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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

 

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

Commission file number: 0-20293

UNION BANKSHARES CORPORATION

(Exact name of registrant as specified in its charter)

 

VIRGINIA   54-1598552

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

212 North Main Street, P.O. Box 446, Bowling Green, Virginia 22427

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code is (804) 633-5031

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock $2 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes  ¨    No  x

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

Yes  x    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

 

Large accelerated filer  ¨   Accelerated filer  x   Non-accelerated filer  ¨

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

Yes  ¨    No  x

The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2005 was approximately $311,565,733.

The number of shares of common stock outstanding as of February 14, 2006 was 8,799,892.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be used in conjunction with the registrant’s 2006 Annual Meeting of Shareholders are incorporated into Part III of this Form 10-K.

 


 

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UNION BANKSHARES CORPORATION

FORM 10-K

INDEX

 

          PAGE

ITEM

     
PART I

Item 1.

   Business    1

Item 1A.

   Risk Factors    8

Item 1B.

   Unresolved Staff Comments    11

Item 2.

   Properties    11

Item 3.

   Legal Proceedings    12

Item 4.

   Submission of Matters to a Vote of Security Holders    12
PART II

Item 5.

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    13

Item 6.

   Selected Financial Data    14

Item 7.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    15

Item 7A.

   Quantitative and Qualitative Disclosures About Market Risk    33

Item 8.

   Financial Statements and Supplementary Data    34

Item 9.

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    65

Item 9A.

   Controls and Procedures    65

Item 9B.

   Other Information    65
PART III

Item 10.

   Directors and Executive Officers of the Registrant    66

Item 11.

   Executive Compensation    66

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    66

Item 13.

   Certain Relationships and Related Transactions    66

Item 14.

   Principal Accounting Fees and Services    66
PART IV

Item 15.

   Exhibits, Financial Statement Schedules    67

 

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PART I

Item 1. – Business

GENERAL

Union Bankshares Corporation (the “Company”) is a multi-bank holding company organized under Virginia law and registered under the Bank Holding Company Act of 1956. The Company is headquartered in Bowling Green, Virginia. The Company is committed to the delivery of financial services through its four community bank subsidiaries (the “Community Banks”) and three non-bank financial services affiliates. The Company’s Community Banks and non-bank financial services affiliates are:

Community Banks

 

Union Bank and Trust Company

   Bowling Green, Virginia

Northern Neck State Bank

   Warsaw, Virginia

Rappahannock National Bank

   Washington, Virginia

Bank of Williamsburg

   Williamsburg, Virginia

Financial Services Affiliates

 

Mortgage Capital Investors, Inc.

   Annandale, Virginia

Union Investment Services, Inc.

   Bowling Green, Virginia

Union Insurance Group, LLC

   Bowling Green, Virginia

The Company was formed in connection with the July 1993 merger of Northern Neck Bankshares Corporation and Union Bancorp, Inc. In connection with the merger, Union Bank & Trust Company (“Union Bank”) and Northern Neck State Bank became wholly owned bank subsidiaries of Union. Union Bankshares Corporation. Although the Company was formed in 1993, The Community Banks are among the oldest in Virginia. Union Bank and Rappahannock National Bank began business in 1902 and Northern Neck State Bank dates back to 1907. On September 1, 1996, King George State Bank and on July 1, 1998, Rappahannock National Bank became wholly-owned subsidiaries of the Company. On February 22, 1999, the Bank of Williamsburg began business as a newly organized bank. In June 1999, King George State Bank was merged into Union Bank and ceased to be a subsidiary bank. The Company acquired Guaranty Financial Corporation and its wholly owned subsidiary, Guaranty Bank (“Guaranty”) on May 1, 2004 operating it as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank.

Each of the Community Banks is a full service retail commercial bank offering consumers and businesses a wide range of banking and related financial services, including checking, savings, certificates of deposit and other depository services, as well as loans for commercial, industrial, residential mortgage and consumer purposes. The Community Banks also issue credit cards and deliver automated teller machine services through the use of reciprocally shared ATMs in the major ATM networks. All of the Community Banks offer Internet banking access for banking services and online bill payment for both consumers and commercial companies.

The Company is one of the largest community banking organizations based in Virginia, providing full service banking to the Central, Rappahannock, Williamsburg and Northern Neck regions of Virginia through 45 locations of its bank subsidiaries. Union Bank currently has 32 locations in the counties of Albemarle, Caroline, Chesterfield, Fluvanna, Hanover, Henrico, King George, King William, Nelson, Spotsylvania, Stafford, Westmoreland and the Cities of Charlottesville and Fredericksburg; Northern Neck State Bank has nine locations in the counties of Essex, Lancaster, Northumberland, Richmond and Westmoreland; Rappahannock National Bank in Washington, Virginia and Bank of Williamsburg, has two locations in Williamsburg and one in Newport News. Effective March 6, 2006, Bank of Williamsburg

 

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will change its name to Bay Community Bank. Addtionally, Union Bank operates a loan production office in Manassas.

The Company provides other financial services through its non-bank affiliates, Union Investment Services, Inc., Mortgage Capital Investors, Inc. (“MCII”) and Union Insurance Group, LLC. The Bank of Williamsburg also owns a non-controlling interest in Johnson Mortgage Company, LLC.

Union Investment Services has provided securities, brokerage and investment advisory services since its formation in February 1993. It has five offices within the Community Banks trade area. It is a full service investment company handling all aspects of wealth management including stocks, bonds, annuities, mutual funds and financial planning.

On February 11, 1999, the Company acquired CMK Corporation t/a “Mortgage Capital Investors, Inc.” a mortgage loan brokerage company headquartered in Springfield, Virginia, by merger of CMK Corporation into MCII, later to become a wholly owned subsidiary of Union Bank. MCII has nine offices located in Virginia (five), Maryland (three) and South Carolina (one), and is also licensed to do business in Washington, D.C. It provides a variety of mortgage products to customers in those states. The mortgage loans originated by MCII are generally sold in the secondary market through purchase agreements with institutional investors.

On August 31, 2003, the Company formed Union Insurance Group, LLC (“UIG”), an insurance agency, in which each of the subsidiary banks owns a proportionate stake based on asset size. This agency operates in a joint venture with Bankers Insurance, LLC, a large insurance agency owned by community banks across Virginia and managed by the Virginia Bankers Association. UIG generates revenue through sales of various insurance products, including long term care insurance and business owner policies.

The Company had assets of $1.8 billion, deposits of $1.5 billion and stockholders’ equity of $179.4 million at December 31, 2005. The Community Banks ranged in asset size from $72.7 million to $1.3 billion at December 31, 2005.

SEGMENTS

The Company has two reportable segments: its traditional full service community banking business and its mortgage loan origination business, each as described above. For more financial data and other information about each of the Company’s operating segments, refer to the “Management’s Discussion and Analysis of Financial Condition and Result of Operations” section, “Community Bank Segment” and to Note 18 “Segment Reporting” in the “Notes to Consolidated Financial Statements”.

ACQUISITION PROGRAM

The Company expands its market area and increases its market share through internal growth, de novo expansion and strategic acquisitions. Strategic acquisitions by the Company to date have included whole bank acquisitions and financial affiliations, as well as branch and deposit acquisitions and purchases of former bank branch facilities. The Company generally considers acquisitions of companies in strong growth markets or with unique products or services that will benefit the entire organization. Targeted acquisitions are priced to be economically feasible with minimal short-term drag to achieve positive long-term benefits. These acquisitions may be paid for in the form of cash, stock, debt or a combination thereof. The amount and type of consideration and deal charges paid could have a dilutive short-term effect on the Company’s earnings per share or book value. However, cost savings and revenue enhancements are anticipated to provide long-term economic benefit to the Company.

During 2005 and 2004, the Company opened six branches in the greater Richmond market, one branch in 2005 and five branches in 2004. These branches compliment the existing operations and further the

 

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Company’s expansion into the Richmond market. During 2005, the Company opened another branch in Williamsburg, Virginia, bringing the Company’s total branch network in that market to three. The Company entered the Charlottesville, Virginia market when the Company acquired Guaranty on May 1, 2004, which operated as a separate subsidiary until September 13, 2004. Thereafter, the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank.

On October 31, 2005, the Company announced the signing of a definitive agreement, pursuant to which it will acquire Prosperity Bank and Trust Company (“Prosperity”) in an all cash transaction valued at $36 million. Prosperity, with nearly $130 million in assets, operates three offices in Springfield, Virginia, located in affluent Fairfax County, a suburb of Washington, D.C. Upon completion of the transaction, the Company will have total assets exceeding $2 billion. The acquisition is expected to close on or about April 1, 2006 with back office data conversion scheduled for September 2006.

EMPLOYEES

As of December 31, 2005, the Company had 589 full-time equivalent employees, including executive officers, loan and other banking officers, branch personnel, operations personnel and other support personnel. None of the Company’s employees is represented by a union or covered under a collective bargaining agreement. Management of the Company considers their employee relations to be excellent.

COMPETITION

The financial services industry remains highly competitive and is constantly evolving. The Company experiences strong competition in all aspects of its business. In its market areas, the Company competes with large national and regional financial institutions, credit unions and other independent community banks, as well as credit unions, consumer finance companies, mortgage companies, loan production offices, mutual funds and life insurance companies. Competition has increasingly come from out-of-state banks through their acquisitions of Virginia-based banks. Competition for deposits and loans is affected by various factors including interest rates offered, the number and location of branches and types of products offered, as well as the reputation of the institution. In addition, credit unions have been allowed to increasingly expand their membership definitions and to offer more attractive loan and deposit pricing due to their favorable tax status. The Company’s non-bank financial services affiliates also operate in highly competitive environments.

The Company is headquartered in Bowling Green, Virginia and is one of the largest independent bank holding companies in Virginia. The Company believes its community bank framework and philosophy provide a competitive advantage, particularly with regards to larger national and regional institutions, allowing the Company to compete effectively in the markets it serves. The Company’s Community Banks generally have strong and growing market shares within the markets they serve. The Company’s deposit market share in Virginia was 1.28% and 0.86 % as June 2005 and 2004, respectively. The increase of 42 basis points is largely a result of the 2004 Guaranty acquisition and the Company’s penetration in existing and new markets within the state.

SUPERVISION AND REGULATION

Bank holding companies and banks are extensively and increasingly regulated under both federal and state law. The following description briefly addresses certain provisions of federal and state laws as well as certain regulations and proposed regulations along with the potential impact of such provisions on the Company and the Community Banks. To the extent statutory or regulatory provisions or proposals are described herein, the description is qualified in its entirety by reference to the particular statutory or regulatory provisions or proposals.

 

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Bank Holding Companies

As a bank holding company registered under the Bank Holding Company Act of 1956 (the “BHCA”), the Company is subject to regulation by the Board of Governors of the Federal Reserve System (the “Federal Reserve”). The Federal Reserve has jurisdiction under the BHCA to approve any bank or non-bank acquisition, merger or consolidation proposed by a bank holding company. The BHCA generally limits the activities of a bank holding company and its subsidiaries to that of banking, managing or controlling banks, or any other activity that is so closely related to banking or to managing or controlling banks as to be a proper incident thereto.

Since September 1995, the BHCA has permitted bank holding companies from any state to acquire banks and bank holding companies located in any other state, subject to certain conditions, including nationwide and state imposed concentration limits. Banks are also able to branch across state lines, provided certain conditions are met, including that applicable state law must expressly permit such interstate branching. Virginia has adopted legislation that permits branching across state lines, provided there is reciprocity with the state in which the out-of-state bank is based. The Company has no plans to branch outside of the Commonwealth of Virginia.

There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy. Collectively, these are designed to reduce potential loss exposure to the depositors of such depository institutions and to the Federal Deposit Insurance Corporation (the “FDIC”) insurance funds in the event the depository institution becomes in danger of default or is in default. For example, under a policy of the Federal Reserve with respect to bank holding company operations, a bank holding company is required to serve as a source of financial strength to its subsidiary depository institutions and to commit resources to support such institutions in circumstances where it might not do so absent such policy. In addition, the “cross-guarantee” provisions of federal law require insured depository institutions under common control to reimburse the FDIC for any loss suffered or reasonably anticipated by either the Savings Association Insurance Fund (“SAIF”) or the Bank Insurance Fund (“BIF”) as a result of the default of a commonly controlled insured depository institution in danger of default. The FDIC may decline to enforce the cross-guarantee provisions if it determines that a waiver is in the best interest of the SAIF or the BIF or both. The FDIC’s claim for damages is superior to claims of stockholders of the insured depository institution or its holding company but is subordinate to claims of depositors, secured creditors and holders of subordinated debt (other than affiliates) of the commonly controlled insured depository institutions.

The Federal Deposit Insurance Act (the “FDIA”) also provides that amounts received from the liquidation or other resolution of any insured depository institution by any receiver must be distributed (after payment of secured claims) to pay the deposit liabilities of the institution prior to payment of any other general creditor or stockholder. This provision would give depositors a preference over general and subordinated creditors and stockholders in the event a receiver is appointed to distribute the assets of such depository institutions.

The Company is registered under the bank holding company laws of Virginia. Accordingly, the Company and the Community Banks (other than Rappahannock National Bank, which is federally regulated) are subject to regulation and supervision by the State Corporation Commission of Virginia (the “SCC”) and the Federal Reserve. Rappahannock National Bank is subject to regulation and supervision by the Office of the Comptroller of the Currency (the “OCC”).

Capital Requirements

The Federal Reserve, the OCC and the FDIC have issued substantially similar risk-based and leverage capital guidelines applicable to United States banking organizations. In addition, those regulatory agencies may from time to time require that a banking organization maintain capital above the minimum

 

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levels because of its financial condition or actual or anticipated growth. Under the risk-based capital requirements of these federal bank regulatory agencies, the Company and each of the Community Banks are required to maintain a minimum ratio of total capital to risk-weighted assets of at least 8%. At least half of the total capital is required to be “Tier 1 capital”, which consists principally of common and certain qualifying preferred shareholders’ equity (including Trust Preferred Securities), less certain intangibles and other adjustments. The remainder (“Tier 2 capital”) consists of a limited amount of subordinated and other qualifying debt (including certain hybrid capital instruments) and a limited amount of the general loan loss allowance. The Tier 1 and total capital to risk-weighted asset ratios of the Company as of December 31, 2005 were 10.97% and 12.14%, respectively, exceeding the minimum requirements.

In addition, each of the federal regulatory agencies has established a minimum leverage capital ratio (Tier 1 capital to average adjusted assets) (“Tier 1 leverage ratio”). These guidelines provide for a minimum Tier 1 leverage ratio of 4% for banks and bank holding companies that meet certain specified criteria, including that they have the highest regulatory examination rating and are not contemplating significant growth or expansion. The Tier 1 leverage ratio of the Company as of December 31, 2005, was 9.09%, which is above the minimum requirements. The guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Limits on Dividends and Other Payments

The Company is a legal entity, separate and distinct from its subsidiary institutions. A significant portion of the revenues of the Company result from dividends paid to it by the Community Banks. There are various legal limitations applicable to the payment of dividends by the Community Banks to the Company, as well as the payment of dividends by the Company to its respective shareholders.

The Community Banks are subject to various statutory restrictions on their ability to pay dividends to the Company. Under the current supervisory practices of the Community Banks’ regulatory agencies, prior approval from those agencies is required if cash dividends declared in any given year exceed net income for that year, plus retained net profits of the two preceding years. The payment of dividends by the Community Banks or the Company may also be limited by other factors, such as requirements to maintain capital above regulatory guidelines. Bank regulatory agencies have the authority to prohibit the Community Banks or the Company from engaging in an unsafe or unsound practice in conducting their business. The payment of dividends, depending on the financial condition of the Community Banks, or the Company, could be deemed to constitute such an unsafe or unsound practice.

Under the FDIA, insured depository institutions such as the Community Banks are prohibited from making capital distributions, including the payment of dividends, if, after making such distribution, the institution would become “undercapitalized” (as such term is used in the statute). Based on the Community Banks’ current financial condition, the Company does not expect that this provision will have any impact on its ability to obtain dividends from the Community Banks. Non-bank subsidiaries pay the parent company dividends periodically on a non-regulated basis.

In addition to dividends it receives from the Community Banks, the Company receives management fees from its affiliated companies for various services provided to them including: data processing, item processing, loan operations, deposit operations, financial accounting, human resources, funds management, credit administration, credit support, sales and marketing, collections, facilities management, call center, legal, compliance and internal audit. These fees are charged to each subsidiary based upon various specific allocation methods measuring the estimated usage of such services by that subsidiary. The fees are eliminated from the financial statements in the consolidation process.

Under federal law, the Community Banks may not, subject to certain limited exceptions, make loans or extensions of credit to, or investments in the securities of, the Company or take securities of the Company

 

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as collateral for loans to any borrower. The Community Banks are also subject to collateral security requirements for any loans or extensions of credit permitted by such exceptions.

The Community Banks

The Community Banks are supervised and regularly examined by the Federal Reserve and the SCC, except for Rappahannock National Bank, which is examined by the OCC and SCC. The various laws and regulations administered by the regulatory agencies affect corporate practices, such as the payment of dividends, incurrence of debt and acquisition of financial institutions and other companies, and affect business practices, such as the payment of interest on deposits, the charging of interest on loans, types of business conducted and location of offices.

The Community Banks are also subject to the requirements of the Community Reinvestment Act (the “CRA”). The CRA imposes on financial institutions an affirmative and ongoing obligation to meet the credit needs of the local communities, including low- and moderate-income neighborhoods, consistent with the safe and sound operation of those institutions. Each financial institution’s efforts in meeting community credit needs currently are evaluated as part of the examination process pursuant to up to ten assessment factors. These factors also are considered in evaluating mergers, acquisitions and applications to open a branch or facility. Many of the banks’ competitors, such as credit unions, are not subject to the requirements of CRA.

As institutions with deposits insured by the BIF, the Community Banks also are subject to insurance assessments imposed by the FDIC. There is a base assessment for all institutions. In addition, the FDIC has implemented a risk-based assessment schedule, imposing assessments ranging from zero to 0.27% of an institution’s average assessment base. The actual assessment to be paid by each BIF member is based on the institution’s assessment risk classification, which is determined based on whether the institution is considered “well capitalized,” “adequately capitalized” or “undercapitalized,” as such terms have been defined in applicable federal regulations, and whether such institution is considered by its supervisory agency to be financially sound or to have supervisory concerns. In 2005, the Company paid only the base assessment rate for “well capitalized” institutions which amounted to $182 thousand in deposit insurance premiums.

Other Safety and Soundness Regulations

The federal banking agencies have broad powers under current federal law to make prompt corrective action to resolve problems of insured depository institutions. The extent of these powers depends upon whether the institutions in question are “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” All such terms are defined under uniform regulations defining such capital levels issued by each of the federal banking agencies. The Community Banks each meet the definition of being “well capitalized” as of December 31, 2005.

The Gramm-Leach-Bliley Act

Effective on March 11, 2001, the Gramm-Leach Bliley Act (the “GLB Act”) allows a bank holding company or other company to certify status as a financial holding company, which will allow such 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 to determine by regulation what other activities are financial in nature, or incidental or complementary thereto.

 

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Filings with the SEC

The Company files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission (“SEC”). These reports are posted and are available at no cost on the Company’s website, www.ubsh.com, through the Investor Relations link, as soon as reasonably practicable after the Company files such documents with the SEC. The Company’s filings are also available through the SEC’s website at www.sec.gov.

USA Patriot Act of 2001

In October, 2001, the USA Patriot Act of 2001 was enacted in response to the terrorist attacks in New York, Pennsylvania and Northern Virginia which occurred on September 11, 2001. The Patriot Act is intended is to strengthen U.S. law enforcements’ and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts. The continuing and potential impact of the Patriot Act and related regulations and policies on financial institutions of all kinds is significant and wide ranging. The Patriot Act contains sweeping anti-money laundering and financial transparency laws, and imposes various regulations, including standards for verifying client identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.

Check 21

On October 28, 2003, President Bush signed into law the Check Clearing for the 21st Century Act, also known as Check 21. Check 21 gives “substitute checks,” such as a digital image of a check and copies made from that image, the same legal standing as the original paper check. Some of the major provisions of Check 21 include:

 

    allowing check truncation without making it mandatory;

 

    demanding that every financial institution communicate to accountholders in writing a description of its substitute check processing program and their rights under the law;

 

    legalizing substitutions for and replacements of paper checks without agreement from consumers;

 

    retaining in place the previously mandated electronic collection and return of checks between financial institutions only when individual agreements are in place;

 

    requiring that when accountholders request verification, financial institutions produce the original check (or a copy that accurately represents the original) and demonstrate that the account debit was accurate and valid; and

 

    requiring recrediting of funds to an individual’s account on the next business day after a consumer proves that the financial institution has erred.

This legislation will likely affect capital spending as many financial institutions assess whether technological or operational changes are necessary to stay competitive and take advantage of the new opportunities presented by Check 21.

 

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Effect of Governmental Monetary Policies

The Company’s operations are affected not only by general economic conditions, but also by the policies of various regulatory authorities. In particular, the Federal Reserve regulates money and credit conditions and interest rates in order to influence general economic conditions. These policies have a significant influence on overall growth and distribution of loans, investments and deposits, and affect interest rates charged on loans or paid for time and savings deposits. Federal Reserve monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to do so in the future. We are unable to predict the effect of possible changes in monetary policies upon the future operating results of the Company.

Proposed Legislation and Regulatory Action

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations, and competitive relationships of the nation’s financial institutions. The Company cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which the Company’s business may be affected by any new regulation or statute.

Item 1A. – Risk Factors

General economic conditions, either national or within the Company’s local markets.

The Company is affected by general economic conditions in the United States and the local markets within which it operates. An economic downturn within the Company’s footprint or the nation as a whole. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond the Company’s control could negatively impact the growth rate of loans (including mortgage originations) and deposits, the quality of the loan portfolio, loan and deposit pricing and other key drivers of the Company’s business. Such negative developments could adversely impact the Company’s financial condition and performance.

Changes in interest rates could affect the Company’s income and cashflows.

The Company’s income and cash flows depend to a great extent on the difference between the interest rates earned on interest-earning assets such as loans and investment securities, and the interest rates paid on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors that are beyond the Company’s control, including general economic conditions and the policies of various governmental and regulatory agencies (in particular, the FRB). Changes in monetary policy, including changes in interest rates, will influence the origination of loans, the prepayment speed of loans, the purchase of investments, the generation of deposits and the rates received on loans and investment securities and paid on deposits or other sources of funding. The impact of these changes may be magnified if the Company does not effectively manage the relative sensitivity of its assets and liabilities to changes in market interest rates. Fluctuations in these areas may adversely affect the Company and its shareholders. Community banks are often at a competitive disadvantage in managing their cost of funds compared to the large regional, super-regional or national banks that have access to the national and international capital markets.

The Company generally seeks to maintain a neutral position in terms of the volume of assets and liabilities that mature or re-price during any period, so that it may reasonably maintain its net interest margin; however, interest rate fluctuations, loan prepayments, loan production and deposit flows are constantly changing and influence the ability to maintain a neutral position. Generally speaking, the Company’s earnings will be more sensitive to fluctuations in interest rates the greater the variance in volume of assets and liabilities that mature and re-price in any period. The extent and duration of the sensitivity will depend on the cumulative variance over time, the velocity and direction of interest rates, and whether the Company is more asset sensitive or liability sensitive. Accordingly, the Company may not be successful in maintaining a neutral position and, as a result, the Company’s net interest margin may be impacted.

 

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The Company faces substantial competition that could adversely affect the Company’s growth and/or operating results.

The Company operates in a competitive market for financial services and faces intense competition from other financial institutions both in making loans and in attracting deposits. Many of these financial institutions have been in business for many years, are significantly larger, have established customer bases, and have greater financial resources and lending limits.

The inability of the Company to successfully manage its growth or implement its growth strategy may adversely affect the result of operations and financial conditions.

The Company may not be able to successfully implement its growth strategy if unable to identify attractive markets, locations or opportunities to expand in the future. The ability to manage growth successfully also depends on whether the Company can maintain capital levels adequate to support its growth, maintain cost controls, asset quality and successfully integrate any businesses acquired into the organization.

As the Company continues to implement its growth strategy by opening new branches or acquiring branches or banks, it expects to incur increased personnel, occupancy and other operating expenses. In the case of new branches, the Company must absorb those higher expenses while it begins to generate new deposits, and there is a further time lag involved in redeploying new deposits into attractively priced loans and other higher yielding earning assets. Thus, the Company’s plans to branch could depress earnings in the short run, even if it efficiently executes a branching strategy leading to long-term financial benefits.

Difficulties in combining the operations of acquired entities with the Company’s own operations may prevent the Company from achieving the expected benefits from acquisitions.

The Company may not be able to achieve fully the strategic objectives and operating efficiencies in an acquisition. Inherent uncertainties exist in integrating the operations of an acquired entity. In addition, the markets and industries in which the Company and its potential acquisition targets operate are highly competitive. The Company may lose customers or the customers of acquired entities as a result of an acquisition. The Company also may lose key personnel, either from the acquired entity or from itself, as a result of an acquisition. These factors could contribute to the Company not achieving the expected benefits from its acquisitions within desired time frames, if at all. Future business acquisitions could be material to the Company and it may issue additional shares of common stock to pay for those acquisitions, which would dilute current shareholders’ ownership interest. Acquisitions also could require the Company to use substantial cash or other liquid assets or to incur debt. In those events, it could become more susceptible to economic downturns and competitive pressures.

The Company exposure to operational risk may adversely affect the Company.

Similar to other financial institutions, the Company is exposed to many types of operational risk, including reputational risk, legal and compliance risk, the risk of fraud or theft by employees or outsiders, unauthorized transactions by employees or operational errors, including clerical or record-keeping errors or those resulting from faulty or disabled computer or telecommunications systems.

The Company’s dependency on its management team and the unexpected loss of any of those personnel could adversely affect operations.

The Company is a customer-focused and relationship-driven organization. Future growth is expected to be driven by a large part in the relationships maintained with customers. While the Company has assembled an experienced management team, is building the depth of that team and has management development plans in place, the unexpected loss of key employees could have a material adverse effect on the Company’s business and may result in lower revenues, reducing earnings.

 

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The Company’s concentration in loans secured by real estate may adversely impact earnings due to changes in the real estate markets.

The Company offers a variety of secured loans, including commercial lines of credit, commercial term loans, real estate, construction, home equity, consumer and other loans. Many of the Company’s loans are secured by real estate (both residential and commercial) in the Company’s market area. A major change in the real estate market, resulting in deterioration in the value of this collateral, or in the local or national economy, could adversely affect the customers’ ability to pay these loans, which in turn could impact the Company. Risk of loan defaults and foreclosures are unavoidable in the banking industry, and the Company tries to limit its exposure to this risk by monitoring extensions of credit carefully. The Company cannot fully eliminate credit risk, and as a result credit losses may occur in the future.

If the Company’s allowance for loan losses becomes inadequate, the results of operations may be adversely affected.

The Company maintains an allowance for loan losses that it believes is a reasonable estimate of known and inherent losses within the loan portfolio. Through a periodic review and consideration of the loan portfolio, management determines the amount of the allowance for loan losses by considering general market conditions, credit quality of the loan portfolio, the collateral supporting the loans and performance of customers relative to their financial obligations with the Company. The amount of future losses is susceptible to changes in economic, operating and other conditions, including changes in interest rates, which may be beyond the Company’s control, and these losses may exceed current estimates. Rapidly growing loan portfolios are, by their nature, unseasoned. As a result, estimating loan loss allowances is more difficult, and may be more susceptible to changes in estimates, and to losses exceeding estimates, than more seasoned portfolios. Although the Company believes the allowance for loan losses is a reasonable estimate of known and inherent losses in the loan portfolio, it cannot fully predict such losses or that loan the loss allowance will be adequate in the future. Excessive loan losses could have a material impact on financial performance. Consistent with the loan loss reserve methodology, the Company expects to make additions to the loan loss reserve levels as a result of its growth strategy, which may affect the Company’s short-term earnings.

Federal and state regulators periodically review the allowance for loan losses and may require the Company to increase its provision for loan losses or recognize further loan charge-offs, based on judgments different than those of management. Any increase in the amount of the provision or loans charged-off as required by these regulatory agencies could have a negative effect on the Company’s operating results.

Legislative or regulatory changes or actions, or significant litigation, could adversely impact the Company or the businesses in which the Company is engaged.

The Company is subject to extensive state and federal regulation, supervision and legislation that govern almost all aspects of its operations. Laws and regulations may change from time to time and are primarily intended for the protection of consumers, depositors and the deposit insurance funds. The impact of any changes to laws and regulations or other actions by regulatory agencies may negatively impact the Company or its ability to increase the value of its business. Additionally, actions by regulatory agencies or significant litigation against the Company could cause it to devote significant time and resources to defending itself and may lead to penalties that materially affect the Company and its shareholders. Future changes in the laws or regulations or their interpretations or enforcement could be materially adverse to the Company and its shareholders.

Changes in accounting standards could impact reported earnings.

The accounting standard setters, including the FASB, SEC and other regulatory bodies, periodically change the financial accounting and reporting standards that govern the preparation of the Company’s consolidated financial statements. These changes can be hard to predict and can materially impact how it records and reports its financial condition and results of operations. In some cases, the Company could be required to apply a new or revised standard retroactively, resulting in the restatement of prior period financial statements.

 

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Item 1B. – Unresolved Staff Comments

The Company does not have any unresolved staff comments to report for the year ended December 31, 2005.

Item 2. – Properties

The Company, through its subsidiaries, owns or leases buildings that are used in the normal course of business. The corporate headquarters is located at 212 N. Main Street, Bowling Green, Virginia, in a building owned by the Company. The Company’s subsidiaries own or lease various other offices in the counties and cities in which they operate. In addition to the properties listed below, the Company is developing plans for the acquisition of land and construction of a new operations center in nearby Carmel Church, Virginia which it anticipates will be completed in the second quarter of 2007. See the “Notes to Consolidated Financial Statements” contained in Item 8, “Financial Statement and Supplementary Data”, of this Form 10-K for information with respect to the amounts at which bank premises and equipment are carried and commitments under long-term leases.

Unless otherwise indicated, the properties listed below are owned by the Company and its subsidiaries as of December 31, 2005.

Locations

 

Corporate Headquarters

  

212 North Main Street

  

Bowling Green, Virginia

Banking Offices - Union Bank and Trust Company

  

211 North Main Street

  

Bowling Green, Virginia

18048 Jefferson Davis Highway

  

Ladysmith, Virginia

U. S Route 301

  

Port Royal, Virginia

4540 Lafayette Boulevard

  

Fredericksburg, Virginia

U. S Route 1 and Ashcake Road

  

Ashland, Virginia

4210 Plank Road

  

Fredericksburg, Virginia

10415 Courthouse Road

  

Spotsylvania, Virginia

9665 Sliding Hill Road

  

Ashland, Virginia

700 Kenmore Avenue

  

Fredericksburg, Virginia

Route 360

  

Manquin, Virginia

9534 Chamberlayne Road

  

Mechanicsville, Virginia

Cambridge and Layhill Road

  

Falmouth, Virginia (leased)

Massaponax Church Road and Route 1

  

Spotsylvania, Virginia (leased)

Brock Road and Route 3

  

Spotsylvania, Virginia (leased)

2811 Fall Hill Avenue

  

Fredericksburg, Virginia

6479 Mechanicsville Turnpike

  

Mechanicsville, Virginia

10045 Kings Highway

  

King George, Virginia

840 McKinney Boulevard

  

Colonial Beach, Virginia

5510 Morris Road

  

Spotsylvania, Virginia

4690 Pouncey Tract Road

  

Glen Allen, Virginia (leased)

8300 Bell Creek Road

  

Mechanicsville, Virginia

1773 Parham Road

  

Richmond, Virginia

11101 Hull Street Road

  

Midlothian, Virginia

13644 Hull Street Road

  

Midlothian, Virginia

400 East Main Street

  

Charlottesville, Virginia (leased)

1700 Seminole Trail

  

Charlottesville, Virginia (leased)

124 Main Street

  

Lovingston, Virginia

1924 Arlington Boulevard

  

Charlottesville, Virginia (leased)

1658 State Farm Boulevard

  

Charlottesville, Virginia

5980 Thomas Jefferson Parkway

  

Palmyra, Virginia

3290 Worth Crossing

  

Charlottesville, Virginia

13700 Midlothian Turnpike

  

Midlothian, Virginia (leased)

 

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Banking Offices - Northern Neck State Bank

  

5839 Richmond Road

  

Warsaw, Virginia

4256 Richmond Road

  

Warsaw, Virginia

17191 Kings Highway

  

Montross, Virginia

1649 Tappahannock Boulevard

  

Tappahannock, Virginia

1660 Tappahannock Boulevard (Wal-Mart)

  

Tappahannock, Virginia (leased)

15043 Northumberland Highway

  

Burgess, Virginia

284 North Main Street

  

Kilmarnock, Virginia

876 Main Street

  

Reedville, Virginia

485 Chesapeake Drive

  

White Stone, Virginia

Banking Office - Rappahannock National Bank

  

7 Bank Road

  

Washington, Virginia

Banking Offices – Bank of Williamsburg

  

5125 John Tyler Highway

  

Williamsburg, Virginia

603 Pilot House Drive

  

Newport News, Virginia (leased)

171 Monticello Avenue

  

Williamsburg, Virginia (leased)

Union Investment Services, Inc.

  

111 Davis Court

  

Bowling Green, Virginia

10469 Atlee Station Road, Suite 100

  

Ashland, Virginia

2811 Fall Hill Avenue

  

Fredericksburg, Virginia

171 Monticello Avenue

  

Williamsburg, Virginia

1658 State Farm Boulevard

  

Charlottesville, Virginia

Mortgage Capital Investors, Inc. (All leased)

  

5440 Jeff Davis Highway, #103

  

Fredericksburg, Virginia

3 Hillcrest Drive #A100

  

Frederick, Maryland

7501 Greenway Center, #140

  

Greenbelt, Maryland

3120 Waccamaw Boulevard, Suite F

  

Myrtle Beach, South Carolina

6330 Newtown Road, #211

  

Norfolk, Virginia

7619 Little River Turnpike, Suite 400

  

Annandale, Virginia

12741 Darby Brooke Court, Suite 102

  

Woodbridge, Virginia

1658 State Farm Boulevard

  

Charlottesville, Virginia

10469 Atlee Station Road, Suite 120

  

Ashland, Virginia

Item 3. – Legal Proceedings

In the ordinary course of its operations, the Company and its subsidiaries are parties to various legal proceedings. Based on the information presently available, and after consultation with legal counsel, management believes that the ultimate outcome in such proceedings, in the aggregate, will not have a material adverse effect on the business or the financial condition or results of operations of the Company.

Item 4. – Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the year ended December 31, 2005.

 

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PART II

Item 5. – Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The Company’s common stock is traded on the NASDAQ National Market under the symbol “UBSH”. The Company’s common stock began trading on the NASDAQ National Market in October 1993.

There were 8,797,325 shares of the Company’s common stock outstanding at the close of business on December 31, 2005, which were held by 2,442 shareholders of record. The closing price of the Company’s stock on December 31, 2005 was $43.10 per share as compared to $38.43 on December 31, 2004.

The following table summarizes the high and low closing sales prices and dividends declared for quarterly periods during the two years ended December 31, 2005.

 

     Market Values    Dividends
Declared
     2005    2004    2005    2004
     High    Low    High    Low          

First Quarter

   $ 37.18    $ 30.74    $ 34.30    $ 30.90    $ —      $ —  

Second Quarter

     39.24      29.39      33.09      27.50      0.37      0.33

Third Quarter

     44.11      37.78      33.50      27.98      —        —  

Fourth Quarter

     49.05      38.49      40.07      30.70      0.40      0.35
                         
               $ 0.77    $ 0.68
                         

Regulatory restrictions on the ability of the Community Banks to transfer funds to the Company at December 31, 2005, are set forth in Note 17 of the Notes to the Consolidated Financial Statements contained in Item 8, Financial Statements and Supplementary Data, of this Form 10-K. A discussion of certain limitations on the ability of the Community Banks to pay dividends to the Company and the ability of the Company to pay dividends on its common stock, is set forth in Part I, Business, of this Form 10-K under the headings “Supervision and Regulation - Limits on Dividends and Other Payments” and “Supervision and Regulation - The Community Banks.”

In October of 2005, the Company announced it would begin paying its dividend on a quarterly basis instead of semi-annually starting in 2006. It is anticipated the dividends will be paid at the end of February, May, August and November of each quarter. In making its decision on the payment of dividends on the Company’s common stock, the Board of Directors considers operating results, financial condition, capital adequacy, regulatory requirements, shareholder returns and other factors.

The Board of Directors renewed authorization for the Company to buy up to 150,000 shares of its outstanding common stock in the open market at prices that management and the Board of Directors determine to be prudent. This authorization expires May 31, 2006. The Company considers current market conditions and the Company’s current capital level, in addition to other factors, when deciding whether to repurchase stock. It is anticipated that any repurchased shares will be used primarily for general corporate purposes, including the dividend reinvestment plan, incentive stock option plan and other employee benefit plans. No shares have been purchased under this authorization to date.

 

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Item 6. – Selected Financial Data

The following table sets forth selected financial data for the Company over the past five years:

 

     2005     2004     2003     2002     2001  
           (in thousands, except per share amounts)  

RESULTS OF OPERATIONS

    

Interest income

   $ 102,317     $ 80,544     $ 67,017     $ 65,205     $ 65,576  

Interest expense

     32,967       25,652       23,905       24,627       32,483  
                                        

Net interest income

     69,350       54,892       43,112       40,578       33,093  

Provision for loan losses

     1,172       2,154       2,307       2,878       2,126  
                                        

Net interest income after provision for loan losses

     68,178       52,738       40,805       37,700       30,967  

Noninterest income

     25,510       23,302       22,840       17,538       16,092  

Noninterest expenses

     58,275       51,221       40,725       35,922       32,447  
                                        

Income before income taxes

     35,413       24,819       22,920       19,316       14,612  

Income tax expense

     10,591       6,894       6,256       4,811       2,933  
                                        

Net income

   $ 24,822     $ 17,925     $ 16,664     $ 14,505     $ 11,679  
                                        

KEY PERFORMANCE RATIOS

          

Return on average assets (ROA)

     1.43 %     1.19 %     1.42 %     1.41 %     1.27 %

Return on average equity (ROE)

     14.49 %     12.18 %     14.88 %     14.91 %     13.55 %

Efficiency ratio (2)

     61.43 %     65.51 %     61.75 %     58.90 %     62.13 %

PER SHARE DATA

          

Net income per share - basic

   $ 2.83     $ 2.13     $ 2.19     $ 1.92     $ 1.55  

Net income per share - diluted

     2.81       2.11       2.17       1.90       1.55  

Cash dividends declared

     0.77       0.68       0.60       0.52       0.46  

Book value at period-end

     20.39       18.61       15.54       13.92       11.82  

FINANCIAL CONDITION

          

Total assets

   $ 1,824,958     $ 1,672,210     $ 1,234,732     $ 1,115,725     $ 983,097  

Total deposits

     1,456,515       1,314,317       999,771       897,642       784,084  

Total loans, net of unearned income

     1,362,254       1,264,841       878,267       714,764       600,164  

Stockholders’ equity

     179,358       162,758       118,501       105,492       88,979  

ASSET QUALITY

          

Allowance for loan losses

   $ 17,116     $ 16,384     $ 11,519     $ 9,179     $ 7,336  

Allowance as % of total loans

     1.26 %     1.30 %     1.31 %     1.28 %     1.22 %

OTHER DATA

          

Market value per share at period-end

   $ 43.10     $ 38.43     $ 30.50     $ 27.25     $ 16.24  

Price to earnings ratio

     15.3       18.2       14.1       14.3       10.5  

Price to book value ratio

     211 %     207 %     196 %     196 %     137 %

Equity to assets

     9.8 %     9.7 %     9.6 %     9.5 %     9.1 %

Dividend payout ratio

     27.21 %     31.92 %     27.40 %     27.08 %     29.68 %

Weighted average shares outstanding, basic

     8,761,999       8,402,791       7,602,872       7,555,906       7,523,566  

Weighted average shares outstanding, diluted

     8,850,049       8,482,142       7,675,437       7,623,169       7,541,572  

Cash basis EPS fully diluted (1)

   $ 2.89     $ 2.19     $ 2.22     $ 1.95     $ 1.59  

Cash basis return on average tangible assets (1)

     1.51 %     1.26 %     1.45 %     1.46 %     1.31 %

Cash basis return on average tangible equity (1)

     19.57 %     15.78 %     16.08 %     16.43 %     14.99 %

 

(1) Refer to Item 7, “Management Discussion and Analysis”, section “Non GAAP Measures” for a reconciliation.

 

(2) Efficiency ratio is calculated by dividing noninterest expense into the sum of net interest income plus noninterest income.

 

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Item 7. – Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis provides information about the major components of the results of operations and financial condition, liquidity and capital resources of the Company and its subsidiaries. This discussion and analysis should be read in conjunction with the “Consolidated Financial Statements” and the “Notes to the Consolidated Financial Statements” presented in Item 8, “Financial Statements and Supplementary Data”, of this Form 10-K.

FORWARD-LOOKING STATEMENTS

Certain statements in this report may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are statements that include projections, predictions, expectations or beliefs about future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualified words (and their derivatives) such as “expect,” “believe,” “estimate,” “plan,” “project,” “anticipate” or other statements concerning opinions or judgment of the Company and its management about future events. Although the Company believes that its expectations with respect to certain forward-looking statements are based upon reasonable assumptions within the bounds of its existing knowledge of its business and operations, there can be no assurance that actual results, performance or achievements of the Company will not differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending on a variety of factors, including, but not limited to, the effects of and changes in: general economic conditions, the interest rate environment, legislative and regulatory requirements, competitive pressures, new products and delivery systems, inflation, changes in the stock and bond markets, technology, and consumer spending and savings habits. The Company does not update any forward-looking statements that may be made from time to time by or on behalf of the Company.

CRITICAL ACCOUNTING POLICIES

General

The accounting and reporting policies of the Company and its subsidiaries are in accordance with U. S. generally accepted accounting principles (“GAAP”) and conform to general practices within the banking industry. The Company’s financial position and results of operations are affected by management’s application of accounting policies, including estimates, assumptions and judgments made to arrive at the carrying value of assets and liabilities and amounts reported for revenues, expenses and related disclosures. Different assumptions in the application of these policies could result in material changes in the Company’s consolidated financial position and/or results of operations.

The more critical accounting and reporting policies include the Company’s accounting for the allowance for loan losses, goodwill and intangibles, and merger and acquisitions. The Company’s accounting policies are fundamental to understanding the Company’s consolidated financial position and consolidated results of operations. Accordingly, the Company’s significant accounting policies are discussed in detail in Note 1 in the “Notes to Consolidated Financial Statements”.

The following is a summary of the Company’s critical accounting policies that are highly dependent on estimates, assumptions and judgments.

Allowance for Loan Losses

The allowance for loan losses is an estimate of the losses that may be sustained in the loan portfolio. The allowance is based on two basic principles of accounting: (i) Statement of Financial Accounting Standard (“SFAS”) No. 5, Accounting for Contingencies, which requires that losses be accrued when occurrence is

 

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probable and estimatable and (ii) SFAS No. 114, Accounting by Creditors for Impairment of a Loan, which requires that losses be accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance.

The Company’s allowance for loan losses is the accumulation of various components that are calculated based on independent methodologies. All components of the allowance represent an estimation performed pursuant to either SFAS No. 5 or SFAS No. 114. Management’s estimate of each SFAS No. 5 component is based on certain observable data that management believes are most reflective of the underlying credit losses being estimated. This evaluation includes credit quality trends; collateral values; loan volumes; geographic, borrower and industry concentrations; seasoning of the loan portfolio; the findings of internal credit quality assessments and results from external bank regulatory examinations. These factors, as well as historical losses and current economic and business conditions, are used in developing estimated loss factors used in the calculations.

The Company adopted SFAS No. 114, which has been amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan – Income Recognition and Disclosures. SFAS No. 114, as amended, requires that the impairment of loans that have been separately identified for evaluation is to be measured based on the present value of expected future cash flows or, alternatively, the observable market price of the loans or the fair value of the collateral. However, for those loans that are collateral dependent (that is, if repayment of those loans is expected to be provided solely by the underlying collateral) and for which management has determined foreclosure is probable, the measure of impairment is to be based on the net realizable value of the collateral. SFAS No. 114, as amended, also requires certain disclosures about investments in impaired loans and the allowance for loan losses and interest income recognized on loans.

Reserves for commercial loans are determined by applying estimated loss factors to the portfolio based on management’s evaluation and “risk grading” of the commercial loan portfolio. Reserves are provided for noncommercial loan categories using estimated loss factors applied to the total outstanding loan balance of each loan category. Specific reserves are determined on a loan-by-loan basis based on management’s evaluation the Company’s exposure for each credit, given the current payment status of the loan and the net realizable value of any underlying collateral.

While management uses the best information available to establish the allowance for loan and lease losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the valuations or, if required by regulators, based upon information available to them at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels may vary from previous estimates.

Goodwill and Intangible Assets

SFAS No. 141, Business Combinations, requires the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, the Company is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review and more frequently if certain impairment indicators are in evidence. Additionally, the Company adopted SFAS 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over their estimated useful lives.

 

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Goodwill totaled $31.3 million and $31.0 million at year ended December 31, 2005 and 2004 respectively. Based on the testing of goodwill for impairment, there were no impairment charges for 2005, 2004 or 2003. Core deposit intangible assets are being amortized over the period of expected benefit, which ranges from 5 to 15 years. Core deposit intangibles, net of amortization, amounted to $8.5 million and $9.7 million at year ended December 31, 2005 and 2004, respectively. Amortization expense of core deposit intangibles for the years ended December 31, 2005, 2004 and 2003 totaled $1.2 million, $1.0 million and $571 thousand, respectively.

Mergers and Acquisitions

On May 1, 2004, the Company completed its acquisition of Guaranty, headquartered in Charlottesville, Virginia. This acquisition was accounted for using the purchase method of accounting. The total consideration paid to Guaranty stockholders in connection with the acquisition was approximately $54.9 million and was comprised of approximately $23.2 million in cash and 1,023,000 shares of the Company’s common stock. Guaranty transactions have been included in the Company’s financial results since May 1, 2004. Acquired assets on May 1, 2004 totaled $248 million, including $165 million in loans and $184 million in deposits. As part of the purchase price allocation at May 1, 2004, the Company recorded $5.8 million in core deposit intangibles and goodwill of approximately $30.1 million.

The acquisition of Guaranty fell under the guidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring.) Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. “Exit costs” are defined to include those costs recorded by Guaranty prior to the merger date and therefore are not included in the Company’s results of operations. In 2004, Guaranty recorded exit costs of $1.3 million relating to severance and costs associated with terminating contracts.

The Company’s exit costs, referred to herein as “merger-related” costs, are defined to include those costs for combining operations such as systems conversions, integration planning consultant fees and marketing consultant fees incurred by the Company prior to and after the merger date and are included in the Company’s results of operations. The Company expensed merger-related costs which totaled approximately $343 thousand for year ended December 31, 2004. The costs associated with these activities are included in noninterest expenses.

On October 31, 2005, the Company announced the signing of a definitive agreement, pursuant to which it will acquire Prosperity Bank and Trust Company (“Prosperity”) in an all cash transaction valued at $36 million. Prosperity, with nearly $130 million in assets, operates three offices in Springfield, Virginia, located in affluent Fairfax County, a suburb of Washington, D.C. Upon completion of the transaction, the Company will have total assets exceeding $2.0 billion. The acquisition is expected to close on or about April 1, 2006 with back office data conversion scheduled for September 2006.

OVERVIEW

Net income for the year 2005 was $24.8 million, up 38.5% from $17.9 million for the same period in 2004. Over this same period, earnings per share on a diluted basis increased from $2.11 to $2.81. Return on average equity for the year ended December 31, 2005 was 14.49%, while return on average assets for the same period was 1.43%, compared to 12.18% and 1.19% respectively, for the year ended December 31, 2004. Results for the first four months of 2004 do not reflect the May 1, 2004 acquisition of Guaranty.

The most significant factor impacting the Company’s operating results in 2005 was the improvement in the net interest margin. This improvement was driven by the Federal Reserve’s increase in short-term interest rates and was enhanced by the Company’s presence in strong markets which provided continued strong asset growth. Short-term rates are expected to increase slightly in 2006 which should help the

 

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Company’s net interest margin, but a flat yield curve, where the gap between short- and long-term rates is small, will put pressure on the Company’s net interest margin.

The Company’s continued expansion in both new and existing markets also impacted results for the year. Two new bank branches were opened in 2005, following the opening of five branches, and the relocation of one of the Company’s convenience store branches (to a larger traditional banking facility) in 2004. The costs associated with these branches include personnel, occupancy, marketing and other related expenses and are typically greater than the revenue generated for the first 18-24 months as the branch expands in customer base in those markets.

The Company experienced steady growth in 2005 as assets grew by 9.1% to $1.82 billion. Net loans were $1.35 billion and $1.25 billion at December 31, 2005 and 2004, respectively, an increase of $100 million. Growth occurred predominately within the commercial real estate, commercial construction, and equity line portfolios. The rising interest rate environment has improved the Company’s yield on earning assets from 5.96% to 6.53%. Total deposits increased from $1.31 billion to $1.46 billion at December 31, 2005. This increase was primarily in large certificates of deposit (those greater than $100 thousand). Demand deposits increased $28 million, which slowing the increase in the cost of funds which was up 29 basis points, from 2.23% to 2.52% year over year.

At December 31, 2005 total assets were $1.82 billion, up 9.1%, or approximately $153 million from $1.67 billion a year earlier. Securities increased to $246.0 million compared to $233.5 million for the same period. The Company’s capital position remained strong with an equity-to-assets ratio of 9.83 %.

Community Bank Segment

For the year ended December 31, 2005, the Community Bank segment net income increased $7.2 million or 43% to $23.7 million from $16.5 million at December 31, 2004. Net interest income expansion of $14.8 million, lower loan loss provisions of $1.0 million, increased noninterest income of $1.1 million, offset by $5.8 million increase in noninterest expenses drove the annual net income increase. Additionally, total assets increased $151.7 million or 9% to $1.8 billion.

The increase in net interest income of $14.8 million was primarily driven by increases in the Federal funds rate coupled with the Community Banks’ asset sensitivity. Additionally, due to the asset sensitive position, yields on interest earning assets re-priced faster than yields on interest bearing deposits. Moreover, noninterest bearing deposits increased as a percentage of deposits favorably contributing to the overall improvement in the margin.

The $1.1 million increase in noninterest income is principally a result of additional service charges and fees totaling $929 thousand, tied largely to the growing customer base. Other operating income increased $212 thousand mainly due to revenue generated from Johnson Mortgage Company, LLC and investments in Bankers Insurance Group and bank owned life insurance.

The $5.8 million or 14% increase in noninterest expense was driven by higher costs associated with salaries and benefits of $3.6 million or 18%, occupancy of $654 thousand or 23%, premises and fixed asset deprecation of $488 thousand or 16%, and other operating expenses of $1.1 million or 8%. Consulting and data processing fees decreased $780 thousand or 25% principally as a result of the 2004 Guaranty acquisition (there was no related 2005 expense), which in turn offset the increase in noninterest expense and or operating expenses.

Mortgage Segment

For the year ended December 31, 2005, the mortgage segment reported net income of $1.1 million, a decline of $0.3 million, or 20% from $1.4 million in 2004. Despite production volumes increasing from

 

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$496.2 million to $556.8 million, or 12.2%, unit levels increased only 1.2% on loan products that were less profitable than those in the prior year. Due to customer demand, the less profitable loan products became a larger percentage of production volume during 2005. Additionally, a flattening yield curve and increased competition have put pressure on profitability. Moreover, MCII’s service area has recently seen a slowdown in purchase activity compared to last year.

NET INTEREST INCOME

Net interest income, which represents the principal source of earnings for the Company, is the amount by which interest income exceeds interest expense. The net interest margin is net interest income expressed as a percentage of average earning assets. Changes in the volume and mix of interest-earning assets and interest-bearing liabilities, as well as their respective yields and rates, have a significant impact on the level of net interest income, the net interest margin and net income.

Since June 2004, there has been an increase in the Federal Funds target at each Federal Reserve Open Market Committee (“FOMC”) meeting, benefiting the Company due to its asset sensitive position. For the year ended December 31, 2005, net interest income on a FTE basis increased $14.1 million or 25% over the same period one year ago. Rising interest rates pushed yields on average earning assets up by 57 basis points, or 9.6%, on growth of $207.1 million in interest-earning assets. The cost of interest-bearing liabilities was tightly controlled, increasing 29 basis points, or 13.2%, on growth of $155.2 million in interest-bearing liabilities. The remaining margin improvement was due to growth of demand deposit accounts of $49.1 million or 25% from 2004.

For year ended December 31, 2004, loan volumes generated interest income to more than offset the decline in volume and rates in other asset categories resulting in an increase in income from earning assets on a FTE basis of $13.4 million, or 19%. At the same time, volume increases in all interest-bearing liabilities were accompanied by rate declines in all categories resulting in an increase in interest expense of only $1.7 million, or 7%. As a result, net interest income on a FTE basis increased $11.6 million, or 26%, compared to the prior year.

Based upon its asset liability management modeling, management anticipates the Company’s net interest margin will moderate at current levels. In an effort to protect its improved net interest margin and reduce its interest rate sensitivity, management will continue to closely monitor its interest rate risk as the FOMC nears the anticipated end of the current tightening cycle.

 

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The following table shows interest income on earning assets and related average yields, as well as interest expense on interest-bearing liabilities and related average rates paid for the periods indicated. Non-accrual loans are included in average loans outstanding.

 

     AVERAGE BALANCES(3) , INCOME AND EXPENSES, YIELDS AND RATES
(TAXABLE EQUIVALENT BASIS)
 
     For the years ended December 31,  
     2005     2004     2003  
     Average
Balance
    Interest
Income/
Expense
   Yield/
Rate
    Average
Balance
    Interest
Income/
Expense
   Yield/
Rate
    Average
Balance
    Interest
Income/
Expense
   Yield/
Rate
 
     (Dollars in thousands)  

Assets:

                     

Securities:

                     

Taxable

   $ 154,954     $ 7,791    5.03 %   $ 159,709     $ 7,709    4.83 %   $ 168,022     $ 8,171    4.86 %

Tax-exempt(1)

     74,936       5,677    7.58 %     80,224       6,049    7.54 %     85,506       6,594    7.71 %
                                                   

Total securities

     229,890       13,468    5.86 %     239,933       13,758    5.73 %     253,528       14,765    5.82 %

Loans, net (1) (2)

     1,315,695       88,089    6.70 %     1,104,942       67,114    6.07 %     789,934       52,266    6.62 %

Loans held for sale

     38,975       2,367    6.07 %     34,326       1,917    5.58 %     45,890       2,351    5.12 %

Federal funds sold

     11,143       349    3.13 %     8,090       102    1.26 %     16,241       138    0.85 %

Money market investments

     73       2    2.79 %     101       1    0.99 %     1,913       22    1.15 %

Interest-bearing deposits in other banks

     1,665       49    2.92 %     3,645       29    0.80 %     2,137       22    1.03 %

Other interest-bearing deposits

     2,598       81    3.13 %     1,889       33    1.75 %     —         —     
                                                   

Total earning assets

     1,600,039       104,405    6.53 %     1,392,926       82,954    5.96 %     1,109,643       69,564    6.27 %
                                 

Allowance for loan losses

     (16,687 )          (14,167 )          (10,279 )     

Total non-earning assets

     154,653            126,098            78,293       
                                       

Total assets

   $ 1,738,005          $ 1,504,857          $ 1,177,657       
                                       

Liabilities and Stockholders’ Equity:

                     

Interest-bearing deposits:

                     

Checking

   $ 198,969     $ 704    0.35 %   $ 175,659     $ 488    0.28 %   $ 136,621     $ 567    0.42 %

Money market savings

     187,673       3,174    1.69 %     159,111       1,555    0.98 %     97,368       967    0.99 %

Regular savings

     119,309       998    0.84 %     112,953       726    0.64 %     90,208       746    0.83 %

Certificates of deposit:

                     

$100,000 and over

     259,185       9,427    3.64 %     190,506       6,582    3.46 %     163,330       6,277    3.84 %

Under $ 100,000

     365,758       11,605    3.17 %     352,589       10,678    3.03 %     322,111       11,316    3.51 %
                                                   

Total interest-bearing deposits

     1,130,894       25,908    2.29 %     990,818       20,029    2.02 %     809,638       19,873    2.45 %

Other borrowings

     175,309       7,059    4.03 %     160,213       5,623    3.51 %     103,866       4,032    3.88 %
                                                   

Total interest-bearing liabilities

     1,306,203       32,967    2.52 %     1,151,031       25,652    2.23 %     913,504       23,905    2.62 %
                                       

Noninterest bearing liabilities:

                     

Demand deposits

     245,587            196,520            140,526       

Other liabilities

     14,994            10,140            11,614       
                                       

Total liabilities

     1,566,784            1,357,691            1,065,644       

Stockholders’ equity

     171,221            147,166            112,013       
                                       

Total liabilities and stockholders’ equity

   $ 1,738,005          $ 1,504,857          $ 1,177,657       
                                       

Net interest income

     $ 71,438        $ 57,302        $ 45,659   
                                 

Interest rate spread

        4.00 %        3.73 %        3.65 %

Interest expense as a percent of average earning assets

        2.06 %        1.84 %        2.15 %

Net interest margin

        4.46 %        4.11 %        4.11 %

 

(1) Income and yields are reported on a taxable equivalent basis using the statutory federal corporate tax rate of 35%

 

(2) Collection of $311 thousand in foregone interest on a previously charged off credit has been excluded.

 

(3) Includes Guaranty from acquisition date of May 1, 2004.

 

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The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates.

VOLUME AND RATE ANALYSIS* (TAXABLE EQUIVALENT BASIS)

(in thousands)

 

     Years Ended December 31,  
     2005 vs. 2004
Increase (Decrease)
Due to Changes in:
    2004 vs. 2003
Increase (Decrease)
Due to Changes in:
 
      Volume     Rate    Total     Volume     Rate     Total  

EARNING ASSETS:

             

Securities:

             

Taxable

   $ (233 )   $ 315    $ 82     $ (402 )   $ (60 )   $ (462 )

Tax-exempt

     (400 )     28      (372 )     (401 )     (144 )     (545 )

Loans, net

     13,654       7,321      20,975       19,424       (4,576 )     14,848  

Loans held for sale

     274       176      450       (631 )     197       (434 )

Federal funds sold

     51       196      247       (86 )     50       (36 )

Money market investments

     —         1      1       (19 )     (2 )     (21 )

Interest-bearing deposits in other banks

     (22 )     42      20       12       (5 )     7  

Other interest-bearing deposits

     16       32      48       33       —         33  
                                               

Total earning assets

     13,340       8,111      21,451       17,930       (4,540 )     13,390  
                                               

INTEREST-BEARING LIABILITIES:

             

Checking

     71       145      216       137       (216 )     (79 )

Money market savings

     320       1,299      1,619       603       (15 )     588  

Regular savings

     43       229      272       165       (185 )     (20 )

CDs $100,000 and over

     2,483       362      2,845       978       (673 )     305  

CDs < $100,000

     408       519      927       1,010       (1,648 )     (638 )
                                               

Total interest-bearing deposits

     3,325       2,554      5,879       2,893       (2,737 )     156  

Other borrowings

     561       875      1,436       2,009       (418 )     1,591  
                                               

Total interest-bearing liabilities

     3,886       3,429      7,315       4,902       (3,155 )     1,747  
                                               

Change in net interest income

   $ 9,454     $ 4,682    $ 14,136     $ 13,028     $ (1,385 )   $ 11,643  
                                               

 

* The change in interest, due to both rate and volume, has been allocated to change due to volume and change due to rate in proportion to the relationship of the absolute dollar amounts of the change in each.

INTEREST SENSITIVITY

An important element of earnings performance and the maintenance of sufficient liquidity is proper management of the interest sensitivity gap and liquidity gap. The interest sensitivity gap is the difference between interest-sensitive assets and interest-sensitive liabilities in a specific time interval. This gap can be managed by re-pricing assets or liabilities, which are variable rate instruments, by replacing an asset or liability at maturity or by adjusting the interest rate during the life of the asset or liability. Matching the amounts of assets and liabilities maturing in the same time interval helps to hedge interest rate risk and to minimize the impact of rising or falling interest rates on net interest income.

The Company determines the overall magnitude of interest sensitivity risk and then formulates policies and practices governing asset generation and pricing, funding sources and pricing, and off-balance sheet commitments. These decisions are based on management’s expectations regarding future interest rate movements, the state of the national, regional and local economy, and other financial and business risk factors. The Company uses computer simulation modeling to measure and monitor the effect of various interest rate scenarios and business strategies on net interest income. This modeling reflects interest rate changes and the related impact on net interest income and net income over specified time horizons.

At December 31, 2005 and 2004, the Company was in an asset sensitive position. As described in the table below, management’s simulation model indicates net interest income will increase as rates increase. An asset-sensitive company generally will be impacted favorably by increasing interest rates while a liability-sensitive company’s net interest margin and net interest income generally will be impacted favorably by declining interest rates. Although the static gap report indicates $193.1 million and $56.5 million at December 31, 2005 and 2004, respectively, more liabilities than assets re-pricing within one year, computer simulation modeling shows the Company’s net interest income tends to increase when interest rates rise and fall when interest rates decline. The explanation for this is that interest rate changes

 

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affect bank products differently. For example, if the prime rate changes by 1.00% (100 basis points or bps), the change on certificates of deposit may only be 0.75% (75 bps), while other interest bearing deposit accounts may only change 0.10% (10 bps). Also, despite their fixed terms, loan products are often refinanced as rates decline, but rarely refinanced as rates rise. Assets and liabilities re-price throughout the year resulting in changes in the earning asset rate, the cost of funds rate, and the net interest margin.

EARNINGS SIMULATION ANALYSIS

Management uses simulation analysis to measure the sensitivity of net interest income to changes in interest rates. The model calculates an earnings estimate based on current and projected balances and rates. This method is subject to the accuracy of the assumptions that underlie the process, but it provides a better analysis of the sensitivity of earnings to changes in interest rates than other analysis, such as the static gap analysis discussed above.

Assumptions used in the model are derived from historical trends and management’s outlook and include loan and deposit growth rates and projected yields and rates. Such assumptions are monitored and periodically adjusted as appropriate. All maturities, calls and prepayments in the securities portfolio are assumed to be reinvested in like instruments. Mortgage loans and mortgage backed securities prepayment assumptions are based on industry estimates of prepayment speeds for portfolios with similar coupon ranges and seasoning. Different interest rate scenarios and yield curves are used to measure the sensitivity of earnings to changing interest rates. Interest rates on different asset and liability accounts move differently when the prime rate changes and are reflected in the different rate scenarios.

The Company uses its simulation model to estimate earnings in rate environments where rates ramp up or down around a “most likely” rate scenario, based on implied forward rates. The analysis assesses the impact on net interest income over a 12-month time horizon by applying 12-month rate ramps (with interest rates rising gradually versus an immediate increase or “shock” in rates) of 50 basis points up to 200 basis points. The following table represents the interest rate sensitivity on net interest income for the Company across the rate paths modeled:

 

     Change in Net Interest Income  

Change in Yield Curve

   (Percent)     ($ in thousands)  

+200 basis points

   5.65 %   $ 4,462  

+50 basis points

   1.36 %     1,074  

Most likely rate scenario

   0.00 %     0  

-50 basis points

   -1.44 %     (1,138 )

-200 basis points

   -5.79 %     (4,567 )

 

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ECONOMIC VALUE SIMULATION

Economic value simulation is used to calculate the estimated fair value of assets and liabilities over different interest rate environments. Economic values are calculated based on discounted cash flow analysis. The net economic value of equity is the economic value of all assets minus the economic value of all liabilities. The change in net economic value over different rate environments is an indication of the longer term earnings capability of the balance sheet. The same assumptions are used in the economic value simulation as in the earnings simulation. The economic value simulation uses instantanious rate shocks to the balance sheet where the earnings simulation uses rate ramps over 12-months. The following chart reflects the estimated change in net economic value over different rate environments using economic value simulation:

 

     Change in Economic Value of Equity  

Change in Yield Curve

   (Percent)     ($ in thousands)  

+200 basis points

   0.19 %   $ 599  

+50 basis points

   0.19 %     610  

Most likely rate scenario

   0.00 %     —    

-50 basis points

   -0.93 %     (2,939 )

-200 basis points

   -6.21 %     (19,734 )

NONINTEREST INCOME

Noninterest income increased by $2.2 million, or 9.5%, from $23.3 in 2004 to $25.5 million in 2005. This increase was largely due to a $1.1 million, or 9.6% increase in gains on the sale of loans which grew to $13 million for the year. Mortgage loan originations increased 12.2%, or $60.6 million driving the increased gains on loan sales. Additionally, other service charges and fees increased $929 thousand, or 27% from $3.4 million to $4.4 million. This increase is principally due to income received from debit cards (due to increased acceptance), letters of credit, exchange fees and brokerage commissions from Union Investment Services, Inc. Service charges on deposit accounts decreased $36 thousand, but contributed $6.8 million for the year ended December 31, 2005. Other operating income increased $197 thousand or 17.4%, including income from the Bank of Williamsburg’s investment in Johnson Mortgage Company, LLC, of $92 thousand and an increase in cash surrender value of bank-owned life insurance of $71 thousand.

Noninterest income increased by $462 thousand, or 2%, from $22.8 million in 2003 to $23.3 million in 2004. This increase was relatively small due to a $1.4 million decrease in gains on sales of loans, which declined from $13.3 million in 2003 to $11.8 million in 2004. Mortgage loan originations were $496.2 million in 2004, down from $535.5 million in 2003, but there was also margin tightening attributable largely to a shift in product mix from fixed rate to adjustable rate products and increasing competitive pressures. Service charges on deposits rose 22.0% from $5.6 million to $6.8 million largely as a result of a new overdraft privilege service which the Community Banks began offering in June, 2003. Other service charges, commissions and fee income increased from $2.5 million in 2003 to $3.4 million in 2004 as net brokerage commissions were up $278 thousand, debit card income was up $218 thousand, and ATM-related fees were up $306 thousand. In addition, other operating income decreased from $1.2 million in 2003 to $1.1 million in 2004. This decrease was the result of a reduction of $205 thousand in income from the Bank of Williamsburg’s investment in Johnson Mortgage Company, LLC, partially offset by an increase in income from Bank-owned life insurance of $126 thousand.

NONINTEREST EXPENSES

Noninterest expenses were up $7.1 million or 13.8% to $58.3 million in 2005, compared to $51.2 million in 2004. Salaries and benefits were $33.6 million in 2005, up $4.4 million or 15.2% compared to $29.1 million in 2004. The increase in salary and benefits is due to the opening of additional branches, hiring support staff, increased commissions in the mortgage segment related to increased loan production, as well as compensation adjustments. Other contributing factors include increased health insurance expense and increases in profit sharing expenses correlating to the improvements in net income. Occupancy expenses were at $4.1 million, up $721 thousand from 2004. The opening of two additional branches in the current year and a full year’s expense for the Guaranty branches, accounted for approximately $535 thousand of the increase in occupancy expense. Furniture and equipment expense was $3.9 million compared to $3.4 million in 2004. This increase of $483 thousand is due to the branch expansion efforts previously mentioned, software purchases and enhancements and additional equipment maintenance. Other operating expense was $16.6 million, up $1.4 million from $15.2 million in 2004.

 

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Of the $1.4 million increase in operating expenses, approximately $527 thousand resulted from increased courier services, internet activity and communication activity with customers, $465 thousand in other bank losses related primarily to customer fraud activity, $304 thousand from media and advertising campaigns, $213 thousand related to amortizing additional core deposit intangibles related to the Guaranty acquisition, $196 thousand from increased directors’ fees as the compensation structure was modified in May 2005, $181 thousand was from increased ATM processing and placement of additional ATM machines within the Company’s existing footprint. An additional $112 thousand was due to data processing costs related to increased activity in the bankcard department. Other expense increases relate to training and seminars of $100 thousand, as well as mileage reimbursement of $75 thousand. These expenses were offset by lower data processing costs of $445 thousand and conversion charges of $326 thousand both relating to the Guaranty acquisition in 2004.

In 2004, noninterest expenses were up $10.5 million or 25.8% to $51.2 million, compared to $40.7 million in 2003. Salaries and benefits were $29.1 million in 2004, up $4.0 million or 15.9% compared to $25.1 million in 2003. Compensation expense related to the operation of the seven former Guaranty branches amounted to $1.9 million of the increase, and includes amounts related to positions which have been eliminated with the integration of the former Guaranty operation into Union Bank. The Community Bank segment’s salaries and benefits, excluding the impact of the Guaranty acquisition, were up $2.4 million from 2003 to 2004. This was the result of a full year of expenses from the addition of one new branch opened in 2003, five new branches opened in 2004, higher cost of group insurance, expanded staffing in the retail locations and merit increases. Occupancy expenses were $3.4 million, up $743 thousand over $2.7 million in 2003. The Guaranty acquisition and the five new branches accounted for $554 thousand of this increase. Equipment expense was $3.4 million versus $2.6 million in 2003, an increase of $835 thousand, of which $493 thousand was related to Guaranty ($349 thousand) and the new branches ($144 thousand). Other operating expense was $15.2 million, up $4.9 million from $10.3 million in 2003.

Consulting expenses related to the overdraft privilege service represented $576 thousand of the increase in 2004. Director expenses also increased by $231 thousand as the Company enhanced its director compensation structure and responded to the additional requirements of Sarbanes-Oxley. This included implementation of a director certification program and engagement of compensation consultants to review executive compensation. The outsourcing of data processing services in September 2003 also contributed approximately $626 thousand to the increase in other expenses in 2004. The Company’s decision to outsource this function reflects the changing face of technology and the Company’s commitment to maintain the appropriate operating foundation for future growth. Amortization of core deposit intangibles increased $439 thousand due to the Guaranty merger, and there were approximately $343 thousand in merger-related expenses including data and systems conversion, marketing, communications, and other integration costs. Marketing and advertising expense increased by $463 thousand over 2003, and other expenses including telephone expense, courier and armored car expense and postage expense were up $497 thousand compared to 2003.

LOAN PORTFOLIO

Loans, net of unearned income, totaled $1.4 billion at December 31, 2005, an increase of $97.4 million, or 7.7%, over $1.3 billion at December 31, 2004. Loans secured by real estate continue to represent the Company’s largest category, comprising 79.6% of the total loan portfolio at December 31, 2005. Residential 1-4 family loans, not including home equity lines, comprised 21.7% of total loans, at December 31, 2005, down from 22.8% in 2004. Loans secured by commercial real estate comprised 28.8% of the total loan portfolio at December 31, 2005, as compared to 29.3% in 2004, and consist of income producing properties, as well as commercial and industrial loans where real estate constitutes a secondary source of collateral. Real estate construction loans accounted for 20.1% of total loans outstanding at December 31, 2005, up significantly from 17.5% in 2004. Home equity lines were flat in 2005, comprising 7.1% of the total loan portfolio both years.

 

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Commercial business loans decreased $8.8 million in 2005, due largely to increasing interest rates. They comprised 9.3% of total loans at the end of 2005, down from 10.7% at the end of 2004. The Company’s consumer loan portfolio consists principally of installment loans. Such loans to individuals for household, family and other personal expenditures totaled 10.0% of total loans at December 31, 2005, up from 9.7% in 2004. Loans to the agricultural industry totaled less than 1.0% of the loan portfolio in each of the last five years.

The following table presents the composition of the Company’s loans (net of unearned income) in dollar amounts and as a percentage of the Company’s total gross loans as of the indicated dates:

LOAN PORTFOLIO

 

     DECEMBER 31,    % of Total  
     2005    2004    2003    2002    2001    2005     2004  
     (in thousands)             

Commercial

   $ 127,048    $ 135,907    $ 112,760    $ 78,289    $ 70,739    9.3 %   10.7 %

Loans to finance agriculture production and other loans to farmers

     884      1,591      818      1,128      4,075    0.1 %   0.1 %

Real estate:

                   

Real estate construction

     273,262      221,190      105,417      85,335      57,940    20.1 %   17.5 %

Real estate mortgage:

                   

Residential (1-4 family)

     295,809      288,358      227,450      190,427      169,426    21.7 %   22.8 %

Home equity lines

     96,490      90,042      48,034      32,320      24,474    7.1 %   7.1 %

Multi-family

     14,648      18,287      11,075      3,066      3,418    1.1 %   1.4 %

Commercial

     394,094      368,816      239,804      200,125      155,093    28.8 %   29.3 %

Agriculture

     11,145      5,530      6,745      4,466      2,497    0.8 %   0.4 %
                                               

Total real estate

     1,085,448      992,223      638,525      515,739      412,848    79.6 %   78.5 %

Loans to individuals:

                   

Consumer

     126,174      113,841      110,285      102,528      94,620    9.3 %   9.0 %

Credit card

     9,388      8,655      7,004      5,350      4,140    0.7 %   0.7 %
                                               

Total loans to individuals

     135,562      122,496      117,289      107,878      98,760    10.0 %   9.7 %

All other loans

     13,312      12,628      8,901      11,836      14,048    1.0 %   1.0 %
                                               

Total loans

     1,362,254      1,264,845      878,293      714,870      600,470    100.0 %   100.0 %

Less unearned income

     —        4      26      106      306     
                                       

Total net loans

   $ 1,362,254    $ 1,264,841    $ 878,267    $ 714,764    $ 600,164     
                                       

The following table displays the remaining maturities and type of rate (variable or fixed) on commercial and real estate constructions loans:

REMAINING MATURITIES OF SELECTED LOANS

At December 31, 2005

(in thousands)

 

     Within 1
year
   VARIABLE RATE:    FIXED RATE:    Total
maturities
        1 to 5 years    After 5
years
   Total    1 to 5 years    After 5
years
   Total   

Commercial

   $ 76,390    $ 4,156    $ 514    $ 4,670    $ 40,704    $ 5,284    $ 45,988    $ 127,048

Real Estate Construction

   $ 264,363    $ 3,481    $ —      $ 3,481    $ 2,906    $ 2,512    $ 5,418    $ 273,262

The Company is focused on providing community-based financial services and discourages the origination of portfolio loans outside of its principal trade area. The Company maintains a policy not to originate or purchase loans to foreign entities or loans classified by regulators as highly leveraged transactions. To manage the growth of the real estate loans in the loan portfolio, facilitate asset/liability management and generate additional fee income, the Company sells a portion of conforming first mortgage residential real estate loans to the secondary market as they are originated. MCII serves as a mortgage brokerage operation, selling the majority of its loan production in the secondary market or selling loans to the Community Banks that meet the banks’ current asset/liability management needs. This venture has provided the Community Bank’s customers with enhanced mortgage products and the Company with improved efficiencies through the consolidation of this function.

ASSET QUALITY - ALLOWANCE/PROVISION FOR LOAN LOSSES

The allowance for loan losses represents management’s estimate of the amount deemed adequate to provide for potential losses inherent in the loan portfolio. Among other factors, management considers the

 

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Company’s historical loss experience, the size and composition of the loan portfolio, the value and adequacy of collateral and guarantors, non-performing credits and current and anticipated economic conditions. There are additional risks of future loan losses, which cannot be precisely quantified nor attributed to particular loans or classes of loans. Because those risks include general economic trends as well as conditions affecting individual borrowers, the allowance for loan losses is an estimate. The allowance is also subject to regulatory examinations and determination as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance in comparison to peer companies identified by regulatory agencies.

Management maintains a list of loans which have a potential weakness that may need special attention. This list is used to monitor such loans and in the determination of the sufficiency of the Company’s allowance for loan losses. As of December 31, 2005, the allowance for loan losses was $17.1 million or 1.26% of total loans as compared to $16.4 million, or 1.30% in 2004. The provision for loan losses was $1.2 million in 2005 and $2.2 million in 2004. Contributing to the year to year decline in the provision for loan losses has been improved credit quality and the payout of a number of low credit quality loans. Recoveries for the year ended December 31, 2005 were lower than the same period a year ago as the Company completed, in 2004, the recovery of principal on a large loan charged-off in prior years. For the year ended December 31, 2005, approximately $311 thousand was collected in foregone interest on the aforementioned credit and recorded in interest income.

ALLOWANCE FOR LOAN LOSSES

 

     DECEMBER 31,  
     2005     2004     2003     2002     2001  
     (in thousands)  

Balance, beginning of year

   $ 16,384     $ 11,519     $ 9,179     $ 7,336     $ 7,389  

Allowance from acquired bank

     —         2,040       —         —         —    

Loans charged-off:

          

Commercial

     25       167       77       310       1,716  

Real estate

     6       5       1       —         3  

Consumer

     809       1,002       877       1,271       880  
                                        

Total loans charged-off

     840       1,174       955       1,581       2,599  
                                        

Recoveries:

          

Commercial

     43       1,388       684       245       154  

Real estate

     —         42       —         33       15  

Consumer

     357       415       304       268       251  
                                        

Total recoveries

     400       1,845       988       546       420  
                                        

Net charge-offs (recoveries)

     440       (671 )     (33 )     1,035       2,179  

Provision for loan losses

     1,172       2,154       2,307       2,878       2,126  
                                        

Balance, end of year

   $ 17,116     $ 16,384     $ 11,519     $ 9,179     $ 7,336  
                                        

Ratio of allowance for loan losses to total loans outstanding at end of year

     1.26 %     1.30 %     1.31 %     1.28 %     1.22 %

Ratio of net charge-offs (recoveries) to average loans outstanding during year

     0.03 %     -0.06 %     0.00 %     0.16 %     0.37 %

The table below shows an allocation among loan categories based upon analysis of the loan portfolio’s composition, historical loan loss experience, and other factors, as well as, the ratio of the related outstanding loan balances to total loans.

 

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ALLOCATION OF ALLOWANCE FOR LOAN LOSSES

 

      2005     2004     2003     2002     2001  
     Allowance    Percent(1)     Allowance    Percent(1)     Allowance    Percent(1)     Allowance    Percent(1)     Allowance    Percent(1)  
     (in thousands)  

December 31:

  

Commercial, financial and agriculture

   $ 4,320    9.4 %   $ 4,971    10.8 %   $ 4,500    12.9 %   $ 3,249    11.1 %   $ 2,846    12.5 %

Real estate construction

     9,229    20.0 %     7,998    17.5 %     4,176    12.0 %     3,492    11.9 %     2,205    9.7 %

Real estate mortgage

     541    59.6 %     518    61.0 %     493    60.7 %     426    60.2 %     383    59.1 %

Consumer & other

     3,026    10.9 %     2,897    10.7 %     2,350    14.4 %     2,012    16.8 %     1,902    18.7 %
                                                                 

Total

   $ 17,116    100.0 %   $ 16,384    100.0 %   $ 11,519    100.0 %   $ 9,179    100.0 %   $ 7,336    100.0 %
                                             

 

(1) Percent is loan in category divided by total loans.

NONPERFORMING ASSETS

Nonperforming assets were $11.2 million at December 31, 2005; flat compared to December 31, 2004. During 2005, foreclosed properties were fully-disposed, reducing the balance to zero from $14 thousand in 2004. The following table presents a five-year comparison of nonperforming assets:

NONPERFORMING ASSETS

 

     DECEMBER 31,  
     2005     2004     2003     2002     2001  
     (in thousands)  

Nonaccrual loans

   $ 11,255     $ 11,169     $ 9,174     $ 136     $ 915  

Foreclosed properties

     —         14       444       774       639  

Real estate investment

     —         —         —         —         129  
                                        

Total nonperforming assets

   $ 11,255     $ 11,183     $ 9,618     $ 910     $ 1,683  
                                        

Loans past due 90 days and accruing interest

   $ 150     $ 822     $ 957     $ 896     $ 2,757  
                                        

Nonperforming assets to year-end loans, foreclosed properties and real estate investment

     0.83 %     0.88 %     1.09 %     0.13 %     0.28 %

Allowance for loan losses to nonaccrual loans

     152.07 %     146.69 %     125.56 %     6749.26 %     801.75 %

Most of the nonperforming assets are secured by real estate within the Company’s trade area. Based on the estimated fair values of the related real estate, management considers these amounts to be recoverable, with any individual deficiency considered in the allowance for loan losses. At December 31, 2005, nonperforming assets totaled $11.2 million, including a single credit relationship totaling $10.8 million. The loans to this relationship are secured by real estate (two assisted living facilities and other real estate). Based on the information currently available, management has allocated $1.3 million in specific reserves to this relationship.

The Company entered into a workout agreement with the borrower in March 2004. Under the terms of the agreement, the Company extended further credit secured by additional property with significant equity. The Company continues to have constructive dialogue with the borrower toward resolution of the affiliated loans; however, bankruptcy filings by some affiliates of the borrower have delayed the accomplishment of targeted actions. The Company continues to anticipate that this workout will ultimately result in a reduction of the Company’s overall exposure to the borrower.

 

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SECURITIES AVAILABLE FOR SALE

At December 31, 2005, the Company had securities available for sale in the amount of $246.0 million or 13% of total assets, as compared to $233.5 million or 14% of total assets at December 31, 2004. The Company seeks to diversify its portfolio to minimize risk and to maintain a large amount of securities issued by states and political subdivisions due to the tax benefits. It also focuses on purchasing mortgage-backed securities because of the reinvestment opportunities from the cash flows and the higher yield offered from these securities. The investment portfolio has a high percentage of municipals and mortgage-backed securities; therefore a higher taxable equivalent yield exists on the portfolio compared to its peers. The Company does not engage in structured derivative or hedging activities. The following table sets forth a summary of the securities available for sale over the past three years:

 

     As of December 31,
     2005    2004    2003
     (in thousands)

Available-for sale securities, at fair value:

        

U.S. government and agency securities

   $ 1,935    $ 8,020    $ 11,709

Obligations of states and political subdivisions

     86,218      83,338      91,027

Corporate and other bonds

     40,779      38,673      57,219

Mortgage-backed securities

     106,706      92,923      75,023

Federal Reserve Bank stock

     2,213      2,153      688

Federal Home Loan Bank stock

     7,392      7,474      3,678

Other securities

     774      886      780
                    
   $ 246,017    $ 233,467    $ 240,124
                    

Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. The following table summarizes the contractual maturity of securities available for sale and their weighted average yields:

 

     DECEMBER 31, 2005  
     1 YEAR
OR LESS
    1-5
YEARS
    5-10
YEARS
    OVER 10
YEARS &
EQUITY
SECURITIES
    TOTAL  
     (in thousands)  

U.S. government and agency securities:

          

Amortized cost

   $ 500     $ 1,477     $ —       $ —       $ 1,977  

Fair value

     490       1,445       —         —         1,935  

Weighted average yield(1)

     2.63 %     4.01 %     —         —         3.66 %

Mortgage backed securities:

          

Amortized cost

   $ —       $ 3,950     $ 51,097     $ 53,529     $ 108,576  

Fair value

     —         3,843       50,239       52,625       106,707  

Weighted average yield(1)

     —         4.05 %     4.62 %     4.77 %     4.68 %

Obligations of states and political subdivisions:

          

Amortized cost

   $ 3,128     $ 13,367     $ 42,947     $ 24,467     $ 83,909  

Fair value

     3,129       13,477       44,408       25,204       86,218  

Weighted average yield(1)

     4.08 %     5.04 %     4.90 %     4.59 %     4.80 %

Other securities:

          

Amortized cost

   $ 4,001     $ 2,042     $ —       $ 42,734     $ 48,777  

Fair value

     4,006       2,013       —         45,138       51,157  

Weighted average yield(1)

     6.02 %     3.59 %     —         6.84 %     6.63 %

Total securities:

          

Amortized cost

   $ 7,629     $ 20,836     $ 94,044     $ 120,730     $ 243,239  

Fair value

     7,625       20,778       94,647       122,967       246,017  

Weighted average yield(1)

     5.01 %     4.64 %     4.75 %     5.47 %     5.10 %

 

(1) Yields on tax-exempt securities have been computed on a tax-equivalent basis.

DEPOSITS

Total deposits increased $142.2 million or 11% to $1.5 billion at December 31, 2005 from December 31, 2004. Total deposits consist of noninterest-bearing demand deposits of $258 million or 18% and interest-bearing deposits of $1.2 billion or 82%.

Average interest-bearing deposits increased $140.1 million or 14% to $1.1 billion year over year in all categories mentioned in the below table. Average NOW accounts and money market accounts account for 37% of the growth and increased $23.3 million or 13% and $28.6 million or 18%, respectively. Time deposits of $100,000 and over account for nearly half the growth of $140.1 million increase in aggregate average deposits and increased $68.6 million due primarily to higher interest rates in the second half of 2005. The average balance in the lowest-cost funding source or noninterest-bearing demand deposits

 

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increased by a total of $49.0 million or 25% to $245.6 million year over year. The Company has no brokered deposits. The average deposits and rates paid for the past three years and maturities of certificates of deposit of $100,000 and over as of December 31, 2005 are as follows:

AVERAGE DEPOSITS AND RATES PAID

 

     DECEMBER 31,  
     2005     2004     2003  
     AMOUNT    RATE     AMOUNT    RATE     AMOUNT    RATE  
     (in thousands)  

Noninterest-bearing demand deposits

   $ 245,587      $ 196,520      $ 141,228   

Interest-bearing deposits:

               

NOW accounts

     198,969    0.35 %     175,659    0.28 %     136,621    0.42 %

Money market accounts

     187,673    1.69 %     159,111    0.98 %     97,368    0.99 %

Savings accounts

     119,309    0.84 %     112,953    0.64 %     90,208    0.83 %

Time deposits of $100,000 and over

     259,185    3.64 %     190,506    3.46 %     163,330    3.84 %

Other time deposits

     365,758    3.17 %     352,589    3.03 %     322,111    3.51 %
                           

Total interest-bearing

     1,130,894    2.29 %     990,818    2.02 %     809,638    2.45 %
                           

Total average deposits

   $ 1,376,481      $ 1,187,338      $ 950,866   
                           

MATURITIES OF CERTIFICATES OF DEPOSIT OF $100,000 AND OVER

 

     WITHIN
3 MONTHS
   3 - 6
MONTHS
   6 - 12
MONTHS
   OVER 12
MONTHS
   TOTAL    PERCENT
OF TOTAL
DEPOSITS
 
     (in thousands)  

December 31, 2005

   $ 95,599    $ 37,064    $ 100,613    $ 100,433    $ 333,709    22.91 %

CAPITAL RESOURCES

Capital resources represent funds, earned or obtained, over which financial institutions can exercise greater or longer control in comparison with deposits and borrowed funds. The adequacy of the Company’s capital is reviewed by management on an ongoing basis with reference to size, composition, and quality of the Company’s resources and consistency with regulatory requirements and industry standards. Management seeks to maintain a capital structure that will assure an adequate level of capital to support anticipated asset growth and to absorb potential losses, yet allow management to effectively leverage its capital to maximize return to shareholders.

The Federal Reserve, along with the OCC and the FDIC, has adopted capital guidelines to supplement the existing definitions of capital for regulatory purposes and to establish minimum capital standards. Specifically, the guidelines categorize assets and off-balance sheet items into four risk-weighted categories. The minimum ratio of qualifying total assets is 8.0%, of which 4.0% must be Tier 1 capital, consisting of common equity, retained earnings and a limited amount of perpetual preferred stock, less certain intangible items. The Company had a ratio of total capital to risk-weighted assets of 12.14% and 11.63% on December 31, 2005 and 2004, respectively. The Company’s ratio of Tier 1 capital to risk-weighted assets was 10.97% and 10.41% at December 31, 2005 and 2004, respectively, allowing the Company to meet the definition of “well-capitalized” for regulatory purposes. Both of these ratios exceeded the fully phased-in capital requirements in 2005 and 2004. The Company’s current strategic plan includes a targeted equity to asset ratio between 8% and 9%. As of December 31, 2005, that ratio was 9.82%.

In connection with the acquisition of Guaranty, the Company issued trust preferred capital notes to fund the cash portion of that acquisition, which approximated $22.5 million. These debt instruments qualify for regulatory treatment as Tier 1 capital and will allow the Company to maintain its categorization as well-capitalized for regulatory purposes.

 

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ANALYSIS OF CAPITAL

 

     DECEMBER 31,  
     2005     2004     2003  
     (in thousands)  

Tier 1 capital:

      

Common stock

   $ 17,595     $ 17,488     $ 15,254  

Surplus

     35,426       33,716       2,401  

Retained earnings

     124,531       106,460       94,102  
                        

Total equity

     177,552       157,664       111,757  

Plus: qualifying trust preferred capital notes

     22,500       22,500       —    

Less: core deposit intangibles/goodwill

     (39,801 )     (40,714 )     (5,779 )
                        

Total Tier 1 capital

     160,251       139,450       105,978  
                        

Tier 2 capital:

      

Allowance for loan losses

     17,116       16,384       11,519  
                        

Total Tier 2 capital.

     17,116       16,384       11,519  
                        

Total risk-based capital

   $ 177,367     $ 155,834     $ 117,497  
                        

Risk-weighted assets

   $ 1,460,607     $ 1,339,900     $ 989,236  
                        

Capital ratios:

      

Tier 1 risk-based capital ratio

     10.97 %     10.41 %     10.71 %

Total risk-based capital ratio

     12.14 %     11.63 %     11.88 %

Tier 1 capital to average adjusted total assets

     9.09 %     8.60 %     8.72 %

Equity to total assets

     9.82 %     10.77 %     9.60 %

COMMITMENTS AND OFF-BALANCE SHEET OBLIGATIONS

The following table represents the Company’s other commitments with balance sheet or off-balance sheet risk as of December 31, 2005 (in thousands):

 

     Total

Commitments with off-balance sheet risk:

  

Commitments to extend credit (1)

   $ 654,590

Standby letters of credit

     28,243

Commitments to purchase securities

     446

Mortgage loan rate lock commitments

     27,159
      

Total commitments with off-balance sheet risk

     710,438
      

Commitments with balance sheet risk:

  

Loans held for sale

     28,068
      

Total commitments with balance sheet risk

     28,068
      

Total other commitments

   $ 738,506
      

 

(1) Includes unfunded overdraft protection.

In the normal course of business, the Company is a party to financial instruments with off-balance sheet risk to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The contractual amounts of these instruments reflect the extent of the Company’s involvement in particular classes of financial instruments. For more information pertaining to these commitments, reference Note 11 “Financial Instruments with Off-Balance Sheet Risk” in the “Notes to Consolidated Financial Statements”.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and letters of credit written is represented by the contractual

 

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amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments. Unless noted otherwise, the Company does not require collateral or other security to support off-balance sheet financial instruments with credit risk.

At December 31, 2005, MCII had rate lock commitments to originate mortgage loans amounting to approximately $27.2 million and loans held for sale of $28.1 million. The mortgage company has entered into corresponding mandatory commitments, on a best-efforts basis, to sell loans servicing released totaling approximately $55.3 million. These commitments to sell loans are designed to eliminate the mortgage company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

LIQUIDITY

Liquidity represents an institution’s ability to meet present and future financial obligations through either the sale or maturity of existing assets or the acquisition of additional funds through liability management. Liquid assets include cash, interest-bearing deposits with banks, money market investments, Federal funds sold, securities available for sale, loans held for sale and loans maturing or re-pricing within one year. Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary through Federal funds lines with several correspondent banks and a line of credit with the Federal Home Loan Bank of Atlanta (“FHLB”). Management considers the Company’s overall liquidity to be sufficient to satisfy its depositors’ requirements and to meet its customers’ credit needs.

At December 31, 2005, cash and cash equivalents and securities classified as available for sale comprised of 17.3% of total assets, compared to 15.9% at December 31, 2004. Asset liquidity is also provided by managing loan and securities maturities and cash flows.

Additional sources of liquidity available to the Company include its capacity to borrow additional funds when necessary. The Community Banks maintain Federal funds lines with several regional banks totaling approximately $65 million at December 31, 2005. Also, the banks had $61 million of outstanding borrowings pursuant to securities sold under agreements to repurchase transactions with a maturity of one day and $47 million of other short-term borrowing at December 31, 2005. Lastly, the Company had a line of credit with the FHLB for $541 million at December 31, 2005.

The below table presents the Company’s contractual obligations and scheduled payment amounts due at the various intervals over the next five years and beyond as of December 31, 2005. For more information pertaining to the below table, reference Note 5 “Bank Premise and Equipment” and Note 8 “Other Borrowings” in the “Notes to Consolidated Financial Statements”.

 

     Payments due by Period
     Total    Less than a
year
   1 -3 years    4-5 years    More than
5 years
     (in thousands)

Long-term debt

   $ 70,196    $ —      $ 15,000    $ 20,000    $ 35,196

Operating leases

     6,231      1,104      2,642      705      1,780

Other short-term borrowings

     42,600      42,600      —        —        —  

Repurchase agreements

     60,828      60,828      —        —        —  
                                  

Total contractual obligations

   $ 179,855    $ 104,532    $ 17,642    $ 20,705    $ 36,976
                                  

Non GAAP Measures

SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. Prior to the issuance of SFAS No. 141, the Company accounted for most of its acquisition activity using the pooling method of accounting. The recent acquisition of Guaranty is the

 

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Company’s most significant business combination to be accounted for using the purchase method of accounting. At December 31, 2005, core deposit intangibles totaled $8.5 million, down from $9.7 million a year earlier and goodwill totaled $31.3 million, up from $31.0 million at December 31, 2004.

In reporting the results of 2005, the Company has provided supplemental performance measures on an operating or tangible basis. Such measures exclude amortization expense related to intangible assets, such as core deposit intangibles. The Company believes these measures are useful to investors as they exclude non-operating adjustments resulting from acquisition activity and allow investors to see the combined economic results of the organization. Cash basis operating earnings per share was $2.89 per share for the year ended December 31, 2005, as compared to $2.19 per share a year earlier. Cash basis return on average tangible equity for 2005 was 19.57% as compared to 15.78% a year earlier, and cash basis return on average tangible assets was 1.51% as compared to 1.26% for 2004.

These measures are a supplement to GAAP used to prepare the Company’s financial statements and should not be viewed as a substitute for GAAP measures. In addition, the Company’s non-GAAP measures may not be comparable to non-GAAP measures of other companies. A reconciliation of these non-GAAP measures from their respective GAAP basis measures can be found in the following table:

 

     December 31,  
     2005     2004  
     (in thousands)  

Net income

   $ 24,822     $ 17,925  

Plus amortization of core deposit intangibles, net of tax

     792       657  
                

Cash basis operating earnings

     25,614       18,582  
                

Average assets

     1,738,005       1,504,857  

Less average goodwill

     (31,227 )     (21,039 )

Less average core deposit intangibles

     (9,112 )     (8,368 )
                

Average tangible assets

     1,697,666       1,475,450  
                

Average equity

     171,221       147,166  

Less average goodwill

     (31,227 )     (21,039 )

Less average core deposit intangibles

     (9,112 )     (8,368 )
                

Average tangible equity

   $ 130,882     $ 117,759  
                

Weighted average shares outstanding

     8,850,049       8,482,142  

Cash basis EPS fully diluted

   $ 2.89     $ 2.19  

Cash basis return on average tangible assets

     1.51 %     1.26 %

Cash basis return on average tangible equity

     19.57 %     15.78 %

 

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QUARTERLY RESULTS

The following table presents the Company’s quarterly performance for the years ended December 31, 2005 and 2004:

 

     2005
     FOURTH    THIRD    SECOND    FIRST    TOTAL
     (in thousands, except per share amounts)

Interest and dividend income

   $ 27,560    $ 26,437    $ 24,888    $ 23,432    $ 102,317

Interest expense

     9,443      8,517      7,866      7,141      32,967
                                  

Net interest income

     18,117      17,920      17,022      16,291      69,350

Provision for loan losses

     275      430      135      332      1,172
                                  

Net interest income after provision for loan losses

     17,842      17,490      16,887      15,959      68,178

Noninterest income

     5,858      7,287      7,017      5,348      25,510

Noninterest expenses

     15,495      14,816      14,494      13,470      58,275
                                  

Income before income taxes

     8,205      9,961      9,410      7,837      35,413

Income tax expense

     2,331      3,078      2,798      2,384      10,591
                                  

Net income

   $ 5,874    $ 6,883    $ 6,612    $ 5,453    $ 24,822
                                  

Net income per share:

              

Basic

   $ 0.67    $ 0.79    $ 0.75    $ 0.62    $ 2.83

Diluted

   $ 0.66    $ 0.78    $ 0.75    $ 0.62    $ 2.81
     2004
     FOURTH    THIRD    SECOND    FIRST    TOTAL
     (in thousands, except per share amounts)

Interest and dividend income

   $ 22,718    $ 21,582    $ 19,354    $ 16,890    $ 80,544

Interest expense

     6,985      6,705      6,188      5,774      25,652
                                  

Net interest income

     15,733      14,877      13,166      11,116      54,892

Provision for loan losses

     520      895      308      431      2,154
                                  

Net interest income after provision for loan losses

     15,213      13,982      12,858      10,685      52,738

Noninterest income

     6,247      6,098      6,274      4,683      23,302

Noninterest expenses

     13,964      13,992      12,755      10,510      51,221
                                  

Income before income taxes

     7,496      6,088      6,377      4,858      24,819

Income tax expense

     2,199      1,631      1,816      1,248      6,894
                                  

Net income

   $ 5,297    $ 4,457    $ 4,561    $ 3,610    $ 17,925
                                  

Net income per share:

              

Basic

   $ 0.62    $ 0.51    $ 0.53    $ 0.47    $ 2.13

Diluted

   $ 0.60    $ 0.51    $ 0.53    $ 0.47    $ 2.11

Item 7A. – Quantitative and Qualitative Disclosures About Market Risk

This information is incorporated herein by reference from Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K.

 

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Item 8. – Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders

Union Bankshares Corporation

Bowling Green, Virginia

We have audited the accompanying consolidated balance sheets of Union Bankshares Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005. We also have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Union Bankshares Corporation and subsidiaries’ management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the Union Bankshares Corporation and subsidiaries’ internal control over financial reporting based on our audits. We did not audit the financial statements of Mortgage Capital Investors, Inc. for 2004 and 2003, a consolidated subsidiary which reflects total assets and revenue constituting 3% and 13%, respectively, in 2004 and 3% and 17%, respectively, in 2003 of the related consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Mortgage Capital Investors, Inc. is based solely on the report of the other auditors.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A corporation’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A corporation’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the corporation; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the corporation are being made only in accordance with authorizations of management and directors of the corporation; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the corporation’s assets that could have a material effect on the financial statements.

 

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Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Union Bankshares Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, based on our audit, management’s assessment that Union Bankshares Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Furthermore, in our opinion, based on our audit, Union Bankshares Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ Yount, Hyde & Barbour, P. C.

Winchester, Virginia

February 13, 2006

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2005 and 2004

(in thousands, except per share amounts)

 

     2005    2004

ASSETS

     

Cash and cash equivalents:

     

Cash and due from banks

   $ 47,731    $ 29,920

Interest-bearing deposits in other banks

     578      523

Money market investments

     94      130

Other interest-bearing deposits

     2,598      2,598

Federal funds sold

     18,537      73
             

Total cash and cash equivalents

     69,538      33,244
             

Securities available for sale, at fair value

     246,017      233,467
             

Loans held for sale

     28,068      42,668
             

Loans, net of unearned income

     1,362,254      1,264,841

Less allowance for loan losses

     17,116      16,384
             

Net loans

     1,345,138      1,248,457
             

Bank premises and equipment, net

     45,332      40,945

Other real estate owned

     —        14

Core deposit intangibles, net

     8,504      9,721

Goodwill

     31,297      30,992

Other assets

     51,064      32,702
             

Total assets

   $ 1,824,958    $ 1,672,210
             

LIABILITIES

     

Noninterest-bearing demand deposits

   $ 258,085    $ 230,055

Interest-bearing deposits:

     

NOW accounts

     197,888      195,309

Money market accounts

     178,346      197,617

Savings accounts

     117,046      117,851

Time deposits of $100,000 and over

     333,709      209,929

Other time deposits

     371,441      363,556
             

Total interest-bearing deposits

     1,198,430      1,084,262
             

Total deposits

     1,456,515      1,314,317
             

Securities sold under agreements to repurchase

     60,828      45,024

Other short-term borrowings

     42,600      24,514

Trust preferred capital notes

     23,196      23,196

Long-term borrowings

     47,000      90,271

Other liabilities

     15,461      12,130
             

Total liabilities

     1,645,600      1,509,452
             

Commitments and contingencies

     

STOCKHOLDERS’ EQUITY

     

Common stock, $2 par value; authorized 24,000,000 shares; issued and outstanding, 8,797,325 shares in 2005 and 8,744,176 shares in 2004

     17,595      17,488

Surplus

     35,426      33,716

Retained earnings

     124,531      106,460

Accumulated other comprehensive income

     1,806      5,094
             

Total stockholders’ equity

     179,358      162,758
             

Total liabilities and stockholders’ equity

   $ 1,824,958    $ 1,672,210
             

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31, 2005, 2004 and 2003

(in thousands, except per share amounts)

 

     2005    2004    2003

Interest and dividend income :

        

Interest and fees on loans

   $ 90,355    $ 68,738    $ 54,312

Interest on Federal funds sold

     349      102      138

Interest on deposits in other banks

     49      29      22

Interest on money market investments

     2      1      22

Interest on other interest-bearing deposits

     81      33      —  

Interest and dividends on securities:

        

Taxable

     7,791      7,709      8,171

Nontaxable

     3,690      3,932      4,352
                    

Total interest and dividend income

     102,317      80,544      67,017
                    

Interest expense:

        

Interest on deposits

     25,908      20,029      19,873

Interest on short-term borrowings

     2,013      697      325

Interest on long-term borrowings

     5,046      4,926      3,707
                    

Total interest expense

     32,967      25,652      23,905
                    

Net interest income

     69,350      54,892      43,112

Provision for loan losses

     1,172      2,154      2,307
                    

Net interest income after provision for loan losses

     68,178      52,738      40,805
                    

Noninterest income:

        

Service charges on deposit accounts

     6,790      6,826      5,597

Other service charges, commissions and fees

     4,360      3,431      2,509

Gains on securities transactions, net

     26      49      113

Gains on sales of loans

     12,973      11,836      13,260

Gains on sales of other real estate owned and bank premises, net

     33      29      165

Other operating income

     1,328      1,131      1,196
                    

Total noninterest income

     25,510      23,302      22,840
                    

Noninterest expenses:

        

Salaries and benefits

     33,556      29,128      25,137

Occupancy expenses

     4,148      3,427      2,684

Furniture and equipment expenses

     3,927      3,444      2,609

Other operating expenses

     16,644      15,222      10,295
                    

Total noninterest expenses

     58,275      51,221      40,725
                    

Income before income taxes

     35,413      24,819      22,920

Income tax expense

     10,591      6,894      6,256
                    

Net income

   $ 24,822    $ 17,925    $ 16,664
                    

Earnings per share, basic

   $ 2.83    $ 2.13    $ 2.19
                    

Earnings per share, diluted

   $ 2.81    $ 2.11    $ 2.17
                    

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

YEARS ENDED DECEMBER 31, 2005, 2004 and 2003

(in thousands, except per share amounts)

 

     Common
Stock
    Surplus     Retained
Earnings
    Accumulated
Other
Comprehensive
Income (Loss)
    Comprehensive
Income (Loss)
    Total  

Balance - December 31, 2002

   $ 15,159     $ 1,442     $ 81,997     $ 6,894       $ 105,492  

Comprehensive income:

            

Net income - 2003

         16,664       $ 16,664       16,664  

Unrealized holding losses arising during the period (net of tax, $39)

             (75 )  

Reclassification adjustment for gains included in net income (net of tax, $38)

             (75 )  
                  

Other comprehensive loss (net of tax, $77)

           (150 )     (150 )     (150 )
                  

Total comprehensive income

           $ 16,514    
                  

Cash dividends - 2003 ($.60 per share)

         (4,559 )         (4,559 )

Issuance of common stock under Dividend Reinvestment Plan (16,501 shares)

     33       426             459  

Issuance of common stock under Incentive Stock Option Plan (26,703 shares)

     54       395             449  

Issuance of common stock for services rendered (8,196 shares)

     16       248             264  

Stock repurchased under Stock Repurchase Plan and option exchange (3,859 shares)

     (8 )     (110 )           (118 )
                                          

Balance - December 31, 2003

   $ 15,254     $ 2,401     $ 94,102     $ 6,744       $ 118,501  

Comprehensive income:

            

Net income - 2004

         17,925       $ 17,925     $ 17,925  

Unrealized holding losses arising during the period (net of tax, $871)

             (1,618 )  

Reclassification adjustment for gains included in net income (net of tax, $17)

             (32 )  
                  

Other comprehensive loss (net of tax, $888)

           (1,650 )     (1,650 )     (1,650 )
                  

Total comprehensive income

           $ 16,275    
                  

Cash dividends - 2004 ($.68 per share)

         (5,567 )         (5,567 )

Issuance of common stock under Dividend Reinvestment Plan (18,678 shares)

     37       529             566  

Issuance of common stock under Incentive Stock Option Plan (66,586 shares)

     134       860             994  

Issuance of common stock for services rendered (8,908 shares)

     17       292             309  

Issuance of common stock in exchange for net assets in acquisition (1,022,756 shares)

     2,046       29,634             31,680  
                                          

Balance - December 31, 2004

   $ 17,488     $ 33,716     $ 106,460     $ 5,094       $ 162,758  

Comprehensive income:

            

Net income - 2005

         24,822       $ 24,822       24,822  

Unrealized holding losses arising during the period (net of tax, $1,762)

             (3,271 )  

Reclassification adjustment for gains included in net income (net of tax, $9)

             (17 )  
                  

Other comprehensive loss (net of tax, $1,771)

           (3,288 )     (3,288 )     (3,288 )
                  

Total comprehensive income

           $ 21,534    
                  

Cash dividends - 2005 ($.77 per share)

         (6,751 )         (6,751 )

Tax benefit from exercise of stock awards

       169             169  

Accelerated vesting of stock options

       64             64  

Award of performance stock grants

       48             48  

Unearned compensation on restricted stock, net of amortization

       (157 )           (157 )

Issuance of common stock under Dividend Reinvestment Plan (19,594 shares)

     40       683             723  

Issuance of common stock under Incentive Stock Option Plan (19,222 shares)

     38       330             368  

Issuance of common stock for services rendered (9,003 shares)

     18       392             410  

Issuance of restricted stock under Incentive Stock Option Plan (5,330 shares)

     11       181             192  
                                          

Balance - December 31, 2005

   $ 17,595     $ 35,426     $ 124,531     $ 1,806       $ 179,358  
                                          

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ending December 31, 2005, 2004 and 2003

(in thousands)

 

     2005     2004     2003  

Operating activities:

      

Net income

   $ 24,822     $ 17,925     $ 16,664  

Adjustments to reconcile net income to net cash and cash equivalents provided by operating activities:

      

Depreciation and amortization of bank premises and equipment

     3,396       2,994       2,041  

Amortization, net

     1,556       1,679       2,237  

Provision for loan losses

     1,172       2,154       2,307  

Gains on securities available for sale

     (26 )     (49 )     (113 )

Origination of loans held for sale

     (556,774 )     (496,153 )     (535,482 )

Proceeds from sales of loans held for sale

     571,374       482,168       546,570  

Gains on sales of other real estate owned and premises, net

     (33 )     (29 )     (165 )

Stock-based compensation expenses

     147       —         —    

Increase in other assets

     (16,946 )     (335 )     (655 )

Increase (decrease) in other liabilities

     3,500       (594 )     (232 )
                        

Net cash and cash equivalents provided by operating activities

     32,188       9,760       33,172  
                        

Investing activities:

      

Purchases of securities available for sale

     (56,417 )     (76,574 )     (71,065 )

Proceeds from sales of securities available for sale

     —         12,354       9,775  

Proceeds from maturities, calls and paydowns of securities available for sale

     38,545       87,806       92,455  

Net increase in loans

     (97,853 )     (218,801 )     (163,470 )

Purchases of bank premises and equipment

     (7,797 )     (9,483 )     (7,678 )

Proceeds from sales of bank premises and equipment

     —         —         15  

Proceeds from sales of other real estate owned

     61       494       486  

Cash paid in bank acquisition

     —         (23,235 )     —    

Cash acquired in bank acquisition

     —         16,701       —    
                        

Net cash and cash equivalents used in investing activities

     (123,461 )     (210,738 )     (139,482 )
                        

Financing activities:

      

Net increase in noninterest-bearing deposits

     28,030       45,129       12,957  

Net increase in interest-bearing deposits

     114,168       84,933       89,878  

Net increase (decrease) in short-term borrowings

     33,890       19,936       (2,175 )

Net increase (decrease) in long-term borrowings

     (42,700 )     37,500       5,000  

Repayment of long-term borrowings

     (571 )     (13,437 )     (1,011 )

Proceeds from trust preferred capital notes

     —         23,196       —    

Cash dividends paid

     (6,751 )     (5,567 )     (4,559 )

Issuance of common stock

     1,501       1,560       908  

Stock repurchased under Stock Repurchase Plan and option exchange

     —         —         (118 )
                        

Net cash and cash equivalents provided by financing activities

     127,567       193,250       100,880  
                        

Increase (decrease) in cash and cash equivalents

     36,294       (7,728 )     (5,430 )

Cash and cash equivalents at beginning of the period

     33,244       40,972       46,402  
                        

Cash and cash equivalents at end of the period

   $ 69,538     $ 33,244     $ 40,972  
                        

Supplemental Disclosure of Cash Flow Information

      

Cash payments for:

      

Interest

   $ 25,221     $ 25,404     $ 23,965  

Income taxes

     12,178       6,896       7,211  

Supplemental schedule of noncash investing and financing activities:

      

Unrealized loss on securities available for sale

     (5,059 )     (2,381 )     (227 )

Issuance of common stock for services rendered

     410       309       —    

Issuance of common stock in exchange for net assets in acquisition

     —         31,680       264  

Issuance of common stock pursuant to restricted stock awards

     192       —         —    

Transactions related to the acquisition of subsidiary:

      

Increase in assets and liabilities:

      

Loans

   $ —       $ 165,062     $ —    

Securities

     —         19,931       —    

Other Assets

     —         39,220       —    

Noninterest bearing deposits

     —         38,503       —    

Interest bearing deposits

     —         145,981       —    

Borrowings

     —         7,000       —    

Other Liabilities

     —         2,130       —    

Issuance of common stock

     —         31,680       —    

See accompanying notes to consolidated financial statements.

 

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UNION BANKSHARES CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

YEARS ENDED DECEMBER 31, 2005, 2004, and 2003

 

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The accounting policies and practices of Union Bankshares Corporation and subsidiaries (the “Company”) conform with accounting principles generally accepted in the United States of America and follow general practice within the banking industry. Major policies and practices are described below:

 

(A) Principles of Consolidation

The consolidated financial statements include the accounts of the Company, which is a bank holding company that owns all of the outstanding common stock of its banking subsidiaries, Union Bank and Trust Company (“Union Bank”), Northern Neck State Bank, Rappahannock National Bank, Bank of Williamsburg and of Union Investment Services. Mortgage Capital Investors, Inc. is a wholly-owned subsidiary of Union Bank. The Bank of Williamsburg has a non-controlling interest in Johnson Mortgage Company, LLC, which is accounted for under the equity method of accounting. The Company’s Statutory Trust I, a wholly-owned subsidiary of the Company, was formed for the purpose of issuing redeemable Capital Securities in connection with the Company’s acquisition of Guaranty. Financial Accounting Standards Board (“FASB”) Interpretation No. 46R “Consolidation of Variable Interest—an interpretation of ARB No. 51” (“FIN 46R”) precludes the Company from consolidating Statutory Trust I, an unconsolidated subsidiary. The subordinated debt payable to the trust is reported as a liability of the Company. All significant inter-company balances and transactions have been eliminated. The accompanying consolidated financial statements for prior periods reflect certain reclassifications in order to conform to the current presentation.

 

(B) Investment Securities

Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. The Company has no securities in this category.

Securities classified as available for sale are those debt and equity securities that management intends to hold for an indefinite period of time, including securities used as part of the Company’s asset/liability strategy, and that may be sold in response to changes in interest rates, liquidity needs or other similar factors. Securities available for sale are reported at fair value, with unrealized gains or losses on, net of deferred taxes, included in accumulated other comprehensive income (loss) in stockholders’ equity.

Securities classified as held for trading are those debt and equity securities that are bought and held principally for the purpose of selling them in the near term and reported at fair value, with unrealized gains and losses included in earnings.

Purchased premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

 

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(C) Loans Held For Sale

Loans originated and intended for sale in the secondary market are sold servicing released and carried at the lower of cost or estimated fair value which is determined in the aggregate based on sales commitments to permanent investors or on current market rates for loans of similar quality and type. In addition, the Company requires a firm purchase commitment from a permanent investor before a loan can be closed, thus limiting interest rate risk. As a result, loans held for sale are stated at fair value. Net unrealized losses, if any, are recognized through a valuation allowance by charges to income.

 

(D) Loans

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans and commercial real estate loans throughout its market area. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for charge-offs, the allowance for loan losses, and any deferred fees or costs on originated loans. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well secured and in process of collection. Credit card loans and other personal loans are typically charged-off no later than 180 days past due. In all cases, loans are placed on non-accrual status or charged-off at an earlier date if collection of principal and interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual status or charged-off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

 

(E) Allowance For Loan Losses

The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance that management considers adequate to absorb potential losses in the portfolio. Loans are charged against the allowance when management believes the collectibility of the principal is unlikely. Recoveries of amounts previously charged-off are credited to the allowance. Management’s determination of the adequacy of the allowance is based on an evaluation of the composition of the loan portfolio, the value and adequacy of collateral, current economic conditions, historical loan loss experience, and other risk factors. Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions, particularly those affecting real estate values. In addition, regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or

 

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observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for various qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.

 

(F) Bank Premises And Equipment

Bank premises and equipment is stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed using either the straight-line or accelerated method based on the type of asset involved. The Company’s policy is to capitalize additions and improvements and to depreciate the cost thereof over their estimated useful lives ranging from 3 to 40 years. Maintenance, repairs and renewals are expensed as they are incurred.

 

(G) Goodwill and Intangible Assets

SFAS No. 141, Business Combinations, requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001. For purchase acquisitions, the Company is required to record assets acquired, including identifiable intangible assets, and liabilities assumed at their fair value, which in many instances involves estimates based on third party valuations, such as appraisals, or internal valuations based on discounted cash flow analysis or other valuation techniques. Effective January 1, 2001, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives but require at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. The Company adopted SFAS 147, Acquisitions of Certain Financial Institutions, on January 1, 2002 and determined that core deposit intangibles will continue to be amortized over the estimated useful life.

 

(H) Income Taxes

Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

 

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(I) Other Real Estate Owned

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at the lower of the carrying amount or fair value at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenue and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

 

(J) Consolidated Statements of Cash Flows

For purposes of reporting cash flows, the Company defines cash and cash equivalents as cash due from banks, interest-bearing deposits in other banks, money market investments, other interest-bearing deposits, and Federal funds sold.

 

(K) Earnings Per Share

Basic earnings per share (“EPS”) is computed by dividing net income by the weighted average number of common shares outstanding during the year. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method.

 

(L) Comprehensive Income (Loss)

Comprehensive income (loss) represents all changes in equity that result from recognized transactions and other economic events of the period. Other comprehensive income (loss) refers to revenues, expenses, gains and losses that under accounting principles generally accepted in the United States of America are included in comprehensive income but excluded from net income, such as unrealized gains and losses on certain investments in debt and equity securities.

 

(M) Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from these estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of goodwill and intangible assets, foreclosed real estate and deferred tax assets and liabilities.

 

(N) Advertising Costs

The Company follows a policy of charging the cost of advertising to expense as incurred. Total advertising costs included in other operating expenses for 2005, 2004 and 2003 were $1.3 million, $1.2 million and $820 thousand, respectively.

 

(O) Off Balance Sheet Credit Related Financial Instruments

In the ordinary course of business, the Company has entered into commitments to extend credit and standby letters of credit. Such financial instruments are recorded when they are funded.

 

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(P) Rate Lock Commitments

The Company enters into commitments to originate mortgage loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. The period of time between issuance of a loan commitment and closing and sale of the loan generally ranges from 30 to 120 days. The Company protects itself from changes in interest rates through the use of best efforts forward delivery commitments, whereby the Company commits to sell a loan at the time the borrower commits to an interest rate with the intent that the buyer has assumed interest rate risk on the loan. As a result, the Company is not exposed to losses nor will it realize significant gains related to its rate lock commitments due to changes in interest rates. The correlation between the rate lock commitments and the best efforts contracts is very high due to their similarity.

The market value of rate lock commitments and best efforts contracts is not readily ascertainable with precision because rate lock commitments and best efforts contracts are not actively traded in stand-alone markets. The Company determines the fair value of rate lock commitments and best efforts contracts by measuring the change in the value of the underlying asset while taking into consideration the probability that the rate lock commitments will close. Because of the high correlation between rate lock commitments and best efforts contracts, no gain or loss occurs on the rate lock commitments.

 

(Q) Variable Interest Entities

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities—an interpretation of ARB No. 51 (“FIN 46”), which states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This interpretation explains how to identify variable interest entities and how an enterprise assesses its interest in a variable interest entity to decide whether to consolidate the entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to the significant implementation concerns, the FASB revised Interpretation No. FIN 46. Management has evaluated the Company’s investment in variable interest entities and potential variable interest entities or transactions, particularly in trust preferred securities structures because these entities constitute the Company’s primary exposure.

Currently, other than the impact described above from the deconsolidation of the trust preferred capital notes, the adoption of FIN 46 and FIN 46R has not had a material impact on the financial condition or the operating results of the Company.

 

(R) Asset Prepayment Rates

The Company purchases amortizing loan pools and investment securities in which the underlying assets are residential mortgage loans subject to prepayments. The actual principal reduction on these assets varies from the expected contractual principal reduction due to principal prepayments resulting from the borrowers’ election to refinance the underlying mortgage based on market and other conditions. The purchase premiums and discounts associated with these assets are amortized or accreted to interest income over the estimated life of the related assets. The estimated life is calculated by projecting future prepayments and the resulting principal cash flows until maturity. Prepayment rate projections utilize actual prepayment speed experience and available market information on like-kind instruments. The prepayment rates form the basis for income recognition of premiums and discounts on the related assets. Changes in prepayment estimates may cause the earnings recognized on these assets to vary over the term

 

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that the assets are held, creating volatility in the net interest margin. Prepayment rate assumptions are monitored and updated monthly to reflect actual activity and the most recent market projections.

 

(S) Concentrations of Credit Risk

Most of the Company’s activities are with customers located in portions of central and Tidewater Virginia. Securities Available for Sale are discussed in Note 2. Loans are discussed in Note 3.

 

(T) Stock Compensation Plan

The Company accounts for the stock options under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based compensation cost is reflected in net income, as all options granted under the Company’s stock option plans have an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation. Included in 2005 was $792 thousand related to shares vesting in connection with the acceleration of stock options.

 

     Years Ended December 31,  
(in thousands except per share data)    2005     2004     2003  

Net income, as reported

   $ 24,822     $ 17,925     $ 16,664  

Total stock-based compensation expense determined under fair value based method for all awards

     (1,194 )     (378 )     (338 )
                        

Pro forma net income

   $ 23,628     $ 17,547     $ 16,326  
                        

Earning per share:

      

Basic - as reported

   $ 2.83     $ 2.13     $ 2.19  
                        

Basic - pro forma

   $ 2.70     $ 2.09     $ 2.15  
                        

Diluted - as reported

   $ 2.81     $ 2.11     $ 2.17  
                        

Diluted - pro forma

   $ 2.67     $ 2.07     $ 2.13  
                        

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

 

     2005     2004     2003  

Dividend yield

   2.30 %   2.39 %   2.43 %

Expected life

   10 years     10 years     10 years  

Expected volatility

   32.93 %   34.54 %   35.54 %

Risk-free interest rate

   4.22 %   4.23 %   4.03 %

 

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(U) Recent Accounting Pronouncements

In November 2005, FASB Staff Position (FSP) 115-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” was issued. The FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP amends FASB Statement No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock”. The FSP applies to investments in debt and equity securities and cost-method investments. The application guidance within the FSP includes items to consider in determining whether an investment is impaired, in evaluating if an impairment is other than temporary and recognizing impairment losses equal to the difference between the investment’s cost and its fair value when an impairment is determined. The FSP is required for all reporting periods beginning after December 15, 2005. Earlier application is permitted. The Company does not anticipate the amendment will have a material effect on its financial statements.

In May 2005, FASB issued Statement No. 154, (“SFAS No. 154”) “Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20 and FASB Statement No. 3.” The new standard changes the requirements for the accounting for and reporting of a change in accounting principle. Among other changes, SFAS No. 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. SFAS No. 154 also provides that (1) a change in method of depreciating or amortizing a long-lived nonfinancial asset be accounted for as a change in estimate (prospectively) that was effected by a change in accounting principle, and (2) correction of errors in previously issued financial statements should be termed a “restatement. “ The new standard is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company does not anticipate this revision will have a material effect on its financial statements.

In December 2004, FASB issued Statement No. 123 (Revised 2004) (SFAS No. 123R) “Share-Based Payment”, which requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. SFAS No. 123R replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS No. 123R requires all share-based payments to employees to be valued using a fair value method on the date of grant and expensed based on that fair value over the applicable vesting period. SFAS No. 123R also amends SFAS No. 95 “Statement of Cash Flows” requiring the benefits of tax deductions in excess of recognized compensation cost be reported as financing instead of operating cash flows. The Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 107 (“SAB 107”), which expresses the SEC’s views regarding the interaction between SFAS No. 123R and certain SEC rules and regulations. Additionally, SAB No. 107 provides guidance related to share-based payment transactions for public companies. The Company will be required to apply SFAS No. 123R as of the annual reporting period that begins after September 15, 2005.

On December 30, 2005, the Company accelerated the vesting of stock options in order to eliminate the recognition of compensation expense associated with the affected options under SFAS No. 123R, which will apply to the Company beginning in the first quarter of 2006. The Company anticipates that the aggregate pre-tax compensation expense associated with the accelerated options that will be avoided by this action is approximately $792 thousand, of which approximately $312 thousand would have been recognized in 2006. The Company believes that it will not be required to recognize any compensation expense in future periods associated with the affected options. However, there can be no assurance that the

 

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acceleration of vesting of these options may not result in some future compensation expense. The Company is seeking consent from option holders affected by Section 422 of the Internal Revenue Code of 1986, as amended, to accelerate options held. If these holders withhold consent the pre-tax compensation expense of approximately $792 thousand will be reduced by approximately $229 thousand.

In December 2003, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. It includes loans purchased by the Company or acquired in business combinations. SOP 03-3 does not apply to loans originated by the Company. The Company adopted the provisions of SOP 03-3 effective January 1, 2005. The initial implementation had no material effect on the Company’s financial statements.

 

(V) Business Combinations

On May 1, 2004, the Company completed its acquisition of Guaranty headquartered in Charlottesville, Virginia. This acquisition was accounted for using the purchase method of accounting. The total consideration paid to Guaranty stockholders in connection with the acquisition was approximately $54.9 million with approximately $23.2 million in cash and 1,023,000 shares of the Company’s common stock. The Company operated Guaranty as a separate subsidiary until September 13, 2004, when the operations of Guaranty were merged with and into the Company’s largest subsidiary, Union Bank. Guaranty transactions have been included in Union Bank’s financial results since May 1, 2004. Acquired assets on May 1, 2004 totaled $248 million, including $165 million in loans and $184 million in deposits. As part of the purchase price allocation at May 1, 2004, Union Bank recorded $5.8 million in core deposit intangibles, and goodwill totaled approximately $30.1 million. The core deposit intangible asset for this acquisition is being amortized over an average of 8.74 years.

The acquisition of Guaranty fell under the guidance of the Emerging Issues Task Force (“EITF”) in EITF Issue No 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring.) Under EITF Issue No. 94-3, an entity recognizes a liability for an exit cost on the date that the entity commits itself to an exit plan. “Exit costs” are defined to include those costs recorded by Guaranty prior to the merger date and therefore are not included in the Company’s results of operations. Guaranty recorded exit costs of $1.3 million relating to severance and costs associated with terminating contracts.

The Company’s exit costs, referred to herein as “merger-related” costs, are defined to include those costs for combining operations such as systems conversions, integration planning consultant fees and marketing consultant fees incurred by the Company prior to and after the merger date and are included in the results of operations. The Company expensed merger-related costs which totaled approximately $343 thousand for year ended December 31, 2004. The costs associated with these activities are included in noninterest expenses.

Additionally, the Company recently announced the signing of a definitive agreement, pursuant to which it will acquire Prosperity Bank and Trust Company (“Prosperity”) in an all cash transaction valued at $36 million. Prosperity, with nearly $130 million in assets, operates three offices in Springfield, Virginia, located in affluent Fairfax County, a suburb of Washington, D.C. This acquisition will close on or about April 1, 2006 with back office data conversion scheduled for September 2006.

 

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2. SECURITIES AVAILABLE FOR SALE

The amortized cost, gross unrealized gains and losses and estimated fair value of securities available for sale at December 31, 2005 and 2004 are summarized as follows (in thousands):

 

     2005
     Amortized
Cost
   Gross Unrealized     Estimated
Fair Value
        Gains    (Losses)    

U.S. government and agency securities

   $ 1,977    $ —      $ (42 )   $ 1,935

Obligations of states and political subdivisions

     83,908      2,487      (177 )     86,218

Corporate and other bonds

     38,423      2,603      (247 )     40,779

Mortgage-backed securities

     108,576      183      (2,053 )     106,706

Federal Reserve Bank stock - restricted

     2,213      —        —         2,213

Federal Home Loan Bank stock - restricted

     7,392      —        —         7,392

Other securities

     750      24      —         774
                            
   $ 243,239    $ 5,297    $ (2,519 )   $ 246,017
                            
     2004
     Amortized
Cost
   Gross Unrealized     Estimated
Fair Value
        Gains    (Losses)    

U.S. government and agency securities

   $ 8,016    $ 14    $ (10 )   $ 8,020

Obligations of states and political subdivisions

     80,051      3,333      (46 )     83,338

Corporate and other bonds

     34,759      3,914      —         38,673

Mortgage-backed securities

     92,425      779      (281 )     92,923

Federal Reserve Bank stock - restricted

     2,153      —        —         2,153

Federal Home Loan Bank stock - restricted

     7,474      —        —         7,474

Other securities

     751      135      —         886
                            
   $ 225,629    $ 8,175    $ (337 )   $ 233,467
                            

The amortized cost and estimated fair value (in thousands) of securities available for sale at December 31, 2005, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

 

     Securities Available for Sale
     Amortized
Cost
   Estimated
Fair Value

Due in one year or less

   $ 7,629    $ 7,625

Due after one year through five years

     20,836      20,778

Due after five years through ten years

     94,044      94,647

Due after ten years

     110,375      112,588
             
     232,884      235,638

Federal Reserve Bank stock - restricted

     7,392      7,392

Federal Home Loan Bank stock - restricted

     2,213      2,213

Other securities

     750      774
             
   $ 243,239    $ 246,017
             

Securities with an amortized cost of approximately $92.2 million and $89.3 million at December 31, 2005 and 2004 were pledged to secure public deposits, repurchase agreements and for other purposes.

 

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Sales, call, maturities and paydowns of securities available for sale produced the following results for the years ended December 31, 2005, 2004 and 2003 (in thousands):

 

     2005    2004     2003  

Proceeds from sales

   $ —      $ 12,354     $ 9,775  

Proceeds from calls, maturities and paydowns

     38,545      87,806       92,455  
                       

Total proceeds

   $ 38,545    $ 100,160     $ 102,230  
                       

Gross realized gains

   $ 26    $ 124     $ 160  

Gross realized (losses)

     —        (75 )     (47 )
                       

Net realized gains (losses)

   $ 26    $ 49     $ 113  
                  &