PINX:MREE Mainstreet Bankshares Quarterly Report 10-Q Filing - 6/30/2012

Effective Date 6/30/2012

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

 

(Mark One)

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended                              June 30, 2012                                                

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                                           to                                          

 

Commission file number 333-86993

 

MainStreet BankShares, Inc.
(Exact name of registrant as specified in its charter)

 

Virginia   54-1956616
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification No.)

 

1075 Spruce Street, Martinsville, Virginia   24112
(Address of principal executive offices)   (Zip Code)

 

Registrant’s telephone number (276) 632-8054

 

 
(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant has (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x           No ¨

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Yes x           No ¨

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated filer ¨ Accelerated filer ¨
   
Non-accelerated filer ¨ Smaller reporting company x

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes ¨           No x

 

 
 

 

APPLICABLE ONLY TO CORPORATE ISSUERS

 

Indicate the number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date:              1,713,375 as of August 10, 2012              

 

 
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Form 10-Q

 

Index

 

    Page No.
     
PART I  FINANCIAL INFORMATION
     
Item 1 Financial Statements 1-32
     
Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations 33-52
     
Item 3 Quantitative and Qualitative Disclosures About Market Risk N/A 53
     
Item 4 Controls and Procedures 53
     
PART II  OTHER INFORMATION
     
Item 1 Legal Proceedings 53
     
Item 1A Risk Factors 53
     
Item 2 Unregistered Sales of Equity Securities and Use of Proceeds 53
     
Item 3 Defaults Under Senior Securities 53
     
Item 4 Mine Safety Disclosures 53
     
Item 5 Other Information 53
     
Item 6 Exhibits 53
     
  Signatures 54
     
  Index to Exhibits 55-56

 

 
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

PART I.     FINANCIAL INFORMATION

 

Item 1.Financial Statements

 

The financial statements filed as part of Item 1 of Part I are as follows:

 

1.Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011 (audited).

 

2.Consolidated Statements of Operations for the quarters ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited).

 

3.Consolidated Statements of Operations for the year-to-date periods ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited).

 

4.Consolidated Statements of Comprehensive Income for the quarters ended June 30, 2012 and June 30, 2011 (unaudited)

 

5.Consolidated Statements of Comprehensive Income (Loss) for the year-to-date periods ended June 30, 2012 and June 30, 2011 (unaudited)

 

7.Consolidated Statements of Cash Flows for the year-to-date periods ended June 30, 2012 (unaudited) and June 30, 2011 (unaudited).

 

8.Notes to Consolidated Financial Statements.

 

 
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

 

   (Unaudited)   (Audited) 
   June 30, 2012   December 31, 2011 
         
ASSETS          
           
Cash and due from banks  $3,718,140   $2,767,395 
Interest-bearing deposits in banks   13,425,337    17,091,438 
Federal funds sold   6,683,510    10,612,680 
Total Cash and Cash Equivalents   23,826,987    30,471,513 
Securities available for sale, at fair value   24,398,000    21,199,884 
Restricted equity securities   760,500    830,000 
Loans held for sale   1,033,045     
           
Loans:          
Total Gross Loans   138,553,501    143,134,494 
Unearned deferred fees and costs, net   88,062    89,510 
Loans, net of unearned deferred fees and costs   138,641,563    143,224,004 
Less:  Allowance for loan losses   (2,563,829)   (3,272,945)
Net Loans   136,077,734    139,951,059 
Bank premises and equipment, net   1,642,231    1,654,496 
Accrued interest receivable   549,246    547,905 
Bank owned life insurance   3,105,271    3,049,696 
Other real estate owned, net of valuation allowance   2,829,592    3,572,518 
Other assets   2,381,064    2,578,240 
           
TOTAL ASSETS  $196,603,670   $203,855,311 
           
LIABILITIES AND SHAREHOLDERS’ EQUITY          
           
Deposits:          
Noninterest bearing demand deposits  $22,709,789   $20,975,660 
Interest bearing deposits   136,809,143    146,107,182 
Total Deposits   159,518,932    167,082,842 
           
Repurchase agreements   13,500,000    13,500,000 
Accrued interest payable and other liabilities   1,109,241    1,031,680 
Total Liabilities   174,128,173    181,614,522 
           
Commitments and contingencies        
           
Shareholders’ Equity:          
Preferred stock, no par value, authorized 10,000,000 shares; none issued        
Common stock, no par value, authorized 10,000,000 shares; issued and outstanding 1,713,375 shares at June 30, 2012 and December 31, 2011   17,866,890    17,866,890 
Retained earnings   4,205,494    3,986,150 
Accumulated other comprehensive income   403,113    387,749 
Total Shareholders’ Equity   22,475,497    22,240,789 
           
TOTAL LIABILITIES AND SHAREHOLDERS'  EQUITY  $196,603,670   $203,855,311 

 

See accompanying notes to consolidated financial statements.

 

2
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

 

   Three Months   Three Months 
   Ended   Ended 
   June 30, 2012   June 30, 2011 
         
Interest and Dividend Income:          
Interest and fees on loans  $1,923,875   $2,169,377 
Interest on interest-bearing deposits   6,003    5,798 
Interest on federal funds sold   3,033    1,501 
Interest on securities available for sale:          
Taxable   133,726    211,844 
Nontaxable   13,819     
Dividends on restricted equity securities   8,009    7,648 
Total Interest and Dividend Income   2,088,465    2,396,168 
           
Interest Expense:          
Interest on deposits   348,423    517,380 
Interest on short-term borrowings   1    5 
Interest on repurchase agreements   134,149    134,149 
Total Interest Expense   482,573    651,534 
           
Net Interest Income   1,605,892    1,744,634 
Provision for (recovery of) loan losses   (27,413)   55,923 
           
Net Interest Income After Provision for Loan Losses   1,633,305    1,688,711 
           
Noninterest Income:          
Service charges on deposit accounts   60,542    76,227 
Mortgage brokerage income   69,921    28,623 
Electronic card fees   46,741    42,082 
Investment fee income   35,121    29,140 
Income on bank owned life insurance   27,972    27,468 
Gain on securities sold/called   1,848     
Other fee income and miscellaneous income   28,940    21,979 
Total Noninterest Income   271,085    225,519 
           
Noninterest Expense:          
Salaries and employee benefits   696,267    701,070 
Occupancy and equipment expense   202,748    208,411 
Professional fees   59,986    43,476 
Outside processing   131,337    105,962 
FDIC assessment   65,058    99,207 
Franchise tax   50,001    52,500 
Regulatory examination fees   27,700    27,935 
Other real estate and repossessions   351,530    398,198 
Other expenses   157,831    124,938 
Total Noninterest Expense   1,742,458    1,761,697 
Net Income Before Tax  $161,932   $152,533 
Income Tax Expense   39,883    40,856 
Net Income  $122,049   $111,677 
Net Income Per Share Basic  $.07   $.07 
Net Income  Per Share Diluted  $.07   $.07 

 

See accompanying notes to consolidated financial statements.

3
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited)

 

   Six Months   Six Months 
   Ended   Ended 
   June 30, 2012   June 30, 2011 
         
Interest and Dividend Income:          
Interest and fees on loans  $3,867,253   $4,430,526 
Interest on interest-bearing deposits   14,483    10,019 
Interest on federal funds sold   7,011    4,020 
Interest on securities available for sale:          
Taxable   267,167    424,036 
Nontaxable   23,689     
Dividends on restricted equity securities   15,829    15,314 
Total Interest and Dividend Income   4,195,432    4,883,915 
           
Interest Expense:          
Interest on deposits   732,371    1,098,881 
Interest on short-term borrowings   1    5 
Interest on repurchase agreements   268,298    266,824 
Total Interest Expense   1,000,670    1,365,710 
           
Net Interest Income   3,194,762    3,518,205 
Provision for loan losses   173,870    909,113 
           
Net Interest Income After Provision for Loan Losses   3,020,892    2,609,092 
           
Noninterest Income:          
Service charges on deposit accounts   125,543    153,569 
Mortgage brokerage income   99,895    58,422 
Electronic card fees   88,872    79,358 
Investment fee income   100,459    75,926 
Income on bank owned life insurance   55,575    54,565 
Gain on securities sold/called   1,848     
Other fee income and miscellaneous income   59,435    45,779 
Total Noninterest Income   531,627    467,619 
           
Noninterest Expense:          
Salaries and employee benefits   1,420,744    1,426,048 
Occupancy and equipment expense   413,750    426,246 
Professional fees   127,974    126,668 
Outside processing   259,726    209,810 
FDIC assessment   132,125    218,069 
Franchise tax   100,002    105,000 
Regulatory examination fees   55,400    55,875 
Other real estate and repossessions   494,532    787,554 
Other expenses   260,242    249,238 
Total Noninterest Expense   3,264,495    3,604,508 
           
Net Income (Loss) Before Tax  $288,024   $(527,797)
Income Tax Expense (Benefit)   68,680    (199,394)
Net Income (Loss)  $219,344   $(328,403)
Net Income (Loss) Per Share Basic  $.13   $(.19)
Net Income (Loss) Per Share Diluted  $.13   $(.19)

 

See accompanying notes to consolidated financial statements.

4
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited)

 

   Three Months   Three Months 
   Ended   Ended 
   June 30, 2012   June 30, 2011 
         
Net Income  $122,049   $111,677 
Other Comprehensive Income:          
Net unrealized holding gains on securities available for sale during the period   83,078    424,552 
Less reclassification adjustments for gains included in net income net of tax of $628   (1,220)    
Deferred income tax expense   (28,246)   (144,348)
Other Comprehensive Income   53,612    280,204 
Total Comprehensive Income  $175,661   $391,881 

 

See accompanying notes to consolidated financial statements.

 

5
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited)

 

   Six Months   Six Months 
   Ended   Ended 
   June 30, 2012   June 30, 2011 
         
Net Income (Loss)  $219,344   $(328,403)
Other Comprehensive Income:          
Net unrealized holding gains on securities available for sale during the period   25,125    502,336 
Less reclassification adjustments for gains included in net income net of tax of $628   (1,220)    
Deferred income tax expense   (8,541)   (170,795)
Other Comprehensive Income   15,364    331,541 
Total Comprehensive Income  $234,708   $3,138 

 

See accompanying notes to consolidated financial statements.

 

6
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited)

 

   Six Months   Six Months 
   Ended   Ended 
   June 30, 2012   June 30, 2011 
Cash Flows From Operating Activities          
Net income (loss)  $219,344   $(328,403)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:          
Provision for loan losses   173,870    909,113 
Depreciation and amortization   98,089    107,809 
Amortization of discounts and premiums, net   95,997    69,739 
Gain on sale of securities   (1,848)    
Loss and impairment on other real estate owned and repossessions   424,963    748,185 
Deferred tax expense (benefit)   198,794    (8,141)
Change in loans held for sale   (1,033,045)    
(Increase) decrease in accrued interest receivable   (1,341)   134,678 
Increase in other assets   (9,531)   (8,487)
Increase in value of bank owned life insurance   (55,575)   (54,565)
Change in reserve for unfunded lending commitments   25,020     
Increase (decrease) in accrued interest payable and other liabilities   52,541    (80,852)
Net cash provided by operating activities   187,278    1,489,076 
           
Cash Flows From Investing Activities          
           
Purchases of bank premises and equipment   (85,824)   (35,947)
Purchases of securities available for sale   (9,577,186)    
Calls/maturities/repayments of securities available for sale   6,308,198    2,681,930 
Redemptions of restricted equity securities   69,500    82,400 
Capital improvements to other real estate owned       (23,750)
Proceeds from sale of other real estate owned and repossessions   2,515,912    1,893,022 
Loan originations and principal collections, net   1,501,506    1,992,870 
Net cash provided by investing activities   732,106    6,590,525 
           
Cash Flows From Financing Activities          
           
Increase in non-interest bearing deposits   1,734,129    2,640,006 
Decrease in interest bearing deposits   (9,298,039)   (5,366,733)
Net cash used in financing activities   (7,563,910)   (2,726,727)
           
Net increase (decrease) in cash and cash equivalents  $(6,644,526)  $5,352,874 
Cash and cash equivalents at beginning of period   30,471,513    18,765,347 
Cash and cash equivalents at end of period  $23,826,987   $24,118,221 
           
Supplemental disclosure of cash flow information:          
Cash paid during the period for interest  $1,021,490   $1,439,213 
Cash paid during the period for taxes  $   $ 
Unrealized gain on securities available for sale  $23,277   $502,336 
Transfers between loans, other real estate & other assets  $2,197,949   $3,348,527 

 

See accompanying notes to consolidated financial statements.

 

7
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Note 1 – Summary of Accounting Policies

 

(a) General

 

The accompanying consolidated financial statements of MainStreet BankShares, Inc. are unaudited. However, in the opinion of management, all adjustments necessary for a fair presentation of the financial statements have been included. All adjustments were of a normal recurring nature, except as otherwise disclosed herein. The consolidated financial statements conform to generally accepted accounting principles and general banking industry practices. The information contained in the footnotes included in MainStreet BankShares, Inc.’s 2011 Annual Report on Form 10-K should be referred to in connection with the reading of these unaudited interim consolidated financial statements.

 

MainStreet BankShares, Inc. (the “Corporation”, “MainStreet”, or “BankShares”) was incorporated in Virginia on January 14, 1999. The Corporation was primarily organized to serve as a bank holding company. Its first wholly-owned subsidiary was located in Martinsville, Virginia and was sold on March 23, 2005. In 2002, MainStreet organized a second bank subsidiary, Franklin Community Bank, National Association (“Franklin Bank”). On February 8, 2007, MainStreet formed a wholly-owned real estate company, MainStreet RealEstate, Inc. (“MainStreet RE”) for the sole purpose of owning the real estate of the Corporation. When MainStreet sold Smith River Bank, the capital was redeployed to Franklin Bank.

 

Franklin Bank was organized as a nationally chartered commercial bank and member of the Federal Reserve Bank of Richmond. Franklin Bank opened for business on September 16, 2002. 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. Franklin Bank’s primary service area is Franklin County, Town of Rocky Mount and surrounding areas. It currently has three banking offices including its main office.

 

The Corporation reports its activities as a single business segment. In determining the appropriateness of segment definition, the Corporation considered components of the business about which financial information is available and will evaluate it regularly relative to resource allocation and performance assessment.

 

(b) Our accounting policies and basic principles have not changed since the summary disclosure of these in our Annual Report on Form 10-K. Please refer to the Form 10-K for these policies.

 

Note 2 – Securities

 

The carrying values, unrealized gains and losses and approximate market values of investment securities at June 30, 2012 and December 31, 2011 are shown in the following tables. The entire investment portfolio is classified as available-for-sale to preserve maximum liquidity for funding needs.

 

8
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

   June 30, 2012 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Approximate 
   Cost   Gains   Losses   Market Value 
U.S. government sponsored agencies  $4,470,836   $12,290   $(2,550)  $4,480,576 
Mortgage backed securities   14,951,495    550,419        15,501,914 
States and political subdivisions   4,427,247    31,293    (43,030)   4,415,510 
                     
Total securities available for sale  $23,849,578   $594,002   $(45,580)  $24,398,000 

 

   December 31, 2011 
       Gross   Gross     
   Amortized   Unrealized   Unrealized   Approximate 
   Cost   Gains   Losses   Market Value 
U. S. government sponsored agencies  $2,804,763   $7,497   $(1,478)  $2,810,782 
Mortgage backed securities   16,758,613    496,577        17,255,190 
States and political subdivisions   1,111,363    22,549        1,133,912 
                     
Total securities available-for-sale  $20,674,739   $526,623   $(1,478)  $21,199,884 

 

All of our mortgage backed securities are either guaranteed by U.S. government agencies or issued by U. S. government sponsored agencies.

 

The amortized costs and market values of securities available for sale at June 30, 2012, by contractual maturity, are shown in the following table. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

   Amortized   Approximate 
   Cost   Market Value 
Due in one year or less  $   $ 
Due after one year but within five years        
Due after five years but within ten years   9,898,354    9,931,630 
Due after ten years   13,951,224    14,466,370 
           
   $23,849,578   $24,398,000 

 

There were $1,848 in gross gains and no gross losses recorded on calls of securities available for sale for the quarter and six month period ending June 30, 2012. There were no gross gains or losses recorded on sales and calls of securities available for sale for the quarter and six month period ending June 30, 2011.

 

9
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Following demonstrates the unrealized loss position of securities available for sale at June 30, 2012 and December 31, 2011.

 

   June 30, 2012 
   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
U. S. government sponsored agencies  $747,450   $(2,550)  $   $   $747,450   $(2,550)
States and political subdivisions   3,067,017    (43,030)           3,067,017    (43,030)
Total securities available-for-sale  $3,814,467   $(45,580)  $   $   $3,814,467   $(45,580)

 

   December 31, 2011 
   Less Than 12 Months   12 Months or More   Total 
   Fair   Unrealized   Fair   Unrealized   Fair   Unrealized 
   Value   Losses   Value   Losses   Value   Losses 
U. S. government sponsored agencies  $2,248,523   $(1,478)  $   $   $2,248,523   $(1,478)
Total temporarily impaired securities  $2,248,523   $(1,478)  $   $   $2,248,523   $(1,478)

 

An impairment is considered “other than temporary” if any of the following conditions are met: the Corporation intends to sell the security, it is more likely than not that the Corporation will be required to sell the security before the recovery of its amortized cost basis, or the Corporation does not expect to recover the security’s entire amortized cost basis (even if the Bank does not intend to sell). At June 30, 2012 and December 31, 2011, there were $3.8 million and $2.2 million, respectively in securities with unrealized losses based on market prices at the respective dates. Declines in fair value are due to interest rate fluctuations and not due to credit deterioration of the issuers. The Corporation does not have any securities that are considered “other than temporarily impaired” at June 30, 2012 and December 31, 2011.

 

Federal Reserve Bank stock is included in restricted equity securities and totaled $435,100 at June 30, 2012 and December 31, 2011. The Corporation’s investment in Federal Home Loan Bank (“FHLB”) stock totaled $325,400 and $394,900 at June 30, 2012 and December 31, 2011, respectively, and is also included in restricted equity securities. FHLB stock is generally viewed as a long term investment and as a restricted investment security which is carried at cost, because there is no market for the stock other than the FHLB or member institutions. Therefore, when evaluating FHLB stock for impairment, its value is based on ultimate recoverability of the par value rather than by recognizing temporary declines in value. Despite the FHLB’s temporary suspension of the repurchases of excess capital stock in earlier years, the Corporation does not consider this investment to be other than temporarily impaired at June 30, 2012 and no impairment has been recognized. FHLB has repurchased excess capital stock during 2012 and 2011.

 

10
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Note 3 – Loans Receivable

 

The major components of gross loans in the consolidated balance sheets at June 30, 2012 and December 31, 2011 are as follows:

 

   June 30, 2012   December 31, 2011 
Commercial  $10,155,682   $11,061,471 
Real Estate:          
Construction and land development   20,861,272    26,102,914 
Residential 1-4 families:          
First liens   36,702,472    37,735,618 
Junior liens   8,578,390    8,486,594 
Home equity lines   6,884,315    7,639,785 
Commercial real estate   53,598,124    50,272,002 
Consumer   1,773,246    1,836,110 
Total Gross Loans  $138,553,501   $143,134,494 
Unearned deferred fees and costs, net   88,062    89,510 
Recorded Investment  $138,641,563   $143,224,004 

 

Overdrafts reclassified to loans at June 30, 2012 and December 31, 2011 were $13,793 and $4,916, respectively.

 

Loan Origination/Risk Management: Franklin Bank’s Board of Directors annually approves and reviews policies and procedures to be utilized as tools by account officers for the purpose of making sound and prudent credit decisions. Every loan transaction is closely evaluated from the perspective of profitability realizing that there is no profit in a loan that becomes a loss. Each credit decision is based on merit and no other factors. Account officers carry a heavy burden of accountability in being assigned the responsibility for the development of Franklin Bank’s loan portfolio by meeting the legitimate credit needs of our customers while also exercising prudence and seasoned judgment. A comprehensive reporting system has been developed to provide senior management timely information related to portfolio performance including growth, delinquency, adversely risk rated, and credit concentrations. The portfolio is constantly reviewed based on segments of concern, past due status, extension of credits along with stress testing the portfolio’s collateral values and debt service coverages for a significant portion of loans within defined loan concentrations. Annually, a loan review plan is developed to identify and mitigate potential weakness in the loan portfolio. Scope is determined based upon a risk assessment of various concentrations and loan product types in which higher risk may exist. The developed plan is presented to the Loan Committee of Franklin Bank’s Board of Directors each year for approval. Overall, the goal is to review 33% of the entire loan portfolio annually. Review segments vary from year to year to ensure a complete cycle of all significant loan product types. Results of each review segment are communicated to the Loan Committee of the Board of Directors of Franklin Bank with a response from Franklin Bank’s senior lender or head of retail lending depending on the product type reviewed.

 

In general all loans exceeding $100,000 are documented by three years of financial reports in conjunction with review and analysis by a credit analyst independent of the lending approval process. Generally all real estate loans are underwritten based on verified income, or cash flow, and margined at 80% or less depending upon the regulatory supervisory limit. All loans are underwritten based upon analysis of all identified primary and secondary repayment sources.

  

11
 

  

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Construction & Land Development: Emphasis is placed on the estimated absorption period of the project based on the intimate knowledge of local demand and geographic concentrations by appraisers and account officers. Projects are monitored by Franklin Bank’s in-house construction inspector to ensure adherence to project specifications and timely completion. Loan to values are manually tracked to ensure conforming collateral coverage is maintained throughout the development phase. Interest carry abilities are determined by analyzing global cash flow and available liquidity. Due to their complex nature, loans for speculative housing and speculative lot requests are underwritten by Franklin Bank’s business lending group. Terms at origination for speculative lot loans are based on collateral margins and on qualifying the borrower to policy requirements based on a ten year amortization period. Speculative housing loan terms generally are held to eighteen months with allowance made for substantial curtailments.

 

Commercial Real Estate: Loans are generally underwritten based on verified income or cash flow to ensure a global coverage ratio of at least 1.25. In general, collateral margin is determined based on appraisal or evaluation market value not to exceed 80 percent of appraised market value or cost, which ever is less. All properties receive proper environmental due diligence prior to funding of the credit. Account officers perform and document a market analysis which may include data on competing businesses and projects. When applicable, market analysis data may be obtained from independent sources. Cash flows and collateral margins are appropriately stress tested. Terms generally range from five to fifteen years, however, may be longer based on approval from Franklin Bank’s President and Chief Credit Officer.

 

Commercial Loans: Loans are generally underwritten based on verified income or cash flow to ensure global debt service coverage ratio of at least 1.25. Terms can range up to seven years based on loan purpose and collateral offered. Based on policy, credit lines have maturities of one year. Generally inventory loans are margined at 50% while equipment loans, depending on age of collateral, range from 90%, if new, to 80%, if used. Receivables are margined at 80% based on the aging of receivables outstanding sixty days or less.

 

Consumer /Residential 1-4 Families and Equity Lines: Loans are generally underwritten based on a maximum debt to income ratio of 40 percent gross. Incomes are verified for all secured loans exceeding $35,000 and unsecured loans totaling $10,000 or more. Policy requires income verification to be documented for all real estate loans. Collateral margins and terms for non-real estate collateral are determined and made available to retail lenders by Franklin Bank’s Chief Credit Officer. Cash flows for all self employed borrowers are determined by Franklin Bank’s independent credit analyst. Policy defines unsecured loan terms at a maximum of thirty six months while individual unsecured lines are underwritten to maturities of less than one year with the line amount being based on a percentage of available liquidity and net worth. Construction loans for individuals are underwritten to policy based on cost overruns of at least fifteen percent. Debt to income ratios for equity lines are underwritten based on the borrower paying 1.5% of the total available line monthly. All equity lines are reviewed annually and filtered based on updated credit scores, average percentage drawn and delinquency. “Watch” accounts are identified based on filters and then individually reviewed by the responsible account officer.

 

Note 4 – Allowance for Loan Losses

 

Changes in the allowance for loan losses for the six months ended June 30, 2012 and 2011 are as follows:

 

   2012   2011 
         
Balance at beginning of year  $3,272,945   $3,584,180 
Provision for loan losses   173,870    909,113 
Recoveries   72,464    83,344 
Charge-offs   (955,450)   (1,513,807)
Balance at period end  $2,563,829   $3,062,830 

 

12
 

 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

A breakdown of the allowance by loan segment for the six months ended June 30, 2012 is as follows:

 

       Real Estate             
       Construction   Residential 1-4 Families   Home   Commercial             
       and Land   First   Junior   Equity   Real             
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Unallocated   Total 
                                     
Beginning Balance  $154,991   $902,644   $1,100,139   $174,809   $98,582   $824,759   $11,911   $5,110   $3,272,945 
Charge-offs   (187)   (245,248)   (616,151)   (93,578)           (286)       (955,450)
Recoveries   1,200    3,443    50,000    9,932            7,889        72,464 
Provision   (32,428)   (167,425)   196,678    60,079    (9,791)   136,846    (4,979)   (5,110)   173,870 
Ending Balance  $123,576   $493,414   $730,666   $151,242   $88,791   $961,605   $14,535   $   $2,563,829 

 

       June 30, 2012             
       Real Estate             
       Construction   Residential 1-4 Families   Home   Commercial             
       and Land   First   Junior   Equity   Real             
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Unallocated   Total 
                                              
Allowance for loan losses:                                             
                                              
Ending Balance:                                             
Individually evaluated for Impairment  $10,253   $25,879   $21,684   $   $   $279,941   $   $   $337,757 
                                              
Ending Balance:                                             
Collectively evaluated for impairment   113,323    467,535    708,982    151,242    88,791    681,664    14,535        2,226,072 
                                              
   $123,576   $493,414   $730,666   $151,242   $88,791   $961,605   $14,535   $   $2,563,829 

 

13
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

       June 30, 2012         
       Real Estate         
       Construction   Residential 1-4 Families   Home   Commercial         
       and Land   First   Junior   Equity   Real       Gross 
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Loans 
                                         
Recorded investment in loans:                                        
                                         
Ending Balance:                                        
Individually evaluated for impairment  $133,165   $906,942   $2,507,743   $404,828   $128,038   $2,178,434   $   $6,259,150 
                                         
Ending Balance:                                        
Collectively evaluated for impairment   10,022,517    19,954,330    34,194,729    8,173,562    6,756,277    51,419,690    1,773,246    132,294,351 
                                         
   $10,155,682   $20,861,272   $36,702,472   $8,578,390   $6,884,315   $53,598,124   $1,773,246   $138,553,501 

 

A breakdown of the allowance for loan losses by loan segment for the year ended December 31, 2011 is as follows:

 

       Real Estate             
       Construction   Residential 1-4 Families   Home   Commercial             
       and Land   First   Junior   Equity   Real             
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Unallocated   Total 
                                     
Beginning Balance  $138,449   $1,086,183   $1,065,683   $243,526   $217,063   $793,308   $39,968   $   $3,584,180 
Charge-offs   (482,651)   (922,440)   (311,265)   (164,907)   (34,745)   (205,824)   (21,670)       (2,143,502)
Recoveries   32,312    62,883    62,755    1,232            12,302        171,484 
Provision   466,881    676,018    282,966    94,958    (83,736)   237,275    (18,689)   5,110    1,660,783 
Ending Balance  $154,991   $902,644   $1,100,139   $174,809   $98,582   $824,759   $11,911   $5,110   $3,272,945 

 

14
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

       December 31, 2011             
       Real Estate             
       Construction   Residential 1-4 Families   Home   Commercial             
       and Land   First   Junior   Equity   Real             
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Unallocated   Total 
                                              
Allowance for loan losses:                                             
                                              
Ending Balance:                                             
Individually evaluated for impairment  $2,075   $292,323   $413,354   $   $   $110,820   $   $   $818,572 
                                              
Ending Balance:                                             
Collectively evaluated for impairment   152,916    610,321    686,785    174,809    98,582    713,939    11,911    5,110    2,454,373 
                                              
   $154,991   $902,644   $1,100,139   $174,809   $98,582   $824,759   $11,911   $5,110   $3,272,945 

 

       December 31, 2011         
       Real Estate         
       Construction   Residential 1-4 Families   Home   Commercial         
       and Land   First   Junior   Equity   Real       Gross 
   Commercial   Development   Liens   Liens   Lines   Estate   Consumer   Loans 
                                         
Recorded investment in loans:                                        
                                         
Ending Balance:                                        
Individually evaluated for impairment  $136,680   $1,624,238   $4,852,061   $424,795   $131,439   $1,533,473   $50,694   $8,753,380 
                                         
Ending Balance:                                        
Collectively evaluated for impairment   10,924,791    24,478,676    32,883,557    8,061,799    7,508,346    48,738,529    1,785,416    134,381,114 
                                         
   $11,061,471   $26,102,914   $37,735,618   $8,486,594   $7,639,785   $50,272,002   $1,836,110   $143,134,494 

 

15
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

An age analysis of past due loans as of June 30, 2012 is as follows:

 

                           Accruing Loans     
   Loans   Loans   Loans 90               90 or More Days   Nonaccrual Loans 
   30-59 Days Past
 Due
   60-89 Days
Past Due
   Or More Days
Past Due
   Total Past 
Due Loans
   Current 
Loans
   Gross 
Loans
   Past Due (Included
in Past Dues)
   (Included in Past
Dues & Current)
 
Commercial  $5,000   $   $5,000   $10,000   $10,145,682   $10,155,682   $5,000   $ 
Real Estate:                                        
Construction and land development   4,480        532,368    536,848    20,324,424    20,861,272        583,455 
Residential 1-4 Families                                        
First Liens   688,973    9,511    1,851,458    2,549,942    34,152,530    36,702,472        2,507,743 
Junior Liens   528,651            528,651    8,049,739    8,578,390        137,228 
Home Equity lines                   6,884,315    6,884,315        128,038 
Commercial Real Estate   553,077    350,402    94,962    998,441    52,599,683    53,598,124    94,962    90,204 
Consumer   19,788            19,788    1,753,458    1,773,246         
                                         
   $1,799,969   $359,913   $2,483,788   $4,643,670   $133,909,831   $138,553,501   $99,962   $3,446,668 

 

An age analysis of past due loans as of December 31, 2011 is as follows:

 

                           Accruing Loans     
                           90 or More Days     
   Loans
30-59 Days Past
 Due
   Loans
60-89 Days
Past Due
   Loans 90
Or More Days
Past Due
   Total Past 
Due Loans
   Current 
Loans
   Gross 
Loans
   Past Due
(Included
in Past Dues)
   Nonaccrual Loans
(Included in Past
Dues & Current)
 
Commercial  $150,390   $4,287   $88,350   $243,027   $10,818,444   $11,061,471   $   $104,579 
Real Estate:                                        
Construction and land development   52,406    43,274    1,526,501    1,622,181    24,480,733    26,102,914        1,624,238 
Residential 1-4 Families                                        
First Liens   836,919    1,674,264    2,689,459    5,200,642    32,534,976    37,735,618        4,852,061 
Junior Liens   208,807            208,807    8,277,787    8,486,594        156,490 
Home Equity lines   26,773            26,773    7,613,012    7,639,785        131,439 
Commercial Real Estate           148,221    148,221    50,123,781    50,272,002        148,221 
Consumer   2,103            2,103    1,834,007    1,836,110        50,694 
                                         
   $1,277,398   $1,721,825   $4,452,531   $7,451,754   $135,682,740   $143,134,494   $   $7,067,722 

 

16
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Impaired loans at June 30, 2012 are as follows:

 

   Unpaid   Recorded   Recorded             
   Contractual   Investment   Investment       Average   Interest 
   Principal   with Related   with No Related   Related   Recorded   Income 
   Balance   Allowance   Allowance   Allowance   Investment   Recognized 
Commercial  $133,165   $128,165   $5,000   $10,253   $124,398   $73 
Real Estate:                              
Construction and land development   928,382    323,487    583,455    25,879    1,043,163     
Residential 1-4 Families                              
First Liens   2,566,312    345,593    2,162,150    21,684    3,351,616     
Junior Liens   404,828        404,828        347,987    185 
Home Equity lines   160,302        128,038        129,625     
Commercial Real Estate   2,178,434    1,818,627    359,807    279,941    1,286,718     
Consumer   86,494                33,496     
                               
   $6,457,917   $2,615,872   $3,643,278   $337,757   $6,317,003   $258 

 

Impaired loans at December 31, 2011 are as follows:

 

   Unpaid   Recorded   Recorded             
   Contractual   Investment   Investment       Average   Interest 
   Principal   with Related   with No Related   Related   Recorded   Income 
   Balance   Allowance   Allowance   Allowance   Investment   Recognized 
Commercial  $170,080   $36,388   $100,292   $2,075   $327,051   $593 
Real Estate:                              
Construction and land development   1,664,551    1,263,551    360,687    292,323    2,163,855    24,174 
Residential 1-4 Families                              
First Liens   4,901,815    2,474,255    2,377,806    413,354    3,618,240    122,856 
Junior Liens   424,795        424,795        570,365    15,383 
Home Equity lines   163,703        131,439        177,972    3,520 
Commercial Real Estate   1,533,473    1,385,252    148,221    110,820    809,181    105,266 
Consumer   142,188        50,694        56,639    653 
                               
   $9,000,605   $5,159,446   $3,593,934   $818,572   $7,723,303   $272,445 

 

17
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Troubled debt restructurings occurred as follows for the year-to-date and quarter-to-date periods ending June 30, 2012:

 

Commercial  $97,502 
Real Estate:     
Construction and land development   323,487 
Residential 1-4 families:     
First liens    
Junior liens    
Home Equity Lines    
Commercial Real Estate   353,177 
Consumer    
   $774,166 

 

For the six months and three months ended June 30, 2012, below describes the troubled debt restructurings at the time of modification:

 

   Pre-Modification   Post-Modification 
   Number       Number     
   of Loans   Balance   of Loans   Balance 
Commercial   1   $97,502    1   $97,502 
Real Estate:                    
Construction and land development   1    323,487    1    323,487 
Residential 1-4 families:                    
First liens                
Junior liens                
Home Equity Lines                
Commercial Real Estate   1    354,156    1    354,156 
Consumer                
    3   $775,145    3   $775,145 

 

The commercial loan restructured was a renewal of an existing loan for a short period of time to allow the borrower to come up with an action plan. The borrower’s debt service ratio had declined moving the credit to a criticized asset. The construction and land development loan was the renewal of a criticized credit for a short term to allow the borrower to sell assets. The commercial real estate loan was the restructure of a stale line of credit into an amortizing loan of a criticized asset.

 

The following table describes the interest earned, reflected in income and lost for the periods.

 

   June 30, 2012   June 30, 2011 
Interest that would have been earned  $173,195   $294,791 
Interest reflected in income   258    33,380 
Lost interest  $172,937   $261,411 

 

18
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

At June 30, 2012 and December 31, 2011 the balance in loans under the terms of troubled debt restructurings not included in nonaccrual loans was $2,447,675 and $1,685,658, respectively. These loans did not have any additional commitments at June 30, 2012 and December 31, 2011, respectively. Loan restructurings generally occur when a modification that would otherwise not be considered is granted to the borrower. These loans may continue to accrue interest as long as the borrower complies with the revised terms and conditions and has demonstrated repayment performance with the modified terms. The borrowers were complying with the modified terms of their contracts at June 30, 2012 and December 31, 2011, respectively. Troubled debt restructurings are included in the impaired loan disclosures.

 

There were no troubled debt restructurings modified during the prior twelve months that defaulted during the three and six month period ended June 30, 2012.

 

The Corporation’s internally assigned grades for credit quality are as follows:

 

Prime (1.00)

Exceptional credits are of the highest quality. These loans are supported by large, well-established borrowers with excellent financial stability and strength, and may be secured by cash or cash equivalents. Where applicable, guarantors have substantial net worth and personal cash flow, and could easily fulfill their obligation should the need arise.

 

Good (2.00)

Superior credits are supported by well-established borrowers with excellent financial stability and strength. The borrower’s cash flow, liquidity, and equity are more than ample. These credits may be secured by cash or cash equivalents. For loans with personal guarantees, the guarantors are high net worth individuals, and have the resources available to satisfy their obligation if necessary.

 

Acceptable (3.00)

Loans in this category are supported by borrowers and guarantors that are financially sound. Cash flow, liquidity and equity are sufficient to provide a comfortable margin in the event of short-term economic disturbances. Assets pledged as collateral would provide a dependable secondary source of repayment.

 

Pass/Watch (4.00)

Credits in this category present the maximum acceptable risk for new facilities. Borrowers generate enough cash for debt service needs, but may not have sufficient resources to weather short-term market fluctuations. Management may lack depth or experience, and industry volatility may be an issue. Where applicable, guarantors have sufficient resources to provide an additional margin of protection.

 

Special Mention (5.00)

Assets in this category demonstrate signs of potential weakness, which, if uncorrected, could result in default. The borrower’s liquidity or equity may be marginal, trends in cash flow and profitability may point to a weakening financial condition, or the borrower’s industry may be slightly unstable or showing early indications of decline. Collateral may be illiquid or provide only a relatively small margin. Migration analysis data is performed and updated quarterly on these loans. It is based on loans downgraded originally into this category. Our loss factor is determined based on charge-offs during the quarter divided by the balance of special mention loans at the beginning of the quarter. This is then increased by the qualitative factors which increases the applied loss factor to 3%.

 

19
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Substandard (6.00)

Loans in this category present an unacceptable credit risk. Borrowers and guarantors may be financially weak, and may lack the sufficient resources to adequately service debt. The abilities of management and industry stability may also be of concern. Collateral may be lacking in quality or liquidity, and offers little additional protection. Migration analysis data is performed and updated quarterly on these loans. It is based on loans downgraded originally into this category. Our loss factor is determined based on charge-offs during the quarter divided by the balance of substandard loans at the beginning of the quarter. This is then increased by the qualitative factors which increases the applied loss factor to 8%. This does not apply to impaired loans where a specific reserve is determined based on the loss, if any, that is calculated.

 

Doubtful (7.00)

 

These loans have an extremely high probability of loss, though the timing and magnitude of the loss may remain unclear. Borrowers and guarantors exhibit major financial shortcomings, and clearly lack the sufficient resources to adequately service debt or honor their commitments. Collateral is lacking in quality or liquidity, and offers little, if any, additional protection.

 

Loss (8.00)

 

The probability of collection on these credits is so low that they may be properly classified as uncollectible.

 

Generally, consumer loans, home equity lines, and residential 1-4 family loans are not risk rated and considered a pass credit unless they are related to a risk rated commercial loan relationship or exhibit criticized asset characteristics.

 

20
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

       June 30, 2012         
       Real Estate         
       Construction   Residential 1-4 Families   Home   Commercial       Gross Loans by 
Internal Risk Rating
Grades
  Commercial   And Land
Development
   First
Liens
   Junior
Liens
   Equity
Lines
   Real
Estate
   Consumer   Internal Risk
Rating Grade
 
Grade:                                        
Pass  $9,842,796   $17,507,163   $31,100,165   $7,712,309   $6,734,369   $48,044,089   $1,724,346   $122,665,237 
Special Mention   37,497    1,032,540    646,103    250,966        1,004,846    6    2,971,958 
Substandard   275,389    2,321,569    4,610,611    615,115    149,946    4,549,189    48,894    12,570,713 
Doubtful           345,593                    345,593 
Loss                                
                                         
   $10,155,682   $20,861,272   $36,702,472   $8,578,390   $6,884,315   $53,598,124   $1,773,246   $138,553,501 

 

       December 31, 2011         
       Real Estate         
       Construction   Residential 1-4 Families   Home   Commercial       Gross Loans by 
Internal Risk Rating
Grades
  Commercial   And Land
Development
   First
Liens
   Junior
Liens
   Equity
Lines
   Real
Estate
   Consumer   Internal Risk
Rating Grade
 
Grade:                                        
Pass  $9,869,976   $21,364,943   $30,016,743   $7,251,555   $7,486,498   $43,885,034   $1,782,754   $121,657,503 
Special Mention   878,058    1,067,783    492,941            1,611,592        4,050,374 
Substandard   312,325    3,377,865    6,812,580    1,235,039    153,287    4,775,376    53,356    16,719,828 
Doubtful   1,112    292,323    413,354                    706,789 
Loss                                
                                         
   $11,061,471   $26,102,914   $37,735,618   $8,486,594   $7,639,785   $50,272,002   $1,836,110   $143,134,494 

 

21
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Note 5 – Borrowings

 

The Corporation has the ability to borrow from Federal Home Loan Bank of Atlanta (“FHLB”). Borrowing capacity is secured by a blanket lien on loans secured by commercial real estate and loans secured by 1-4 family first liens, second liens, and equity lines. There were no FHLB advances outstanding at June 30, 2012 and December 31, 2011.

 

There were no overnight federal funds purchased at June 30, 2012 and December 31, 2011.

 

The Corporation has an internal Corporate Cash Management account for customers to sweep their excess demand deposit accounts on an overnight basis in order to earn interest. This account is not FDIC insured but the Corporation is required to pledge agency funds at 100% towards these balances. There were no Corporate Cash Management sweep accounts at June 30, 2012 and December 31, 2011, respectively.

 

Note 6 – Repurchase Agreements

 

The Corporation entered into a repurchase agreement with Citigroup Global Markets, Inc. (“CGMI”) in the amount of $7,500,000 on September 18, 2007. The repurchase date is September 18, 2012. The interest rate was fixed at 4.22% until maturity or until it is called. Beginning September 18, 2008, the repurchase agreement became callable by CBMI and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by agency mortgage backed securities. The interest rate remained at 4.22% at June 30, 2012.

 

The Corporation entered into a repurchase agreement with Barclays Capital on January 2, 2008 in the amount of $6,000,000. The repurchase date is January 2, 2013. The interest rate was fixed at 3.57% until maturity or until it is called. Beginning January 2, 2009 the repurchase agreement became callable and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by agency mortgage backed securities. The interest rate remained at 3.57% at June 30, 2012.

 

Note 7 – Net Income (Loss) Per Share

 

The following tables show the weighted average number of shares used in computing earnings (loss) per share and the effect on weighted average number of shares of diluted potential common stock. Potential dilutive common stock had no effect on income available to common shareholders.

 

   Six Months Ended   Six Months Ended 
   June 30, 2012   June 30, 2011 
   Shares   Per Share
Amount
   Shares   Per Share
Amount
 
Earnings (loss) per share, basic   1,713,375   $.13    1,713,375   $(.19)
Effect of dilutive securities:                  
Stock options and warrants    —          —      
Earnings (loss) per share, diluted   1,713,375   $.13    1,713,375   $(.19)

 

Options and warrants not included in the calculation of diluted earnings per share because they were anti-dilutive were 161,272 for the year-to-date periods ending June 30, 2012 and 2011, respectively.

 

22
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

The following tables show the weighted average number of shares used in computing earnings (loss) per share and the effect on weighted average number of shares of diluted potential common stock. Potential dilutive common stock had no effect on income available to common shareholders.

 

   Three Months Ended   Three Months Ended 
   June 30, 2012   June 30, 2011 
   Shares   Per Share
Amount
   Shares   Per Share
Amount
 
Earnings per share, basic   1,713,375   $.07    1,713,375   $.07 
Effect of dilutive securities:                    
Stock options and warrants                  
Earnings per share, diluted   1,713,375   $.07    1,713,375   $.07 

 

Options and warrants not included in the calculation of diluted earnings per share because they were anti-dilutive were 161,272 for the quarters ending June 30, 2012 and 2011, respectively.

 

Note 8 – Stock Options and Warrants

 

The shareholders of MainStreet approved the 2004 Key Employee Stock Option Plan, (the “Plan”), at its Annual Meeting on April 15, 2004. The Plan permitted the grant of Non-Qualified Stock Options and Incentive Stock Options to persons designated as “Key Employees” of BankShares or its subsidiaries. The Plan was approved by the Board of Directors as of January 21, 2004 and terminated on January 21, 2009, except with respect to awards made prior to and outstanding on that date which remain valid in accordance with their terms. Option awards were granted with an exercise price equal to the market value of MainStreet’s stock at the date of grant. The options issued in 2007 and 2006 had a vesting period of three years and have a ten year contractual term. The options issued in 2005 vested immediately upon grant and have a ten year contractual term. All share awards provided for accelerated vesting if there was a change in control (as defined in the Plan). The maximum number of shares that could have been issued under the Plan could not exceed 150,700. As of June 30, 2012, there were 136,527 stock options granted under this Plan of which 822 have been exercised and 7,433 were forfeited.

 

Options in the amount of 33,000, all of which are vested and exercisable, have been granted at the then fair market value of $9.55 to a former employee.

 

As of June 30, 2012 the Corporation has reserved 161,272 shares of authorized but unissued shares of common stock related to the stock option agreements.

 

The Black-Scholes model was utilized to calculate the fair-value of the stock options on the date of grant for grants prior to 2008 using the assumptions of risk-free interest rate; expected life of options; expected volatility of the stock price and expected dividend yield. Expected volatilities are based on the historical volatility of MainStreet’s stock. Stock options granted in 2006 and forward were included in the calculation of compensation cost. The risk-free rate for the period within the contractual life of the option is based upon the ten year Treasury rate at the date of the grant. Expected life was calculated using the simplified method based on the average of the vesting period and contractual life of the options.

 

23
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Following is a status and summary of changes in stock options during the six months ended June 30, 2012:

 

           Weighted     
       Weighted   Average     
   Six Month   Average   Remaining   Aggregate 
   Period Ended   Exercise   Contractual   Intrinsic 
   June 30, 2012   Price   Term   Value 
Outstanding at Beginning of year   161,272   $12.17           
Granted                  
Exercised                  
Forfeited                  
Expired                  
Outstanding at June 30, 2012   161,272   $12.17    3.17   $ 
Exercisable at June 30, 2012   161,272   $12.17    3.17   $ 

 

The aggregate intrinsic value of a stock option in the table above represents the total pre-tax intrinsic value (the amount by which the current market value of the underlying stock exceeds the exercise price of the option) that would have been received by the option holders had all option holders exercised their options on June 30, 2012. This amount changes based on changes in the market value of the Corporation’s stock.

 

As of June 30, 2012 and 2011, there was no unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plan. The original unrecognized compensation cost was recognized over a weighted-average period of three years.

 

As of June 30, 2012, stock options and warrants outstanding and exercisable are summarized as follows:

 

    Stock Options     
Range of   and Warrants   Remaining 
Exercise   Outstanding   Contractual 
Prices   And Exercisable   Life 
          
 9.55    33,000    1.00 
 12.09    85,147    3.40 
 12.09    17,299    3.50 
 15.00    13,260    5.45 
 16.75    12,566    4.50 
$9.55 - $16.75    161,272      

 

Note 9 – Financial Instruments With Off-Balance-Sheet Risk

 

In the normal course of business to meet the financing needs of its customers, BankShares is a party to financial instruments with off-balance-sheet risk. These financial instruments involve commitments to extend credit. These instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated balance sheets.

  

24
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

The Corporation’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit is represented by the contractual amount of those instruments. The ame credit policy is used in making commitments as is used for on-balance-sheet risk. At June 30, 2012, outstanding commitments to extend credit including letters of credit were $17,675,496. There are no commitments to extend credit on impaired loans.

 

Commitments to extend credit are agreements to lend to a customer as long as there is no breach of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The commitments may expire without ever being drawn upon; therefore, the total commitment amounts do not necessarily represent future cash outlays for the Corporation.

 

Note 10 – Fair Value Measurements

 

Generally accepted accounting principles specifies a hierarchy of valuation techniques based on whether the inputs to those valuation techniques are observable or unobservable. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect MainStreet’s market assumptions. The three levels of the fair value hierarchy based on these two types of inputs are as follows:

 

  Level 1 –   Valuation is based on quoted prices in active markets for identical assets and liabilities.
       
  Level 2 –   Valuation is based on observable inputs including quoted prices in active markets for similar assets and liabilities, quoted prices for identical or similar assets and liabilities in less active markets, and model-based valuation techniques for which significant assumptions can be derived primarily from or corroborated by observable data in the market.
       
  Level 3 –   Valuation is based on model-based techniques that use one or more significant inputs or assumptions that are unobservable in the market.

 

The following describes the valuation techniques used by MainStreet to measure certain financial assets and liabilities recorded at fair value on a recurring basis in the financial statements:

 

Securities available for sale: Securities available for sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted market prices, when available (Level 1). If quoted market prices are not available, fair values are measured utilizing independent valuation techniques of identical or similar securities for which significant assumptions are derived primarily from or corroborated by observable market data. Third party vendors compile prices from various sources and may determine the fair value of identical or similar securities by using pricing models that consider observable market data (Level 2). We only utilize third party vendors to provide fair value data for the purposes of recording amounts related to our fair value measurements of our securities available for sale portfolio. We obtain SSAE16 reports from our third party vendor on an annual basis. Our third party vendor also utilizes a reputable pricing company for security market data that utilizes a matrix pricing model. For government sponsored agencies the model gathers information from market sources and integrates relative credit information, observed market movements and sector news. For agency mortgage backed securities the model incorporates the current weighted average maturity and takes into account additional pool level information supplied directly by the agency or government sponsored enterprise. The third party vendor system has controls and edits in place for month-to-month market checks and zero pricing. We make no adjustments to the pricing service data received for our securities available for sale.

 

Loans held for sale: Loans held for sale are recorded at fair value on a recurring basis which is the carrying value. Loans held for sale, generally, are closed and sold within two weeks.

 

25
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

The following table presents the balances of financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2012 and December 31, 2011:

  

       Fair Value Measurements at June 30, 2012 Using 
       Quoted Prices         
       in Active   Significant     
       Markets for   Other   Significant 
       Identical   Observable   Unobservable 
   Balance as of   Assets   Inputs   Inputs 
Description  June 30, 2012   (Level 1)   (Level 2)   (Level 3) 
Available-for-sale securities:                    
U. S. government sponsored agencies  $4,480,576   $   $4,480,576   $ 
Mortgage backed securities   15,501,914        15,501,914     
States and political subdivisions   4,415,510        4,415,510     
Total available-for-sale securities   24,398,000        24,398,000     
Loans held for sale   1,033,045        1,033,045     
Total assets at fair value  $25,431,045   $   $25,431,045   $ 

 

       Fair Value Measurements at December 31, 2011 Using 
       Quoted Prices         
       in Active   Significant     
       Markets for   Other   Significant 
       Identical   Observable   Unobservable 
   Balance as of   Assets   Inputs   Inputs 
Description  December 31, 2011   (Level 1)   (Level 2)   (Level 3) 
Available-for-sale securities:                    
U. S. government sponsored agencies  $2,810,782   $   $2,810,782   $ 
Mortgage backed securities   17,255,190        17,255,190     
States and political subdivisions   1,133,912        1,133,912     
Total available-for-sale securities  $21,199,884   $   $21,199,884   $ 
Total assets at fair value  $21,199,884   $   $21,199,884   $ 

 

Certain assets are measured at fair value on a nonrecurring basis in accordance with GAAP. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets.

 

The following describes the valuation techniques used by MainStreet to measure certain assets recorded at fair value on a nonrecurring basis in the financial statements:

 

26
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Impaired Loans: Loans are designated as impaired when, in the judgment of management based on current information and events, it is probable that all amounts due according to the contractual terms of the loan agreement will not be collected. The measurement of loss associated with impaired loans can be based on either the observable market price of the loan or the fair value of the collateral. Fair value is measured based on the value of the collateral securing the loans. Collateral may be in the form of real estate or business assets including equipment, inventory, and accounts receivable. The vast majority of the collateral is real estate. The value of real estate collateral is determined utilizing an income or market valuation approach based on an appraisal conducted by an independent, licensed appraiser outside of MainStreet using observable market data (Level 2). However, if the collateral is a house or building in the process of construction or if an appraisal of the real estate property is over two years old, then the fair value is considered Level 3. The value of business equipment is based upon an outside appraisal if deemed significant, or the net book value on the applicable business’ financial statements if not considered significant using observable market data. Likewise, values for inventory and accounts receivables collateral are based on financial statement balances or aging reports (Level 3). Impaired loans allocated to the allowance for loan losses are measured at fair value on a nonrecurring basis. Any fair value adjustments are recorded in the period incurred as provision for loan losses on the Consolidated Statements of Operations.

 

Other Real Estate Owned (OREO): Foreclosed assets are adjusted to fair value upon transfer of the loans to OREO. Subsequently, OREO is carried at the lower of carrying value or fair market value less selling costs. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, the Corporation records the OREO as nonrecurring Level 2. When the appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the OREO as nonrecurring Level 3.

 

The following table summarizes MainStreet’s financial assets that were measured at fair value on a nonrecurring basis as of June 30, 2012 and December 31, 2011.

 

       Carrying value at June 30, 2012 
       Quoted Prices in   Significant     
       Active Markets   Other   Significant 
       for Identical   Observable   Unobservable 
   Balance as of   Assets   Inputs   Inputs 
Description  June 30, 2012   (Level 1)   (Level 2)   (Level 3) 
Impaired Loans  $3,119,262   $   $823,096   $2,296,166 
Other real estate owned   2,829,592        1,617,997    1,211,595 
Total assets at fair value  $5,948,854   $   $2,441,093   $3,507,761 

 

       Carrying value at December 31, 2011 
       Quoted Prices in   Significant     
       Active Markets   Other   Significant 
       for Identical   Observable   Unobservable 
   Balance as of   Assets   Inputs   Inputs 
Description  December 31, 2011   (Level 1)   (Level 2)   (Level 3) 
Impaired Loans  $4,867,822   $   $4,218,384   $649,438 
Other real estate owned   3,572,518        1,596,190    1,976,328 
Total assets at fair value  $8,440,340   $   $5,814,574   $2,625,766 

 

27
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

The changes in Level 3 assets measured at estimated fair value on a nonrecurring basis during the period ended June 30, 2012 were as follows:

 

   Fair Value Measurements at June 30, 2012 
  

Impaired

Loans

  

Other Real Estate

Owned

 
Balance – January 1, 2012  $649,438   $1,976,328 
Total gains (losses) realized/unrealized          
Included in earnings (write downs)       (93,242)
Newly Impaired / New OREO   720,033    1,544,449 
Sales   (88,350)   (2,355,565)
Settlements / Foreclosures / Paydowns / charge offs   (198,242)    
Transfers into Level 3   1,213,287    139,625 
Transfers out of Level 3        
Balance – June 30, 2012  $2,296,166   $1,211,595 

 

The following table displays quantitative information about Level 3 Fair Value Measurements for June 30, 2012:

  

   Quantitative information about Level 3 Fair Value Measurements for June 30, 2012 
  

Fair

Value

  

Valuation

Technique(s)

  

Unobservable

Input

  

Range

(Weighted

Average)

 
Assets                    
Impaired loans  $622,531    Discounted appraised value    Selling cost    5% - 10%   (8)%
    1,123,722    Discounted cash flows    Discounted cash flows    8% - 44% (18)%
    549,913    Internal evaluations    Internal evaluations    5% - 10%   (6)%
Other real estate owned  $600,000    Discounted appraised value    Selling cost    0% - 27% (27)%
    611,595    Internal evaluations    Internal evaluations    0% - 6%     (6)%

 

28
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

 

(a)Short-Term Financial Instruments

The carrying value of short-term financial instruments including cash and cash equivalents, federal funds sold and interest-bearing deposits in domestic banks approximate the fair value of these instruments. These financial instruments generally expose the Corporation to limited credit risk and have no stated maturity or have an average maturity of 30-45 days and carry interest rates which approximate market value.

 

(b)Securities Available-for-Sale

The fair value of investments is estimated based on quoted market prices or dealer quotes.

 

(c)Restricted Equity Securities

The carrying value of restricted equity securities approximates fair value based on the redemption provisions of the appreciable entities.

 

(d)Loans Held for Sale

The carrying value of these loans approximates the fair value. These loans close in our name but are generally sold within a two-week period.

 

(e)Loans

Fair values are estimated for portfolios of loans with similar financial characteristics. Loans are segregated by type such as commercial, real estate – commercial, real estate – construction, real estate – mortgage and other consumer. Each loan category is further segmented into fixed and adjustable rate interest terms and by performing and nonperforming categories. The fair value of performing loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan as well as estimates for operating expenses and prepayments. The estimate of maturity is based on management’s assumptions with repayment for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.

 

(f)Accrued Interest

The carrying amounts of accrued interest approximate fair value.

 

(g)Bank Owned Life Insurance

The carrying amount is a reasonable estimate of fair value.

 

(h)Deposits

The fair value of demand, interest checking, savings and money market deposits is the amount payable on demand. The fair value of fixed maturity time deposits and certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities and repayment characteristics.

 

(i)Repurchase Agreements

The fair value of repurchase agreements is estimated using a discounted cash flow calculation that applies contracted interest rates being paid on the debt to the current market interest rate of similar debt.

 

(j)Short-term Borrowings

The carrying amount is a reasonable estimate of fair value.

 

29
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

(k)Long-term Borrowings

The fair value of long-term borrowings is estimated using a discounted cash flow calculation that applies contracted interest rates being paid on the debt to the current market interest rate of similar debt.

 

(l)Commitments to Extend Credit and Standby Letters of Credit

The only amounts recorded for commitments to extend credit and standby letters of credit are the fees arising from these unrecognized financial instruments.

 

The carrying values and estimated fair values of financial instruments at June 30, 2012 and December 31, 2011 are as follows:

 

       Fair Value Measurements at June 30, 2012 using     
       Quoted
Prices in Active
Markets for
Identical Assets
   Significant Other
Observable Inputs
   Significant
Unobservable
Inputs
     
   Carrying Value   Level 1   Level 2   Level 3   Fair Value 
FINANCIAL ASSETS:                         
Cash and due from banks  $3,718,140   $3,718,140   $   $   $3,718,140 
Interest-bearing deposits in banks   13,425,337    13,425,337            13,425,337 
Federal funds sold   6,683,510    6,683,510            6,683,510 
Securities available-for-sale   24,398,000        24,398,000        24,398,000 
Restricted equity securities   760,500        760,500        760,500 
Loans held for sale   1,033,045        1,033,045        1,033,045 
Loans, net   136,077,734        132,523,357    2,296,166    134,819,523 
Accrued interest receivable   549,246        549,246        549,246 
Bank owned life insurance   3,105,271        3,105,271        3,105,271 
                          
FINANCIAL LIABILITIES:                         
Deposits:                         
Non-interest bearing demand deposits  $22,709,789   $   $22,709,789   $   $22,709,789 
Interest bearing deposits   136,809,143        137,430,194        137,430,194 
Repurchase agreements   13,500,000        13,656,661        13,656,661 
Accrued interest payable   204,791        204,791        204,791 

 

30
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

   December 31, 2011 
   Carrying Value   Fair Value 
         
FINANCIAL ASSETS:          
Cash and due from banks  $2,767,395   $2,767,395 
Interest-bearing deposits in other banks   17,091,438    17,091,438 
Federal funds sold   10,612,680    10,612,680 
Securities available-for-sale   21,199,884    21,199,884 
Restricted equity securities   830,000    830,000 
Loans, net   139,951,059    138,716,777 
Accrued interest receivable   547,905    547,905 
Bank owned life insurance   3,049,696    3,049,696 
           
FINANCIAL LIABILITIES:          
Deposits:          
Non-interest bearing demand deposits  $20,975,660   $20,975,660 
Interest bearing deposits   146,107,182    146,767,245 
Repurchase agreements   13,500,000    13,874,422 
Accrued interest payable   225,611    225,611 

 

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Corporation’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Corporation’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Fair value estimates are based on existing on-and-off-balance sheet financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments.

 

The Corporation assumes interest rate risk (the risk that general interest rate levels will change) as a result of its normal operations. As a result, the fair values of the Corporation’s financial instruments will change when interest rate levels change and that change may be either favorable or unfavorable to the Corporation. Management attempts to match maturities of assets and liabilities to the extent believed necessary to minimize interest rate risk. However, borrowers with fixed rate obligations are less likely to prepay in a rising rate environment and more likely to prepay in a falling rate environment. Conversely, depositors who are receiving fixed rates are more likely to withdraw funds before maturity in a rising rate environment and less likely to do so in a falling rate environment. Management monitors rates and maturities of assets and liabilities and attempts to minimize interest rate risk by adjusting terms of new loans and deposits and by investing in securities with terms that mitigate the Corporation’s overall interest rate risk.

 

Note 11 – Contingencies and Other Matters

The Corporation currently is not involved in any litigation.

 

Note 12 – Subsequent Events

In preparing these financial statements, the Corporation has evaluated events and transactions for potential recognition or disclosure through the date the financial statements were issued.

 

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Notes to Consolidated Financial Statements

(Unaudited)

 

June 30, 2012

 

Note 13 – Regulatory

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 is intended to demonstrate the Bank’s commitment to review/enhance certain aspects of various policies. The Agreement describes Franklin Bank’s commitment to enhance practices related to credit administration and liquidity. While Franklin Bank expects to achieve full compliance and has submitted the responses required in the respective time frames, we are required to show sustained performance with various requirements under the Agreement and compliance with certain obligations are dependent, in part, on factors that we may not control. Therefore, we cannot assume that we will be able to achieve full compliance.

 

On 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. The MOU restricted MainStreet from declaring or paying any dividends without the prior written approval of the Federal Reserve. Under the MOU, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve. 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 as follows. The bank holding company is required to comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act (12 U.S.C. 1828(k)) and Part 359 of the Federal Deposit Insurance Corporation’s regulations (12 C.F.R. Part 359). Also, the Corporation may not appoint any individual to the board or employ or change the responsibilities of any individual as senior executive officer if the Federal Reserve notifies the Corporation of disapproval within the required time limits. MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. Management believes the holding company is appropriately using its financial and managerial resources to assist Franklin Bank to function in a safe and sound manner.

 

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June 30, 2012

 

Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking Statements

 

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.

 

General

 

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. MainStreet was incorporated on January 14, 1999 in the Commonwealth of Virginia and is the bank holding company for its subsidiary bank, Franklin Community Bank, National Association (“Franklin Bank’) which serves the Franklin County area of Virginia. MainStreet provides 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 Mount and Franklin County. MainStreet also 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) branch 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 Bank must comply with the Agreement while it is outstanding. The Bank submitted the responses required in the respective time frames described below. The Bank continues to submit periodic reports and take other actions as required by the Agreement to achieve sustained performance.

 

Within 30 days, Franklin Bank was required to adopt sublimits for concentrations in acquisition and development loans, speculative lot loans, and speculative single-family housing construction loans and determine if any action was necessary to reduce these concentrations. Franklin Bank reviewed and amended these limits and certain concentrations were lowered.

 

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June 30, 2012

 

Within 60 days, Franklin Bank was required to do the following:

 

§Franklin Bank was required to establish an effective program for early identification of emerging and potential problem credits to include accurate ratings, accrual status, continued financial analyses, and formal work out plans. Franklin Bank developed an attestation process monthly for loan officers to include risk rating and the accrual status of their loan portfolios. Franklin Bank has a Problem Loan Committee made up of senior management and one Board Loan Committee director that meets monthly. Criticized loan worksheets were enhanced and 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 on the worksheets. Franklin Bank’s internal loan review function reports to the loan committee of the board of directors rather than to management. This committee of the board meets quarterly and reporting has been enhanced to include 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 identification of the loan officer who originated each loan reported; concentrations of credit; and loans to executive officers and directors.
§Franklin Bank was required to develop a written underwriting program to include reasonable amortization of speculative lot and single family housing construction loans and ensure updated appraisals are documented. Our credit policy was amended to address the amortization periods. Personnel have been designated to ensure the reporting system has updated appraisals and evaluations. All files were reviewed to ensure correct appraisal information. A credit analyst position was created in December 2008. The analyst performs required financial analysis on all loans $100,000 and over at origination or renewal and at the receipt of new financial statements. In addition, new software was purchased to assist with this process and to assist the credit analyst and lenders in the risk rating of loans.
§Franklin Bank also had to eliminate the basis of criticism of assets criticized by the OCC. Franklin Bank has dedicated an experienced employee to work through problem assets. The other actions described above also assist in achieving compliance with this requirement. Franklin Bank continually strives to lower its problem assets.
§Franklin Bank was required to enhance its asset liability management policy to ensure monitoring of its liquidity position which included more detailed reporting to the Board. The Agreement also required Franklin Bank to increase its liquidity immediately and to take action to ensure adequate sources of liquidity. Franklin Bank increased its sources by adding correspondent bank lines; becoming a member of QwickRate (an internet certificate of deposit program); becoming a member of the Certificate of Deposit Account Registry Service (“CDARS”); and partnering with certain institutions to acquire brokered deposits. According to the Agreement, brokered deposits cannot exceed 15% of total deposits. At June 30, 2012 and December 31, 2011, brokered deposits were $5.3 million and $6.9 million, respectively, and were less than 5% of total deposits in both comparisons. Franklin Bank also participated loans during the first half of 2009 which improved our liquidity. Franklin Bank revised its Contingency Liquidity Plan to include crises relevant to current balance sheet composition. New reports created to assist with asset liability and liquidity include a maturity schedule of certificates of deposit; the volatility of demand deposits; loan commitments and letters of credit; borrowing lines and continued availability; an analysis of the impact of decreased cash flow from the loss of income from nonperforming loans and loans sold or participated; rolling sources and uses report; rollover risk analysis; and prioritization of funding sources and uses. Franklin Bank was required to review and enhance the analysis of the allowance for loan losses. The Bank has continued to review and enhance the process.

 

Within 90 days, Franklin Bank was required to develop and implement a three-year detailed capital plan. The Plan was put in place and is continually updated as appropriate. The plan includes detailed projections for growth and capital requirements; projections for primary sources and secondary sources of capital; and a revised dividend policy. The Agreement prohibits the Bank from paying dividends until compliance with the program and certain other conditions are met.

 

Under the Agreement, a Compliance Committee of three members of the Franklin Bank’s Board of Directors was formed to monitor the progress and make regular reports to the OCC. Failure to comply with the provisions of the Agreement could subject Franklin Bank and its directors to additional enforcement actions. The Compliance Committee of Franklin Bank continues to meet monthly to ensure adherence and compliance with the Agreement.

 

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June 30, 2012

 

The Compliance Committee reviews the Agreement by article in detail at each meeting along with the corresponding actions of Franklin Bank within each article. The Committee reports monthly to the full board of directors. While Franklin Bank intends to continue to take such actions as may be necessary to enable it to comply with the requirements of the Agreement, there can be no assurance that it will be able to comply fully with the provisions of the Agreement. Such compliance is costly and affects the operations of Franklin Bank and the Corporation. Franklin Bank has met all of the required time lines for submission of information to the OCC along with regular reporting. Franklin Bank must demonstrate sustained performance under the Agreement.

 

On 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. The MOU restricted MainStreet from declaring or paying any dividends without the prior written approval of the Federal Reserve. Under the MOU, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve. Since then, MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. On January 26, 2011, the MOU with the Federal Reserve was replaced with a new MOU which includes the same provisions as the prior MOU and also requires MainStreet to comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act (12 U.S.C. 1828(k)) and Part 359 of the Federal Deposit Insurance Corporation’s regulations (12 C.F.R. Part 359). Also, the Corporation may not appoint any individual to the board or employ or change the responsibilities of any individual as senior executive officer if the Federal Reserve notifies the Corporation of disapproval within the required time limits. Management believes the holding company is appropriately using its financial and managerial resources to assist Franklin Bank to function in a safe and sound manner.

 

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. 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.

 

The amount of the allowance is based on management’s evaluation of the collectibility 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, then, 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.

 

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

Overview

 

Total assets at June 30, 2012 were $196.6 million compared to $203.9 million at year-end December 31, 2011, a decline of $7.3 million. Our balance sheet has declined since year-end due to our continued strategy to lower our deposit costs. In addition, the resolution of problem credits has caused our loans to decline along with the fact that loan demand in our market place continues to be soft. At June 30, 2012, loans, net of unearned deferred fees and costs, declined $4.6 million from year-end 2011, but remained stable with the prior quarter end. Securities available for sale increased $3.2 million due to purchases of $9.6 million offset by pay downs on mortgage backed securities and called securities. Deposits declined $7.6 million. The shrinkage in our balance sheet has had a positive impact on our capital ratios. Total cash and cash equivalents decreased from year-end 2011 by $6.6 million, primarily due to the purchase of securities. Liquidity is an important focus for our Company during these tumultuous times and our liquid assets were 18.69% of total liabilities at June 30, 2012 which 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 deposits. We maintained our core relationships as can be evidenced by the increase 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; however, these asset quality levels have improved significantly since year-end 2011 and since the first quarter of 2012. We transferred $2.2 million of loans into other real estate and other repossessed assets during the first six months of 2012. None the less, our other real estate properties declined to $2.8 million at June 30, 2012 compared to $3.6 million at December 31, 2011. As can be seen by the addition of properties, but overall decline in balance at quarter end, we have sold approximately $3.0 million of properties in other real estate and have additional properties under contract.

 

Total shareholders’ equity was $22.5 million at June 30, 2012. MainStreet and Franklin Bank were well capitalized at June 30, 2012 under bank regulatory capital classifications. The book value of shareholders’ equity at June 30, 2012 was $13.12 per share.

 

Our year-to-date net income at June 30, 2012 was $219,344, or $.13 per basic share. This income equated to an annualized return on average assets of .22% and an annualized return on average shareholders’ equity of 1.96%. Net loss for the same period in 2011 was $(328,403), or $(.19) per basic share. This equated to an annualized loss on average assets and annualized loss on average shareholders’ equity of (.31%) and (2.99%), respectively. Credit related expenses such as losses on sales of other real estate properties, impairment losses on other real estate properties, loss of interest on nonaccrual loans, and provision expense continue to negatively impact our operating results. 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 sale together accounted for $668,402 and $1,696,667 in expense for the six month periods ending June 30, 2012 and June 30, 2011, respectively.

 

Net income for the second quarter of 2012 was $122,049, or $.07 per basic share compared to $111,677, or $.07 per basic share, for the second quarter of 2011. Provision expense and other real estate and repossession expenses, write-downs and losses on sale together were $324,117 for the second quarter of 2012 compared to $454,121 for the second quarter of 2011. Credit related issues continue to have a negative impact on our Company’s net income.

 

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

Results 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 period ending June 30, 2012 and 2011 was $3,194,762 and $3,518,205, respectively, a decline of $323,443, or 9.19%. 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 an increase in lost interest income on nonaccrual loans. For the six months ending June 30, 2012 and 2011, the net interest margin was 3.48% and 3.58%, respectively, a 10 basis point decrease. The yield on interest earning assets for the year-to-date period ending June 30, 2012 was 4.56% compared to 4.97% for the year-to-date period ending June 30, 2011, a decline of 41 basis points. However, the funding side of the interest margin also dropped during this time period by a favorable 31 basis points in the year-to-year comparison. 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, lack of loan demand reducing loan fee income, and continued lost interest on nonaccrual loans. Lost interest for the period ending June 30, 2012 and 2011 was $172,937 and $261,411, 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% which has been effective since 2008. The Federal Reserve has also indicated that interest rates will remain at this level until late 2014. Franklin Bank has a portfolio of variable rate loans. In a rising interest rate environment, this 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 at 3.25% which is the interest rate basis for many of our loans, MainStreet’s net interest margin has been adversely affected by the prolonged, recessionary low interest rate environment.

 

The net interest margin and net interest income should show improvement with the maturity of the repurchase agreements. The rates on these are above current market rates. Of these repurchase agreements, $7.5 million matures in September 2012 and $6.0 million matures in early January 2013.

 

Net interest income for the three month period ending June 30, 2012 and 2011 was $1,605,892 and $1,744,634, respectively, a decline of $138,742, or 7.95%. This equated to a net interest margin of 3.44% and 3.59% at June 30, 2012 and 2011, 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 collectibility 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.

 

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

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 three-year average (twelve quarters) 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 2012 and 2011 was $173,870 and $909,113, respectively. Our loan portfolio, net of unearned deferred fees and costs, declined $4.6 million or 3.20% from year-end 2011; however, we have continued to add to our loan loss reserve based on our quarterly detailed allowance calculation which includes the level of criticized and classified loans, our qualitative factors, migration, historical loss analysis, charge-offs and our specific reserve analysis. Gross charge-offs year-to-date 2012 were $955,450 compared to $1,513,807 year-to-date 2011. We transferred $2.2 million from loans to other real estate and other repossessed assets during the year-to-date period ending June 30, 2012. Based on updated appraisals we received on these properties, along with other loans, we charged off the balance noted above. The allowance for loan losses was $2.6 million at June 30, 2012 and $3.3 million at December 31, 2011, a decline of $.7 million due to charge offs, offset by additional provision expense and some modest recoveries. The allowance for loan losses was 1.85% and 2.29% of loans net of unearned at June 30, 2012 and December 31, 2011, respectively. Our criticized and classified loans that are evaluated by historical loss migration declined $3.2 million at June 30, 2012 compared to year-end 2011. The loans evaluated collectively by pools increased $1.9 million at June 30, 2012 versus December 31, 2011. Impaired loans evaluated individually were $6.3 million and $8.8 million at June 30, 2012 and December 31, 2011, respectively, with specific reserves of $337,757 and $818,572, respectively. The decline in the allowance for loan losses to loans, net of unearned deferred fees, from year end 2011 was primarily because the volumes of our adverse rated loans and our impaired loans declined. The allowance for loan losses was not replenished by the entire $955,450 of gross charge offs because the loans were provided for in our allowance for loan losses at year-end 2011. Net charge-offs of $882,986 and $1,430,463 for the six months of 2012 and 2011 equated to 1.26% and 1.83%, 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.

 

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

Provision expense for the second quarter of 2012 and 2011 was ($27,413) and $55,923, respectively. We had a modest recovery of reserve during the second quarter of 2012 primarily due to the improvement in our criticized and classified loan totals. Qualitative factors also noted an improvement in our allowance calculation. The allowance for loan losses was $2.6 million at June 30, 2012 and March 31, 2012. The allowance for loan losses was 1.85% and 1.89% of loans net of unearned at June 30, 2012 and March 31, 2012, respectively. Our criticized and classified loans that are evaluated by historical loss migration declined $776.6 thousand at June 30, 2012 compared to prior quarter end. The loans evaluated collectively by pools increased $1.2 million at June 30, 2012 versus March 31, 2012. Impaired loans evaluated individually were $6.3 million and $5.6 million at June 30, 2012 and March 31, 2012, respectively, with specific reserves of $337,757 and $295,249, respectively. The decline in the allowance for loan losses to loans, net of unearned deferred fees, from year end 2011 was primarily because the volumes of loans declined in our adverse rated loans and our impaired loans and due to the level of charge offs provided at year end and charged off in 2012. Gross charges offs and recoveries for the second quarter of 2012 were $95,907 and $66,370, respectively. Net charge-offs of $29,537 for the three months of the second quarter of 2012 equated to .09%, 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 loan, loans past due 90 days and still accruing, and troubled debt restructurings.

 

   June 30, 2012   December 31, 2011 
Commercial  $133,165   $136,680 
Real Estate:          
Construction and land development   906,942    1,624,238 
Residential 1-4 families:          
First liens   2,507,743    4,852,061 
Junior liens   404,828    424,795 
Home equity loans   128,038    131,439 
Commercial real estate   2,178,434    1,533,473 
Consumer       50,694 
Total Nonperforming Loans  $6,259,150   $8,753,380 

 

Total nonperforming loans showed significant improvement by declining $2.5 million, or 28.49%, at the end of June 2012 compared to year-end 2011. Nonaccrual loans (included in the impaired loans above) were $3,446,668 and $7,067,722 at June 30, 2012 and December 31, 2011, respectively, which represented 2.49% and 4.93%, 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 accruing troubled debt restructurings. 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, 2012 and December 31, 2011, loans secured by residential 1-4 family first liens were the largest category of impaired loans at $2.5 million and $4.9 million, respectively. Commercial real estate loans at $2.2 million at June 30, 2012 were the next largest of the impaired loan categories compared to $1.6 million of construction and land development loans at December 31, 2011.

 

Many of the asset quality issues in our loan portfolio are the result of our borrowers having to sell various real estate properties at depressed prices to repay the loan. In addition, borrowers’ incomes have been reduced which increases their debt to income ratio. The overall economy in Franklin County continues to struggle based on unemployment, a continued slowing of building activity, a slowing of transportation and warehousing, and excessive supply of real estate in the Smith Mountain Lake resort area as discussed below. There is continued economic pressure on consumers and business enterprises and unemployment is at 6.2%. Absorption analysis in our market place shows increased turnover rates for various inventories. 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 Lake is 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.

 

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MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

Noninterest Income

 

Total noninterest income was $531,627 and $467,619 for the six months ending June 30, 2012 and 2011, respectively, an increase of $64,008, or 13.69%. The following chart demonstrates the categories of change:

 

Noninterest Income  YTD 6/30/12   YTD 6/30/11   Dollar Change   Percentage
Change
 
Service charges on deposit accounts  $125,543   $153,569   $(28,026)   (18.25)%
Mortgage brokerage income   99,895    58,422    41,473    70.99 
Electronic card fees   88,872    79,358    9,514    11.99 
Investment fee income   100,459    75,926    24,533    32.31 
Income on bank owned life insurance   55,575    54,565    1,010    1.85 
Gain on securities sold/called   1,848        1,848    100.00 
Other fee income & miscellaneous   59,435    45,779    13,656    29.83 

 

As noted above, total noninterest income increased $64,008 for the six months ending June 30, 2012 compared to the six months ending June 30, 2011. Service charges on deposit accounts were not included in the increase but declined $28,026 in the year to year comparison. This decline is primarily due to a decline in NSF charges. Mortgage brokerage demonstrated a substantial increase in the year to year comparison by $41,473, or 70.99%; however, 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 brokerage commission. Within our partnerships, we have begun to close some mortgage loans in our name and then sell them to our partners within a very short period of days. Our partners provide the underwriting of the loans. This new process allows us to change our commission levels and has increased our income. Electronic card fees experienced an increase of $9,514 for the six months ended June 30, 2012 as compared to June 30, 2011. Franklin Bank has an investment advisor which partners with Infinex Financial Group to 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 2012 and 2011was $100,459 and $75,926, respectively, an increase of $24,533, or 32.31%. Franklin Bank has bank owned life insurance on the lives of the two executive officers. The balance at June 30, 2012 was $3.1 million. Income on this investment was stable with a slight increase compared to the prior year. There were gains of $1,848 on called securities during the second quarter of 2012. Other fee income and miscellaneous income experienced an increase of $13,656, or 29.83%. This increase is primarily due to modest increases in title fee income, evaluation fee income, and checkbook charges. Title fee income is generated from a small interest purchased in a title insurance company by Franklin Bank.

 

Total noninterest income was $271,085 and $225,519 for the three months ending June 30, 2012 and 2011, respectively, an increase of $45,566, or 20.21%. The following chart demonstrates the categories of change:

 

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June 30, 2012

 

Noninterest Income  QTD 6/30/12   QTD 6/30/11   Dollar Change   Percentage
Change
 
Service charges on deposit accounts  $60,542   $76,227   $(15,685)   (20.58)%
Mortgage brokerage income   69,921    28,623    41,298    144.28 
Electronic card fees   46,741    42,082    4,659    11.07 
Investment fee income   35,121    29,140    5,981    20.53 
Income on bank owned life insurance   27,972    27,468    504    1.84 
Gain on securities sold/called   1,848        1,848    100.00 
Other fee income & miscellaneous   28,940    21,979    6,961    31.67 

 

The same comments concerning noninterest income in the year to year comparison also apply to the variances that occurred in the quarter to quarter comparison. Overall noninterest income increased in all of the categories with the exception of service charges on deposit accounts which declined primarily due to a decline in NSF fee income.

 

Noninterest Expense

 

Total noninterest expense was $3,264,495 and $3,604,508 for the six month period ending June 30, 2012 and 2011, respectively, a decrease of $340,013, or 9.43%. Excluding the nonrecurring expenses of other real estate and repossessions, noninterest expense declined $46,991, or 1.67%. The following chart shows the categories of noninterest expenses for the six month period ending June 30, 2012 and 2011, the dollar change, and the percentage change:

 

Expense  YTD 6/30/12   YTD 6/30/11   Dollar Change   Percentage 
Change
 
Salaries and employee benefits  $1,420,744   $1,426,048   $(5,304)   (0.37)%
Occupancy and equipment   413,750    426,246    (12,496)   (2.93)
Professional  fees   127,974    126,668    1,306    1.03 
Outside processing   259,726    209,810    49,916    23.79 
FDIC Assessment   132,125    218,069    (85,944)   (39.41)
Franchise tax   100,002    105,000    (4,998)   (4.76)
Regulatory examination fees   55,400    55,875    (475)   (0.85)
Other real estate and repossessions   494,532    787,554    (293,022)   (37.21)
Other expenses   260,242    249,238    11,004    4.42 

 

MainStreet’s employees continue to be its most valuable resource and asset. Salaries and employee benefits expense comprise the largest category of noninterest expense at 43.52% and 39.56%, respectively, of total noninterest expense for the six-month period ending June 30, 2012 and 2011. Our overall costs have remained stable in the year-to-year comparison primarily because we elected to freeze employees’ salaries in 2011 and 2012. Occupancy and equipment costs comprise the next largest category of recurring noninterest expense and include rent, utilities, janitorial service, repairs and maintenance, real estate taxes, equipment rent, service maintenance contracts and depreciation expense. This category declined $12,496 which was attributable to a decline in depreciation expense and a decline in service maintenance expense. Professional fees include fees for audit, legal, and other professional fees and showed a modest increase in the year to year comparison. Outside processing expenses increased $49,916, or 23.79% in the year to year comparison primarily due to an increase in data processing fees and in our bank insurance costs for our bond and director and officer insurance. FDIC assessment declined $85,944 due to the decline in assets and the new method adopted by the FDIC for its calculation using assets as its base; however, the overall premium is still burdensome. The turmoil in the financial services industry has resulted in the need to increase FDIC insurance premiums to sustain the insurance fund depending on the length and depth of the recession. This assessment may increase again depending on the health of the financial services sector. Other real estate and repossessions represent the second largest category of noninterest expense but are nonrecurring. The losses, write-downs and expenses associated with our other real estate properties experienced a significant decline of $293,022, or 37.21%, compared to the same period in 2011.

 

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June 30, 2012

 

Total noninterest expense was $1,742,458 and $1,761,697 for the three month period ending June 30, 2012 and 2011, respectively, a decrease of $19,239, or 1.09%. Excluding the nonrecurring expenses of other real estate and repossessions, noninterest expense increased $27,429, or 2.01%. The following chart shows the categories of noninterest expenses for the six month period ending June 30, 2012 and 2011, the dollar change, and the percentage change:

 

Expense  YTD 6/30/12   YTD 6/30/11   Dollar Change   Percentage
Change
 
Salaries and employee benefits  $696,267   $701,070   $(4,803)   (0.69)%
Occupancy and equipment   202,748    208,411    (5,663)   (2.72)
Professional  fees   59,986    43,476    16,510    37.98 
Outside processing   131,337    105,962    25,375    23.95 
FDIC Assessment   65,058    99,207    (34,149)   (34.42)
Franchise tax   50,001    52,500    (2,499)   (4.76)
Regulatory examination fees   27,700    27,935    (235)   (0.84)
Other real estate and repossessions   351,530    398,198    (46,668)   (11.72)
Other expenses   157,831    124,938    32,893    26.33 

 

Overall, the same explanations for the year to date comparisons are applicable to the quarterly comparisons of noninterest expense.

 

Income Taxes

 

MainStreet is subject to both federal and state income taxes. Franklin Bank is not subject to state income taxes. A bank in Virginia is 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, 2012 and June 30, 2011. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. MainStreet recorded income tax expense in the amount of $39,883 and $68,660 for the three month period and six month period ending June 30, 2012, respectively. MainStreet recorded income tax expense of $40,856 for the three month period ending June 30, 2011 and an income tax benefit of $199,394 for the six month period ending June 30, 2011.

 

BALANCE SHEET

 

Investment Portfolio

 

The Corporation’s investment portfolio is used for several purposes as follows:

 

1)To maintain sufficient liquidity to cover deposit fluctuations and loan demand.
2)To use securities to fulfill pledging collateral requirements.

 

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June 30, 2012

 

3)To utilize the maturity/repricing mix of portfolio securities to help balance the overall interest rate risk position of the balance sheet.
4)To make a reasonable return on investments.

 

Funds not utilized for capital expenditures or lending are invested in securities of the U.S. Government and 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, Federal Reserve Bank stock and Federal Home Loan Bank stock. 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. The entire securities portfolio was categorized as available for sale at June 30, 2012 and is carried at estimated fair value. Unrealized market valuation gains and losses on securities classified as available for sale are recorded as a separate component of shareholders’ equity. Please refer to Note 2 of the Notes to Consolidated Financial Statements for the breakdown of the securities available for sale portfolio.

 

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, 2012   December 31, 2011 
Commercial  $10,155,682    7.33%  $11,061,471    7.73%
Real Estate:                    
Construction & land development   20,861,272    15.06    26,102,914    18.24 
Residential 1-4 families:                    
First liens   36,702,472    26.49    37,735,618    26.36 
Junior liens   8,578,390    6.19    8,486,594    5.93 
Home equity lines   6,884,315    4.97    7,639,785    5.34 
Commercial real estate   53,598,124    38.68    50,272,002    35.12 
Consumer   1,773,246    1.28    1,836,110    1.28 
Total Gross Loans  $138,553,501    100.00%  $143,134,494    100.00%
Unearned deferred fees & costs, net   88,062         89,510      
Recorded Investment  $138,641,563        $143,224,004      

 

Gross loans declined $4,580,993, or 3.20% at June 30, 2012 compared to December 31, 2011. As can be seen by the chart above, Franklin Bank has a high concentration in real estate loans. These loans represented 91.39% and 90.99% of gross loans at June 30, 2012 and December 31, 2011, respectively. Accordingly, the Bank took steps to reduce certain concentrations, within the real estate loans, including participating loans. 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 continue 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 participation in these loan markets. Our loan to deposit ratio for June 30, 2012 was 86.91% compared to 85.72% at December 31, 2011, relatively stable. We lowered our policy loan to deposit ratio thus increasing liquidity and have maintained the lower percentage because of lower loan demand. 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.

 

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June 30, 2012

 

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.

 

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, less estimate selling expense, 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 have reviewed and revised numerous components and conditions within our credit policies over the last three years. Concentration limits were revised to better reflect the current economic environment and we are within our established limits. We added floors to our home equity lines and certain commercial loan products. We reduced our maximum debt to income ratio for all retail loans to 40% from 45%. On our retail products, we terminated the use of interest only payments except on construction loans and bridge loans and unsecured retail lines with a one-year term which are underwritten on strict guidelines. The credit policy was modified to reflect new maximum loan-to-values on new loans originated as discussed earlier. We engaged an outside service to perform environmental risk assessments prior to funding. Our home equity line products had a prior maturity of 20 years with a three or five year review feature. The loan policy was modified for these loans to mature in five years and be renewed only upon proper underwriting. Other banks have similarly tightened credit availability, particularly for real estate related 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 25% of our loan portfolio consists of variable rate loans. Variable rate commercial loans are underwritten to the current fully indexed rate at origination with cash flow analysis in underwriting at fully drawn lines. In most cases account officers stress borrowers at 2% over the fully indexed rate. Home equity lines are underwritten at 1.5% of the full committed loan amount.

 

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June 30, 2012

 

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 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. There are three industry concentrations that are broken out in the tables below by our loan segments.

 

   June 30, 2012         
       Loans for         
       Construction of   Loans for     
   Loans for   Heavy & Civil   Real Estate     
   Construction   Engineering   Including     
   of Buildings   Buildings   Construction   Total 
Commercial  $1,193,727   $558,087   $462,005   $2,213,819 
Real Estate                    
Construction and land development   2,070,880    4,764,430    3,474,531    10,309,841 
Residential, 1-4 families                    
First Liens   5,153,543    845,329    7,491,466    13,490,338 
Junior Liens   1,082,644        707,894    1,790,538 
Home Equity Lines   9,976            9,976 
Commercial real estate   3,702,502        23,160,450    26,862,952 
Consumer   771            771 
Total  $13,214,043   $6,167,846   $35,296,346   $54,678,235 

 

   December 31, 2011         
       Loans for         
       Construction of   Loans for     
   Loans for   Heavy & Civil   Real Estate     
   Construction   Engineering   Including     
   of Buildings   Buildings   Construction   Total 
Commercial  $1,253,591   $483,320   $1,498,370   $3,235,281 
Real Estate                    
Construction and land development   2,492,124    5,301,322    3,623,938    11,417,384 
Residential, 1-4 families                    
First Liens   5,496,770    1,301,934    6,179,892    12,978,596 
Junior Liens   577,046    124,413    763,513    1,464,972 
Home Equity Lines   9,845            9,845 
Commercial real estate   3,995,367    315,979    23,396,327    27,707,673 
Consumer   10,602            10,602 
Total  $13,835,345   $7,526,968   $35,462,040   $56,824,353 

 

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.

 

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June 30, 2012

 

   June 30, 2012     
   Total
Concentration
   Concentrations
Included Above
   Net Addition to
Concentrations
 
Acquisition & development  $473,218   $473,218   $ 
Speculative lot loans   5,472,998    3,838,812    1,634,186 
Speculative single-family housing construction   3,787,459    2,170,287    1,617,172 

 

   December 31, 2011     
   Total
Concentration
   Concentrations
Included Above
   Net Addition to
Concentrations
 
Acquisition & development  $498,228   $223,228   $275,000 
Speculative lot loans   7,267,049    3,223,647    4,043,402 
Speculative single-family housing construction   6,200,835    4,194,489    2,006,346 

 

Overall, our concentrations continue to decline due to our efforts to lower them and due to the economy.

 

Following is a breakdown of our nonperforming loans and assets.

 

   For the Periods Ended 
   June 30, 2012   December 31, 2011 
Nonaccrual loans and leases  $3,446,668   $7,067,722 
Loans past due 90 days or more and still accruing   94,962     
Troubled debt restructurings (not on nonaccrual)   2,447,675    1,685,658 
Other impaired loans   269,845     
Total nonperforming loans   6,259,150    8,753,380 
Foreclosed real estate   2,829,592    3,572,518 
Other foreclosed property   103,649    103,649 
Total foreclosed property   2,933,241    3,676,167 
Total nonperforming assets  $9,192,391   $12,429,547 

 

Impaired loans totaled $6,259,150 and $8,753,380 at June 30, 2012 and December 31, 2011, respectively. Nonaccrual loans declined $3.6 million at June 30, 2012 compared to year end 2011. The troubled debt restructurings increased $.8 million, as we continue to work with our troubled borrowers when appropriate. 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.

 

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. An officer now manages our problem assets on a full-time basis. A credit analyst performs required financial analysis on all loans $100,000 and 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.

 

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June 30, 2012

 

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, 2012 and December 31, 2011 were $159,518,932 and $167,082,842, respectively, a decline of $7,563,910, or 4.53%. The decline in deposits is largely attributable to the continued implementation of our strategy to lower deposit costs. The deposit mix was as follows:

 

   June 30, 2012   December 31, 2011 
Demand  $22,709,789    14.24%  $20,975,660    12.56%
Interest checking   9,783,176    6.13    7,472,911    4.47 
Money markets   23,417,775    14.68    24,651,034    14.75 
Savings   13,020,863    8.16    14,093,416    8.44 
Time deposits $100,000 and over   37,671,731    23.62    42,776,337    25.60 
Other time deposits   52,915,598    33.17    57,113,484    34.18 
                     
Total  $159,518,932    100.00%  $167,082,842    100.00%

 

The largest components of deposits continues to be time deposits including those $100,000 and over representing 56.79% of total deposits at June 30, 2012 compared to 59.78% at December 31, 2011. 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 by the increase in demand deposits which do not pay interest. Demand deposits are now 14.24% of total deposits as compared to 12.56% at December 31, 2011. The dollar amount of our demand deposits has also increased $1.7 million from year end 2011. A further increase in demand deposits would improve the net interest margin and the total yield on interest bearing deposits. Money markets remained stable as a percentage of total deposits along with the dollar amount. Savings deposits declined $1.1 million while interest checking increased $2.3 million. Our total deposits have declined $7.6 million since year end 2011 primarily caused by 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 as they experienced a $9.3 million decrease since year end.

 

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 deposit and loan relationships and not just certificates of deposit. Loan demand has been soft and parallels our deposit strategy. Our strategic plan in 2012 also 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 1.07% and 1.44%, respectively, for the six months ended June 30, 2012 and June 30, 2011. This decline of 37 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.

 

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June 30, 2012

 

Borrowings

 

We have several sources for borrowings generally to assist with liquidity. At June 30, 2012 and December 31, 2011, we had no balances outstanding with 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, 2012 and December 31, 2011 were $105,077,536 and $103,468,835, 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 FDIC insured but the Bank is required to pledge agency funds at 100% towards these balances. The Corporate Cash Management sweep accounts totaled $0 at June 30, 2012 and December 31, 2011.

 

Repurchase Agreements

 

The Bank entered into a repurchase agreement with Citigroup Global Markets, Inc. (“CGMI”) in the amount of $7,500,000 on September 18, 2007. The repurchase date is September 18, 2012. The interest rate was fixed at 4.22% until maturity or until it is called. Beginning September 18, 2008, the repurchase agreement became callable by CBMI and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by federal agency and agency mortgage backed securities. The interest rate remained at 4.22% at June 30, 2012.

 

The Bank entered into a repurchase agreement with Barclays Capital (“Barclays”) on January 2, 2008 in the amount of $6,000,000. The repurchase date is January 2, 2013. The interest rate was fixed at 3.57% until maturity or until it is called. Beginning January 2, 2009 the repurchase agreement became callable by Barclays and can be called quarterly with two business days prior notice. Interest is payable quarterly. The repurchase agreement is collateralized by federal agency and agency mortgage backed securities. The interest rate remained at 3.57% at June 30, 2012.

 

Shareholders’ Equity

 

Total shareholders’ equity was $22,475,497 and $22,240,789 at June 30, 2012 and December 31, 2011, respectively. Book value per share was $13.12 and $12.98 at June 30, 2012 and December 31, 2011, respectively.

 

The maintenance of appropriate levels of capital is a priority and is continually monitored. MainStreet and 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 MainStreet and 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. Franklin Bank was required under the Agreement with the OCC to implement a three year capital program which, among other things, required Franklin Bank to plan for adequate capital to meet its current and future needs. While MainStreet and Franklin Bank were considered well-capitalized under established regulatory classifications at June 30, 2012 and December 31, 2011, 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. The following are MainStreet’s capital ratios at:

 

   June 30, 2012   December 31, 2011 
Tier I Leverage Ratio (Actual)   11.25%   10.74%
Tier I Leverage Ratio (Quarterly Ave.)   11.41    10.68 
Tier I Risk-Based Capital Ratio   15.72    15.09 
Tier II Risk-Based Capital Ratio   16.98    16.36 

 

48
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

Under the MOU with the Federal Reserve Bank of Richmond, MainStreet is restricted from declaring or paying any dividends without the prior written approval of the Federal Reserve Bank of Richmond. Also, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve Bank of Richmond.

 

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’s material off-balance sheet obligations were primarily loan commitments of the Bank in the amount of $17,675,496 at June 30, 2012. 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’s discount window, and the ability to borrow long-term and short-term from the Federal Home Loan Bank of Atlanta. At June 30, 2012 and December 31, 2011, we had available credit from borrowing in the amount of $46,033,482, and $45,091,542, respectively. Our ratio of liquid assets to total liabilities at June 30, 2012 and December 31, 2011 was 18.69% and 19.17%, respectively.

 

Core deposits are the primary foundation for our Corporation’s liquidity. 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. Franklin Bank has experienced shrinkage in deposits from year end due to the strategic efforts to reduce deposit costs. The shrinkage of the balance sheet had a positive impact on capital. We have also experienced a decline in our loans which has complemented the decline in deposits. 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 million in FDIC insurance. The Bank receives the deposits and forwards them to CDARS and receives deposits back if wanted. The send and receive transaction is called a reciprocal transaction. CDARS deposits are also considered brokered deposits. Franklin Bank had accepted brokered deposits, including CDARS deposits, in the amount of $4.3 million as of June 30, 2012 which is less than 5% of total deposits. The Bank is restricted by its Agreement with the OCC to not have more than 15% brokered deposits as a percentage of total deposits. We are well within this margin. At June 30, 2012, this would allow the Bank to gather an additional $18.7 million in brokered deposits. Franklin Bank became a member of QwickRate in order to bid for internet certificates of deposit as another source of liquidity. At June 30, 2012, Franklin Bank had $5.8 million in 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. MainStreet has partnered with Compass Bank using 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.

 

49
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

The following table demonstrates the percentage change in net interest income from the level prime rate of 3.25% at June 30, 2012 in 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%   7.00%   12.00%
+300 bp   6.25    5.00    10.00 
+200 bp   5.25    4.00    7.00 
+100 bp   4.25    2.00    3.00 
-100 bp   2.25    -1.00    -1.00 
-200 bp   1.25    -1.00    -2.00 
-300 bp   .25    -2.00    -5.00 

 

 

There is little impact on net interest income in the down interest rate scenarios in both the ramp and shock changes from the level rate scenario. We have been proactively adding floors to our new and existing variable rate loans upon renewal. We can see the positive impact that this has on our net interest income in the declining interest rate environment. In the upward interest rate scenarios, net interest income experiences positive changes to interest income due to the level of variable rate loans and the assumed repricing of our interest bearing liabilities.

 

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 Governors of the Federal Reserve Systems (“FRB”) including recently “quantitative easing” as well as whether and how the fiscal issues confronting the United States are resolved can have a great effect on our profitability. Management continually strives to manage the relationship between interest-sensitive assets and liabilities. MainStreet and 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 MainStreet and 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

 

BankShares approved 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 BankShares and 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.

 

Recent Accounting Developments

 

In April 2011, the FASB issued ASU 2011-03, “Transfers and Servicing (Topic 860) – Reconsideration of Effective Control for Repurchase Agreements.” The amendments in this ASU remove from the assessment of effective control (1) the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee and (2) the collateral maintenance implementation guidance related to that criterion. The amendments in this ASU are effective for the first interim or annual period beginning on or after December 15, 2011. The guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. The adoption of the new guidance did not have a material impact on the Corporation’s consolidated financial statements.

 

50
 

 

MAINSTREET BANKSHARES, INC. AND SUBSIDIARIES

 

June 30, 2012

 

In May 2011, the FASB issued ASU 2011-04, “Fair Value Measurement (Topic 820) – Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop a single, converged fair value framework on how (not when) to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP (Topic 820), with many of the amendments made to eliminate unnecessary wording differences between U.S. GAAP and International Financial Reporting Standards (IFRS). The amendments are effective for interim and annual periods beginning after December 15, 2011 with prospective application. Early application is not permitted. The Corporation has included the required disclosures in its consolidated financial statements.

 

In June 2011, the FASB issued ASU 2011-05, “Comprehensive Income (Topic 220) – Presentation of Comprehensive Income.” The objective of this ASU is to improve the comparability, consistency and transparency of financial reporting and to increase the prominence of items reported in other comprehensive income by eliminating the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that all non-owner changes in stockholders’ equity be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The single statement of comprehensive income should include the components of net income, a total for net income, the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. In the two-statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present all the components of other comprehensive income, a total for other comprehensive income, and a total for comprehensive income. The amendments do not change the items that must be reported in other comprehensive income, the option for an entity to present components of other comprehensive income either net of related tax effects or before related tax effects, or the calculation or reporting of earnings per share. The amendments in this ASU should be applied retrospectively. The amendments are effective for fiscal years and interim periods within those years beginning after December 15, 2011. Early adoption is permitted because compliance with the amendments is already permitted. The amendments do not require transition disclosures. The Corporation has included the required disclosures in its consolidated financial statements.

 

In September 2011, the FASB issued ASU 2011-08, “Intangible – Goodwill and Other (Topic 350) – Testing Goodwill for Impairment.”  The amendments in this ASU permit an entity to first assess qualitative factors related to goodwill to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill test described in Topic 350.  The more-likely-than-not threshold is defined as having a likelihood of more than 50 percent.  Under the amendments in this ASU, an entity is not required to calculate the fair value of a reporting unit unless the entity determines that it is more likely than not that its fair value is less than its carrying amount.  The amendments in this ASU are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted, including for annual and interim goodwill impairment tests performed as of a date before September 15, 2011, if an entity’s financial statements for the most recent annual or interim period have not yet been issued.  The adoption of the new guidance did not have a material impact on the Corporation’s consolidated financial statements.

 

In December 2011, the FASB issued ASU 2011-11, “Balance Sheet (Topic 210) – Disclosures about Offsetting Assets and Liabilities.” This ASU requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master netting arrangement. An entity is required to apply the amendments for annual reporting periods beginning on or after January 1, 2013, and interi