This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements, which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. The Corporation takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins; (3) general economic conditions, either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; and (4) legislative or regulatory changes including changes in accounting standards, may adversely affect the business. 33
MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014General We use the term "MainStreet" or "Corporation" to refer to MainStreet BankShares, Inc.We use the term "Bank" or " Franklin Bank" to refer to Franklin Community Bank, National Association. We use "we", "us", or "our" to refer to the consolidated businesses of the Corporation and its subsidiaries unless the content indicates otherwise. MainStreetwas incorporated on January 14, 1999in the Commonwealth of Virginiaand is the bank holding company for Franklin Bank which serves the Franklin Countyarea of Virginia. MainStreetprovides a wide variety of banking services through Franklin Bank. Franklin Bank operates as a locally-owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. It relies on local advertising and the personal contacts of its directors, employees, and shareholders to attract customers and business to the Bank. Franklin Bank has three banking offices in Rocky Mountand Franklin County. MainStreetalso has a wholly-owned real estate company, MainStreet RealEstate, Inc.which owns the real estate of the Corporation. MainStreet RealEstate, Inc.owns the Union Hall(Southlake) office of Franklin Bank. On April 16, 2009, Franklin Bank entered into a formal agreement ("Agreement") with The Comptroller of the Currency ("OCC"). The Agreement required Franklin Bank to perform certain actions within designated time frames. The Agreement was intended to demonstrate the Bank's commitment to review/enhance certain aspects of various policies and practices related to credit administration and liquidity. Franklin Bank achieved full compliance
with the Agreement. The Agreement was terminated in
June 17, 2009, MainStreet BankShares, Inc.entered into a Memorandum of Understanding ("MOU") with the Federal Reserve Bank of Richmond("Federal Reserve"). The MOU required the bank holding company to utilize its financial and managerial resources to assist Franklin Bank in functioning in a safe and sound manner and restricted MainStreetfrom conducting various activities. On January 26, 2011, we entered into a new MOU with the Federal Reserve which contained the same terms of the previous MOU (which was terminated) but added provisions regarding compliance with certain laws and regulations. This MOU was terminated in September 2013. There are no longer any restrictions or stipulations attributable to the MOU. Critical Accounting Policies Our financial statements are prepared in accordance with accounting principles generally accepted in the United States(GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Allowance for Loan Losses We use historical loss factors, peer comparisons, regulatory factors, concentrations of credit, past dues, and the trend in the economy as factors in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk. The allowance for loan losses reflects our best estimate of the losses inherent in our loan portfolio. The allowance is based on two basic principles of accounting: (i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which reflects management's best estimate of probable credit losses inherent in the loan portfolio and is, therefore, believed to be appropriate. 34 MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014The amount of the allowance is based on management's evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions and other risks inherent in the portfolio. Management reviews the past due reports and risk-rated loans and discusses individually the loans on these reports with the responsible loan officers. Management uses these tools and provides a quarterly analysis of the allowance based on our historical loan loss experience, risk-rated loans, past dues, concentrations of credit, unsecured loans, loan exceptions, and the economic trend. These are generally grouped by homogeneous loan pools. Impaired loans are reviewed individually to determine possible impairment based on one of the three recognized methods which are fair value of collateral, present value of expected cash flows, or observable market price. A specific reserve is allocated for the amount of the impairment. Although management uses available information to recognize losses on loans, the substantial uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, make it possible that a material change in the allowance for loan losses in the near term may be appropriate. However, the amount of the change cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms. Deferred Tax Assets The Corporation uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance may be established. Management considers the determination of this valuation allowance to be a critical accounting policy due to the need to exercise significant judgment in evaluating the amount and timing of recognition of deferred tax liabilities and assets, including projections of future taxable income. These judgments and estimates are reviewed on a continual basis as regulatory and business factors change. A valuation allowance for deferred tax assets may be required if the amounts of taxes recoverable through loss carry backs decline, or if we project lower levels of future taxable income. If such a valuation allowance is deemed necessary in the future, it would be established through a charge to income tax expense that would adversely affect our operating results. Overview We continue 2014 with a low interest rate environment and sluggish loan demand in our market, which has negatively impacted our net interest margin. Despite these continued challenges, we are pleased to report a decrease in our nonperforming assets and a moderate increase in our loan portfolio as compared to year end 2013. We continue to maintain an aggressive posture in resolving our problem assets. We believe this strategy will strengthen the Corporation's position and prepare us for future growth. 35 MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014Total assets at June 30, 2014were $166.3 millioncompared to $169.0 millionat year-end December 31, 2013, a decline of $2.7 million. Our balance sheet has declined since year-end due to our continued strategy to lower our deposit costs. At June 30, 2014, loans, net of unearned deferred fees and costs, increased $2.9 millionfrom year-end 2013. Our overall strategy for 2014 also includes loan growth in an effort to improve our net interest margin and increase our net income. Despite the continued effort to resolve our problem credits and sluggish loan demand, our loan portfolio experienced an overall increase. Securities available for sale decreased $7.7 millionfrom December 31, 2013primarily due to calls of securities, pay downs on mortgage backed securities, and the transfer of $5.6 millionof municipal bonds into the held to maturity category. Due to the maturity and repayment of all repurchase agreements, we now have additional securities that can be utilized and pledged for other purposes as needed. Deposits decreased $3.3 millionsince year end 2013. Our higher cost time deposits have declined since year end 2013. Other real estate owned has declined by $.5 millionsince December 31, 2013. Our continued aggressive approach to rid our balance sheet of nonperforming assets has worked as our balance in other real estate owned has declined to a balance of $218,340. The intentional shrinkage in our balance sheet has had a positive impact on our capital ratios. Total cash and cash equivalents decreased from year-end 2013 by $2.3 million. Liquidity continues to be an important focus for our Corporation during these tumultuous times and our liquid assets were 24.29% of total liabilities at June 30, 2014which remains strong. We monitor our liquidity daily to ensure we have prudent levels of liquidity while we strive to lower our deposit costs. This strategy also resulted in a lowering of our overall interest bearing deposits. We maintained our core relationships as can be evidenced by the stability in demand deposits, which are our free funds. We continue to focus on our asset quality due to the elevated level of nonperforming loans, criticized and classified assets, economic uncertainty and unemployment levels. Nonperforming loans decreased $2.3 millionfrom year end 2013 to June 30, 2014. Nonaccrual loans decreased by $1.0 millionduring the first six months of 2014. Troubled debt restructurings (not on nonaccrual) decreased by $1.2 millionduring the first six months of 2014. Other impaired loans decreased by $60,000in the first half of 2014. Our loans rated special mention or worse (excluding troubled debt restructurings and those in nonaccrual status) increased at June 30, 2014as compared to year end 2013 in the amount of $2.2 million. We transferred $249,016of loans into other real estate and other repossessed assets during the first six months of 2014. Our other real estate properties have declined to $218,340at June 30, 2014compared to $728,163at December 31, 2013. A substantial amount of our foreclosed properties have been sold as of June 30, 2014. We continue to take an aggressive approach to our other real estate properties to rid our balance sheet of nonperforming assets. Total shareholders' equity was $24.8 millionat June 30, 2014. MainStreetand Franklin Bank were well capitalized at June 30, 2014under bank regulatory capital classifications. The book value of shareholders' equity at June 30,
$14.47per share. Our year-to-date net income at June 30, 2014was $597,736, or $.35per common basic share. This net income equated to an annualized return on average assets of 0.73% and an annualized return on average shareholders' equity of 4.93%. The net loss for the same period in 2013 was $(99,683), or $(.06)per common basic share. This net income equated to an annualized return on average assets and annualized return on average shareholders' equity of (.11%) and (.82%), respectively. Credit related expenses such as the provision for loan losses, realized losses on sales of other real estate properties, impairment losses on other real estate properties, and loss of interest on nonaccrual loans continue to negatively impact our operating results, although to a lesser extent than the prior year. In addition, the lack of loan volume has negatively impacted loan fee income and interest income. Provision expense, other real estate and repossession expenses, write downs and losses on sales together accounted for $85,850and $1,357,501in expense for the six month periods ending June 30, 2014and June 30, 2013, respectively. Net income for the second quarter of 2014 was $349,510, or $.20per common basic share as compared to a net loss in the amount of $(335,540), or $(.20)per common basic share for the second quarter of 2013. Provision expense, other real estate and repossession expenses, write downs and losses on sales together accounted for $8,605and $1,107,658for the quarters ended June 30, 2014and 2013, respectively. Credit related issues continue to have a negative impact on our Corporation's net income. 36 MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014Results of Operations Net interest income is the difference between total interest income and total interest expense. The amount of net interest income is determined by the volume of interest-earning assets, the level of interest rates earned on those assets, and the cost of supporting funds. The difference between rates earned on interest-earning assets and the cost of supporting funds is measured by the
net interest margin.
Net interest income for the six month periods ending
June 30, 2014and 2013 was $3,045,725and $3,139,778, respectively, a modest decrease of $94,053, or 3.00%. Both interest income and interest expense dollars dropped in comparison to last year, primarily due to volume and the lowering of deposit costs. The decline in interest income was also due to lost interest income on continued elevated levels of nonaccrual loans. For the six months ending June 30, 2014and 2013, the net interest margin was 3.89% and 3.72%, respectively, a 17 basis point increase. The yield on interest earning assets for the year-to-date period ending June 30, 2014was 4.37% compared to 4.38% for the year-to-date period ending June 30, 2013, a decrease of 1 basis point. However, the funding side of the interest margin also dropped during this time period by a favorable 18 basis points in the year-to-year comparison. The maturity and repayment of our repurchase agreements has had a positive impact on our net interest margin. We engaged a consultant to assist us in the lowering of our deposit costs. We have realized the positive impact of our strategic effort. The yield on interest earning assets has declined due to the interest rate environment, sluggish loan demand reducing loan fee income, and continued lost interest on nonaccrual loans. Lost interest for the six month periods ending June 30, 2014and 2013 was $96,422and $86,942, respectively. Lost interest for the three month periods ending June 30, 2014and 2013 was $43,247and $54,118, respectively. Franklin Bank's growth is also quite dependent on the recovery in consumer and real estate based lending and there is concern over the timing of recoveries in these markets given the current economic environment. Franklin Bank's future growth and earnings may be negatively affected if real estate and consumer based markets remain depressed or deteriorate further. The low interest rate environment continues with the Federal Reserve leaving short-term interest rates within a range of 0% - .25%. This low rate environment has been in effect since 2008. In determining how long to maintain the current target range, the Federal Reserve will assess progress towards its objectives of maximum employment and 2% inflation. It is anticipated that it will likely be appropriate to maintain the current target rate for a considerable time after the asset purchase program ends, especially if projected inflation runs below the 2% longer-run goal. It is also anticipated that economic conditions may for some time warrant keeping the target rate below levels the Federal Reserve views as normal in the longer run. Franklin Bank has a portfolio of variable rate loans. A rising interest rate environment generally has a positive impact on the net interest margin because deposits rates are slower to increase. Although low interest rates have been beneficial for our cost of funds, with prime presently at 3.25% which is the interest rate basis for many of our loans, MainStreet'snet interest margin has been adversely affected by the prolonged, recessionary low interest rate environment. The net interest margin and net interest income have shown improvement with the maturity of our repurchase agreements. The rates on these repurchase agreements were above current market rates. Of these repurchase agreements, $7.5 millionmatured in September 2012and $6.0 millionmatured in early January 2013. Net interest income for the three month periods ending June 30, 2014and 2013 was $1,551,797and $1,546,133, respectively, a modest increase of $5,664, or .37%. This equated to a net interest margin of 3.96% and 3.60% at June 30,
2014 and 2013, respectively. Provision for Loan Losses A provision for loan losses is charged to earnings for the purpose of establishing an allowance for loan losses that is maintained at a level which reflects management's best estimate of probable credit losses inherent in the loan portfolio and is, therefore, believed to be appropriate. The amount of the allowance is based on management's evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Management reviews the past due reports and risk ratings and discusses individually the loans on these reports with the responsible loan officers. Management provides a detailed quarterly analysis of the allowance based on homogenous loan pools, identifying impairment, historical losses, credit concentrations, economic conditions, and other risks. As the allowance is maintained losses are, in turn, charged to this allowance rather than being reported as a direct expense. 37 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Our methodology for determining the allowance is based on two basic principles of accounting as follows: i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. Our analysis is based on an individual review of all credits rated Pass/Watch and lower in our risk rating system by account officers in addition to a review of management information system reports on numerous portfolio segments. The analysis of the allowance is solely based on historical and qualitative factors with historical losses adjusted to higher factors for our criticized and classified loans compared to similar banks with comparable real estate concentrations nationally. Our process allows loan groups to be identified and properly categorized. Our impaired loans are individually reviewed to determine possible impairment based on one of three recognized methods which are fair value of collateral, present value of expected cash flows, or observable market price. A specific reserve is then allocated for the amount of the impairment. Impairment is defined as a loan in which we feel it is probable (meaning likely, not virtually certain) that we will be unable to collect all amounts due under the contractual terms of the loan agreement. Possible loss for loans risk rated special mention or lower are then allocated based on a historical loss migration and adjusted for qualitative factors. Remaining loans are pooled based on homogenous loan groups and allocated based on Franklin Bank's historical net loss experience. These pools are as follows: 1) commercial loans; 2) construction and land development; 3) residential 1-4 family first liens; 4) residential 1-4 family junior liens; 5) home equity lines; 6) commercial real estate; and 7) consumer loans. Historical loss is calculated based on a twelve-quarter average history. Historical net loss data is adjusted and applied to pooled loans based on qualitative factors. We utilize the following qualitative factors: 1) changes in the value of underlying collateral such as loans not conforming to supervisory loan to value limits; 2) national and local economic conditions; 3) changes in portfolio volume and nature such as borrower's living outside our primary trade area; 4) changes in past dues, nonaccruals; and 5) quality and impact and effects of defined credit concentrations. The methodology has continued to evolve as our company has grown and our loan portfolio has grown and become more diverse. Provision expense for the first six months of 2014 was
$86,872as compared to $1,252,502for the first six months of 2013. Our loan portfolio, net of unearned deferred fees and costs, increased $2.9 millionor 2.34% from year-end 2013. Gross charge-offs year-to-date 2014 were $313,583compared to $972,785year-to-date 2013. We transferred $249,016from loans to other real estate and other repossessed assets during the year-to-date period ending June 30, 2014. The allowance for loan losses was $2.2 millionat June 30, 2014and $2.4 millionat December 31, 2013, a minimal decrease of $.2 million, which is discussed below. The allowance for loan losses was 1.77% and 1.92% of loans net of unearned deferred fees and costs at June 30, 2014and December 31, 2013, respectively. Our criticized and classified loans that are evaluated by historical loss migration increased $2,178,197at June 30, 2014compared to year-end 2013. The loans evaluated collectively by pools increased $2.9 millionat June 30, 2014versus December 31, 2013. Impaired loans evaluated individually were $3.7 millionand $6.0 millionat June 30, 2014and December 31, 2013, respectively, with specific reserves of $331,195and $575,926, respectively. The relatively unchanged balance in the allowance for loan losses from year end 2013 was primarily due to decreased specific reserves on nonaccrual loans and minimal reduced allocations on loan volumes evaluated collectively by pools in the amount of $38,729, all offset by an increase in adversely rated loans. The primary factors contributing to the minimal reduction in loans evaluated collectively by pools are percentages due to historical charge offs and the level of past dues and nonaccruals present in the loan portfolio. There were no changes in the economy or second trade area factors. Despite a decrease in our past dues and nonaccrual loans, the level of adversely rated credits increased primarily due to one credit in the amount of $1.2 millionwhich was reported as a troubled debt restructuring (not on nonaccrual) at year end, but is considered a special mention credit at June 30, 2014. The ratio of the allowance for loan losses to loans, net of unearned fees and costs actually declined due to the increase in the loan portfolio since year end 2013. The allowance for loan losses was not replenished by the full $313,583of gross charge offs because approximately $90,000of that total gross charge off amount was provided for in our allowance for loan losses at year-end 2013 as a specific reserve. An unallocated amount of $30,000was included in the reserve at June 30, 2014, but there was no unallocated amount at December 31, 2013. Net charge-offs of $220,931and $937,606for the first six months of 2014 and 2013 equated to .35% and 1.44%, respectively, of average loans outstanding net of unearned income and deferred fees. The amount of charge-offs can fluctuate substantially based on the financial condition of the borrowers, business conditions in the borrower's market, collateral values and other factors which are not capable of precise projection at any point in time. 38 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Provision expense for the second quarter of 2014 and 2013 was $13,384and $1,064,897, respectively. The allowance for loan losses was $2.2 millionat June 30, 2014and $2.4 millionat March 31, 2014. The allowance for loan losses was 1.77% and 1.86% of loans net of unearned at June 30, 2014and March 31, 2014, respectively. Our criticized and classified loans that are evaluated by historical loss migration increased $1.4 millionat June 30, 2014compared to prior quarter end. The loans evaluated collectively by pools decreased $.4 millionat June 30, 2014versus March 31, 2014. Impaired loans evaluated individually were $3.7 millionand $4.3 millionat June 30, 2014and March 31, 2014, respectively, with specific reserves of $331,195and $481,885, respectively. The relatively unchanged balance in the allowance for loan losses from the end of the first quarter of 2014 was primarily due to decreased specific reserves on nonaccrual loans and reduced allocations on loan volumes evaluated collectively by pools, all offset by an increase in adversely rated loans. Gross charges offs and recoveries for the second quarter of 2014 were $150,525and $30,192, respectively. Net charge-offs of $120,333for the second quarter of 2014 equated to .38%, of quarterly average loans outstanding net of unearned income and deferred fees. Following is a breakdown of our nonperforming loans by balance sheet type which includes nonaccrual loans, loans past due 90 days and still accruing, troubled debt restructurings (not on nonaccrual), and other impaired loans. June 30, 2014 December 31, 2013 Commercial $ 614,669$ 725,863 Real Estate:
Construction and land development 422,715 576,552
Residential 1-4 families: First liens 470,214 1,130,961 Junior liens 132,380 182,170 Home equity loans 69,950 71,338 Commercial real estate 2,033,393 3,308,733 Consumer - - Total Nonperforming Loans
$ 3,743,321$ 5,995,617 Total nonperforming loans decreased in the amount of $2,252,296or 37.57% at June 30, 2014as compared to December 31, 2013. Nonaccrual loans (included in the impaired loans above) were $2,972,011and $4,005,618at June 30, 2014and December 31, 2013, respectively, which represented 2.35% and 3.24%, respectively, of loans, net of unearned deferred fees and costs. Management considers these loans impaired along with loans 90 days or more past due and still accruing, troubled debt restructurings (not on nonaccrual), and other impaired loans. Loans once considered impaired are included in the reserve, but if well collateralized, no specific reserve is allocated for them. Please refer to Note 4 to the financial statements for a breakdown of the allowance by category, specific reserves by category, and impaired loans by category. Note 4 also gives information related to which categories of loans and dollar amounts had specific reserves allocated. At June 30, 2014loans secured by commercial real estate were the largest category of impaired loans at $2.0 million. At December 31, 2013loans secured by commercial real estate were the largest category of impaired loans at $3.3 million. Commercial loans were the next largest of the impaired loan categories at June 30, 2014at $.6 million. Residential 1-4 family first liens were the next largest of the impaired loan categories at December 31, 2013at $1.1 million. 39 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Many of the asset quality issues in our loan portfolio are the result of our borrowers having to sell various real estate properties to repay the loan. In order to sell the properties and repay the loan, there must be buyers in the marketplace to acquire the properties. Our market, mainly real estate, continues to produce few buyers. In addition, borrowers' incomes have been reduced which increases their debt to income ratio. The overall economy in Franklin Countyhas shown little improvement over the last year. We continue to struggle with high unemployment, a continued slowing of building activity, a slowing of transportation and warehousing, and excessive supply of real estate in the Smith Mountain Lakeresort area as discussed below. There is continued economic pressure on consumers and business enterprises and unemployment is at 5.2% ( March 2014data), down from 5.4% at February 28, 2014. Absorption analysis in our market place shows increased turnover rates for various inventories over historical levels. Data obtained also revealed declines in real estate values based on listing prices to selling price. Locally and nationally there has been an overall loss of wealth in real estate and equities. Smith Mountain Lakeis a core area for development in Franklin County. It is a resort area and largely follows the national trend rather than the local trend and has been particularly adversely affected as a result. Until unemployment declines and consumer confidence increases, these trends may continue. While we continue to address our asset quality issues and have shown great improvement, no assurance can be given that continuing adverse economic conditions or other circumstances will not result in increased provisions in the future. Noninterest Income Total noninterest income was $448,321and $601,594for the six months ending June 30, 2014and 2013, respectively, a decrease of $153,273, or 25.48%. The following chart demonstrates the categories of change: Percentage Noninterest Income YTD 6/30/14 YTD 6/30/13
Dollar Change Change
Service charges on deposit accounts
$ 121,838 $ 129,205 $ (7,367 )(5.70 )% Mortgage commissions 54,026 151,543 (97,517 ) (64.35 ) Electronic card fees 87,557 91,934 (4,377 ) (4.76 ) Investment fee income 107,987 89,998 17,989 19.99
Income on bank owned life insurance 27,952 18,972 8,980 47.33 Gain on securities sold/called - 47,194 (47,194 ) (100.00 ) Other fee income & miscellaneous 48,961 72,748
(23,787 ) (32.70 ) As noted above, total noninterest income decreased
$153,273for the six months ending June 30, 2014compared to the six months ending June 30, 2013. Service charges on deposit accounts decreased $7,367in the year to year comparison. This decrease is primarily due to a decrease in NSF charges, returned deposit item fees, and miscellaneous service charges on accounts, all offset by increases in demand deposit service charges, business account charges, and a decline in demand deposit charge-offs. Mortgage commissions decreased in the year to year comparison by $97,517, or 64.35%. Mortgage volumes have decreased in part by the economic environment and additional regulatory enactments. Franklin Bank partners with several organizations in which we originate residential mortgage loans that are sold to other companies. Franklin Bank receives the mortgage commission. With applications taken prior to mid-May of this year, we would close some mortgage loans in our name and then sell them to our partners within a short period of days. Beginning in mid-May, Franklin Bank no longer closes mortgage loans in our name for resale. Our partners provide the underwriting of the loans. 40 MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014
Electronic card fees experienced a decrease of
$4,377or 4.76% for the six months ended June 30, 2014as compared to June 30, 2013. Franklin Bank has an investment advisor which partners with Infinex Financial Groupto advise and manage investment portfolios for our clients. Franklin Bank receives fee income from this partnership based upon volume. Fee income received on investment income during the first six months of 2014 and 2013 was $107,987and $89,998, respectively, an increase of $17,989, or 19.99%. Franklin Bank has bank owned life insurance on the life of one of its current executive officers. Prior to the death of Larry Heatonin December 2012, Franklin Bank insured the lives of two executive officers. The balance at June 30, 2014was $1.9 million. Income on this investment increased $8,980or 47.33% compared to the prior year due to the purchase of an additional policy in late 2013. There were no gains on securities sold or called during the six months ending June 30, 2014. Other fee income and miscellaneous income experienced a decrease of $23,787, or 32.70%. This decrease is primarily due to a decrease in title fee income and miscellaneous income, all offset by small increases in wire fee charges and checkbook charges. Title fee income decreased by $10,301in the year to year comparison. Title fee income is generated from a small interest purchased in a title insurance company by Franklin Bank. Franklin Bank elected to present assets and liabilities related to derivatives on its mortgage loans held for sale on a gross basis. Derivatives in a gain position were recorded as other assets and those in a loss position were recorded as other liabilities, with the offset being miscellaneous income and miscellaneous expense, respectively. This quarterly entry caused fluctuations in these accounts. Since Franklin Bank no longer closes its mortgage loans in its name to sell within a short period of days, there is no longer a mortgage loan derivative recorded as of June 30, 2014. A decrease to miscellaneous income was experienced in the amount of $16,358in the year to year comparison as a result of changes in mortgage derivative assets.
Total noninterest income was
Percentage Noninterest Income QTD 6/30/14 QTD 6/30/
13 DollarChange Change Service charges on deposit accounts $ 64,758 $ 59,217$ 5,541 9.36 % Mortgage commissions 30,559 77,557 (46,998 ) (60.60 ) Electronic card fees 47,651 48,168 (517 ) (1.07 ) Investment fee income 56,640 48,754 7,886 16.18
Income on bank owned life insurance 14,115 9,533 4,582 48.06 Gain on securities sold/called - 47,194 (47,194 ) (100.00 ) Other fee income & miscellaneous 23,759 45,292
(21,533 ) (47.54 )
Service charges on deposit accounts increased primarily due to an increase in NSF fee income. There were no gains on securities sold/called during the quarter ended
June 30, 2014. The same comments concerning noninterest income in the year to year comparison are applicable to the quarterly comparisons of noninterest income for all other categories. Overall noninterest income decreased in four of the categories and increased in three of the categories. Noninterest Expense Total noninterest expense was $2,535,175and $2,669,683for the six month period ending June 30, 2014and 2013, respectively, a decrease of $134,508, or 5.04%. Excluding the nonrecurring expenses of other real estate and repossessions, noninterest expense decreased $28,487, or 1.11%. The following chart shows the categories of noninterest expenses for the six month periods ending June 30, 2014and 2013, the dollar change, and the percentage change: 41 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Percentage Noninterest Expense YTD 6/30/14 YTD 6/30/ 13 DollarChange Change Salaries and employee benefits $ 1,416,856 $ 1,341,604 $ 75,2525.61 % Occupancy and equipment 380,475 379,430
1,045 0.28 Professional fees 115,544 119,514 (3,970 ) (3.32 ) Outside processing 161,434 208,848 (47,414 ) (22.70 ) FDIC Assessment 59,868 104,795 (44,927 ) (42.87 ) Franchise tax 118,250 108,000 10,250 9.49
Regulatory examination fees 33,823 52,607 (18,784 ) (35.71 ) Other real estate and repossessions (1,022 ) 104,999
(106,021 ) (100.97 ) Other expenses 249,947 249,886 61 0.02
MainStreet'semployees continue to be its most valuable resource and asset. Salaries and employee benefits expense comprise the largest category of noninterest expense at 55.89% and 50.25%, respectively, of total noninterest expense for the six month periods ending June 30, 2014and 2013. Salaries and employee benefits increased $75,252or 5.61% in the first six months of 2014 as compared to the first six months of 2013. Of this increase, total salaries increased $63,257and employee benefits increased $11,995. Commissions were only paid to mortgage and investment personnel. Referral fees were also paid to employees for mortgage and investment referrals. The primary contributor to the increase in employee benefits was an increase in supplemental executive retirement plan expense. Occupancy and equipment costs include rent, utilities, janitorial service, repairs and maintenance, real estate taxes, equipment rent, service maintenance contracts and depreciation expense. This category increased a nominal amount of $1,045or .28% in the year to year comparison. Professional fees include fees for audit, legal, and other professional fees and showed a $3,970decrease in comparing the six months ended June 30, 2014to the same period in 2013. Outside processing expenses decreased $47,414or 22.70% in the year to year comparison primarily due to a decrease in data processing fees. FDICassessment declined $44,927or 42.87% due to changes in the factors used in the calculation of the assessment and an overall decline in our asset base. However, the overall premium is still burdensome. The turmoil in the financial services industry resulted in the need to increase prepaid FDICinsurance premiums 3 years ago to sustain the insurance fund. Depending on the length and depth of the recessionary environment, there could be additional increased prepaid assessments depending on the health of the financial services sector. Franchise tax increased by $10,250in the year to year comparison primarily due to anticipated increases in capital and a reduction of other real estate owned. Regulatory examination fees decreased $18,784in the first six months of 2014 as compared to the first six months of 2013. With the termination of the formal agreement with the OCC, the surcharge on our regulatory assessment fee is no longer applicable. Other real estate and repossessions are nonrecurring expenses in the category of noninterest expense. The losses, write-downs and expenses associated with our other real estate properties experienced a decrease of $106,021, or 100.97%, compared to the same period in 2013. The Company continues to take an aggressive approach to disposing of its other real estate properties to rid its balance sheet of nonperforming assets. As of June 30, 2014our other real estate owned balance has declined to $218,340. Other expenses increased nominally in the amount of $61in the year to year comparison. Total noninterest expense was $1,263,368and $1,340,313for the three month periods ending June 30, 2014and 2013, respectively, a decrease of $76,945or 5.74%. Excluding the nonrecurring expenses of other real estate and repossessions, noninterest expense decreased $29,405or 2.27%. The following chart shows the categories of noninterest expenses for the three month periods ending June 30, 2014and 2013, the dollar change, and the percentage change: 42 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Percentage Noninterest Expense QTD 6/30/14 QTD 6/30/ 13 DollarChange Change Salaries and employee benefits $ 708,692 $ 677,275 $ 31,4174.64 % Occupancy and equipment 184,168 189,243 (5,075 ) (2.68 ) Professional fees 61,735 59,373 2,362 3.98 Outside processing 76,435 104,055 (27,620 ) (26.54 ) FDIC Assessment 32,321 50,866 (18,545 ) (36.46 ) Franchise tax 59,000 54,000 5,000 9.26
Regulatory examination fees 11,274 26,304 (15,030 ) (57.14 ) Other real estate and repossessions (4,779 ) 42,761
(47,540 ) (111.18 ) Other expenses 134,522 136,436 (1,914 ) (1.40 )
Overall, the same explanations for the year to date comparisons are applicable to the quarterly comparisons of noninterest expense. Noninterest expense increased in three of the categories and decreased in six of the categories.
MainStreetis subject to both federal and state income taxes. Franklin Bank is not subject to state income taxes. A bank in Virginiais required to pay a franchise tax that is based on the capital of the entity. The liability (or balance sheet) approach is used in financial accounting and reporting for income taxes. Deferred income tax assets and liabilities are computed quarterly for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. No valuation allowances were deemed necessary at June 30, 2014and December 31, 2013. Income tax expense (benefit) is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. MainStreetrecorded income tax expense and an income tax benefit in the amounts of $274,263and $(81,130)for the six month periods ending June 30, 2014and June 30, 2013, respectively. MainStreetrecorded income tax expense and an income tax benefit in the amounts of $163,017and $(187,822)for the three month periods ending June 30, 2014and June 30, 2013, respectively. BALANCE SHEET Investment Portfolio
The Corporation's investment portfolio is used for several purposes as follows:
· To maintain sufficient liquidity to cover deposit fluctuations and loan demand.
· To use securities to fulfill pledging collateral requirements.
· To utilize the maturity/repricing mix of portfolio securities to help balance
the overall interest rate risk position of the balance sheet.
· To make a reasonable return on investments.
MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014Funds not utilized for capital expenditures or lending are invested in securities of the U.S. Governmentand its agencies, mortgage-backed securities, municipal bonds, corporate debt securities and certain equity securities. Currently, we have invested in U.S. Agencies, mortgage-backed securities, municipal bonds, corporate debt securities, Federal Reserve Bankstock and Federal Home Loan Bankstock. The value of our investment portfolio is susceptible to the impact of monetary and fiscal policies of the United States, particularly whether and how the current debate over fiscal issues are resolved. Our mortgage backed securities are either guaranteed by U.S. government agencies or issued by U.S. government sponsored agencies. Our securities portfolio, with the exception of our municipal bonds, was categorized as available for sale at June 30, 2014and is carried at estimated fair value. Our municipal securities are now categorized as held to maturity and are carried at amortized cost. The unrealized market valuation gains and losses on securities classified as available for sale and the held to maturity transfer adjustment on our municipal bonds are recorded as separate components of shareholders' equity. Please refer to Note 2 of the Notes to Consolidated Financial Statements for the breakdown of the securities available for sale and securities held to maturity portfolios. Loan Portfolio We have established a credit policy detailing the credit process and collateral in loan originations. Loans to purchase real estate and personal property are generally collateralized by the related property with loan amounts established based on certain percentage limitations of the property's total stated or appraised value. Credit approval is primarily a function of the credit worthiness of the individual borrower or project based on pertinent financial information, the amount to be financed, and collateral. The loan portfolio
was as follows: June 30, 2014 December 31, 2013 Commercial
$ 10,194,9338.06 % $ 9,426,1887.63 % Real Estate:
Construction & land development 15,738,882 12.44
16,394,964 13.26 Residential 1-4 families: First liens 34,287,121 27.10 33,787,645 27.33 Junior liens 7,079,779 5.59 6,331,233 5.12 Home equity lines 6,746,222 5.33 5,764,941 4.66 Commercial real estate 51,194,330 40.46 50,579,103 40.91 Consumer 1,287,639 1.02 1,353,312 1.09 Total Gross Loans
$ 126,528,906100.00 % $ 123,637,386100.00 %
Unearned deferred fees & costs, net 91,985
86,600 Recorded Investment
$ 126,620,891 $ 123,723,986Gross loans increased $2,891,520, or 2.34% at June 30, 2014compared to December 31, 2013. As can be seen by the chart above, Franklin Bank has a high concentration in real estate loans. These loans represented 90.92% and 91.28% of gross loans at June 30, 2014and December 31, 2013, respectively. Accordingly, the Bank took steps to reduce certain concentrations within the real estate loans, including participating loans in our loan portfolio. The loan committee of the board of directors reviews all new loans and renewals of loans within our target concentrations for approval. During this economic environment, the credit markets have tightened substantially and the real estate market continues to be soft. These and other factors indicate diminished economic activity, higher risk in these loans, and lower loan demand. Moreover, Franklin Bank's current concentration in real estate related loans reduces the Bank's ability to participate in these loan categories. Our loan to deposit ratio for June 30, 2014was 90.78% compared to 86.63% at December 31, 2013, an increase of 4.15%. We lowered our policy loan to deposit ratio, thus increasing liquidity, and have maintained a lower percentage because of lower loan demand. However, the percentage has increased by 4.15% since year end and will be monitored on an ongoing basis. We will continue to serve our customers, but in doing so will be governed by the necessity of preserving the institution's history of safety and soundness during these difficult economic times. Our loan portfolio is our primary source of profitability; therefore, our underwriting approach is critical and is designed throughout our policies to have an acceptable level of risk. Cash flow adequacy has always been a necessary condition of creditworthiness. If the debt cannot be serviced by the borrower's cash flow, there must be an additional secondary source of repayment. As we have discussed, many of our loans are real estate based so they are also secured by the underlying collateral, the value of which has been under stress due to economic conditions. We strive to build relationships with our borrowers, so it is very important to continually understand and assess our borrowers' financial strength and condition. 44 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Our credit policy requires that new loans originated must have a maximum loan-to-value of 80% while certain loans have lower limits as follows: raw land (65%); improved land (75%); non-obsolete inventory (60% of value); used automobiles (75% of purchase price); and stock (75%). We do not require mortgage insurance; however, loans exceeding supervisory loan to value limits are one of our qualitative factors in the allowance for loan loss methodology. Our credit policy requires updated appraisals to be obtained on existing loans whereby collateral value is critical to the repayment of the loan and market value may have declined by 15% or more. In regard to development projects a new appraisal should be obtained when the project sale out rate is less than 25% of the original assumptions documented by the existing appraisal in the file. Development loans must be reviewed at least annually or sooner in a declining real estate cycle. Once an appraisal exceeds 18 months it must be updated and reviewed before additional funding may occur. An appraisal in file may not be used for additional funding under any circumstances after 36 months. Loan account officers prepare criticized loan workout sheets for the Problem Loan Committee on all loans risk rated special mention or lower and any loan delinquent 60 days or more. Account officers who indicate a loan is impaired are required to determine collateral value by one of three recognized methods which are 1) fair value of collateral; 2) present value of expected cash flows; or 3) observable market value. The difference in the collateral value minus estimated selling expenses, the present value of expected future cash flows, or the observable market value as compared to the recorded loan balance is allocated as a specific reserve in the loan loss analysis. Any collateral declines dropping loans below supervisory loan to value limits is included in the qualitative factors based on loan pools in the loan loss analysis. We continue to review and enhance our credit policies based on economic and environmental changes. We have developed a list of critical exceptions that require additional monitoring of loans which contain them. Financials are required for business and retail loans less than $35,000and annual financials are required on all business term loans exceeding $250,000. Our credit policy requires detailed rent rolls on all commercial income producing properties at origination and renewal. We also require real estate site visits by the originating officer on loans over $250,000. We believe there is great value in looking at the collateral upon which we are taking a lien. We have eliminated interest only periods for speculative lot loans and require amortization at origination. The bank introduced an interest only home equity line product in late 2013. These new lines require a loan to value of 80% or less with debt to income being calculated at 1.5% of the outstanding balance. Loans must be collateralized by a first or second deed of trust on the primary residence of the borrower. Other banks have similarly tightened credit availability, particularly for real estate related loans. Moreover higher standards for consumer real estate loans under the Dodd-Frank Act further restrict the ability to provide residential loans. Generally this has the effect of reducing qualified buyers for real estate and therefore the value of real estate. This in turn can lead to lower appraisals and additional charge offs within our loan portfolio and other real estate properties as well as increased provision which reduce income.
In addition, we hired an experienced in-house credit analyst and purchased software to assist lenders with cash flow and certain ratio analysis. We also purchased software to assist with the credit ratings of loans upon origination, renewal, and the receipt of new financials. Please refer to Notes #3 and #4 to the financial statements for further discussion of underwriting and risk ratings of loans. Approximately 27% of our loan portfolio consists of variable rate loans. Variable rate commercial loans are stressed 2% above the current rate to communicate the impact of potential rate increases to account officers. Retail loans with variable rate features are underwritten 2% over the current rate. Home equity lines are underwritten at 1.5% of the full committed loan amount for debt to income purposes. 45
MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014
We monitor our loan portfolio by the loan segments found in Note #3 of the financial statements. In addition, we look at the trends of significant industries within the loan segments. Loan segments are categorized primarily based upon regulatory guidelines, which follows the underlying collateral. For the most part, our business activity is with customers located in our primary market area. Accordingly, operating results are closely correlated with the economic trends within the region and influenced by the significant industries in the region including pre-built housing, real estate development, agriculture, and resort and leisure services. In addition, the ultimate collectability of the loan portfolio is susceptible to changes in the market condition of the region. The real estate market in our area, particularly
Smith Mountain Lake, is also affected by the national economy because a substantial portion of our lending is real estate based and dependent on buyers who move into our region. We continue to monitor portfolio concentrations and have established guide limits based on loss exposure and potential impact to capital. Our defined concentration limits arte within regulatory guidelines. There are two industry concentrations that are broken out in the tables below by our loan segments. MainStreetdoes not currently consider its loans for construction of heavy and civil engineering buildings to be a concentration of credit because their total does not exceed 25% of total capital as of June 30, 2014. June 30, 2014 Loans for Loans for Real Estate Construction Including of Buildings Construction Total Commercial $ 272,156 $ 182,366 $ 454,522Real Estate
Construction and land development 1,701,443 1,942,138 3,643,581 Residential, 1-4 families First Liens 3,321,860 8,788,251 12,110,111 Junior Liens 635,355 452,915 1,088,270 Home Equity Lines 9,597 343,178 352,775 Commercial real estate 2,591,600 24,874,239 27,465,839 Consumer 863 10,763 11,626 Total
$ 8,532,874 $ 36,593,850 $ 45,126,724December 31, 2013 Loans for Construction of Loans for Loans for Heavy & Civil Real Estate Construction Engineering Including of Buildings Buildings Construction Total Commercial $ 296,178$ 687,341 $ 221,608 $ 1,205,127Real Estate Construction and land development 2,366,758 4,138,105 2,014,334 8,519,197 Residential, 1-4 families First Liens 3,666,276 795,653 8,179,695 12,641,624 Junior Liens 529,732 - 472,819 1,002,551 Home Equity Lines 9,880 34,667 334,442 378,989 Commercial real estate 2,552,156 - 24,556,483 27,108,639 Consumer 2,735 - 13,209 15,944 Total $ 9,423,715 $ 5,655,766 $ 35,792,590 $ 50,872,07146 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014
Overall, our concentrations decreased nominally from year end to the end of the second quarter of 2014, excluding loans for construction of heavy and civil engineering buildings. We continue to monitor them on an ongoing basis in an effort to control their growth. Disclosed below are concentrations in acquisition and development loans, speculative lot loans, and speculative single-family housing construction. Some of these amounts are also included in the above concentrations as shown below. June 30, 2014 Total Concentrations Net Addition to Concentration Included Above Concentrations
Acquisition & development
$ 491,664$ 44,295 $ 447,369 Speculative lot loans 3,295,859 433,372 2,862,487 Speculative single-family housing construction 3,144,681
569,371 2,575,310 December 31, 2013 Total Concentrations Net Addition to Concentration Included Above Concentrations
Acquisition & development
$ 455,405$ - $ 455,405 Speculative lot loans 4,007,894 3,138,066 869,828 Speculative single-family housing construction 1,971,059
Following is a breakdown of our nonperforming loans and assets.
For the Periods Ended June 30, 2014 December 31, 2013 Nonaccrual loans and leases
$ 2,972,011$ 4,005,618 Loans past due 90 days or more and still accruing - - Troubled debt restructurings (not on nonaccrual) 771,310 1,929,999 Other impaired loans - 60,000 Total nonperforming loans 3,743,321 5,995,617 Foreclosed real estate 218,340 728,163 Other foreclosed property - - Total foreclosed property 218,340 728,163 Total nonperforming assets $ 3,961,661$ 6,723,780 Impaired loans totaled $3,743,321and $5,995,617at June 30, 2014and December 31, 2013, respectively. Nonaccrual loans decreased $1,033,607at June 30, 2014compared to year end 2013. Troubled debt restructurings (not on nonaccrual) decreased $1,158,689from year end 2013. There were no loans past due more than 90 days, and still accruing, at June 30, 2014or December 31, 2013. Other impaired loans decreased by $60,000from December 31, 2013. We are continuing to work with our troubled borrowers. We move quickly to identify and resolve any problem loans. Please refer to Note #4 to the consolidated financial statements for detailed information of nonaccrual loans, impaired loans, and nonperforming assets. Also, please refer to Provision Expense in this Management's Discussion and Analysis. 47 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014
To ensure timely identification of nonaccrual loans, loan account officers review monthly their individual portfolios along with past due reports to determine the proper accrual status. Account officers also prepare criticized loan workout sheets for all loans risk rated special mention or lower and all loans 60-days or more delinquent are reported to the Franklin Bank's Problem Loan Committee made up of senior management. The accrual status of these loans is reviewed and approved by the Problem Loan Committee. Account officers must attest to the accrual status and risk rating of all loans in their portfolio on a monthly basis. Attestations are presented to and reviewed by the Problem Loan Committee. The criticized loan worksheets are presented to the Problem Loan Committee quarterly. The Committee meets monthly to review updates on these loans along with the attestation sheets completed by the account officers. The criticized loan worksheets were expanded to include a summary of the most recent financial analysis; most recent collateral valuation factoring possible liquidation and timing discount; and enhanced action plans with target dates. Primary and secondary repayment sources are detailed. A dedicated officer now manages our problem assets, although currently on a less than full-time basis due to decreased volumes. A credit analyst performs required financial analysis on all loans
$100,000and over at origination or renewal and at the receipt of new financial statements. In addition, software was purchased to assist with this process. Software assists the credit analyst and lender in the risk rating of each loan. We have an internal loan review function that has an annual loan review plan approved by the loan committee and the President. Enhanced reporting includes the overall quality of the loan portfolio; the identification, type, rating, and amount of problem loans; the identification and amount of delinquent loans; credit and collateral documentation exceptions; the identification and status of credit-related violations of law; the loan officer who originated each loan reported; concentrations of credit; and loans to executive officers and directors. Deposits
Total deposits at
June 30, 2014and December 31, 2013were $139,475,153and $142,821,438, respectively, a decrease of $3,346,285, or 2.34%. We continue in 2014 our strategy to lower overall deposit costs, which is discussed in more detail below. The deposit mix was as follows: June 30, 2014 December 31, 2013 Demand deposits $ 26,543,86719.03 % $ 26,856,99018.80 % Interest checking deposits 9,290,501 6.66 9,248,249 6.48 Money market deposits 25,891,481 18.57 23,660,000 16.57 Savings deposits 15,947,967 11.43 16,240,448 11.37 Time deposits $100,000and over 30,285,261 21.71 29,977,151 20.99 Other time deposits 31,516,076 22.60 36,838,600 25.79 Total $ 139,475,153100.00 % $ 142,821,438100.00 % The largest component of deposits continues to be time deposits including those $100,000and over representing 44.31% of total deposits at June 30, 2014compared to 46.78% at December 31, 2013. As a percentage of total deposits, the mix continues to change somewhat. The levels and mix of deposits are influenced by such factors as customer service, interest rates paid, service charges, and the convenience of banking locations. Our core deposit relationships remained as can be seen in the table above. Demand deposits, which do not pay interest, are now 19.03% of total deposits as compared to 18.80% at December 31, 2013. However, the dollar amount of our demand deposits has decreased by a nominal amount since year end 2013. An increase in demand deposits would improve the net interest margin and the total yield on interest bearing deposits. Money market deposits and interest checking accounts each increased as a percentage of total deposits along with the dollar amount. Savings deposits increased nominally as a percentage of total deposits, but have decreased in dollar amount since year end 2013. Money market deposits have increased $2,231,481since year end 2013 and as a percentage of total deposits. Our total deposits have decreased $3.3 millionsince year end 2013 primarily due to a $5.0 milliondecline in our time deposits, offset by a total increase in our lower deposit cost accounts in the amount of $1.7 million. This is all part of our strategic efforts to lower our deposit costs while maintaining ample liquidity to fill our needs and for contingency planning. As we lowered interest rates, our time deposits especially declined, although at a slower rate than last year, as they experienced a $5.0 milliondecrease since year end. 48 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 Competition remains strong in our market from other depository institutions. Management attempts to identify and implement the pricing and marketing strategies that will help control the overall cost of deposits and to maintain a stable deposit mix. Our goal has been to strive to gather the whole customer relationship, including deposits and loans, and not just certificates of deposit. We have been successful in lowering our deposit costs and maintaining liquidity. Loan demand has been soft overall, despite our increase in loans since year end, and parallels our deposit strategy. Our strategic plan in 2014 includes continued lowering of our deposit costs to benefit net income, which includes increasing our demand deposits. The overall cost of interest bearing deposits was .68% and .90%, respectively, for the six months ended June 30, 2014and June 30, 2013. This decline of 22 basis points is due to the continued monitoring of deposit rates and the rollover of many deposits into lower current market interest rates. We monitor this closely to keep deposit costs low, but to maintain ample liquidity. We are a member of the CDARS programs and of QwickRate. Borrowings
We have several sources for borrowings generally to assist with liquidity. At
June 30, 2014and December 31, 2013, we had no balances outstanding with the Federal Home Loan Bank of Atlanta("FHLB"), overnight federal funds purchased, or corporate cash management accounts. The FHLB holds a blanket lien on loans secured by commercial real estate and loans secured by 1-4 family first liens, second liens, and equity lines, which provide a source of liquidity to the Corporation. Loans included in these portfolios at June 30, 2014and December 31, 2013were $99,012,164and $96,223,160, respectively. The Bank has an internal Corporate Cash Management account for customers into which excess demand deposit accounts are swept on an overnight basis in order to earn interest. This account is not FDICinsured but the Bank is required to pledge agency funds at 100% towards these balances. The Corporate Cash Management sweep accounts totaled $0at June 30, 2014and December 31, 2013. Repurchase Agreements The Bank entered into a repurchase agreement with Barclays Capital("Barclays") on January 2, 2008in the amount of $6,000,000. The repurchase date was January 2, 2013. The interest rate was fixed at 3.57% until maturity or until it was called. Beginning January 2, 2009the repurchase agreement became callable and could have been called quarterly with prior notice of two business days. Interest was payable quarterly. The repurchase agreement was collateralized by federal agency and agency mortgage backed securities. Shareholders' Equity
Total shareholders' equity was
$24,800,161and $23,987,541at June 30, 2014and December 31, 2013, respectively. Book value per share was $14.47and $14.00at June 30, 2014and December 31, 2013, respectively. The maintenance of appropriate levels of capital is a priority and is continually monitored. MainStreetand Franklin Bank are subject to various regulatory capital requirements administered by the federal and state banking agencies. Quantitative measures established by regulations to ensure capital adequacy require MainStreetand Franklin Bank to maintain minimum capital ratios. Failure to meet minimum capital ratios can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a material effect on the consolidated financial statements. Also, declining capital can impact the ability of Franklin Bank to grow other assets. The required level of capital can also be affected by earnings, asset quality, and other issues. While MainStreetand Franklin Bank were considered well-capitalized under established regulatory classifications at June 30, 2014and December 31, 2013, in the current economic circumstances, capital resources are a focus for the Corporation. Capital adequacy levels are also monitored to support the Bank's safety and soundness. Should it be necessary or appropriate to obtain additional capital, then the current shareholder base could suffer dilution. 49 MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014
The following are
June 30, 2014 December 31,
Tier I Leverage Ratio (Actual) 14.36 % 13.62 % Tier I Leverage Ratio (Quarterly Ave.) 14.45
Tier I Risk-Based Capital Ratio 19.50
Tier II Risk-Based Capital Ratio 20.75
Liquidity and Asset Liability Management
Asset liability management functions to maximize profitability within established guidelines for liquidity, capital adequacy, and interest rate risk. It also helps to ensure that there is adequate liquidity to meet loan demand or deposit outflows and interest rate fluctuations. Liquidity is the ability to meet maturing obligations and commitments, withstand deposit fluctuations, fund operations, and provide for loan requests. In this economic environment liquidity remains a concern.
MainStreet'smaterial off-balance sheet obligations were primarily loan commitments of the Bank in the amount of $20,865,780at June 30, 2014. We have a liquidity contingency plan that provides guidance on the maintenance of appropriate liquidity and what action is required under various liquidity scenarios. Our liquidity is provided by cash and due from banks, interest-bearing deposits, federal funds sold, securities available for sale, and loan repayments. The Bank has overnight borrowing lines available with their correspondent banks, the ability to borrow from the Federal Reserve Bank'sdiscount window, and the ability to borrow long-term and short-term from the Federal Home Loan Bank of Atlanta. At June 30, 2014and December 31, 2013, we had available credit from borrowing in the amounts of $47,648,065and $43,687,459, respectively. Our ratio of liquid assets to total liabilities at June 30, 2014and December 31, 2013was 24.29% and 26.88%, respectively. Core deposits are the primary foundation for our Corporation's liquidity. Our core deposit relationships remained as can be seen by the stability of our demand deposits. Competition in our markets is strong and customers seek higher interest rates especially during this low interest rate environment. Lines of credit are essential to our business while other funding sources may be utilized. Due to our strategic efforts to reduce deposit costs, total time deposits and savings deposits have decreased from year end 2013; however, interest checking accounts and money market deposits increased over 2013 levels. Demand deposits decreased nominally in the amount of $313,123since year end 2013. Total deposits actually decreased $3.3 millionfrom year end 2013. The shrinkage of the balance sheet has had a positive impact on our capital. We monitor the deposits and our liquidity daily to ensure we have ample liquidity. The Bank is a member of the Certificate of Deposit Account Registry Service ("CDARS"). This allows us to provide the Bank's depositors with up to $50 millionin FDICinsurance. In a reciprocal transaction, the Bank receives the deposits and forwards them to CDARS and receives deposits back, if wanted. We can also bid on deposits in a one-way buy transactions which would allow for new depositors. CDARS deposits are also considered brokered deposits. Franklin Bank had accepted brokered deposits, including CDARS deposits, in the amount of $5.1 millionas of June 30, 2014. Franklin Bank became a member of QwickRate in order to bid for internet certificates of deposit as another source of liquidity. At June 30, 2014, Franklin Bank had $3.4 millionin internet certificates of deposit. Interest rate sensitivity is measured by the difference, or gap, between interest sensitive earning assets and interest sensitive interest bearing liabilities and the resultant change in net interest income due to market rate fluctuations, and the effect of interest rate movements on the market. Management utilizes these techniques to manage interest rate risk in order to minimize change in net interest income with interest rate changes. MainStreethas partnered with Compass Bankusing the Sendero model to help measure interest rate risk. The asset liability management process requires a number of key assumptions. Management determines the most likely outlook for the economy and interest rates measuring the effect on net interest income in a rising and declining 100, 200, 300, and 400 interest rate environment, as applicable. A shock report for these rates along with a ramped approach with each is modeled. With the shock, net interest income is modeled assuming that interest rates move the full rate change in the first month. With the ramp, net interest income is modeled assuming rates move one quarter of the full rate change in each quarter. With this approach, management also reviews the economic value of equity which is the net present value of the balance sheet's cash flows or the residual value of future cash flows ultimately due to shareholders. 50 MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES June 30, 2014 The following table demonstrates the percentage change in net interest income from the level prime rate of 3.25% at June 30, 2014in a rising and declining 100, 200, 300, and 400 basis point interest rate environment, as applicable: Net Interest Income Percentage Change From Level Rates Rate Shift Prime Rate Change From Level Ramp Change from Level Shock +400 bp 7.25 % 4.00 % 7.00 % +300 bp 6.25 3.00 5.00 +200 bp 5.25 2.00 4.00 +100 bp 4.25 1.00 2.00 -100 bp 2.25 -1.00 -1.00 -200 bp 1.25 -1.00 -3.00 -300 bp .25 -2.00 -5.00 MainStreetis sensitive to change in the interest rate environment particularly due to the level of variable rate loans in our loan portfolio, the short-tern of fixed rate loans, and the assumed repricing of our interest bearing liabilities. Management seeks to lower the impact on the net interest margin. The addition of floors to segments of our variable rate loan portfolio has contributed significantly to management of the interest income component of our net interest margin. Historically, Franklin Bank has been asset sensitive. However, due to the large amount of repricing deposit liabilities in the near term, the Bank has shifted to a liability sensitive position. Inflation Most of our assets are monetary in nature and therefore are sensitive to interest rate fluctuations. We do not have significant fixed assets or inventories. Fluctuations in interest rates and actions of the Board of Governorsof the Federal Reserve Systems ("FRB"), including "quantitative easing" during the Great Recession, as well as whether and how the fiscal issues confronting the United Statesare resolved can have a great effect on our profitability. Management continually strives to manage the relationship between interest-sensitive assets and liabilities. MainStreetand Franklin Bank must comply with numerous federal and state laws and regulations. In light of the increasing government involvement in the financial services industry and to address the underlying causes of the recent credit crunch, it is likely that financial institutions like MainStreetand Franklin Bank will have to meet additional legal requirements, all of which add to our cost of doing business. In addition, regulatory concerns over real estate related assets on the balance sheets of financial institutions and liquidity due to deposit fluctuations and other factors are likely to translate into higher regulatory scrutiny of financial institutions. This could impact MainStreet. Stock Compensation Plans BankSharesapproved the 2004 Key Employee Stock Option Plan at its Annual Meeting of Shareholders, April 15, 2004. This plan permitted the granting of Incentive and Non-Qualified stock options as determined by BankShares'Board of Directors to persons designated as "Key Employees" of BankSharesand its subsidiaries. The Plan terminated on January 21, 2009. Awards made under the Plan prior to and outstanding on that date remain valid in accordance with
their terms. 51
MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014
Recent Accounting Developments
January 2014, the FASB issued ASU 2014-04, "Receivables-Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure (a consensus of the FASB Emerging Issues Task Force)." The amendments in this ASU clarify that an in substance repossession or foreclosure occurs, and a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either (1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or (2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. Additionally, the amendments require interim and annual disclosure of both (1) the amount of foreclosed residential real estate property held by the creditor and (2) the recorded investment in consumer mortgage loans collateralized by residential real estate property that are in the process of foreclosure according to local requirements of the applicable jurisdiction. The amendments in this ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. The Corporation is currently assessing the impact that ASU 2014-04 will have on its consolidated financial statements. In April 2014, the FASB issued ASU 2014-08, "Presentation of Financial Statements (Topic 205) and Property, Plant, and Equipment (Topic 360): Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity." The amendments in this ASU change the criteria for reporting discontinued operations while enhancing disclosures in this area. Under the new guidance, only disposals representing a strategic shift in operations should be presented as discontinued operations. Those strategic shifts should have a major effect on the organization's operations and financial results and include disposals of a major geographic area, a major line of business, or a major equity method investment. The new guidance requires expanded disclosures about discontinued operations that will provide financial statement users with more information about the assets, liabilities, income, and expenses of discontinued operations. Additionally, the new guidance requires disclosure of the pre-tax income attributable to a disposal of a significant part of an organization that does not qualify for discontinued operations reporting. The amendments in the ASU are effective for public business entities for annual periods, and interim periods within those annual periods, beginning after December 15, 2014. Early adoption is permitted. The Corporation does not expect the adoption of ASU 2014-08 to have a material impact on its consolidated financial statements. In June 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers: Topic 606". This ASU applies to any entity using U.S. GAAP that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards. The guidance supersedes the revenue recognition requirements in Topic 605, "Revenue Recognition", most industry-specific guidance, and some cost guidance included in Subtopic 605-35, "Revenue Recognition-Construction-Type and Production-Type Contracts". The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To be in alignment with the core principle, an entity must apply a five step process including: identification of the contract(s) with a customer, identification of performance obligations in the contract(s), determination of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue when (or as) the entity satisfies a performance obligation. Additionally, the existing requirements for the recognition of a gain or loss on the transfer of nonfinancial assets that are not in a contract with a customer have also been amended to be consistent with the guidance on recognition and measurement. The amendments in this ASU are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted. The Corporation is currently assessing the impact that ASU 2014-09 will have on its consolidated financial statements.
MAINSTREET BANKSHARES, INC.AND SUBSIDIARIES June 30, 2014In June 2014, the FASB issued ASU No. 2014-11, "Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures". This ASU aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. The new guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement. The amendments in the ASU also require a new disclosure for transactions economically similar to repurchase agreements in which the transferor retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction. Additional disclosures will be required for the nature of collateral pledged in repurchase agreements and similar transactions accounted for as secured borrowings. The amendments in this ASU are effective for the first interim or annual period beginning after December 15, 2014; however, the disclosure for transactions accounted for as secured borrowings is required to be presented for annual periods beginning after December 15, 2014, and interim periods beginning after March 15, 2015. Early adoption is not permitted. The Corporation is currently assessing the impact that ASU 2014-11 will have on its consolidated financial statements. In June 2014, the FASB issued ASU No. 2014-12, "Compensation - Stock Compensation (Topic 718): Accounting for Share-Based Payments When the Terms of an Award Provide That a Performance Target Could Be Achieved after the Requisite Service Period". The new guidance applies to reporting entities that grant employees share-based payments in which the terms of the award allow a performance target to be achieved after the requisite service period. The amendments in the ASU require that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. Existing guidance in "Compensation - Stock Compensation (Topic 718)", should be applied to account for these types of awards. The amendments in this ASU are effective for annual periods and interim periods within those annual periods beginning after December 15, 2015. Early adoption is permitted and reporting entities may choose to apply the amendments in the ASU either on a prospective or retrospective basis. The Corporation is currently assessing the impact that ASU 2014-12 will have on its consolidated financial statements.