OR PLAN OF OPERATION
Management's discussion and analysis is included to assist shareholders in understanding our financial condition, results of operations, and cash flow. This discussion should be reviewed in conjunction with the consolidated financial statements (unaudited) and notes presented in this report and the supplemental financial data appearing throughout this report. Since the primary asset of the Company is its wholly-owned subsidiary, most of the discussion
and analysis relates to the Bank.
Management's Discussion and Analysis of Financial Condition and Results of Operations and other portions of this quarterly report contain certain "forward-looking statements" concerning the future operations. We desire to take advantage of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1996 and are including this statement for the express purpose of availing the Company of protections of such safe harbor with respect to all "forward-looking statements" contained in this Form 10-Q. Forward looking statements may relate to, among other matters, the financial condition, results of operations, plans, objectives, future performance, and business of the Company. Forward-looking statements are based on many assumptions and estimates and are not guarantees of future performance. Actual results may differ materially from those anticipated in any forward-looking statements. The words "may", "would", "could", "should", "will", "expect", "anticipate", "predict", "project", "potential", "continue", "assume", "believe", "intend", "plan", "forecast", "goal", and "estimate", as well as similar expressions, are meant to identify such forward-looking statements. Potential risks and uncertainties that could cause our actual results to differ materially from those anticipated in our forward-looking statements include, without limitations, those described under the heading "Risk Factors" in our Annual Report on Form 10-K for the year ended
December 31, 2013as filed with the Securities and Exchange Commission(the SEC) and the following: 27
• Risk from changes in economic, monetary policy, and industry conditions
• Changes in interest rates, shape of the yield curve, deposit rates, the net
interest margin and funding sources
• Market risk (including net income at risk analysis and economic value of equity
risk analysis) and inflation
• Risk inherent in making loans including repayment risks and changes in the
value of collateral
• Loan growth, the adequacy of the allowance for loan losses, provisions for loan
losses, and the assessment of problem loans
• Level, composition, and re-pricing characteristics of the securities portfolio
• Deposit growth, change in the mix or type of deposit products and services
• Continued availability of senior management
• Technological changes
• Ability to control expenses
• Changes in compensation
• Risks associated with income taxes including potential for adverse adjustments
• Changes in accounting policies and practices
• Changes in regulatory actions, including the potential for adverse adjustments
• Recently enacted or proposed legislation
• Current uncertainty in the financial service industry
These risks are exacerbated by the development over the last five years in national and international financial markets, and we are unable to predict what effect continued uncertainty in market conditions will have on us. There can be no assurance that the unprecedented developments experienced over the last five years will not materially and adversely affect our business, financial condition and results of operations. All forward-looking statements in this report are based on information available to us as of the date of this report. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that these expectations will be achieved. We will undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made to reflect the occurrence of unanticipated events. In addition, certain statements in our future filings with the
SEC, in our press releases, and in our oral and written statements, which are not statements of historical fact, constitute forward looking statements. Overview Bank of South Carolina Corporation(the Company) is a financial institution holding company headquartered in Charleston, South Carolina, with $336.6 millionin assets as of March 31, 2014and net income of $955,798for the three months ended March 31, 2014. The Company offers a broad range of financial services through its wholly-owned subsidiary, The Bank of South Carolina(the Bank). The Bank is a state-chartered commercial bank which operates primarily in the Charleston, Dorchesterand Berkeleycounties of South Carolina. The Bank's original and current concept is to be a full service financial institution specializing in personal service, responsiveness, and attention to detail to foster long standing relationships. The following is a discussion of our financial condition as of March 31, 2014as compared to December 31, 2013and the results of operations for the three months ended March 31, 2014as compared to the three months ended March 31, 2013. The discussion and analysis identifies significant factors that have affected our financial position and operating results and should be read in conjunction with the financial statements and the related notes included in this report. We derive most of our income from interest on loans and investments (interest bearing assets). The primary source of funding for making these loans and investments is our interest and non-interest bearing deposits. Consequently, one of the key measures of our success is the amount of net interest income, or the difference between the income on our interest earning assets, such as loans and investments, and the expense on our interest bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest bearing assets and the rate we pay on our interest bearing liabilities. 28
A consequence of lending activities is that we may incur credit losses. The amount of such losses will vary depending upon the risk characteristics of the loan and lease portfolio as affected by economic conditions such as rising interest rates and the financial performance of borrowers. The reserve for credit losses consists of the allowance for loan and lease losses (the "Allowance") and a reserve for unfunded commitments (the "Unfunded Reserve"). The Allowance provides for probable and estimable losses inherent in our loan and lease portfolio. The Allowance is increased or decreased through the provisioning process. For a detailed discussion on the allowance for loan losses see "Allowance for Loan Losses". In addition to earning interest on loans and investments, we earn income through fees and other expenses we charge to the customer. The various components of non-interest income as well as non-interest expense are described in the following discussion. CRITICAL ACCOUNTING POLICIES
We have adopted various accounting policies that govern the application of principles generally accepted in
the United Statesand with general practices within the banking industry in the preparation of our financial statements. Our significant accounting policies are described in the footnotes to our unaudited consolidated financial statements as of March 31, 2014and our notes included in the consolidated financial statements in our 2013 Annual Report on Form 10-K as filed with the SEC. Certain accounting policies involve significant judgments and assumptions by the Company that have a material impact on the carrying value of certain assets and liabilities. We consider these accounting policies to be critical accounting policies. The judgment and assumptions we use are based on historical experience and other factors, which we believe to be reasonable under the circumstances. Because of the number of the judgments and assumptions that we make, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of our assets and liabilities and our results of operations.
We consider our policies regarding the allowance for loan losses to be our most subjective accounting policy due to the significant degree of management judgment. We have developed what we believe to be appropriate policies and procedures for assessing the adequacy of the allowance for loan losses, recognizing that this process requires a number of assumptions and estimates with respect to our loan portfolio. Our assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations and the discovery of information with respect to borrowers which were not known at the time of the issuance of the consolidated financial statements. For additional discussion concerning our allowance for loan losses and related matters, see "Allowance for Loan Losses." BALANCE SHEET CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and noninterest-bearing deposits, and interest-bearing deposits. All amounts are readily convertible to cash and have maturities of less than 90 days. Total cash and cash equivalents decreased 49.15% or
$10,874,738to $11,249,358at March 31, 2014, from $22,124,096at December 31, 2013. This decrease was primarily due to a decrease in deposits in other banks and an increase in loans. Regulations set by the Federal Reserve require that we maintain certain average cash reserve balances. For the three months ended March 31, 2014and 2013 our cash reserve requirement with the Federal Reserve was satisfied by vault cash. LOANS We focus our lending activities on small and middle market businesses, professionals and individuals in our geographic markets. At March 31, 2014, outstanding loans (plus deferred loan fees of $79,198) totaled $227,240,465which equaled 75.78% of total deposits and 67.51% of total assets. Substantially all loans were to borrowers located in our market area of Charleston, Dorchesterand Berkeleycounties of South Carolina. 29
The quality of our loan portfolio is contingent upon our risk selection and underwriting practices. Every credit with over
$100,000in exposure is summarized by our Credit Departmentand reviewed by the Loan Committee on a monthly basis. The Board of Directors review credits over $500,000monthly with annual credit analyses conducted on these borrowers upon the receipt of updated financial information. Prior to any extension of credit, every loan request goes through sound credit underwriting. The Credit Departmentconducts detailed cash flow analysis on each proposal using the most current financial information. Relevant trends and ratios are evaluated. The breakdown of total loans by type and the respective percentage of total loans are as follows: March 31, December 31, 2014 2013 2013 Commercial loans $ 53,233,24055,724,957 $ 53,303,569Commercial real estate:
Commercial real estate construction 1,496,366 1,730,252
1,516,545 Commercial real estate other 107,489,145 105,451,553 104,740,578 Consumer: Consumer real estate 60,682,506 49,241,306 54,669,359 Consumer other 4,339,208 4,044,962 4,090,253 227,240,465 216,193,030 218,320,304 Allowance for loan losses (3,323,565 ) (3,418,953 ) (3,292,277 ) Loans, net
$ 223,916,900 $ 212,774,077 $ 215,028,027Percentage of Loans March 31, December 31, 2014 2013 2013 Commercial loans 23.43 % 25.77 % 24.41 %
Commercial real estate construction .66 % .80 %
.70 % Commercial real estate other 47.30 % 48.78 % 47.98 % Consumer real estate 26.70 % 22.78 % 25.04 % Consumer other 1.91 % 1.87 % 1.87 % Total 100.00 % 100.00 % 100.00 %
INVESTMENT SECURITIES AVAILABLE FOR SALE
We use the investment securities portfolio for several purposes. It serves as a vehicle to manage interest rate and prepayment risk, to generate interest and dividend income from investment of funds, to provide liquidity to meet funding requirements, and to provide collateral for pledges on public funds. Investments are classified into three categories (1) Held to Maturity (2) Trading and (3) Available for Sale. We believe that maintaining our securities in the Available for Sale category provides greater flexibility in the management of the overall investment portfolio. The average yield on investments at
March 31, 2014was 2.20% compared to 2.46% at December 31, 2013. The amortized cost of the investments available for sale at March 31, 2014, March 31, 2013and December 31, 2013and percentage of each category to total investments are as follows: 30 INVESTMENT PORTFOLIO December 31, March 31, 2014 March 31, 2013 2013 US Treasury Notes $ 10,747,414 $ 6,188,438 $ 15,832,401Government-Sponsored Enterprises 45,639,243 18,250,090 43,635,038 Municipal Securities 33,842,675 33,977,335 35,180,782 $ 90,229,332 $ 58,415,863 $ 94,648,221US Treasury Notes 11.91 % 10.59 % 16.73 % Government-Sponsored Enterprises 50.58 % 31.24 % 46.10 % Municipal Securities 37.51 % 58.17 % 37.17 % 100.00 % 100.00 % 100.00 % All investment securities were classified as Available for Sale (debt and equity securities that may be sold under certain conditions), at March 31, 2014and December 31, 2013. The securities were reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders' equity, net of income taxes. Unrealized losses on securities due to fluctuations in fair value are recognized when it is determined that an other than temporary decline in value has occurred. Gains or losses on the sale of securities are recognized on a specific identification, trade date basis. (See "non-interest income" for discussion on the sale of investment securities.)
The amortized cost and fair value of investment securities available for sale are summarized as follows as of
MARCH 31, 2014 GROSS GROSS UNREALIZED UNREALIZED ESTIMATED AMORTIZED COST GAINS LOSSES FAIR VALUE
U.S. Treasury Notes
$ 10,814,112$ - $ 66,698 $ 10,747,414Government-Sponsored Enterprises 45,649,870 275,417 286,044 45,639,243 Municipal Securities 32,058,959 1,851,462
67,746 33,842,675 Total
$ 88,522,941 $ 2,126,879 $ 420,488 $ 90,229,332DECEMBER 31, 2013 GROSS GROSS UNREALIZED UNREALIZED ESTIMATED AMORTIZED COST GAINS LOSSES FAIR VALUE
U.S. Treasury Notes
$ 15,841,901 $ 58,429 $ 67,929 $ 15,832,401Government-Sponsored Enterprises 43,582,119 363,981 311,062 43,635,038 Municipal Securities 33,706,898 1,599,638
125,754 35,180,782 Total
$ 93,130,918 $ 2,022,048 $ 504,745 $ 94,648,22131 The amortized cost and fair value of investment securities available for sale at March 31, 2014, and December 31, 2013, by contractual maturity are as follows: March 31, 2014 AMORTIZED COST ESTIMATED FAIR VALUE Due in one year or less $ 4,721,793$ 4,775,047 Due in one year to five years 49,580,835
Due in five years to ten years 25,422,397 26,214,686 Due in ten years and over 8,797,916 9,085,735 Total
$ 88,522,541$ 90,229,332 December 31, 2013 AMORTIZED COST ESTIMATED FAIR VALUE
Due in one year or less
Due in five years to ten years 31,907,109 32,503,090 Due in ten years and over 10,864,864 11,083,530 Total
$ 93,130,918$ 94,648,221
The fair value of investment securities available for sale with unrealized losses at
MARCH 31, 2014 Less than 12 months 12 months or longer Total Unrealized Unrealized Unrealized
Description of Securities Fair Value Losses Fair Value
Losses Fair Value Losses U.S. Treasury Notes
$10,747,414 $ 66,698$ - $ - $10,747,414 $ 66,698Government-Sponsored Enterprises 25,293,461 286,044
- - 25,293,461 286,044 Municipal Securities 1,924,577 67,746 - - 1,924,577 67,746 Total
$ 37,965,452 $ 420,488$ - $ - $ 37,965,452 $ 420,48832 DECEMBER 31, 2013 Less than 12 months 12 months or longer Total Unrealized Unrealized
Description of Securities Fair Value Losses Fair Value Unrealized Losses Fair Value Losses
U.S. Treasury Notes
$ 9,713,619 $ 67,929$ - $ - $ 9,713,619 $ 67,929Government-Sponsored Enterprises 20,027,016 311,062
- - 20,027,016 311,062 Municipal Securities 2,496,742 125,652 401,624 102 2,898,366 125,754 Total
$ 32,237,377 $ 504,643 $ 401,624$ 102 $ 32,639,001 $ 504,745
March 31, 2014, we had four US Treasury Notes with an unrealized loss of $66,698, six Agency Notes with an unrealized loss of $286,044and three Municipal Securitieswith an unrealized loss of $67,746. At December 31, 2013we had three US Treasury Notes with an unrealized loss of $67,929, five Agency Notes with an unrealized loss of $311,062and six Municipal Securitieswith an unrealized loss of $125,754. The unrealized losses on investments were caused by interest rate increase. The contractual terms of these investments do not permit the issuer to settle the securities at a price less than the amortized cost of the investment. Therefore, these investments are not considered other-than-temporarily impaired. We have the ability to hold these investments until market price recovery or maturity.
Deposits remain our primary source of funding for loans and investments. Average interest bearing deposits provided funding for 64.40% of average earning assets for the three months ended
March 31, 2014, and 66.07% for the twelve months ended December 31, 2013. The Company encounters strong competition from other financial institutions as well as consumer and commercial finance companies, insurance companies and brokerage firms located in the primary service area of the Bank. However, the percentage of funding provided by deposits has remained stable. The breakdown of total deposits by type and the respective percentage of total deposits are as follows: March 31, December 31, 2014 2013 2013 Non-interest bearing demand $ 85,613,981 $ 86,883,466 $ 90,574,330Interest bearing demand 75,233,813 76,682,220 78,576,851 Money market accounts 50,885,257 52,807,591 47,190,365 Certificates of deposit $100,000and over 50,291,095 42,410,373 52,516,487 Other time deposits 15,485,341 15,815,284 15,730,187 Other savings deposits 22,368,706 18,379,803 20,654,435 Total Deposits $ 299,878,193 $ 292,978,737 $ 305,242,655Percentage of Deposits March 31, December 31, 2014 2013 2013 Non-interest bearing demand 28.55 % 29.66 % 29.67 % Interest bearing demand 25.09 % 26.17 % 25.74 % Money market accounts 16.97 % 18.02 % 15.46 %
Certificates of deposit
$100,000and over 16.77 % 14.48 %
17.21 % Other time deposits 5.16 % 5.40 % 5.51 % Other savings deposits 7.46 % 6.27 % 6.77 % Total Deposits 100.00 % 100.00 % 100.00 % 33
Deposits increased 2.35% or
March 31, 2014and December 31, 2013, we had no outstanding federal funds purchased with the option to borrow up to $19,000,000on short term lines of credit. In March 2012, we established a $6 millionREPO Line with Raymond James. There have been no borrowings under this agreement. We also established a Borrower-In-Custody arrangement with the Federal Reserve as a secondary source of liquidity. This arrangement permits us to retain possession of loans pledged as collateral to secure advances from the Federal Reserve Discount Window. Under this agreement we could borrow up to $65.5 millionand $69 millionat March 31, 2014and December 31, 2013, respectively. There have been no borrowings under this arrangement.
Comparison of Three Months Ended
Net income decreased
$43,007or 4.31% to $955,798, or basic and diluted earnings per share of $.21and $.21, respectively, for the three months ended March 31, 2014, from $998,805, or basic and diluted earnings per share of $.22and $.22, respectively, for the three months ended March 31, 2013. Our return on average assets and average equity for the three months ended March 31, 2014were 1.15% and 10.92%, respectively, compared with 1.26% and 11.72%, respectively, for the three months ended March 31, 2013.
Net Interest Income
Net interest income is affected by the size and mix of our balance sheet components as well as the spread between interest earned on assets and interest paid on liabilities. Net interest margin is a measure of the difference between interest income on earning assets and interest paid on interest bearing liabilities relative to the amount of interest bearing assets. Net interest income increased
$144,703or 4.89% to $3,105,362for the three months ended March 31, 2014from $2,960,659for the three months ended March 31, 2013. The increase in net interest income was primarily due to an increase in interest and dividends from investment securities. We made a decision to invest some of our excess cash in securities rather than leaving it at the Federal Reserve where it was earning .25%. Average investments increased $36,060,067or 61.90% for the three months ended March 31, 2014from the three months ended March 31, 2013, with a yield of 2.11%. We had a modest increase in average loans of $713,864to $226,323,287for the three months ended March 31, 2014from $225,609,423for the three months ended March 31, 2013. The yield on average loans remained relatively stable at 4.86% for the three months ended March 31, 2013from 4.87% for the three months ended March 31, 2013. Total average interest bearing assets increased $14,328,096or 4.54% to $330,194,832for the three months ended March 31, 2014. Our average interest bearing deposits increased $8,767,971or 4.30% to $212,653,464for the three months ended March 31, 2014from $203,885,493for the three months ended March 31, 2013. The yield on these deposits remained relatively unchanged from .20% for the three months ended March 31, 2013to .19% for the three months ended March 31, 2014.
Allowance for Loan Losses
The allowance for loan losses represents management's estimate of probable losses inherent in the loan portfolio. The adequacy of the allowance for loan losses (the "allowance") is reviewed monthly by the Loan Committee and on a quarterly basis by the Board of Directors. For purposes of this analysis, adequacy is defined as a level sufficient to absorb estimated losses in the loan portfolio as of the balance sheet date presented. The methodology employed for this analysis has had various modifications over the years to better reflect the economic environment and to implement regulatory guidance. This allowance is reviewed on a monthly basis by Credit Personnel (who have no lending authority nor complete the allowance). In addition, the allowance is validated on a periodic basis by the Company's Risk Manager. The revised methodology is based on a Reserve Model that is comprised of the three components listed below:
1) Specific Reserve analysis for impaired loans based on Financial Accounting
2) General reserve analysis applying historical loss rates based on FASB ASC
3) Qualitative or environmental factors.
Loans are reviewed for impairment on a quarterly basis if any of the following criteria are met:
1) Any loan on non-accrual
2) Any loan that is a troubled debt restructuring
3) Any loan over 60 days past due
4) Any loan rated sub-standard, doubtful, or loss
5) Excessive principal extensions are executed
6) If we are provided information that indicates we will not collect all
principal and interest as scheduled
The aforementioned methodology applies to both secured and unsecured loans, yet it does not apply to large groups of smaller balance loans that are collectively evaluated. Impairment is measured by the present value of the future cash flow discounted at the loan's effective interest rate, or, alternatively the fair value of the collateral if the loan is collateral dependent. An impaired loan may not represent an expected loss. A general reserve analysis is performed on all loans, excluding impaired loans. This analysis includes a pool of loans that are reviewed for impairment but are not found to be impaired. Historical losses are segregated into risk-similar groups and a loss ratio is determined for each group over a three year period. The three year average loss ratio by type is then used to calculate the estimated loss based on the current balance of each group. The three year historical loss percentage was .10% and .22% at
March 31, 2014and March 31, 2013, respectively. Qualitative and environmental factors include external risk factors that management believes are representative of the overall lending environment of the Company. Management believes that the following factors create a more comprehensive system of controls in which we can monitor the quality of the
loan portfolio. 1) Portfolio risk
a. Levels and trends in delinquencies and impaired loans
b. Trends in volume and terms of loans
c. Over-margined real estate lending risk
2) National and local economic trends and conditions
3) Effects of changes in risk selection and underwriting practices
4) Experience, ability and depth of lending management staff
5) Industry conditions
6) Effects of changes in credit concentrations
a. Loan concentration b. Geographic concentration c. Regulatory concentration
7) Loan and credit administration risk
a. Collateral documentation
b. Insurance risk
c. Maintenance of financial information risk
The sum of each component's analysis results represents the "estimated loss" within the Company's total portfolio.
Portfolio risk includes the levels and trends in delinquencies, impaired loans and changes in the loan rating matrix, trends in volume and terms of loans and overmargined real estate lending. Management is satisfied with the stability of the past due and non-performing loans and believes there has been no decline in the quality of the loan portfolio due to any trend in delinquent or adversely classified loans. Sizable unsecured principal balances on a non-amortizing basis are monitored. Although the vast majority of our real estate loans are underwritten on a cash flow basis, the secondary source of repayment is typically tied to our ability to realize on the collateral. We closely monitor loan to value ratios. The maximum collateral advance rate is 80% on all real estate transactions, with the exception of raw land at 65% and land development at 70%. 35
Occasionally, we extend credit beyond our normal collateral advance margins in real estate lending. Although infrequent, the aggregate of these loans represent a notable part of our portfolio. Accordingly, these loans are monitored and the balances reported to the Board every quarter. An excessive level of this practice (as a percentage of capital) could result in additional regulatory scrutiny, competitive disadvantages and potential losses if forced to convert the collateral. The consideration of overmargined real estate loans directly relates to the capacity of the borrower to repay. Management often requests additional collateral to bring the loan to value ratio within the policy guidelines and also requires a strong secondary source of repayment in addition to the primary source of repayment. Although significantly under the threshold of 100% of capital (currently approximately
$35 million), the number of over-margined real estate loans currently totals approximately $20.9 millionor approximately 9.21% of our loan portfolio at March 31, 2014compared to $19.1 millionor approximately 8.48% of the loan portfolio at March 31, 2013. A credit rating matrix is used to rate all extensions of credit and to provide a more specified picture of the risk each loan poses to the quality of the loan portfolio. There are eight possible ratings used to determine the quality of each loan based on nine different qualifying characteristics: cash flow, collateral quality, guarantor strength, financial condition, management quality, operating performance, the relevancy of the financial statements, historical loan performance, and the borrower's leverage position. The matrix is designed to meet management's standards and expectations of loan quality. One hundred percent of our loans are graded. National and local economic trends and conditions are constantly changing and result in both positive and negative impact on borrowers. Most macroeconomic conditions are not controllable by us and are incorporated into the qualitative risk factors. Natural and environmental disasters, wars and the recent collapse of the subprime lending market as well as problems in the traditional mortgage market are a few of the trends and conditions that are currently affecting the national and local economies. Changes in the national and local economy have impacted borrowers' ability, in many cases, to repay loans in a timely manner. On occasion, a loan's primary source of repayment (i.e., personal income, cash flow, or lease income) may be eroded as a result of unemployment, lack of revenues, or the inability of a tenant to make rent payments. The quality of our loan portfolio is contingent upon our risk selection and underwriting practices. Every credit with over $100,000in exposure is summarized by our Credit Departmentand reviewed by the Loan Committee on a monthly basis. The Board of Directors reviews credits over $500,000monthly with annual credit analyses conducted on these borrowers upon the receipt of updated financial information. Prior to any extension of credit, every significant commercial loan goes through sound credit underwriting. The Credit Departmentconducts a detailed cash flow on each proposal using the most current financial information. Relevant trends and ratios are evaluated. Between March 31, 2013and March 31, 2014we originated $9.6 millionin new equity lines, an increase of 23.23%. Equity lines have always been a significant portion of our loan portfolio and, as of March 31, 2014, comprise 26.70% of all loans. We have over 350 years of lending management experience among twelve members of our lending staff. In addition to the lending staff, we have an Advisory Boardfor each office comprised of business and community leaders from the specific office market area. An additional Advisory Boardwas created during the year ended December 31, 2012, to support our business efforts in the North Charlestonarea of South Carolina. The Bank recently announced its intention to open an office in North Charleston, South Carolinaon Highway 78and Ingleside Boulevard. We have signed a lease with an anticipated opening in 2015. Management meets with these advisory boards quarterly to discuss the trends and conditions in each respective market. Management is aware of the many challenges currently facing the banking industry. As other banks look to increase earnings in the short term, we will continue to emphasize the need to maintain safe and sound lending practices and core deposit growth.
There continues be an influx of large banks in our geographic area. This increase has decreased the local industry's overall margins as a result of pricing competition. Management believes that our borrowing base is well established and therefore unsound price competition is not necessary.
The risks associated with the effects of changes in credit concentration include loan concentration, geographic concentration and regulatory concentration.
March 31, 2014, there were only four Standard Industrial Code groups that comprised more than 2% of our total outstanding loans. The four groups are activities related to real estate, offices and clinics of doctors, real estate agents and managers, and legal services. We are located along the coast and on an earthquake fault, increasing the chances that a natural disaster may impact us and our borrowers. We have a Disaster Recovery Plan in place; however, the amount of time it would take for our customers to return to normal operations is unknown. This plan is reviewed and tested annually.
Loan and credit administration risk includes collateral documentation, insurance risk and maintaining financial information risk.
The majority of our loan portfolio is collateralized with a variety of our borrowers' assets. The execution and monitoring of the documentation to properly secure the loan is the responsibility of our lenders and
Loan Department. We require insurance coverage naming us as the mortgagee or loss payee. Although insurance risk is also considered collateral documentation risk, the actual coverage, amounts of coverage and increased deductibles are important to management. Recent legislation passed by Congressaddresses the need for reform to the National Flood Insurance Program. This legislation, known as the Biggert Waters Flood Insurance Reform and Modernization Act of 2012, has resulted in significant unintended consequences causing dramatic increases in the cost of flood insurance coverage and its potential unaffordability. However, on March 14, 2014the President signed the 2014 Homeowner Flood Insurance Affordability Act. This new law allows most properties to retain their subsidized premiums. Annual rate increases are also limited to 18% per year and the grandfather plan has been reinstated. In addition, the new law requires the Federal Emergency Management Agency("FEMA") to refund policy holders who overpaid for premiums under the Biggert Waters Flood Insurance Reform and Modernization Act of 2012. Risk includes a function of time during which the borrower's financial condition may change; therefore, keeping financial information up to date is important to us. Our policy requires all new loans, regardless of the customer's history with us, to have updated financial information. In addition, we monitor appraisals closely as real estate values continue to fluctuate. Based on our allowance for loan loss model, we recorded a provision for loan loss of $30,000for the three months ended March 31, 2014compared to $75,000for the three months ended March 31, 2013. At March 31, 2014the three year average loss ratios were: .142% Commercial, .706% Consumer, .116% 1-4 Residential, .000% Real Estate Constructionand .044% Real Estate Mortgage. The three year historical loss ratio used at March 31, 2014was .10% compared to .22% at March 31, 2013. During the three months ended March 31, 2014charge-offs of $6,018and recoveries of $7,306were recorded to the allowance for loan losses, resulting in an allowance for loan losses of $3,323,565or 1.46% of total loans at March 31, 2014, compared to charge-offs of $93,953and recoveries of $5,062resulting in an allowance for loan losses of $3,418,953or 1.58% of total loans at March 31, 2013.
We had impaired loans totaling
$7,020,982as of March 31, 2014compared to $11,503,291at March 31, 2013. The impaired loans include non-accrual loans with balances at March 31, 2014, and 2013, of $1,501,158and $4,021,870, respectively. We had four restructured loans ("TDR") at March 31, 2014and five restructured loans at March 31, 2013. According to GAAP, we are required to account for certain loan modifications or restructuring as a troubled debt restructuring, when appropriate. In general, the modification or restructuring of a debt is considered a TDR if we, for economic or legal reasons related to a borrower's financial difficulties, grants a concession to the borrower that we would not otherwise consider. At March 31, 2014the four restructured loans had an aggregate balance of $1,184,994compared to the five restructured loans with an aggregate balance of $1,602,025at March 31, 2013. Included in the impaired loans at March 31, 2013, was one credit totaling $2,623,556which is entirely secured by a first mortgage, improving the Bank's existing second real estate mortgage secured position and including the existing unsecured debt. This loan was paid off in the second quarter of 2013. We do not know of any loans which will not meet their contractual obligations that are not otherwise discussed herein. 37
The accrual of interest is generally discontinued on loans, which become 90 days past due as to principal or interest. The accrual of interest on some loans, however, may continue even though they are 90 days past due if the loans are well secured or in the process of collection and management deems it appropriate. If non-accrual loans decrease their past due status to less than 30 days for a period of 6 to 9 months, they are reviewed individually by management to determine if they should be returned to accrual status. There was one loan over 90 days past due still accruing interest at
March 31, 2014and no loans over 90 days past due still accruing interest at March 31, 2013. Total loans past due greater than 30 days decreased $1,886,757from $5,204,431at March 31, 2013to $3,317,674at March 31, 2014. This decrease was due to the payoff of two loans totaling $1.87 million.
Net recoveries for the three months ended
The following table represents the net charge-offs by loan type.
Net recovery (charge-offs) March 31, 2014 March 31, 2013 Commercial Loans $ -
$ (92,464 )Commercial Real Estate 3,147 3,000 Consumer Real Estate - - Consumer Other (1,859 ) 573 Net recovery (Charge-Offs) $ 1,288 $ (88,891 )
$481,529, in unallocated reserves at March 31, 2014related to other inherent risk in the portfolio compared to unallocated reserves of $340,874at March 31, 2013. We believe this amount is appropriate and properly supported through the environmental factors of our allowance for loan losses. We believe the allowance for loan losses at March 31, 2014, is adequate to cover estimated losses in our loan portfolio; however, assessing the adequacy of the allowance is a process that requires considerable judgment. Our judgments are based on numerous assumptions about current events which we believe to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current allowance amount or that future increases in the allowance will not be required. No assurance can be given that our ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the allowance, thus adversely affecting our operating results.
The following table presents a breakdown of the allowance for loan losses as of
March 31, 2014 March 31, 2013Percentage Percentage Allowance by of loans to
Allowance by of loans to
loan type total loans loan type total loans Commercial Loans
$ 1,395,08723 % $ 1,337,96726 % Commercial Real Estate 958,270 48 % 368,395 49 % Consumer Real Estate 405,361 27 %
693,705 23 % Consumer Other 83,318 2 % 70,473 2 % Unallocated 481,529 0 % 948,413 0 % Total
$ 3,323,565100 % $ 3,418,953100 % The allowance is also subject to examination testing by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require us to adjust our allowance based on information available to them at the time of their examination. 38 The methodology used to determine the reserve for unfunded lending commitments, which is included in other liabilities, is inherently similar to that used to determine the allowance for loan losses described above adjusted for factors specific to binding commitments, including the probability of funding and historical loss ratio. No provision was recorded during the three months ended March 31, 2014or the three months ended March 31, 2013, resulting in no change to the balance of $20,825. Non-interest Income Our non-interest income decreased $192,084or 26.26% to $539,335for the three months ended March 31, 2014, from $731,419for the three months ended March 31, 2013. This decrease was primarily due to a decrease in mortgage banking income of $266,957or 54.04% to $227,055for the three months ended March 31, 2014as compared to $494,012for the three months ended March 31, 2013. Higher interest rates and an increase in home prices impacted our mortgage loan originations. These trends began in the second half of 2013 and have resulted in lower discount fees earned and lower service release premiums. Discount fees decreased $202,870or 45.04% and service release premiums decreased $232,793or 73.54% for the three months ended March 31, 2014. The decrease in mortgage banking income was offset by a gain of $84,898on the sale of $14,000,000in investment securities. This sale included one $3,000,000Agency Note and three US Treasury Notes that totaled $11,000,000. The investments were replaced by one $5,000,000Agency Note and two US Treasury Notes that totaled $6,000,000.
Non-interest expense increased
$73,743or 3.40% to $2,240,499for the three months ended March 31, 2014, from $2,166,756for the three months ended March 31, 2013. This increase was primarily due to increases in salaries and employee benefits and an increase in occupancy expense offset by a decrease in other operating expenses. Salaries and employee benefits increased $47,828or 3.73% from $1,282,083for the three months ended March 31, 2013to $1,329,911for the three months ended March 31, 2014, as a result of annual merit increases and an increase in the cost of providing medical insurance. Wages increased $50,892to $1,048,282for the three months ended March 31, 2014. The Compensation Committee of the Board of Directors recommended and the Board of Directors approved a $15,000salary increase for Executive Officers for the year ending December 31, 2014. All other employees received annual merit increases. In addition to the salary increases, the cost of providing insurance for employees increased $11,648from $119,081for the three months ended March 31, 2013to $130,729for the three months ended March 31, 2014. Our net occupancy expense increased $37,134to $364,672for the three months ended March 31, 2014. This increase was primarily due to the increases in rent paid on our banking houses in Summerville, Meeting Streetand the larger space obtained for our Mortgage Department. In addition, we had an increase of $14,828in maintenance contracts as well as an increase of $4,662in depreciation on furniture and fixtures.
Our other operating expenses decreased as the result of lower professional fees and a decrease in fees paid for professional meetings. Our professional fees decreased as a result of lower legal fees, a decrease of
$6,500or 52.00% to $6,000for the three months ended March 31, 2014. Our fees paid for professional meetings decreased $9,945or 68.92% to $4,484for the three months ended March 31, 2014from $14,429for the three months ended March 31, 2013.
Income Tax Expense
For the three months ended
Off Balance Sheet Arrangements
In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used by us for general corporate purposes or for customer needs. Corporate purpose transactions are used to help manage credit, interest rate and liquidity risk or to optimize capital. Customer transactions are used to manage customer requests for funding. Our off-balance sheet arrangements consist principally of commitments to extend credit described below. We estimate probable losses related to binding unfunded lending commitments and record a reserve for unfunded lending commitments in other liabilities on the consolidated balance sheet. At
March 31, 2014and 2013 the balance of this reserve was $20,825. At March 31, 2014and 2013, we had no interests in non-consolidated special purpose entities. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The amount of collateral obtained if deemed necessary by the Company upon extension of credit is based on management's credit evaluation of the borrower. Collateral held varies but may include accounts receivable, negotiable instruments, inventory, property, plant and equipment, and real estate. Commitments to extend credit, including unused lines of credit, amounted to $61,498,207and $57,583,876at March 31, 2014and 2013, respectively. Standby letters of credit represent our obligation to a third party contingent upon the failure of our customer to perform under the terms of an underlying contract with the third party or obligates us to guarantee or stand as surety for the benefit of the third party. The underlying contract may entail either financial or nonfinancial obligations and may involve such things as the shipment of goods, performance of a contract, or repayment of an obligation. Under the terms of a standby letter, generally drafts will be drawn only when the underlying event fails to occur as intended. We can seek recovery of the amounts paid from the borrower. The majority of these standby letters of credit are unsecured. Commitments under standby letters of credit are usually for one year or less. The maximum potential amount of undiscounted future payments related to standby letters of credit at March 31, 2014and 2013 was $557,593and $734,712, respectively. We originate certain fixed rate residential loans and commit these loans for sale. The commitments to originate fixed rate residential loans and the sales commitments are freestanding derivative instruments. We had forward sales commitments, totaling $6,809,498at March 31, 2014, to sell loans held for sale of $6,809,498. At March 31, 2013, we had forward sales commitments of $10,193,974. The fair value of these commitments was not significant at March 31, 2014or 2013. We had no embedded derivative instruments requiring separate accounting treatment.
Once we sell certain fixed rate residential loans, the loans are no longer reportable on our balance sheet. With most of these sales, we have an obligation to repurchase the loan in the event of a default of principal or interest on the loan. This recourse period ranges from three to six months with unlimited recourse as a result of fraud. The unpaid principal balance of loans sold with recourse was
$10.8 millionat March 31, 2014and $57.8 millionat March 31, 2013. For the three months ended March 31, 2014and March 31, 2013there were no loans repurchased. Liquidity Historically, we have maintained our liquidity at levels believed by management to be adequate to meet requirements of normal operations, potential deposit outflows and strong loan demand and still allow for optimal investment of funds and return on assets. 40 We manage our assets and liabilities to ensure there is sufficient liquidity to enable management to fund deposit withdrawals, loan demand, capital expenditures, reserve requirements, operating expenses, dividends and to manage daily operations on an ongoing basis. Funds are primarily provided by the Bank through customer deposits, principal and interest payments on loans, mortgage loan sales, the sale or maturity of securities, temporary investments and earnings. Proper liquidity management is crucial to ensure that we are able to take advantage of new business opportunities as well as meet the credit needs of our existing customers. Investment securities are an important tool in our liquidity management. Our primary liquid assets are cash and due from banks, federal funds sold, investments available for sale, other short-term investments and mortgage loans held for sale. Our primary liquid assets accounted for 32.17% and 33.99% of total assets at March 31, 2014and 2013, respectively. Securities classified as available for sale, which are not pledged, may be sold in response to changes in interest rates and liquidity needs. All of the securities presently owned are classified as Available for Sale. Net cash provided by operations and deposits from customers have been the primary sources of liquidity. At March 31, 2014, we had unused short-term lines of credit totaling approximately $19 million(which can be withdrawn at the lender's option). Additional sources of funds available to us for additional liquidity needs include borrowing on a short-term basis from the Federal Reserve System, increasing deposits by raising interest rates paid and selling mortgage loans held for sale. In March 2012, we established a $6 millionREPO Line with Raymond James(formerly Morgan Keegan). There have been no borrowings under this agreement. We also established a Borrower-In-Custody arrangement with the Federal Reserve. This arrangement permits us to retain possession of assets pledged as collateral to secure advances from the Federal Reserve Discount Window. At March 31, 2014we could borrow up to $65.5 million. There have been no borrowings under this arrangement. Our core deposits consist of non-interest bearing accounts, NOW accounts, money market accounts, time deposits and savings accounts. We closely monitor our reliance on certificates of deposit greater than $100,000and other large deposits. We believe our liquidity sources are adequate to meet our operating needs and do not know of any trends, events or uncertainties that may result in a significant adverse effect on our liquidity position. At March 31, 2014and 2013, our liquidity ratio was 26.48% and 23.97%, respectively.
Our capital needs have been met to date through the
$10,600,000in capital raised in our initial offering, the retention of earnings less dividends paid and the exercise of stock options for a total shareholders' equity at March 31, 2014, of $35,278,526. The rate of asset growth since our inception has not negatively impacted this capital base. The current risk-based capital guidelines for financial institutions are designed to highlight differences in risk profiles among financial institutions and to account for off-balance sheet risk. The current guidelines established require a minimum risk-based capital ratio of 8% for bank holding companies and banks. The risk-based capital ratio at March 31, 2014for the Bank was 14.51% and 13.65% at March 31, 2013. Our management does not know of any trends, events or uncertainties that may result in our capital resources materially increasing or decreasing. On June 23, 2011the Board of Directors voted to file a shelf registration (Form S-3) with the Securities and Exchange Commission("SEC"). This shelf registration statement on Form S-3 provides for the offer and sale from time to time over a three year period, in one or more public offerings, up to $10 millionin common stock or debt securities. Specific terms and prices will be determined at the time of each offering under a separate prospectus supplement, which will be filed with the SECat the time of the offering. The registration statement was filed with the SECon June 23, 2011. The filing of the shelf registration does not require us to issue securities. Although we have no current commitments to sell additional stock or securities, the shelf registration will provide us with a source of additional capital for acquisitions, capital expenditures, and repayment of indebtedness we may incur in the future, working capital and other general corporate purposes. 41 The shelf registration will expire in June 2014. As of the date of this filing, the Board of Directors has not determined whether another Form S-3 will be filed when the shelf registration expires. We are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory - and possibly additional discretionary - actions by regulators that, if undertaken, could have a material effect on the financial statements. Under current capital adequacy guidelines and the regulatory framework for prompt corrective action, we must meet specific capital guidelines that involve quantitative measures of our assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices. Our capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Current quantitative measures established by regulation to ensure capital adequacy require that we maintain minimum amounts and ratios of total and Tier 1 capital to risk-weighted assets and to average assets. Management believes, as of March 31, 2014, that the Company and the Bank meet all capital adequacy requirements to which they are subject. At March 31, 2014and 2013, the Company and Bank are categorized as "well capitalized" under the regulatory framework for prompt corrective action. To be categorized as "well capitalized" the Company and the Bank must maintain minimum total risk based, Tier 1 risk based and Tier 1 leverage ratios of 10%, 6% and 5%, respectively, and to be categorized as "adequately capitalized," the Company and the Bank must maintain minimum total risk based, Tier 1 risk based and Tier 1 leverage ratios of 8%, 4% and 4%, respectively. There are no current conditions or events that management believes would change the Company's or
the Bank's category. On
July 2, 2013, the Federal Reserve Boardapproved the final rules implementing the Basel Committee on Banking Supervision's("BCBS") capital guidelines for US banks. Under the final rules, minimum requirements will increase our quantity and quality of the capital. The rules include a new common equity Tier 1 capital to risk-weighted assets ratio of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets. The final rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4% to 6% and requires a minimum leverage ratio of 4%. The final rule also implements strict eligibility criteria for regulatory capital instruments and improves the methodology for calculating risk-weighted assets to enhance risk sensitivity. On July 9, 2013the FDICalso approved, as an interim final rule, the regulatory capital requirements for US banks, following the actions of the Federal Reserve Bank. The FDIC'srule is identical in substance to the final rules issued by the Federal Reserve Bank.
The phase-in-period for the final rules will begin on
January 1, 2015, with full compliance with all of the final rule requirements phased in over a multi-year schedule. Management believes that as of March 31, 2014, the Company and the Bank would remain "well capitalized" under the new rules. 42 ITEM 3