ITEM 1. BUSINESS
Eagle Bancorp, Inc. (the "Company"), headquartered in Bethesda, Maryland, was incorporated under the laws of the State of
Maryland on October 28, 1997, to serve as the bank holding company for EagleBank (the "Bank"). The Company was formed by a group of local
businessmen and professionals with significant prior experience in community banking in the Company's market area, together with an experienced community bank senior management team. The Company has
one direct non-banking subsidiary, Eagle Commercial Ventures, LLC ("ECV"), which provides subordinated financing for the acquisition, development and construction of real estate
projects.
The
Bank, a Maryland chartered commercial bank, which is a member of the Federal Reserve System, is the Company's principal operating subsidiary. It commenced banking operations on
July 20, 1998. As of December 31, 2012, the Bank operated seventeen offices: seven in Montgomery County, Maryland located in Rockville (three), Bethesda, Silver Spring, Potomac and Chevy
Chase; five located in the District of Columbia; and five in Northern Virginia located in Tysons Corner, Ballston, Rosslyn, Reston and Merrifield. The Bank plans to open an additional office projected
to open in Alexandria, Virginia in March 2013. The Bank seeks additional banking offices consistent with its strategic plan, although there can be no assurance that the Bank will establish any
additional offices, or that any branch office will prove to be profitable.
The
Bank has two direct subsidiaries: Bethesda Leasing, LLC and Eagle Insurance Services, LLC. Bethesda Leasing, LLC holds title to and operates real estate owned
acquired through foreclosure. Eagle Insurance Services, LLC facilitates the placement of commercial and retail insurance products through a referral arrangement with The Meltzer Group, a large
well known insurance brokerage within the Company's market area.
The
Bank operates as a community bank alternative to the super-regional financial institutions which dominate its primary market area. The cornerstone of the Bank's philosophy is to
provide superior, personalized service to its clients. The Bank focuses on relationship banking, providing each client with a number of services, familiarizing itself with, and addressing itself to,
client needs in a proactive, personalized fashion. Management believes that the Bank's target market segments, small to medium-sized for profit and non-profit businesses and the consumer
base working or living in and near of the Bank's market area, demand the convenience and personal service that a smaller, independent financial institution such as the Bank can offer. It is these
themes of convenience and proactive personal service that form the basis for the Bank's business development strategies.
Description of Services.
The Bank offers a full range of commercial banking services to its business and professional clients, as well
as complete
consumer banking services to individuals living or working in the service area. The Bank emphasizes providing commercial banking services to sole proprietorships, small and medium-sized businesses,
partnerships, corporations, non-profit organizations and associations, and investors living and working in and near the Bank's primary service area. A full range of retail banking services
are offered to accommodate the individual needs of both corporate customers as well as the community the Bank serves. The Bank also offers online banking, mobile banking and a remote deposit service
which allows clients to facilitate and expedite deposit transactions through the use of electronic scanning devices.
The
Bank provides a variety of commercial and consumer lending products to small to medium-sized businesses and individuals for various business and personal purposes, including
(i) commercial loans for a variety of business purposes such as for working capital, equipment purchases, real estate lines of credit, and government contract financing; (ii) asset based
lending and accounts receivable financing (on a limited basis); (iii) construction and commercial real estate loans; (iv) business equipment financing; (v) consumer home equity
lines of credit, personal lines of credit and term loans; (vi) consumer installment loans such as
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auto
and personal loans; (v) personal credit cards offered through an outside vendor; and (vi) residential mortgage loans.
The
Bank maintains a loan portfolio consisting primarily of traditional business and real estate secured loans, with a substantial portion having variable and adjustable rates, and where
the cash flow of the borrower/borrower's business is the principal source of debt service with a secondary emphasis on collateral. Real estate loans are made generally for commercial purposes and are
structured using both variable and fixed rates and renegotiable rates which adjust in three to five years, with maturities of five to ten years.
The
Bank's consumer loans portfolio is comprised primarily of home equity lines of credit that are structured with an interest only draw period followed either by a balloon maturity or a
fully amortized repayment schedule. The Bank consumer loan portfolio also includes some first lien residential mortgage loans, although the Bank's general practice is to selling such loans released to
third party investors. The Bank has also developed significant expertise and commitment as a Small Business Administration ("SBA") lender.
The
direct lending activities in which the Bank engages carry the risk that the borrowers will be unable to perform on their obligations. As such, interest rate policies of the Board of
Governors of the Federal Reserve System (the "Federal Reserve Board") and general economic conditions, nationally and in the Bank's primary market area, have a significant impact on the Bank's and the
Company's results of operations. To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Bank in full, in a timely
manner, resulting in decreased earnings or losses to the Bank. To the extent the Bank makes fixed rate loans, general increases in interest rates will tend to reduce the Bank's spread as the interest
rates the Bank must pay for deposits may increase while interest income may be unchanged. Economic conditions may also adversely affect the value of property pledged as security for loans.
The
Bank's goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent
risks in managing
loan assets include: carefully enforcing loan policies and procedures, evaluating each borrower's business plan during the underwriting process and throughout the loan term, identifying and monitoring
primary and alternative sources for loan repayment, and obtaining collateral to mitigate economic loss in the event of liquidation. Specific loan reserves are established based upon credit and/or
collateral risks on an individual loan basis. A risk rating system is employed to proactively estimate loss exposure and provide a measuring system for setting general and specific reserve
allocations.
The
Bank is an approved SBA lender. As a preferred lender under the SBA's Preferred Lender Program, the Bank can originate certain SBA loans in-house without prior SBA
approval. SBA loans are made through programs designed by the federal government to assist the small business community in obtaining financing from financial institutions that are given government
guarantees as an incentive to make the loans. Under certain circumstances, the Bank attempts to further mitigate commercial term loan losses by using loan guarantee programs offered by the SBA. SBA
lending is subject to federal legislation that can affect the availability and funding of the program. From time to time, this dependence on legislative funding causes limitations and uncertainties
with regard to the continued funding of such programs, which could potentially have an adverse financial impact on our business.
The
composition of the Bank's loan portfolio is heavily weighted toward commercial real estate, both owner occupied and investment real estate. Owner occupied commercial real estate and
owner occupied commercial real estate construction represent 13.1% of the loan portfolio. At December 31, 2012, commercial real estate and real estate construction combined represented
approximately 71.1% of the loan portfolio. Accordingly, when owner occupied commercial real estate is excluded, the percentage that commercial real estate loans represent to total loans decreases to
58.0%. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower
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cash
flow and general economic conditions. The Bank typically requires a maximum loan to value of 80% or less and minimum cash flow debt service coverage of 1.15 to 1.0. Personal guarantees are
generally required, but may be limited. In making real estate commercial mortgage loans, the Bank generally requires that interest rates adjust not less frequently than five years.
The
Bank is also an active traditional commercial lender providing loans for a variety of purposes, including cash flow, equipment and account receivable financing. This loan category
represents approximately 22% of the Bank's loan portfolio at December 31, 2012 and is generally variable or adjustable rate. Commercial loans meet reasonable underwriting standards, including
appropriate collateral, and cash flow necessary to support debt service. Personal guarantees are generally required, but may be limited. SBA loans represent 2% of the commercial loan category of
loans. In originating SBA loans, the Company assumes the risk of non-payment on the uninsured portion of the credit. The Company generally sells the insured portion of the loan generating
noninterest income
from the gains on sale, as well as servicing income on the portion participated. SBA loans are subject to the same cash flow analyses as other commercial loans. SBA loans are subject to a maximum loan
size established by the SBA.
Approximately
4% of the loan portfolio at December 31, 2012 consists of home equity loans and lines of credit and other consumer loans. These credits, while making up a smaller
portion of the loan portfolio, demand the same emphasis on underwriting and credit evaluation as other types of loans advanced by the Bank.
The
remaining 3% of the loan portfolio consists of residential home mortgage loans. These credits represent first liens on residential property loans originated by the Bank. While the
Bank's general practice is to originate and sell (servicing released) loans made by its Residential Lending division, certain loan terms do not satisfy the requirements of third party investors and
are instead maintained in the Bank's portfolio. These type loans exhibit minimal credit risk.
Our
lending activities are subject to a variety of lending limits imposed by state and federal law. These limits will increase or decrease in response to increases or decreases in the
Bank's level of capital. At January 31, 2013, the Bank had a legal lending limit of $54.4 million. In accordance with internal lending policies, the Bank occasionally sells
participations in its loans to other area banks, which allows the Bank to manage risk involved in these loans and to meet the lending needs of its clients. The Bank has also participated loans to the
Company until such time as the Bank could accommodate the participation within its internal lending limit or the loan could be participated to another lender. No loan participations to the Company are
outstanding at December 31, 2012. The ability of the Company to assist the Bank with these credits has expanded the flexibility and service the Bank can offer its customers
From
time to time the Company may make loans for its own portfolio or through its higher risk loan affiliate, ECV, which under its operating agreement conducts lending only to real
estate projects, as to which the Company's directors or lending officers have significant expertise. Such loans may have higher risk characteristics than loans made by the Bank, such as lower priority
security interests and/or higher loan to value ratios. The Company seeks an overall financial return on these transactions commensurate with the risks and structure of each individual loan. Certain
transactions bear current interest at a rate with a significant premium to normal market rates. Other loan transactions carry a standard rate of current interest, but also earn additional interest
based on a fixed rate or a percentage of the profits of the underlying project. Refer to the discussion under "Management's Discussion and AnalysisNoninterest Income" at page 49
and "Loan Portfolio" at page 54, for further information on the Company's and ECV's higher risk lending activities. At December 31, 2012, ECV had four outstanding loan transactions
totaling $3.5 million.
The
risk of nonpayment (or deferred payment) of loans is inherent in commercial banking. The Bank's marketing focus on small to medium-sized businesses may result in the assumption by
the Bank of certain lending risks that are different from those attendant to loans to larger companies. The management and director committees of the Bank carefully evaluate all loan applications and
attempt to minimize
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credit
risk exposure by use of extensive loan application data, due diligence, and approval and monitoring procedures; however, there can be no assurance that such procedures can significantly reduce
such lending risks.
The
Bank originates residential mortgage loans primarily as a correspondent lender. With only minor exceptions, the loans are registered with one of the designated investors at the time
of application with intentions of immediate sale to that investor on a servicing released basis. This activity is managed by utilizing the available pricing, programs and lock periods, which produce
market gains on the sale of the loan. Activity in the residential mortgage loan market is highly sensitive to changes in interest rates and product availability. While the Bank does have delegated
underwriting authority from most of its investors, it also employs the services of the investor to underwrite the loans. Because the loans are originated with investor guidelines and designated
automated underwriting and product specific requirements as part of the loan application, the loans sold have a limited recourse provision. Most contracts with investors contain recourse periods. In
general, the Company may be required to repurchase a previously sold mortgage loan or indemnify the investor if there is non-compliance with defined loan origination or documentation
standards, including fraud, negligence or material misstatement in the loan documents. In addition, the Company may have an obligation to repurchase a loan if the mortgagor has defaulted early in the
loan term. The potential default repurchase period is up to approximately twelve months after sale of the loan to the investor. Mortgages subject to recourse are collateralized by single-family
residential properties, have loan-to-value ratios of 80% or less, or have private mortgage insurance. In certain instances, the Bank may provide equity loans (second position
financing) in combination with residential first mortgage lending for purchase money and refinancing purposes. The Bank also brokers loan transactions with two investors, where the Bank refers, but
does not underwrite and does not close the loan transaction. In this situation the Bank has no recourse liability for the loan.
The
general terms and underwriting standards for each type of commercial real estate and construction loan are incorporated into the Bank's lending policies. These policies are analyzed
periodically by management, and the policies are reviewed and approved by the Board on an annual basis. The Bank's loan policies and practices described in this report are subject to periodic change,
and each guideline or standard is subject to waiver or exception in the case of any particular loan, by the appropriate officer or committee, in accordance with the Bank's loan policies. Policy
standards are often stated in mandatory terms, such as "shall" or "must", but these provisions are subject to exceptions. Policy requires that loan value not exceed a percentage of "market value" or
"fair value" based upon appraisals or evaluations obtained in the ordinary course of the Bank's underwriting practices.
Loans
are secured primarily by duly recorded first deeds of trust. In some cases, the Bank may accept a recorded second trust position. In general, borrowers will have a proven ability
to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is required.
Construction
loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Bank. Guaranteed, fixed price
construction contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.
Loans
intended for residential land acquisition, lot development and construction are made on the premise that the land: 1) is or will be developed for building sites for
residential structures; and 2) will ultimately be utilized for construction or improvement of residential zoned real properties, including the creation of housing. Residential development and
construction loans will finance projects such as single family subdivisions, planned unit developments, townhouses, and condominiums. Residential land acquisition, development and construction loans
generally are underwritten with a maximum term of 36 months, including extensions approved at origination.
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Commercial
land acquisition and construction loans are secured by real property where loan funds will be used to acquire land and to construct or improve appropriately zoned real
property for the creation of income producing or owner user commercial properties. Borrowers are required to contribute equity into each project at levels determined by the appropriate Loan Committee.
Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.
Loan-to-value
("LTV") ratios, with few exceptions, are maintained consistent with or below supervisory guidelines.
All
construction draw requests must be presented in writing on American Institute of Architects documents and certified by the contractor, the borrower and the borrower's architect. Each
draw request shall also include the borrower's soft cost breakdown certified by the borrower or its Chief Financial Officer. Prior to an advance, the Bank or its contractor inspects the project to
determine that the work has been completed, to justify the draw requisition.
Commercial
permanent loans are secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must
be satisfactory to support a permanent loan. The debt service coverage ratio is ordinarily at least 1.15 to 1. As part of the underwriting process, debt service coverage ratios are stress tested
assuming a 200 basis point increase in interest rates from their current levels.
Commercial
permanent loans are generally subject to re-pricing after 5 years and are underwritten with a term not greater than 10 years or the remaining useful
life of the property, whichever is lower. The preferred term is between 5 to 7 years, with amortization to a maximum of 25 years.
Personal
guarantees are generally received from the principals on commercial real estate loans, and only in instances where the loan-to-value is sufficiently low
and the debt service is sufficiently high is consideration given to either limiting or not requiring personal recourse.
Updated
appraisals for real estate secured loans are obtained as necessary and appropriate to borrower financial condition, project status, loan terms, and market conditions.
The
Company's loan portfolio includes loans made for real estate Acquisition, Development and Construction ("ADC") purposes, including both investment and owner occupied projects. ADC
loans amounted to $562.5 million at December 31, 2012. The ADC loans containing loan funded interest reserves represent approximately 31% of the outstanding ADC loan portfolio at
December 31, 2012. The decision to establish a loan-funded interest reserve is made upon origination of the ADC loan and is based upon a number of factors considered during
underwriting of the credit including: (i) the feasibility of the project; (ii) the experience of the sponsor; (iii) the creditworthiness of the borrower and guarantors;
(iv) borrower equity contribution; and (v) the level of collateral protection. When appropriate, an interest reserve provides an effective means of addressing the cash flow
characteristics of a properly underwritten ADC loan. The Company does not significantly utilize interest reserves in other loan products. The Company recognizes that one of the risks inherent in the
use of interest reserves is the potential masking of underlying problems with the project and/or the borrower's ability to repay the loan. In order to mitigate this inherent risk, the Company employs
a series of reporting and monitoring mechanisms on all ADC loans, whether or not an interest reserve is provided, including: (i) construction and development timelines which are monitored on an
ongoing basis which track the progress of a given project to the timeline projected at origination; (ii) a construction loan administration department independent of the lending function;
(iii) third party independent construction loan inspection reports; (iv) monthly interest reserve monitoring reports detailing the balance of the interest reserves approved at
origination and the days of interest carry represented by the reserve balances as compared to the then current anticipated time to completion and/or sale of speculative projects; and
(v) quarterly commercial real estate construction meetings among senior Company management which includes monitoring of current and projected real estate market conditions. If a project has not
performed as expected, it is not the customary practice of the Company to increase loan funded interest reserves.
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Despite
the softening economy and real estate markets in general, to date, the Company has not experienced any significant issues with increased vacancy rates or lower rents for income
producing properties financed. However, the construction loan portfolio has felt to some extent the impacts of a softer market and slower absorption, although the Washington, D.C. metropolitan area
real estate market has been very strong, as compared to other markets in the U.S. Some general slowness in turn of projects has impacted the liquidity of borrowers and guarantors. As a result the
Company has maintained higher allocation factors for the allowance for loan losses ("ALLL") for the real estate loan portfolio. As part of its overall risk assessments, management
carefully reviews the Bank's loan portfolio and general economic and market conditions on a regular basis and will continue to adjust both the specific and environmental reserve factors as necessary.
Deposit
services include business and personal checking accounts, NOW accounts, tiered savings and money market account and time deposits with varying maturity structures and customer
options. A complete individual retirement account program is available. In cooperation with Goldman Sachs Asset Management, the bank offers a Goldman Sachs Investment Sweep Account, a check writing
cash management account that sweeps funds to one of several off-balance sheet investment accounts managed by Goldman Sachs. The Bank also participates in the Promontory Interfinancial
Network Certificate of Deposit Account Registry Service (CDAR's) and its Insured Cash Sweep (ICS) program.
The
Bank offers a full range of on-line banking services for both personal and business accounts and has recently introduced a Mobile Banking application. Other services
include cash management services, business sweep accounts, lock box, remote deposit capture, account reconciliation services, merchant card services, safety deposit boxes and Automated Clearing House
origination. After-hours depositories and ATM service are also available.
The
Bank and Company maintain portfolios of short term investments and investment securities consisting primarily of U.S. Government Agency bonds and government sponsored enterprise
mortgage backed securities, and municipal bonds. The Company also owns equity investments related to membership in the Federal Reserve System and the Federal Home Loan Bank of Atlanta ("FHLB"). The
Company's securities portfolio also consists of equity investments in the form of common stocks of a few local banking companies. These portfolios provide the following objectives: liquidity
management, additional income to the Company and Bank in the form of interest and gain on sale opportunities, collateral to facilitate borrowing arrangements and assistance with meeting interest rate
risk management objectives.
The
Company and Bank have formalized an asset and liability management process and have a standing Asset Liability Committee ("ALCO") consisting both of outside and inside directors and
senior management. The ALCO operates under established policies and practices, which are updated and re-approved annually. A typical Committee meeting includes discussion of current
economic conditions and strategies, including interest rate trends and volumes positions, the current balance sheet and earnings position, cash flow estimates, liquidity positions and funding
alternatives as necessary, interest rate risk position (quarterly), capital positions of the Company and Bank, reviews (and including independent reviews) of the investment portfolio of the Bank and
the Company, and the approval of investment transactions. The current Investment Policy limits the Bank to investments of high quality, U.S. Treasury securities, U.S. Government Agency securities and
high grade municipal
securities. High risk investments and non traditional investments are prohibited. Investment maturities are generally limited to ten to fifteen years, except as specifically approved by the ALCO, and
mortgage backed pass through securities with average lives generally not to exceed eight years.
The
Bank's customer base has benefited from the extensive business and personal contacts of its Directors and Executive Officers. To introduce new customers to the Bank, enhanced
reliance is expected on proactively designed officer calling programs, active participation in business organizations, advisory board structures and enhanced referral programs.
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Internet Access to Company Documents.
The Company provides access to its Securities and Exchange Commission ("SEC") filings through its
web site at
www.eaglebankcorp.com by linking to the SEC's web site. After accessing the web site, the filings are available upon selecting "Investor Relations SEC Filings." Reports available include the annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably
practicable after the reports are electronically filed with or furnished to the SEC.
MARKET AREA AND COMPETITION
The Bank's main office and the headquarters of the Company and the Bank are located at 7815 Woodmont Avenue, Bethesda, Maryland 20814. The Bank has six additional
Maryland offices, located at 110 North Washington Street, Rockville; 8665 Georgia Avenue, Silver Spring; 130 Rollins Avenue, Rockville; 9600 Blackwell Road, Rockville; 15 Wisconsin Circle, Chevy
Chase; and 12505 Park Potomac Avenue, Potomac. There are five offices in Washington, D.C., located at 2001 K Street, NW; 1044 Wisconsin Ave, NW; 1228 Connecticut Ave, NW, 1425 K Street, NW; and 700
7
th
Street, NW. The Bank has five offices in Virginia, located at 8601 Westwood Center Drive, Vienna; 4420 N. Fairfax Drive, Arlington; 1919 North Lynn St, Arlington; 12011 Sunset
Hills Road, Reston; and 2905 District Avenue, Fairfax. The Bank is planning to open its eighteenth branch office in Alexandria, Virginia at 277 S. Washington Street, in March 2013.
The
primary service area of the Bank is the Washington, D.C. metropolitan area. With a population of approximately 6,200,000 (January, 2009), the region is the
5
th
largest market in the U.S. Total employment in the region is approximately 2,400,000. The region has the highest total of job creation of any market in the country with
reported new job creation of more than 285,000 jobs since 2000 and 34,300 new jobs were created in 2012. The Washington, D.C. metropolitan area contains a substantial federal workforce, as well as
supporting a variety of support industries such as attorneys, lobbyists, government contractors, real estate developers and investors, non-profit organizations, tourism and consultants.
The Gross Regional Product ("GDP") for 2010 was reported at $436 billion. Of this amount, approximately $79 billion or 18% is spending by the federal government for procurement as of
fiscal year 2010. The economic engine is well balanced with 36% contributed by local businesses. The regional economy is further supplied by national and international businesses at 17%. The region
also has a very active non-profit sector including trade associations, colleges and universities and major hospitals.
Montgomery
County, Maryland with a total population of approximately 972,000 (2010) and occupying an area of about 500 square miles is located roughly 30 miles southwest of Baltimore and
is a diverse and healthy segment of Maryland's economy. Montgomery County is a thriving business center and is Maryland's most populous jurisdiction. Population in the county is expected to grow 3.8%
between 2010 and 2015. While the State of Maryland boasts a demographic profile superior to the U.S. economy at large, the economy in and around Montgomery County is among the very best in Maryland.
According to data from the Maryland National Capital Parks and Planning Commission, the number of jobs in the County has been relatively stable in the recent past with the public sector contributing
about 19% of the employment. This is due to federal as well as state and local government employment. The unemployment rate in Montgomery County is among the lowest in the state at 4.9% (December
2012). A very educated population has contributed to favorable median household income of $95,660 with the number of households totaling 355,434. According to the 2010 census update, approximately 57%
of the County's residents (between 2007 and 2011) hold college or advanced degrees, placing the population of Montgomery County among the most educated in the nation. The area boasts a diverse
business climate of over 34,000 businesses with 510,000 jobs in addition to a strong federal government presence. Major areas of employment include a substantial technology sector, biotechnology,
software development, a housing construction and renovation sector, and a legal, financial services and professional services sector. Major private employers include Adventist Healthcare, Lockheed
Martin, Giant Food, and Marriott International. The county is also an incubator for firms engaged in biotechnology and the area has
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traditionally
attracted significant amounts of venture capital. Transportation congestion remains the biggest threat to future economic development and the quality of life in the area.
Montgomery
County is home to many major federal and private sector research and development and regulatory agencies, including the National Institute of Standards and Technology, the
National Institutes of Health, National Oceanic and Atmospheric Administration, Naval Research and
Development Center, Naval Surface Warfare Center, Nuclear Regulatory Commission, the Food and Drug Administration and the Walter Reed National Military Medical Center in Bethesda.
Washington,
D.C. in addition to being the seat of the Federal government is a vibrant city with a well- educated, diverse population. According to survey data from the latest
U.S. Census, the estimated 2012 population of the District of Columbia is approximately 632,323, up from 601,723 in 2010. Median household income, at $61,835 between 2007 and 2011, is above the
national median level of $52,762. The growth of residents in the city is due partially to improvements in the city's services and also to the many housing options available, ranging from grand old
apartment buildings to Federal era town homes to the most modern condominiums. As of 2010, the housing market has grown to over 298,900 units. During 2011, the absorption of condominium units in the
District has continued at a satisfactory pace. While the Federal government and its employees are a major factor in the economy, over 100 million square feet of commercial office space support
a dynamic business community of more than 20,000 companies. These include law and accounting firms, trade and professional associations, information technology companies, international financial
institutions, health and education organizations and research and management companies. This was the second lowest vacancy rate in rankings of the largest downtown U.S. markets. Unemployment has
declined slightly with the rate for December 2012 at 8.6%, below December 2011 at 9.8%. The disparity between the high level of unemployment among District residents and the strong employment trends
reflects the high level of jobs held by residents of the surrounding suburban jurisdictions. The District has a well- educated and highly paid work force. The Federal Government accounts
for approximately 30% of the employment and professional service firms provide an additional 21%. Other large employers include the many local universities and hospitals. Another significant factor in
the economy is the leisure and hospitality industry, as Washington, D.C. remains a popular tourist destination for both national and international travelers.
Fairfax
County, Virginia is a large, affluent jurisdiction with a population of approximately 1,081,700 as of 2010. This county of about 395 square miles is located west of Washington,
D.C. Fairfax County is one of the leading technology centers in the United States. Six Fortune 500 companies are headquartered in the county and 26 of the largest 100 technology federal contractors in
the Washington metropolitan area are located in Fairfax County. The county has over 113 million square feet of office space and is one of the largest suburban office markets in the United
States. The midyear 2011 office vacancy rate was 12.8%, below the national average of 17.4%, as measured in early 2011. It is a thriving residential as well as business center with 381,700 households,
which are expected to grow at about 1% per annum over the next 5 to 10 years. The county is among the most affluent in the country with average annual household income of $108,439 per annum
between 2007 and 2011. Total employment was over 558,900 as of 2010. Major companies headquartered in the county, which are also major employers, include Capital One Financial, CSC, Gannett, General
Dynamics, Hilton Hotels, SAIC and Sallie Mae. The county is also home to several federal agencies including the CIA, Fort Belvoir and a major facility of the Smithsonian Institution.
In
2011, the Company's footprint expanded into Arlington County, Virginia which has an estimated population of over 216,000 as of 2011. The county is made up of 26 square miles and is
situated just west of Washington, D.C., directly across the Potomac River. There are approximately 92,436 households with a median household income of $99,651 on average between 2007 and 2011. There
were over 168,900 employees as of June 2011, working predominantly in the public sector. Significant private sector employers include Deloitte, Lockheed Martin Corporation, Virginia Hospital Center
and Marriott International, Inc. Unemployment was 3.3% as of December 2012. These numbers compare
favorably to the region, the rest of Virginia and the country. Arlington County has approximately 36.3 million square
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feet
of office space with a vacancy rate of approximately 10.1% as of the fourth quarter 2011. The population is highly educated, with about 71% of residents over 25 years of age holding at
least a bachelor's degree as of 2011.
The
most recent addition to the Company's branch network will be in Alexandria, Virginia in early 2013. Alexandria is a city with an estimated population of 144,301 as of 2011. The city
is made up of just over 15 square miles and sits on the west bank of the Potomac River just south of Arlington, Virginia. There are approximately 64,217 households with a median household income of
$82,899 on average between 2007 and 2011. The employment base was approximately 94,651 employees as of September 2012, with 77% working in the private sector and 23% working in government roles.
Alexandria has over 8,000 businesses and organizations, located in the more than 20 million square feet of office space and 11 million square feet of retail space existing in the city
today. Unemployment was just 4.2% as of December 2012. The population is highly educated, with over 60% of residents over 25 years of age holding at least a bachelor's degree as of 2011.
Deregulation
of financial institutions and holding company acquisitions of banks across state lines has resulted in widespread, fundamental changes in the financial services industry.
This transformation, although occurring nationwide, is particularly intense in the greater Washington, D.C. metropolitan area because of the changes in the area's economic base in recent years and
changing state laws authorizing interstate mergers and acquisitions of banks, and the interstate establishment or acquisition of branches.
Throughout
the Washington, D.C. metropolitan area, competition is keen from large banking institutions headquartered outside of Maryland. In addition, the Bank competes with other
community banks, savings and loan associations, credit unions, mortgage companies, finance companies and others providing financial services. Among the advantages that many of these large institutions
have over the Bank are their abilities to finance extensive advertising campaigns, maintain extensive branch networks and technology investments, and to directly offer certain services, such as
international banking and trust services, which are not offered directly by the Bank. Further, the greater capitalization of the larger institutions allows for substantially higher lending limits than
the Bank. Certain of these competitors have other advantages, such as tax exemption in the case of credit unions, and lesser regulation in the case of mortgage companies and finance companies,
although this regulatory oversight is undergoing dramatic change. As a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), enacted
in July 2010, regulation of all financial firms has been heightened. Under current law, unlimited interstate
de novo
branching is available to all state
and federally chartered banks. As a result, institutions which previously were ineligible to establish
de novo
branches in the Company's market area may
elect to do so.
EMPLOYEES
At December 31, 2012 the Bank employed 393 persons on a full time basis (nine of whom are executive officers of the Bank) which compares to 338 employees
at December 31, 2011. None of the Bank's employees are represented by any collective bargaining group and the Bank believes that its employee relations are good. At December 31, 2012,
the Bank provided a benefit program which included health and dental insurance, a 401(k) plan, life and long term disability insurance. Additionally, the Company maintains an employee stock purchase
plan and a stock-based compensation plan for employees of the Bank who meet certain eligibility requirements.
REGULATION
Our business and operations are subject to extensive federal and state governmental regulation and supervision. The following is a brief summary of certain
statutes and rules and regulations that affect or will affect us. This summary is not intended to be an exhaustive description of the statutes or regulations
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applicable
to our business. Supervision, regulation, and examination of the Company by the regulatory agencies are intended primarily for the protection of depositors rather than our stockholders.
The Company.
The Company is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, (the "Act") and
is subject to
regulation and supervision by the Board of
Governors of the Federal Reserve Board. The Act and other federal laws subject bank holding companies to restrictions on the types of activities in which they may engage, and to a range of supervisory
requirements and activities, including regulatory enforcement actions for violations of laws and regulations and unsafe and unsound banking practices. As a bank holding company, the Company is
required to file with the Federal Reserve Board an annual report and such other additional information as the Federal Reserve Board may require pursuant to the Act. The Federal Reserve Board may also
examine the Company and each of its subsidiaries.
The
Act requires approval of the Federal Reserve Board for, among other things, a bank holding company's direct or indirect acquisition of control of more than five percent (5%) of the
voting shares, or substantially all the assets, of any bank or the merger or consolidation by a bank holding company with another bank holding company. The Act also generally permits the acquisition
by a bank holding company of control or substantially all the assets of any bank located in a state other than the home state of the bank holding company, except where the bank has not been in
existence for the minimum period of time required by state law; but if the bank is at least 5 years old, the Federal Reserve Board may approve the acquisition.
With
certain limited exceptions, a bank holding company is prohibited from acquiring control of any voting shares of any company which is not a bank or bank holding company and from
engaging directly or indirectly in any activity other than banking or managing or controlling banks or furnishing services to or performing service for its authorized subsidiaries. A bank holding
company may, however, engage in or acquire an interest in, a company that engages in activities which the Federal Reserve Board has determined by order or regulation to be so closely related to
banking or managing or controlling banks as to be properly incident thereto. In making such a determination, the Federal Reserve Board is required to consider whether the performance of such
activities can reasonably be expected to produce benefits to the public, such as convenience, increased competition or gains in efficiency, which outweigh possible adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices. The Federal Reserve Board is also empowered to differentiate between activities
commenced
de novo
and activities commenced by the acquisition, in whole or in part, of a going concern. Some of the activities that the Federal Reserve
Board has determined by regulation to be closely related to banking include making or servicing loans, performing certain data processing services, acting as a fiduciary or investment or financial
advisor, and making investments in corporations or projects designed primarily to promote community welfare.
Subsidiary
banks of a bank holding company are subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or any of its
subsidiaries, or investments in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower. Further, a bank holding company and any
subsidiary bank are prohibited from engaging in certain tie-in arrangements in connection with the extension of credit. A subsidiary bank may not extend credit, lease or sell property, or
furnish any services, or fix or vary the consideration for any of the foregoing on the condition that: (i) the customer obtain or provide some additional credit, property or services from or to
such bank other than a loan, discount, deposit or trust service; (ii) the customer obtain or provide some additional credit, property or service from or to the Company or any other subsidiary
of the Company; or (iii) the customer not obtain some other credit, property or service from competitors, except for reasonable requirements to assure the soundness of credit extended.
Effective
on March 11, 2000, the Gramm Leach-Bliley Act of 1999 (the "GLB Act") allows a bank holding company or other company to certify status as a financial holding company,
which allows such
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company
to engage in activities that are financial in nature, that are incidental to such activities, or are complementary to such activities. The GLB Act enumerates certain activities that are deemed
financial in nature, such as underwriting insurance or acting as an insurance principal, agent or broker, underwriting, dealing in or making markets in securities, and engaging in merchant banking
under certain restrictions. It also authorizes the Federal Reserve Board to determine by regulation what other activities are financial in nature, or incidental or complementary thereto. The GLB Act
allows a wider array of companies to own banks, which could result in companies with resources substantially in excess of the Company's entering into competition with the Company and the Bank. The
Company has not elected financial holding company status.
The Bank.
The Bank, as a Maryland chartered commercial bank which is a member of the Federal Reserve System (a "state member bank") and
whose
accounts are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (the "FDIC") up to the maximum legal limits of the FDIC, is subject to regulation, supervision and
regular examination by the Maryland Department of Financial Institutions and the Federal Reserve Board. The regulations of these various agencies govern most aspects of the Bank's business, including
required reserves against deposits, loans, investments, mergers and acquisitions, borrowing, dividends and location and number of branch offices.
The
laws and regulations governing the Bank generally have been promulgated to protect depositors and the deposit insurance funds, and not for the purpose of protecting shareholders.
Competition
among commercial banks, savings and loan associations, and credit unions has increased following enactment of legislation which greatly expanded the ability of banks and bank
holding companies to engage in interstate banking or acquisition activities. As a result of federal and state legislation, banks in the Washington, D.C./Maryland/Virginia area can, subject to limited
restrictions, acquire or merge with a bank in another of the jurisdictions, and can branch
de novo
in any of the jurisdictions.
Banking
is a business which depends on interest rate differentials. In general, the differences between the interest paid by a bank on its deposits and its other borrowings and the
interest received by a bank on loans extended to its customers and securities held in its investment portfolio constitute the major portion of the bank's earnings. Thus, the earnings and growth of the
Bank will be subject to the
influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve Board, which
regulates the supply of money through various means including open market dealings in United States government securities. The nature and timing of changes in such policies and their impact on the
Bank cannot be predicted.
Branching and Interstate Banking.
The federal banking agencies are authorized to approve interstate bank merger transactions without
regard to
whether such transaction is prohibited by the law of any state, unless the home state of one of the banks has opted out of the interstate bank merger provisions of the Riegle-Neal
Interstate Banking and Branching Efficiency Act of 1994 (the "Riegle-Neal Act") by adopting a law after the date of enactment of the Riegle-Neal Act and prior to June 1,
1997 which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions
of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. Such interstate bank mergers and branch acquisitions are also subject to the nationwide
and statewide insured deposit concentration limitations described in the Riegle-Neal Act. The District of Columbia, Maryland and Virginia have each enacted laws which permit interstate
acquisitions of banks and bank branches. The Dodd-Frank Act authorizes national and state banks to establish
de novo
branches in other
states to the same extent as a bank chartered by that state would be permitted to branch. Previously, banks could only establish branches in other states if the host state expressly permitted
out-of-state banks to establish branches in that state. Although the District of Columbia, Maryland and Virginia had all enacted laws which permitted banks in these
jurisdictions to branch freely, the branching provisions of the Dodd-Frank Act could result in banks from a wider variety of states establishing
de
novo
branches in the Bank's market area.
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The
GLB Act made substantial changes in the historic restrictions on non-bank activities of bank holding companies, and allows affiliations between types of companies that
were previously prohibited. The GLB Act also allows banks to engage in a wider array of non banking activities through "financial subsidiaries."
USA Patriot Act.
Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct
Terrorism Act,
commonly referred to as the "USA Patriot Act" or the "Patriot Act," financial institutions are subject to prohibitions against specified financial transactions and account relationships, as well as
enhanced due diligence standards intended to detect, and prevent, the use of the United States financial system for money laundering and terrorist financing activities. The Patriot Act requires
financial institutions, including banks, to establish
anti-money laundering programs, including employee training and independent audit requirements, meet minimum standards specified by the act, follow minimum standards for customer
identification and maintenance of customer identification records, and regularly compare customer lists against lists of suspected terrorists, terrorist organizations and money launderers. The costs
or other effects of the compliance burdens imposed by the Patriot Act or future anti-terrorist, homeland security or anti-money laundering legislation or regulation cannot be
predicted with certainty.
Capital Adequacy Guidelines.
The Federal Reserve Board and the FDIC have adopted risk based capital adequacy guidelines pursuant to
which they assess
the adequacy of capital in examining and supervising banks and bank holding companies and in analyzing bank regulatory applications. Risk-based capital requirements determine the adequacy
of capital based on the risk inherent in various classes of assets and off-balance sheet items. Under the Dodd-Frank Act, the Federal Reserve Board is required to apply
consolidated capital requirements to depository institution holding companies that are no less stringent than those currently applied to depository institutions. The Dodd-Frank Act
additionally requires capital requirements to be countercyclical so that the required amount of capital increases in times of economic expansion and decreases in times of economic contraction,
consistent with safety and soundness.
State
member banks are expected to meet a minimum ratio of total qualifying capital (the sum of core capital (Tier 1) and supplementary capital (Tier 2) to risk weighted
assets of 8%. At least half of this amount (4%) should be in the form of core capital.
Tier 1
Capital generally consists of the sum of common shareholders' equity and perpetual preferred stock (subject in the case of the latter to limitations on the kind and amount
of such stock which may be included as Tier 1 Capital), less goodwill, without adjustment for changes in the market value of securities classified as
"available-for-sale," together with a limited amount of other qualifying interests, including trust preferred securities. The cumulative perpetual stock issued to the United
States Department of the Treasury (the "Treasury") pursuant to the Trouble Assets Relief Program Capital Purchase Program (the "Capital Purchase Program") is eligible for treatment as Tier 1
capital without limitation. Tier 2 Capital consists of the following: hybrid capital instruments; perpetual preferred stock which is not otherwise eligible to be included as Tier 1
Capital; term subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses and excess restricted core capital elements. Assets
are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no risk-based capital) for
assets such as cash, to 100% for the bulk of assets which are typically held by a bank holding company, including certain multi-family residential and commercial real estate loans, commercial business
loans and consumer loans. Residential first mortgage loans on one to four family residential real estate and certain seasoned multi-family residential real estate loans, which are not 90 days
or more past due or nonperforming and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain
privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics.
Under guidance adopted
by the federal banking regulators, banks which have concentrations in construction, land development or commercial real estate loans (other than loans for
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majority
owner occupied properties) would be expected to maintain higher levels of risk management and, potentially, higher levels of capital.
In
addition to the risk-based capital requirements, the Federal Reserve Board has established a minimum 3.0% Leverage Capital Ratio (Tier 1 Capital to total adjusted
assets) requirement for the most highly-rated banks, with an additional cushion of at least 100 to 200 basis points for all other banks, which effectively increases the minimum Leverage Capital Ratio
for such other banks to 4.0%5.0% or more. The highest-rated banks are those that are not anticipating or experiencing significant growth and have well diversified risk, including no undue
interest rate risk exposure, excellent asset quality, high liquidity, good earnings and, in general, those which are considered a strong banking organization. A bank having less than the minimum
Leverage Capital Ratio requirement shall, within 60 days of the date as of which it fails to comply with such requirement, submit a reasonable plan describing the means and timing by which the
bank shall achieve its minimum Leverage Capital Ratio requirement. A bank which fails to file such plan is deemed to be operating in an unsafe and unsound manner, and could subject the bank to a
cease-and-desist order. Any insured depository institution with a Leverage Capital Ratio that is less than 2.0% is deemed to be operating in an unsafe or unsound condition
pursuant to Section 8(a) of the Federal Deposit Insurance Act (the "FDIA") and is subject to potential termination of deposit insurance. However, such an institution will not be subject to an
enforcement proceeding solely on account of its capital ratios, if it has entered into and is in compliance with a written agreement to increase its Leverage Capital Ratio and to take such other
action as may be necessary for the institution to be operated in a safe and sound manner. The capital regulations also provide, among other things, for the issuance of a capital directive, which is a
final order issued to a bank that fails to maintain minimum capital or to restore its capital to the minimum capital requirement within a specified time period. Such directive is enforceable in the
same manner as a final cease-and-desist order.
Proposed Changes in Capital Requirements.
In December 2010, the Basel Committee on Banking Supervision released its final framework for
strengthening
international capital and liquidity regulation ("Basel III"). Basel III, when implemented by the U.S. banking agencies and fully phased-in, will require bank holding companies and their
bank subsidiaries to maintain more capital, with a greater emphasis on common equity. Implementation was to be phased in between 2013 and 2019, but has been delayed pending further review of the
proposed implementing regulations discussed below.
The
Basel III final capital framework, among other things, (i) introduces as a new capital measure "Common Equity Tier 1" ("CET1"), (ii) specifies that Tier 1
capital consists of CET1 and "Additional Tier 1 capital" instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital
measures be made to CET1 and not to the other components of capital and (iv) expands the scope of the adjustments as compared to existing regulations.
When
fully phased in, Basel III requires banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least
4.5%, plus a "capital conservation buffer" of 2.5%; (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0%, plus the capital conservation buffer;
(iii) a minimum ratio of Total (Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0% plus the capital conservation buffer and (iv) as a newly
adopted international standard, a minimum leverage ratio of 3%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures
(computed as the average for each quarter of the month-end ratios for the quarter).
Basel
III also provides for a "countercyclical capital buffer," generally to be imposed when national regulators determine that excess aggregate credit growth becomes associated with a
buildup of systemic risk that would be a CET1 add-on to the capital conservation buffer in the range of 0% to 2.5% when fully implemented. The capital conservation buffer is designed to
absorb losses during periods of economic stress. Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the
combined capital conservation buffer and countercyclical capital buffer,
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when
the latter is applied) may face constraints on dividends, equity repurchases and compensation based on the amount of the shortfall.
The
Basel III final framework provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing rights, deferred
tax assets dependent upon future taxable income and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds
10% of CET1 or all such categories in the aggregate exceed 15% of CET1.
The
Federal Reserve Board, the FDIC and the Office of the Comptroller of the Currency(the "OCC") issued a joint Notice of Proposed Rulemaking in June 2012 (the "Basel III Notice"), which
proposes to implement Basel III under regulations substantially consistent with the above. One additional proposed change from current practice proposed in the Basel III Notice, included as part of
the definition of CET1 capital, would require banking institutions to generally include the amount of Additional Other
Comprehensive Income (which primarily consists of unrealized gains and losses on available-for-sale securities which are not required to be treated as OTTI, net of tax) in
calculating regulatory capital. The Basel III Notice also proposes a 4% minimum leverage ratio.
Additionally,
the Federal Reserve Board, the FDIC and the OCC issued a second Notice of Proposed Rulemaking in June 2012 (the "Standardized Approach Notice") which would change the
manner of calculating risk weighted assets. Under this Notice, new methodologies for determining risk-weighted assets in the general capital rules are proposed, including revisions to
recognition of credit risk mitigation, including a greater recognition of financial collateral and a wider range of eligible guarantors. They also include risk weighting of equity exposures and past
due loans, potential changes in the weighting of residential mortgage loans depending on the risk characteristics of the loan; and higher (greater than 100%) risk weighting for certain commercial real
estate exposures that have higher credit risk profiles, including higher loan to value and equity components.
The
components of the Basel III framework remain subject to revision or amendment, as are the rules proposed by the U.S. regulatory agencies in the Basel III Notice and Standardized
Approach Notice. Accordingly, the regulations ultimately applicable to us may be substantially different from the Basel III final framework as published in December 2010, and as proposed in the Basel
III Notice and Standardized Approach Notice. Requirements to maintain higher levels of capital or to maintain higher levels of liquid assets, and changes in the manner of calculating risk weighted
assets, could adversely impact our net income and return on equity.
Prompt Corrective Action.
Under Section 38 of the FDIA, each federal banking agency is required to implement a system of prompt
corrective
action for institutions which it regulates. The federal banking agencies have promulgated substantially similar regulations to implement the system of prompt corrective action established by
Section 38 of the FDIA. Under the regulations, a bank shall be deemed to be: (i) "well capitalized" if it has a Total Risk Based Capital Ratio of 10.0% or more, a Tier 1 Risk
Based Capital Ratio of 6.0% or more, a Leverage Capital Ratio of 5.0% or more and is not subject to any written capital order or directive; (ii) "adequately capitalized" if it has a Total Risk
Based Capital Ratio of 8.0% or more, a Tier 1 Risk Based Capital Ratio of 4.0% or more and a Tier 1 Leverage Capital Ratio of 4.0% or more (3.0% under certain circumstances) and does not
meet the definition of "well capitalized;" (iii) "undercapitalized" if it has a Total Risk Based Capital Ratio that is less than 8.0%, a Tier 1 Risk based Capital Ratio that is less than
4.0% or a Leverage Capital Ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a Total Risk Based Capital Ratio that is less than
6.0%, a Tier 1 Risk Based Capital Ratio that is less than 3.0% or a Leverage Capital Ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible
equity to total assets that is equal to or less than 2.0%.
An
institution generally must file a written capital restoration plan which meets specified requirements with an appropriate federal banking agency within 45 days of the
date the institution receives
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notice
or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. A federal banking agency must provide the institution with written notice
of approval or disapproval within 60 days after receiving a capital restoration plan, subject to extensions by the applicable agency.
An
institution which is required to submit a capital restoration plan must concurrently submit a performance guaranty by each company that controls the institution. Such guaranty shall
be limited to the lesser of (i) an amount equal to 5.0% of the institution's total assets at the time the institution was notified or deemed to have notice that it was undercapitalized or
(ii) the amount necessary at such time to restore the relevant capital measures of the institution to the levels required for the institution to be classified as adequately capitalized. Such a
guaranty shall expire after the federal banking agency notifies the institution that it has remained adequately capitalized for each of four consecutive calendar quarters. An institution which fails
to submit a written capital restoration plan within the requisite period, including any required performance guaranty, or fails in any material respect to implement a capital restoration plan, shall
be subject to the restrictions in Section 38 of the FDIA which are applicable to significantly undercapitalized institutions.
A
"critically undercapitalized institution" is to be placed in conservatorship or receivership within 90 days unless the FDIC formally determines that forbearance from such action
would better protect the deposit insurance fund. Unless the FDIC or other appropriate federal banking regulatory agency makes specific further findings and certifies that the institution is viable and
is not expected to fail, an institution that remains critically undercapitalized on average during the fourth calendar quarter after the date it becomes critically undercapitalized must be placed in
receivership. The general rule is that the FDIC will be appointed as receiver within 90 days after a bank becomes critically undercapitalized unless extremely good cause is shown and an
extension is agreed to by the federal regulators. In general, good cause is defined as capital which has been raised and is imminently available for infusion into the Bank except for certain technical
requirements which may delay the infusion for a period of time beyond the 90 day time period.
Immediately
upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA, which (i) restrict payment of capital
distributions and management fees; (ii) require that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital; (iii) require
submission of a capital restoration plan; (iv) restrict the growth of the institution's assets; and (v) require prior approval of certain expansion proposals. The appropriate federal
banking agency for an undercapitalized institution also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems
of the institution at the least possible long-term cost to the deposit insurance fund, subject in certain cases to specified procedures. These discretionary supervisory actions include:
requiring the institution to raise additional capital; restricting transactions with affiliates; requiring divestiture of the institution or the sale of the institution to a willing purchaser; and any
other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically
undercapitalized institutions.
Additionally,
under Section 11(c)(5) of the FDIA, a conservator or receiver may be appointed for an institution where: (i) an institution's obligations exceed its assets;
(ii) there is substantial dissipation of the institution's assets or earnings as a result of any violation of law or any unsafe or unsound practice; (iii) the institution is in an unsafe
or unsound condition; (iv) there is a willful violation of a cease-and-desist order; (v) the institution is unable to pay its obligations in the ordinary course
of business; (vi) losses or threatened losses deplete all or substantially all of an institution's capital, and there is no reasonable prospect of becoming "adequately capitalized" without
assistance; (vii) there is any violation of law or unsafe or unsound practice or condition that is likely to cause insolvency or substantial dissipation of assets or earnings, weaken the
institution's condition, or otherwise seriously prejudice the interests of depositors or the insurance fund; (viii) an institution ceases to be insured; (ix) the institution is
undercapitalized and
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has
no reasonable prospect that it will become adequately capitalized, fails to become adequately capitalized when required to do so, or fails to submit or materially implement a capital restoration
plan; or (x) the institution is critically undercapitalized or otherwise has substantially insufficient capital.
Regulatory Enforcement Authority.
Federal banking law grants substantial enforcement powers to federal banking regulators. This
enforcement authority
includes, among other things, the ability to assess civil money penalties, to issue cease-and-desist or removal orders and to initiate injunctive actions against banking
organizations and institution-affiliated parties. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or
inactions may provide the basis for enforcement action, including misleading or untimely reports filed with regulatory authorities.
As
a result of the volatility and instability in the financial system in recent years, the Congress, the bank regulatory authorities and other government agencies have called for or
proposed additional regulation and restrictions on the activities, practices and operations of banks and their holding companies. While many of these proposals relate to institutions that have
accepted investments from, or sold troubled assets to, the Department of the Treasury or other government agencies, or otherwise participate in government programs intended to promote financial
stabilization, the Congress and the federal banking agencies have broad authority to require all banks and holding companies to adhere to more rigorous or costly operating procedures, corporate
governance procedures, or to engage in activities or practices which they would not otherwise elect. Any such requirement could adversely affect the Company's business and results of operations.
The Dodd-Frank Act.
The financial crisis of 2008, including the downturn of global economic, financial and money markets and the threat
of collapse of numerous financial institutions, and other recent events have led to the adoption of numerous new laws and regulations that apply to, and focus on, financial institutions. The most
significant of these new laws is the Dodd-Frank Act, which makes significant changes to the current bank regulatory structure and affects the lending, deposit, investment, trading and
operating activities of financial institutions and their holding companies. The Dodd-Frank Act requires a number of federal agencies to adopt a broad range of new rules and regulations,
and to prepare various studies and reports for Congress. The federal agencies are given significant discretion in drafting these rules and regulations, and consequently, many of the details and much
of the impact of the Dodd-Frank Act may not be known for some time. Although it is not possible to determine the ultimate impact of this statute until the extensive rulemaking is complete
and becomes effective, the following provisions are considered to be of greatest significance to the Company:
-
-
Expands the authority of the Federal Reserve Board to examine bank holding companies and their subsidiaries, including
insured depository institutions.
-
-
Requires a bank holding company to be well capitalized and well managed to receive approval of an interstate bank
acquisition.
-
-
Provides mortgage reform provisions regarding a customer's ability to pay and making more loans subject to provisions for
higher-cost loans and new disclosures.
-
-
Creates a new Consumer Financial Protection Bureau ("CFPB") that will have rulemaking authority for a wide range of
consumer protection laws that would apply to all banks and would have broad powers to supervise and enforce consumer protection laws.
-
-
Creates the Financial Stability Oversight Council with authority to identify institutions and practices that might pose a
systemic risk.
-
-
Introduces additional corporate governance and executive compensation requirements on companies subject to the 1934 Act,
as amended.
-
-
Permits FDIC-insured banks to pay interest on business demand deposits.
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-
-
Codifies the requirement that holding companies and other companies that directly or indirectly control an insured
depository institution to serve as a source of financial strength.
-
-
Makes permanent the $250 thousand limit for federal deposit insurance.
-
-
Permits national and state banks to establish interstate branches to the same extent as the branch host state allows
establishment of in-state branches.
Consumer Financial Protection Bureau.
The Dodd-Frank Act created the CFPB, a new, independent federal agency within the Federal Reserve
System having broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real
Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Practices Act, the consumer financial privacy provisions of the Gramm-Leach-Bliley Act and certain other statutes. The
CFPB, which began operations on July 21, 2011, has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets. Smaller
institutions, including the Bank, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for compliance with federal consumer protection
laws and regulations. The CFPB also has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The
Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state
attorneys general to enforce compliance with both the state and federal laws and regulations.
The
CFPB has proposed or issued a number of important rules affecting a wide range of consumer financial products. Many of these rules have not been implemented, which has created
significant uncertainty for the Company and the financial services industry in general. It is difficult to predict at this time the specific impact the Dodd-Frank Act and CFPB rulemakings
will have on our busin ess. The changes resulting from the Dodd-Frank Act and CFPB rulemakings may impact the profitability of our business activities, limit our ability to make, or the
desirability of making, certain types of loans, including non-qualified mortgage loans, require us to change certain of our business practices, impose upon us more stringent capital,
liquidity and leverage ratio requirements or otherwise adversely affect our business or profitability. The changes may also require us to dedicate significant management attention and resources to
evaluate and make necessary changes to comply with the new statutory and regulatory requirements.
FDIC Insurance Premiums.
The FDIC maintains a risk-based assessment system for determining deposit insurance premiums. Four risk
categories (I-IV), each subject to different premium rates, are established based upon an institution's status as well capitalized, adequately capitalized or undercapitalized, and the
institution's supervisory rating. An insured institution is required to pay deposit insurance premiums on its assessment base in accordance with its risk category. There are three adjustments that can
be made to an institution's initial base assessment rate: (1) a potential decrease for long-term unsecured debt, including senior and subordinated debt and, for small institutions,
a portion of Tier 1 capital; (2) a potential increase for secured liabilities above a threshold amount; and (3) for non-Risk Category I institutions, a
potential increase for brokered deposits above a threshold amount. The FDIC may also impose special assessments from time to time.
The
Dodd-Frank Act permanently increased the maximum deposit insurance amount for banks, savings institutions and credit unions to $250,000 per depositor, and extended
unlimited deposit insurance to noninterest bearing transaction accounts through December 31, 2012. The Dodd-Frank Act also broadened the base for FDIC insurance assessments.
Assessments are now based on a financial institution's average consolidated total assets less tangible equity capital. The Dodd-Frank Act requires the FDIC to increase the reserve ratio of
the Deposit Insurance Fund from 1.15% to 1.35% of insured deposits by 2020 and eliminates the requirement that the FDIC pay dividends to insured depository institutions when the reserve ratio exceeds
certain thresholds. The Dodd-Frank Act eliminated the statutory prohibition against the payment of interest on business checking accounts, effective in July 2011.
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ITEM 1A. RISK FACTORS
An investment in our common stock involves a high degree of risk. Before making an investment decision, you
should carefully read and consider the risk factors described below as well as the other information included in this report and other documents we file with the SEC, as the same may be updated from
time to time. Any of these risks, if they actually occur, could materially adversely affect our business, financial condition, and results of operations. Additional risks and uncertainties not
currently known to us or that we currently deem to be immaterial may also materially and adversely affect us. In any such case, you could lose all or a portion of your original
investment.
The price of our common stock may fluctuate significantly, which may make it difficult for investors to resell shares of common stock at time or prices they find attractive.
Our stock price may fluctuate significantly as a result of a variety of factors, many of which are beyond our control. These factors
include:
-
-
Actual or anticipated quarterly fluctuations in our operating results and financial condition;
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Changes in financial estimates or publication of research reports and recommendations by financial analysts or actions
taken by rating agencies with respect to us or other financial institutions;
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Speculation in the press or investment community generally or relating to our reputation or the financial services
industry;
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Strategic actions by us or our competitors, such as acquisitions, restructurings, dispositions or financings;
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Fluctuations in the stock price and operating results of our competitors;
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Future sales of our equity or equity-related securities;
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Proposed or adopted regulatory changes or developments;
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Anticipated or pending investigations, proceedings, or litigation that involve or affect us;
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Domestic and international economic factors unrelated to our performance; and
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General market conditions and, in particular, developments related to market conditions for the financial services
industry.
In
addition, in recent years, the stock market in general has experienced extreme price and volume fluctuations. This volatility has had a significant effect on the market price of
securities issued by many companies, including for reasons unrelated to their operating performance. These broad market fluctuations may adversely affect our stock price, notwithstanding our operating
results. We expect that the market price of our common stock will continue to fluctuate and there can be no assurances about the levels of the market prices for our common stock.
Trading in the common stock has been moderate. As a result, shareholders may not be able to quickly and easily sell their common stock, particularly in large quantities.
Although our common stock is listed for trading on the NASDAQ Capital Market and a number of brokers offer to make a market in the
common stock on a regular basis, trading volume to date has been limited, averaging approximately 53,810 shares per day during 2012, and there can be no assurance that a continuously active and liquid
market for the common stock can be maintained. As a result, shareholders may find it difficult to sell a significant number of shares at the prevailing market price.
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Our ability to pay dividends on the common stock, or repurchase shares of common stock may be limited.
Although no dividend is currently being paid on the common stock, under the terms of the our Senior Non-Cumulative
Perpetual Preferred Stock, Series B (the "Series B Preferred Stock") issued under the Small Business Lending Fund Program (the "SBLF"), our ability to declare or pay dividends or
distributions on, or purchase, redeem or otherwise acquire for consideration, shares of common stock is subject to restrictions. No repurchases of common stock may be effected, and no dividends may be
declared or paid on the common stock during the current quarter and for the next three quarters following the failure to declare and pay dividends on the Series B Preferred Stock.
Under
the terms of the Series B Preferred Stock, the Company may only declare and pay a dividend on the common stock, or repurchase shares of any such class or series of stock,
if, after payment of such dividend, the dollar amount of the Company's Tier 1 Capital would be at least 90% of the Signing Date Tier 1 Capital, as set forth in the Articles Supplementary
relating to the Series B Preferred Stock, excluding any subsequent net charge-offs and any redemption of the Series B Preferred Stock (the "Tier 1 Dividend
Threshold"). The Tier 1 Dividend Threshold is subject to reduction, beginning on the second anniversary of issuance and ending on the tenth anniversary, by 10% for each one percent increase in
QSBL over the baseline level. See "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Common Equity" at page 32 for additional information on limitations
of our ability to pay dividends.
We may issue additional equity securities, or engage in other transactions which dilute our book value or affect the priority of the common stock, which may adversely affect
the market price of our common stock.
Our board of directors may determine from time to time that we need to raise additional capital by issuing additional shares of our
common stock or other securities. We are not restricted from issuing additional shares of common stock, including securities that are convertible into or exchangeable for, or that represent the right
to receive, common stock. Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the
amount, timing or nature of any future offerings, or the prices at which such offerings may be affected. Such offerings, including an offering to fund the redemption of our Series B Preferred
Stock, could be dilutive to common shareholders. New investors also may have rights, preferences and privileges that are senior to, and that adversely affect, our then current common shareholders.
Additionally, if we raise additional capital by making additional offerings of debt or preferred equity securities, upon liquidation, holders of our debt securities and shares of preferred stock, and
lenders with respect to other borrowings, will receive distributions of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our
existing shareholders or reduce the market price of our common stock, or both. Holders of our common stock are not entitled to preemptive rights or other protections against dilution.
Directors and executive officers of the Company own approximately 12.7% of the outstanding common stock. As a result of their combined ownership, they could make it more
difficult to obtain approval for some matters submitted to shareholder vote, including acquisitions of the Company. The results of the vote may be contrary to the desires or interests of the public
shareholders.
Directors and executive officers of the Company and their affiliates own approximately 12.7% of the outstanding shares of common stock,
excluding shares which may be acquired upon the exercise of options. By voting against a proposal submitted to shareholders, the directors and officers, as a group, may be able to make approval more
difficult for proposals requiring the vote of shareholders, such as some mergers, share exchanges, asset sales, and amendments to the articles of incorporation.
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Substantial regulatory limitations on changes of control and anti-takeover provisions of Maryland law may make it more difficult for you to receive a change in
control premium.
With certain limited exceptions, federal regulations prohibit a person or company or a group of persons deemed to be "acting in
concert" from, directly or indirectly, acquiring more than 10% (5% if the acquirer is a bank holding company) of any class of our voting stock or obtaining the ability to control in any manner the
election of a majority of our directors or otherwise direct the management or policies of our company without prior notice or application to and the approval of the Federal Reserve Board. There are
comparable prior approval requirements for changes in control under Maryland law. Also, Maryland corporate law contains several provisions that may make it more difficult for a third party to acquire
control of the Company without the approval of the Company's board of directors, and may make it more difficult or expensive for a third party to acquire a majority of our outstanding common stock.
The current economic environment poses significant challenges for us and could adversely affect our financial condition and results of operations.
The Company is operating in a challenging and uncertain economic environment. Financial institutions continue to be affected by
softness in the real estate market and
constrained financial markets, highlighted by historically low market interest rates. Dramatic declines in the housing market over the past years, with falling home prices and high levels of
foreclosures and unemployment, have resulted in significant write-downs of asset values by financial institutions, although such conditions in the past year have been less severe than in 2010 and
2011. While conditions appear to have begun to improve, generally and in the Company's market area, should declines in real estate values, home sales volumes, and financial stress on borrowers as a
result of the uncertain economic environment re-emerge, such events could have an adverse effect on our borrowers or their customers, which could adversely affect our financial condition
and results of operations. A worsening of these conditions would likely exacerbate the adverse effects on the Company and others in the financial institutions industry. For example, further
deterioration in local economic conditions in our market could drive losses beyond that which is provided for in our allowance for loan losses. The Company may also face the following risks in
connection with these events:
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Economic conditions that negatively affect housing prices and the job market (including loss of federal and local
government jobs in our marketplace) may result in a deterioration in credit quality of our loan portfolios, and such deterioration in credit quality has had, and could continue to have, a negative
impact on our business;
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Market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing
increases in delinquencies and default rates on loans and other credit facilities;
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The methodologies we use to establish our allowance for loan losses may no longer be reliable because they rely on complex
judgments, including forecasts of economic conditions, which may no longer be capable of accurate estimation;
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Continued turmoil in the market, and loss of confidence in the banking system, could require the Bank to pay higher
interest rates to obtain deposits to meet the needs of its depositors and borrowers, resulting in reduced margin and net interest income. If conditions worsen significantly, it is possible that banks
such as the Bank may be unable to meet the needs of their depositors and borrowers, which could, in the worst case, result in the Bank being placed into receivership; and
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Compliance with increased regulation of the banking industry may increase our costs, limit our ability to pursue business
opportunities, and divert management efforts.
If
these conditions or similar ones continue to exist or worsen, the Company could experience continuing or increased adverse effects on its financial condition.
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Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are
required to increase our allowance for loan losses.
Historically, we have enjoyed a relatively low level of nonperforming assets and net charge-offs, both in absolute dollars,
as a percentage of loans and as compared to many of our peer institutions. As a result of this historical experience, we have incurred a relatively lower loan loss provision expense, which has
positively impacted our earnings. However, experience in the banking industry indicates that a portion of our loans will become delinquent, that some of our loans may only be partially repaid or may
never be repaid and we may experience other losses for reasons beyond our control. Despite our underwriting criteria and historical experience, we may be particularly susceptible to losses due to:
(1) the geographic concentration of our loans; (2) the concentration of higher risk loans, such as commercial real estate, construction and commercial and industrial loans;
(3) the relative lack of seasoning of certain of our loans. As a result, we may not be able to maintain our relatively low levels of nonperforming assets and charge-offs. Although
we believe that our allowance for loan losses is maintained at a level adequate to absorb any inherent losses in our loan portfolio, these estimates of loan losses are necessarily subjective and their
accuracy depends on the outcome of future events. If we need to make significant and unanticipated increases in our loss allowance in the future, our results of operations and financial condition
would be materially adversely affected at that time.
While
we strive to carefully monitor credit quality and to identify loans that may become nonperforming, at any time there are loans included in the portfolio that will result in losses,
but that have not been identified as nonperforming or potential problem loans. We cannot be sure that we will be able to identify deteriorating loans before they become nonperforming assets, or that
we will be able to limit losses on those loans that are identified. As a result, future additions to the allowance may be necessary.
Economic
conditions and increased uncertainty in the financial markets could adversely affect our ability to accurately assess our allowance for credit losses. Our ability to assess the
creditworthiness of our customers or to estimate the values of our assets and collateral for loans will be reduced if the models and approaches we use become less predictive of future behaviors,
valuations, assumptions or estimates. We estimate losses inherent in our credit exposure, the adequacy of our allowance for loan
losses and the values of certain assets by using estimates based on difficult, subjective, and complex judgments, including estimates as to the effects of economic conditions and how these economic
conditions might affect the ability of our borrowers to repay their loans or the value of assets.
Our continued growth depends on our ability to meet minimum regulatory capital levels. Growth and shareholder returns may be adversely affected if sources of capital are not
available to help us meet them.
While the Company had a very successful common stock raise in 2012, as we grow, we will have to maintain our regulatory capital levels
at or above the required minimum levels. If earnings do not meet our current estimates, if we incur unanticipated losses or expenses, or if we grow faster than expected, we may need to obtain
additional capital sooner than expected or we may be required to reduce our level of assets or reduce our rate of growth in order to maintain regulatory compliance. Under those circumstances net
income and the rate of growth of net income may be adversely affected. Additional issuances of equity securities could have a dilutive effect on existing shareholders.
Our results of operations, financial condition and the value of our shares may be adversely affected if we are not able to maintain our historical growth rate.
Since opening for business in 1998, our asset level has increased rapidly, including a 20% increase in 2012. Over the past five fiscal
years (2008 - 2012), our net income has increased at a compounded annual rate of 36%, with an increase in net income of 44% in 2012. We may not be able to achieve comparable
results in future years. As our asset size and earnings increase, it may become more difficult to achieve high rates of increase in assets and earnings. Additionally, it may become more difficult to
achieve
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continued
improvements in our expense levels and efficiency ratio. We may not be able to maintain the relatively low levels of nonperforming assets that we have experienced. Declines in the rate of
growth of income or assets or deposits, and increases in operating expenses or nonperforming assets may have an adverse impact on the value of the common stock.
We are subject to liquidity risk in our operations.
Liquidity risk is the possibility of being unable to meet obligations as they come due, pay deposits when withdrawn, and fund loan and
investment opportunities as they arise because of an inability to liquidate assets or obtain adequate funding on a timely basis, at a reasonable cost and within acceptable risk tolerances. If a
financial institution is unable to meet its payment obligations on a daily basis, it is subject to being placed into receivership, regardless of its capital levels. Our largest source of liquidity is
customer deposit accounts, including noninterest bearing demand deposit accounts, which at December 31, 2012, constituted 30% of our total deposits.
The
Dodd-Frank Act provided for temporary unlimited deposit insurance coverage for noninterest bearing demand deposit accounts through December 31, 2012, at no additional premium
to the bank holding the deposit. Congress did not extend this unlimited deposit insurance coverage provision past December 31, 2012, which means that deposits in such accounts in excess of the
generally applicable $250,000 coverage limit will no longer be insured. In the absence of such insurance, customers who would have uninsured deposits may decide to move their deposits to institutions
which are perceived as safer, sounder, or "too big to fail" or could elect to use other non-deposit funding products, such as repurchase agreements, that would require the Bank to pay
interest and to provide securities as collateral for the Bank's repurchase obligation. At December 31, 2012, the Bank had approximately $699 million of deposits in noninterest bearing
demand accounts that would be uninsured deposits, or 24% of our total deposits. Based on activity through February 28, 2013, the Bank has not experienced any significant loss of deposits as a
result of this law's expiration.
While
we believe that our strong earnings, capital position, relationship banking model and reputation as a safe and sound institution mitigate the risk of losing deposits now that
unlimited insurance coverage for these accounts has expired, there can be no assurance that that we will not have to replace a significant amount of deposits with alternative funding sources, such as
repurchase agreements, federal funds lines, certificates of deposit, brokered deposits, other categories of interest bearing deposits and FHLB borrowings, all of which are more expensive than
noninterest bearing deposits. While we believe that we would be able to maintain adequate liquidity at reasonable cost, the loss of a significant amount of noninterest bearing deposits could have a
material adverse affect on our earnings, net interest margin, rate of growth and stock price.
We may not be able to successfully manage continued growth.
We intend to seek further growth in the level of our assets and deposits and selectively in the number of our branches, both within our
existing footprint and possibly to expand our footprint in the Maryland and Virginia suburbs, and in Washington, D.C. We may not be able to manage increased levels of assets and liabilities, and an
expanded branch system, without increased expenses and higher levels of nonperforming assets. We may be required to make additional investments in equipment and personnel to manage higher asset levels
and loan balances and a larger branch network, which may adversely impact earnings, shareholder returns and our efficiency ratio.
Increases in operating expenses or nonperforming assets may have an adverse impact on the value of our common stock.
We may face risks with respect to future expansion or acquisition activity.
We selectively seek to expand our banking operations through limited
de novo
branching
or opportunistic acquisition activities, and expect to continue to explore such opportunities. We cannot be
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certain
that any expansion activity, through
de novo
branching, acquisition of branches of another financial institution or a whole institution, or
acquisition of nonbanking financial service companies, will prove profitable or will increase shareholder value. The success of any acquisition will depend, in part, on our ability to realize the
estimated cost savings and revenue enhancements from combining the businesses of the Company and the target company. Our ability to realize increases in revenue will depend, in part, on our ability to
retain customers and employees, and to capitalize on existing relationships for the provision of additional products and services. If our estimates turn out to be incorrect or we are not able to
successfully combine companies, the anticipated cost savings and increased revenues may not be realized fully or at all, or may take longer to realize than expected. It is possible that the
integration process could result in the loss of key employees, the disruption of each company's ongoing business or inconsistencies in standards, controls, procedures and policies that adversely
affect our ability to maintain relationships with clients and employees or to achieve the anticipated benefits of the merger. As with any combination of banking institutions, there also may be
disruptions that cause us to lose customers or cause customers to withdraw their deposits from our bank. Customers may not readily accept changes to their banking arrangements that we make as part of
or following an acquisition. Additionally, the value of an acquisition to the Company is dependent on our ability to successfully identify and estimate the magnitude of any asset quality issues of
acquired companies.
Our concentrations of loans may create a greater risk of loan defaults and losses.
A substantial portion of our loans are secured by real estate in the Washington, D.C. metropolitan area and substantially all of our
loans are to borrowers in that area. We also have a significant amount of real estate construction loans and land related loans for residential and commercial developments. At December 31,
2012, 78% of our loans were secured by real estate,
primarily commercial real estate. Management believes that the commercial real estate concentration risk is mitigated by diversification among the types and characteristics of real estate collateral
properties, sound underwriting practices, and ongoing portfolio monitoring and market analysis. Of these loans, $562.5 million, or 23% were construction and land development loans. An
additional $545.1 million, or 22% of portfolio loans, were commercial and industrial loans which are generally not secured by real estate. The repayments of these loans often depends on the
successful operation of a business or the sale or development of the underlying property and as a result, are more likely to be adversely affected by adverse conditions in the real estate market or
the economy in general. While we believe that our loan portfolio is well diversified in terms of borrowers and industries, these concentrations expose us to the risk that adverse developments in the
real estate market, or in the general economic conditions in the Washington, D.C. metropolitan area, could increase the levels of nonperforming loans and charge-offs, and reduce loan
demand. In that event, we would likely experience lower earnings or losses. Additionally, if, for any reason, economic conditions in our market area deteriorate, or there is significant volatility or
weakness in the economy or any significant sector of the area's economy, our ability to develop our business relationships may be diminished, the quality and collectability of our loans may be
adversely affected, the value of collateral may decline and loan demand may be reduced.
Commercial,
commercial real estate and construction loans tend to have larger balances than single family mortgages loans and other consumer loans. Because the loan portfolio contains a
significant number of commercial and commercial real estate and construction loans with relatively large balances, the deterioration of one or a few of these loans may cause a significant increase in
nonperforming assets. An increase in nonperforming loans could result in: a loss of earnings from these loans, an increase in the provision for loan losses, or an increase in loan
charge-offs, which could have an adverse impact on our results of operations and financial condition.
Further,
under guidance adopted by the federal banking regulators, banks which have concentrations in construction, land development or commercial real estate loans (other than loans for
majority owner occupied properties) would be expected to maintain higher levels of risk management and, potentially,
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higher
levels of capital. We may be required to maintain higher levels of capital than we would otherwise be expected to maintain as a result of our levels of construction, development and commercial
real estate loans, which may require us to obtain additional capital sooner than we would otherwise seek it, which may reduce shareholder returns.
Additionally,
through ECV, we provide subordinated financing for the acquisition, development and construction of real estate or other projects, the primary financing for which may be
provided by the Bank. These subordinated financings and the business of ECV will generally entail a higher risk profile (including lower priority and higher loan to value ratios) than loans made by
the Bank. A portion of the amount which the Company expects to receive for such loans will be payments based on the
success, sale or completion of the underlying project, and as such the income of the Company may be more volatile from period to period, based on the status of such projects. The Company may not be
able to successfully operate or manage the business of providing higher loan to value financing.
We may not be able to maintain growth in our Residential Lending department.
Over the past two years, an increasing percentage of our noninterest income has been provided by the Bank's Residential Lending
department, which originates residential mortgage loans on a pre-sold servicing released basis, for secondary market sale. The volume of loans originated and sold has increased
significantly over the past few years to $1.5 billion of loans originated in 2012 as compared to $816 million in 2011. The residential mortgage business is highly competitive, and highly
susceptible to changes in market interest rates, consumer confidence levels, employment statistics, the capacity and willingness of secondary market purchasers to acquire and hold or securitize loans,
and other factors beyond our control. Additionally, in many respects, the mortgage origination business is relationship based, and dependent on the services of individual mortgage loan officers. The
loss of services of one or more loan officers could have the effect of reducing the level of our mortgage production, or the rate of growth of production. As a result of these factors we cannot be
certain that we will not be able to continue to increase the volume or percentage of revenue or net income produced by the residential mortgage business.
Our financial condition, earnings and asset quality could be adversely affected if we are required to repurchase loans originated for sale by our Residential Lending
department.
The Bank originates residential mortgage loans for sale to secondary market investors, subject to contractually specified and limited
recourse provisions. In 2012, the Bank originated $1.5 billion and sold $1.4 billion to investors, as compared to $872 million originated and $717 million sold in 2011 and
$461 million originated and $450 million sold in 2010. Because the loans are intended to be originated within investor guidelines, designated automated underwriting and product specific
requirements as part of the loan application, the loans sold have a limited recourse provision. In general, the Bank may be required to repurchase a previously sold mortgage loan or indemnify the
investor if there is non-compliance with defined loan origination or documentation standards, including fraud, negligence, material misstatement in the loan documents or noncompliance with
applicable law. In addition, the Company may have an obligation to repurchase a loan if the mortgagor has defaulted early in the loan term. The potential mortgagor early default repurchase period is
up to approximately twelve months after sale of the loan to the investor. The recourse period for fraud, material misstatement, breach of representations and warranties, noncompliance with law, or
similar matters could be as long as the term of the loan. Mortgages subject to recourse are collateralized by single-family residential properties, have loan-to-value ratios of
80% or less, or have private mortgage insurance. From January 1, 2010 to December 31, 2012, we have only been required to repurchase a loan or indemnify a purchaser on two occasions.
However, if we become required to repurchase a significant number of loans, whether because of early default, fraud, breach of representations, material
misstatement, legal noncompliance or otherwise, our financial condition, earnings and asset quality could be adversely impacted, which could adversely impact our share price.
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Changes in interest rates and other factors beyond our control could have an adverse impact on our financial performance and results.
Our operating income and net income depend to a great extent on our net interest margin, i.e., the difference between the
interest yields we receive on loans, securities and other interest bearing assets and the interest rates we pay on interest bearing deposits and other liabilities. Net interest margin is affected by
changes in market interest rates, because different types of assets and liabilities may react differently, and at different times, to market interest rate changes. When interest bearing liabilities
mature or re-price more quickly than interest earning assets in a period, an increase in market rates of interest could reduce net interest income. Similarly, when interest earning assets
mature or re-price more quickly than interest bearing liabilities, falling interest rates could reduce net interest income. These rates are highly sensitive to many factors beyond our
control, including competition, general economic conditions and monetary and fiscal policies of various governmental and regulatory authorities, including the Federal Reserve Board.
We
attempt to manage our risk from changes in market interest rates by adjusting the rates, maturity, re-pricing, and balances of the different types of interest earning
assets and interest bearing liabilities, but interest rate risk management techniques are not exact. As a result, a rapid increase or decrease in interest rates could have an adverse effect on our net
interest margin and results of operations. At December 31, 2012, our cumulative net asset sensitive twelve month gap position was 16.41% of total assets, which includes loans currently at their
floor rates. As such, we expect modest decreases of approximately minus 0.2% and minus 6.1%, respectively, in projected net interest income and net income over a twelve month period resulting from a
100 basis point increase in rates, as loans currently at floor rates which are above the calculated contractual rate do not adjust upon a rate increase, and our residential mortgage origination and
sale volume could decline as interest rates increase. The results of our interest rate sensitivity simulation model depend upon a number of assumptions, which may not prove to be accurate. There can
be no assurance that we will be able to successfully manage our interest rate risk.
Adverse
changes in the real estate market in our market area could also have an adverse affect on our cost of funds and net interest margin, as we have a large amount of noninterest
bearing deposits related to real estate sales and development. While we expect that we would be able to replace the liquidity provided by these deposits, the replacement funds would likely be more
costly, negatively impacting earnings.
We may not be able to successfully compete with others for business.
The Washington, D.C. metropolitan area in which we operate is considered highly attractive from an economic and demographic viewpoint,
and is a highly competitive banking market. We compete for loans, deposits, and investment dollars with numerous regional and national banks, online divisions of out-of-market
banks, and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions,
mortgage brokers, and private lenders. Many competitors have substantially greater resources than us, and operate under less stringent regulatory environments. The differences in resources and
regulations may make it harder for us to compete profitably, reduce the rates that we can earn on loans and investments, increase the rates we must offer on deposits and other funds, and adversely
affect our overall financial condition and earnings.
The
Company has been very successful in developing new customer relationships by capitalizing on the reluctance of many large regional and nationwide banks to lend over the past several
years, and the demise of the commercial mortgage backed securities market and other nonbank sources of financing. These new relationships have resulted in significant increases in both loans and
deposits, and have contributed to increased earnings. As the economy improves and these competitors recommence lending, we may not be able to retain the loans and deposits produced by these new
relationships. While we believe that our relationship banking model will enable us to keep a significant percentage of these new relationships, there can be no assurance that we will be able to do so,
that we would be able to maintain
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favorable
pricing, margins and asset quality, or that we will be able to grow at the same rate we did when such alternative financing was not widely available.
Government regulation will significantly affect the Bank's business, and may result in higher costs and lower shareholder returns.
The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds
and depositors, not shareholders. The Company and Bank are regulated and supervised by the Maryland Department of Financial Regulation, the Federal Reserve Board and the FDIC. The Bank is also subject
to regulations promulgated by the CFPB. The burden imposed by federal and state regulations puts banks at a competitive disadvantage
compared to less regulated competitors such as finance companies, mortgage banking companies and leasing companies. Changes in the laws, regulations and regulatory practices affecting the banking
industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo
continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition. Federal economic and monetary
policy may also affect our ability to attract deposits and other funding sources, make loans and investments, and achieve satisfactory interest spreads.
New or changed legislation or regulation and regulatory initiatives could subject us to increased regulation, increase our costs of doing business and adversely affect us.
Changes in federal and state legislation and regulation may affect our operations. New and modified regulation, such as the
Dodd-Frank Act and Basel III, may have unforeseen or unintended consequences on our industry. The Dodd-Frank Act has implemented, and is expected to further implement,
significant changes to the U.S. financial system, including the creation of new regulatory agencies (such as the Financial Stability Oversight Council to oversee systemic risk and the CFPB to develop
and enforce rules for consumer financial products), changes in retail banking regulations, and changes to deposit insurance assessments. Additionally, proposed rules to implement Basel III would
revise risk-based and leverage capital requirements and also limit capital distributions and certain discretionary bonuses if a banking organization does not hold a "capital conservation
buffer." This additional regulation could increase our compliance costs and otherwise adversely affect our operations. The potential also exists for additional federal or state laws or regulations, or
changes in policy or interpretations, affecting many of our operations, including capital levels, lending and funding practices, insurance assessments, and liquidity standards. The effect of any such
changes and their interpretation and application by regulatory authorities cannot be predicted, may increase the Company's cost of doing business and otherwise affect our operations, may significantly
affect the markets in which the Company does business, and could have a materially adverse effect on the Company.
In
addition, recent government responses to the condition of the global financial markets and the banking industry has, among other things, increased our costs and may further increase
our costs for items such as federal deposit insurance. The FDIC insures deposits at FDIC-insured institutions, such as the Bank, up to applicable limits. The FDIC charges the insured
financial institutions premiums to maintain the Deposit Insurance Fund at a certain level. Current economic conditions have placed greater stress on the Deposit Insurance Fund due to an increase in
bank failures in which case the FDIC would pay all deposits of a failed bank up to the insured amount from the Deposit Insurance Fund. Increases in deposit insurance premiums could adversely affect
the Company's net income.
The
CFPB, which has now been in operation for over a year, has concentrated much of its rulemaking efforts on reforms related to residential mortgage transactions. In 2013, the CFPB
issued final rules related to a borrower's ability to repay and qualified mortgage standards, mortgage servicing standards, loan originator compensation standards, requirements for
high-cost mortgages, appraisal
and escrow standards and requirements for higher-priced mortgages. Several of the CFPB's rulemakings were issued in January
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2013,
and we continue to analyze their requirements to determine the impact of the rules to our businesses. During 2013, we expect the CFPB to focus its rulemaking efforts on integrating disclosure
requirements for lenders and settlement agents and expanding the scope of information lenders must report in connection with mortgage and other housing-related loan applications under the Home
Mortgage Disclosure Act. These rules include significant regulatory and compliance changes and are expected to have a broad impact on the financial services industry.
On
January 10, 2013, the CFPB issued a final rule to implement sections of the Dodd-Frank Act that will require lenders to determine whether a consumer has the ability
to repay a mortgage loan. The rule, which goes into effect on January 10, 2014, establishes certain minimum requirements for creditors when making ability to pay determinations, and establishes
certain protections from liability for mortgages meeting the definition of "qualified mortgages." Generally, the rule applies to all consumer-purpose, closed-end loans secured by a
dwelling including home-purchase loans, refinances and home equity loans-whether first or subordinate lien. The rule does not cover, among other things, home equity lines of credit or
other open-end credit; temporary or "bridge" loans with a term of 12 months or less, such as a loan to finance the initial construction of a dwelling; a construction phase of
12 months or less of a construction-to-permanent loan; and business-purpose loans, even if secured by a dwelling. The rule affords greater legal protections for lenders
making qualified mortgages that are not "higher priced." Qualified mortgages must generally satisfy detailed requirements related to product features, underwriting standards, and a points and fees
requirement whereby the total points and fees on a mortgage loan cannot exceed specified amounts or percentages of the total loan amount. Mandatory features of a qualified mortgage include:
(1) a loan term not exceeding 30 years; and (2) regular periodic payments that do not result in negative amortization, deferral of principal repayment, or a balloon payment.
Further, the rule clarifies that qualified mortgages do not include "no-doc" loans and loans with negative amortization, interest-only payments, or balloon payments. The rule
creates a special category of qualified mortgages originated by certain smaller creditors that operate in predominantly rural or underserved areas, as defined by the CFPB. Concurrently with the final
"ability to repay" rule, the CFPB released a proposal that, among other things, may define a separate category of qualified mortgages for certain smaller creditors. Our business strategy, product
offerings, and profitability may change as the rule become becomes effective and is interpreted by the regulators and courts.
On
January 17, 2013, the CFPB issued final rules containing new mortgage servicing standards which will take effect on January 10, 2014. The final rules impose new
requirements regarding force-placed insurance, mandate certain notices prior to rate adjustments on adjustable-rate mortgages, and establish requirements for periodic disclosures to borrowers. These
requirements will affect notices to be given to consumers as to delinquency, foreclosure alternatives, modification applications, interest rate adjustments and options for avoiding "force-placed"
insurance. Servicers will be prohibited from
processing foreclosures when a loan modification is pending, and must wait until a loan is more than 120 days delinquent before initiating a foreclosure action. Servicers must provide direct
and ongoing access to its personnel, and provide prompt review of any loss mitigation application. Servicers must maintain accurate and accessible mortgage records for the life of a loan and until one
year after the loan is paid off or transferred. These new standards are expected to increase the cost and compliance risks of servicing mortgage loans. While the Bank has a general practice of selling
the residential mortgage loans it originates in the secondary market, it continues to engage in servicing activities for the loans it maintains in its portfolio. We cannot predict the ultimate outcome
of these inquiries, actions, or regulatory changes or the impact that they could have on our financial condition, results of operations, or business.
While
the full impact of the Dodd-Frank Act and the CFPB rulemakings cannot be assessed until all implementing regulations are released and become effective, the
Dodd-Frank Act's extensive requirements may have a significant effect on the financial markets, and may affect the availability or terms of financing from our lender counterparties and the
availability or terms of mortgage-backed securities, both of which may have an adverse effect on our financial condition and results of operations. The CFPB's rules are
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likely
to result in increased compliance costs and fees, along with possible restrictions on our operations, any of which may have a material adverse affect on our operating results and financial
condition.
Our customers, and businesses in the Washington, D.C. metropolitan area in general, may be adversely impacted as a result of the Federal government budget sequestration.
Sequestration is the process of automatic, largely across-the board, spending reductions under which federal budgetary
resources are permanently canceled by a uniform percentage, is required pursuant to the Budget Control Act of 2011 ("BCA") or the Pay-As-You-Go-Act of
2010 under certain circumstances. While there are multiple sequestration triggers relating to the federal budget, one trigger for sequestration under the BCA is if Congress fails to enact legislation
developed by the Joint Select Committee on Deficit Reduction (the "Deficit Committee") by January 15, 2012 to reduce the federal budget by at least $1.2 trillion. This deadline was not met, and
as a result, the first spending cut was scheduled to commence on January 2, 2013, but legislation was enacted to delay its commencement to March 1, 2013. As a result of the failure to
enact a further delay or appropriate budget measures, spending cuts are scheduled to go into effect.
While
the Company does not have a significant level of loans to federal government contractors or their subcontractors, the impact of a decline in federal government spending, or a delay
in payments to such contractors, could have a ripple effect. Temporary layoffs, salary reductions or furloughs of government employees or government contractors could have adverse impacts on other
businesses in the Company's market and the general economy of the greater Washington D.C. metropolitan area, and may indirectly lead to a loss of revenues by the Company's customers, including vendors
and lessors to the federal government and government contractors or to their employees, as well as a wide variety of commercial and retail businesses.. Accordingly, sequestration could lead to
increases in past due loans, nonperforming loans, loan loss reserves, and charge offs, and a decline in liquidity.
Our operations rely on certain external vendors.
Our business is dependent on the use of outside service providers that support our day-to-day operations
including data processing and electronic communications. Our operations are exposed to risk that a service provider may not perform in accordance with established performance standards required in our
agreements for any number of reasons including equipment or network failure, a change in their senior management, their financial condition, their product line or mix and how they support existing
customers, or a simple change in their strategic focus. While we have comprehensive policies and procedures in place to mitigate risk at all phases of service provider management from selection, to
performance monitoring and renewals, the failure of a service provider to perform in accordance with contractual agreements could be disruptive to our business, which could have a material adverse
effect on our financial conditions and results of our operations.
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