new lines of businesses. The capital restoration
plan must include a guarantee by the institution's holding company that the
institution will comply with the plan until it has been adequately capitalized
on average for four consecutive quarters, under which the holding company would
be liable up to the lesser of 5% of the institution's total assets or the amount
necessary to bring the institution into capital compliance as of the date it
failed to comply with its capital restoration plan. A "significantly
undercapitalized" institution, as well as any undercapitalized institution that
does not submit an acceptable capital restoration plan, may be subject to
regulatory demands for recapitalization, broader application of restrictions on
transactions with affiliates, limitations on interest rates paid on deposits,
asset growth and other activities, possible replacement of directors and
officers, and restrictions on capital distributions by any bank holding company
controlling the institution. Any company controlling the institution may 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 approval and the institution is prohibited from
making payments of principal or interest on its subordinated debt. In their
discretion, the federal banking regulators may also impose the foregoing
sanctions on an undercapitalized institution if the regulators determine that
such actions are necessary to carry out the purposes of the prompt corrective
provisions. If an institution's ratio of tangible capital to total assets falls
below the "critical capital level" established by the appropriate federal
banking regulator, the institution will be subject to conservatorship or
receivership within specified time periods.
Under the implementing regulations, the federal banking regulators,
including the FDIC, generally measure an institution's capital adequacy on the
basis of its total risk-based capital ratio (the ratio of its total capital to
risk-weighted assets), Tier 1 risk-based capital ratio (the ratio of its core
capital to risk-weighted assets) and leverage ratio (the ratio of its core
capital to adjusted total assets). The following table shows the capital ratios
required for the various prompt corrective action categories.
<TABLE>
<CAPTION>
Adequately Significantly
Well Capitalized Capitalized Undercapitalized Undercapitalized
---------------- ----------- ---------------- -----------------
<S> <C> <C> <C> <C>
Total risk-based
capital ratio 10.0% or more 8.0% or more Less than 8.0% Less than 6.0%
Tier 1 risk-based
capital ratio 6.0% or more 4.0% or more Less than 4.0% Less than 3.0%
Leverage ratio 5.0% or more 4.0% or more * Less than 4.0% * Less than 3.0%
<FN>
-----------
* 3.0% if institution has a composite 1 CAMELS rating.
</FN>
</TABLE>
A "critically undercapitalized" savings institution is defined as an institution
that has a ratio of "tangible equity" to total assets of less than 2.0%.
Tangible equity is defined as core capital plus cumulative perpetual preferred
stock (and related surplus) less all intangibles other than qualifying
supervisory goodwill and certain purchased mortgage
27
<PAGE>
servicing rights. The FDIC may reclassify a well capitalized savings 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 undercapitalized) if
the FDIC 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.
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."
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,
2000 of $1.7 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, 2000, we had $20.0 million in
advances outstanding from the FHLB of Atlanta.
28
<PAGE>
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 $4.9 million and $42.8 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, 2000, 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, 2000, 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.
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, 2000, 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:
o a total risk-based capital ratio of less than 8%;
o a Tier 1 risk-based capital ratio of less than 4%; or
29
<PAGE>
o 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 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. ss.1972 on certain tying arrangements
and extensions of credit by correspondent banks. Section 22(g) of the Federal
Reserve Act requires loans to executive officers of depository institutions not
be made on terms more favorable than those afforded to other borrowers, requires
approval by the board of directors of a depository institution for extension of
credit to executive officers of the institution, and imposes reporting
requirements for and additional restrictions on the type, amount and terms of
credits to such officers. Section 1972 (i) prohibits a depository institution
from extending credit to or offering any other services, or fixing or varying
the consideration for such extension of credit or service, on the condition that
the customer obtain some additional service from the institution or certain of
its affiliates or not obtain services of a competitor of the institution,
subject to certain exceptions, and (ii) prohibits extensions of credit
30
<PAGE>
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 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:
o 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;
31
<PAGE>
o acquiring all or substantially all of the assets of another bank
or bank holding company; or
o 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:
o operating a savings institution, mortgage company, finance
company, credit card company or factoring company;
o performing certain data processing operations;
o providing certain investment and financial advice;
o underwriting and acting as an insurance agent for certain types
of credit-related insurance;
o leasing property on a full-payout, non-operating basis;
o selling money orders, travelers' checks and United States Savings
Bonds;
o real estate and personal property appraising;
o providing tax planning and preparation services; and,
o 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
32
<PAGE>
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 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.
33
<PAGE>
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 fiscal 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 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 7.00%
of federal taxable income as computed under the Internal Revenue Code, subject
to certain prescribed adjustments. This rate will be reduced to 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 in our
Annual Report to Stockholders filed as Exhibit 13 to this document.
34
<PAGE>
ITEM 2. PROPERTIES
-------------------
The following table sets forth the location and certain additional
information regarding our offices at September 30, 2000.
<TABLE>
<CAPTION>
Book Value at Deposits at
Year Owned or September 30, Approximate September 30,
Opened Leased 2000 (1) Square Footage 2000
------ ------ ---------- -------------- -------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C>
MAIN OFFICE:
445 S. Main Street 1988 Owned $ 3,695 33,700 $ 95,916
Burlington, NC 27215
BRANCH OFFICES:
2294 N. Church Street 1984 Leased (2) 262 2,600 24,562
Burlington, NC 27215
503 Huffman Mill Road 1982 Owned 353 2,600 42,683
Burlington, NC 27215
102 S. 5th Street 1973 Owned 53 2,000 34,066
Mebane, NC 27302
211 N. Main Street 1974 Owned 127 2,700 39,614
Graham, NC 27253
3466 S. Church Street 1996 Owned 1,420 4,000 17,458
Burlington, NC 27215
1203 S. Main Street 2000 Owned 1,325 4,000 106
Graham, NC 27253
<FN>
----------
(1) Land and building only.
(2) Land is leased. Lease expires on July 5, 2009, with options to extend for
three five-year periods.
</FN>
</TABLE>
The book value of our investment in premises and equipment was $8.5
million at September 30, 2000. 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
-------
The information contained under the sections captioned "Market
Information" in the Company's Annual Report to Stockholders for the Fiscal Year
Ended September 30, 2000 (the "Annual Report") filed as Exhibit 13 hereto is
incorporated herein by reference.
35
<PAGE>
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 18 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 8 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 19 through 55 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 2001
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.
(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.
36
<PAGE>
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.
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(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, 2000 and 1999
Consolidated Statements of Income for the Years Ended September 30,
2000, 1999 and 1998
Consolidated Statements of Stockholders' Equity and Comprehensive
Income for the Years Ended September 30, 2000, 1999 and 1998
Consolidated Statements of Cash Flows for the Years Ended September
30, 2000, 1999 and 1998
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.
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 1st State Bancorp, Inc. 2000 Stock Option and Incentive Plan
10.2 1st State Bancorp, Inc. Management Recognition Plan
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))
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
37
<PAGE>
(b) REPORTS ON FORM 8-K. On September 15, 2000, the Company filed a
-------------------
Current Report on Form 8-K reporting under Item 5: Other Events that the Company
had declared a special cash distribution in the amount of $5.17 per share.
(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.
38
<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 27, 2000 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 27, 2000
-----------------------------------------------------
James C. McGill
President, Chief Executive Officer and Director
(Principal Executive Officer)
/s/ A. Christine Baker December 27, 2000
-----------------------------------------------------
A. Christine Baker
Executive Vice President, Chief Financial
Officer, Secretary and Treasurer
(Principal Financial and Accounting Officer)
/s/ Richard C. Keziah December 27, 2000
-----------------------------------------------------
Richard C. Keziah
Chairman of the Board
/s/ James A. Barnwell, Jr. December 27, 2000
-----------------------------------------------------
James A. Barnwell, Jr.
Director
/s/ Bernie C. Bean December 27, 2000
-----------------------------------------------------
Bernie C. Bean
Director
/s/ Ernest A. Koury, Jr. December 27, 2000
-----------------------------------------------------
Ernest A. Koury, Jr.
Director
/s/ James G. McClure December 27, 2000
-----------------------------------------------------
James G. McClure
Director
/s/ T. Scott Quakenbush December 27, 2000
-----------------------------------------------------
T. Scott Quakenbush
Director
/s/ Richard H. Shirley December 27, 2000
-----------------------------------------------------
Richard H. Shirley
Director
/s/ Virgil L. Stadler December 27, 2000
-----------------------------------------------------
Virgil L. Stadler
Director
