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NASB FINANCIAL INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.(Edgar Glimpses Via Acquire Media NewsEdge) FORWARD-LOOKING STATEMENTS We may from time to time make written or oral "forward-looking statements," including statements contained in our filings with the Securities and Exchange Commission ("SEC"). These forward-looking statements may be included in this quarterly report and in other communications by the Company, which are made in good faith by us pursuant to the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include statements about our beliefs, plans, objectives, goals, expectations, anticipations, estimates and intentions, that are subject to significant risks and uncertainties, and are subject to change based on various factors, some of which are beyond our control. The words "may," "could," "should," "would," "believe," "anticipate," "estimate," "expect," "intend," "plan," and similar expressions are intended to identify forward-looking statements. The following factors, as well as those discussed under Item 1A. "Risk Factors" in our Annual Report on Form 10-K for the year ended September 30, 2013, filed with the Securities and Exchange Commission, among others, could cause our financial performance to differ materially from the plans, objectives, goals, expectations, anticipations, estimates and intentions expressed in the forward-looking statements: • the strength of the U.S. economy in general and the strength of the local economies in which we conduct operations; • the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board; • the effects of, and changes in, foreign and governmental policy; inflation, interest rate, market and monetary fluctuations; • the timely development and acceptance of our new products and services and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors' products and services; • the willingness of users to substitute competitors' products and services for our products and services; • our success in gaining regulatory approval of our products, services and branching locations, when required; • the impact of changes in financial services' laws and regulations, including laws concerning taxes, banking, securities and insurance; • technological changes; • acquisitions and dispositions; • changes in consumer spending and saving habits; • our success at managing the risks involved in our business; and • changes in the fair value or economic value of, impairments of, and risks associated with the Bank's investments in real estate owned, mortgage backed securities and other assets. This list of important factors is not all-inclusive. We do not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company or the Bank. For further discussion of these factors, see "Item 1A. Risk Factors" in our Annual Report on Form 10-K for the year ended September 30, 2013, filed with the Securities and Exchange Commission, and in our Quarterly Reports, if applicable. GENERAL NASB Financial, Inc. was formed in 1998 as a unitary thrift holding company of North American Savings Bank, F.S.B. The Bank is a federally chartered stock savings bank, with its headquarters in the Kansas City area. The Bank began operating in 1927, and became a member of the Federal Home Loan Bank of Des Moines ("FHLB") in 1940. Its customer deposit accounts are insured by the Deposit Insurance Fund ("DIF"), a division of the Federal Deposit Insurance Corporation ("FDIC"). The Bank converted to a stock form of ownership in September 1985. The Bank's primary market area includes the counties of Jackson, Cass, Clay, Buchanan, Andrew, Platte, and Ray in Missouri, and Johnson and Wyandotte counties in Kansas. The Bank currently has nine retail deposit offices in Missouri including one each in Grandview, Lee's Summit, Independence, Harrisonville, Excelsior Springs, Platte City, and St. Joseph, and two in Kansas City. North American also operates loan production offices in Kansas City, Lee's Summit and Springfield in Missouri. The economy of the Kansas City area is diversified with major employers in agribusiness, greeting cards, automobile production, transportation, telecommunications, and government. 33 -------------------------------------------------------------------------------- The Bank's principal business is to attract deposits from the general public and to originate real estate loans, other loans and short-term investments. The Bank obtains funds mainly from deposits received from the general public, sales of loans and loan participations, advances from the FHLB, and principal repayments on loans and mortgage-backed securities ("MBS"). The Bank's primary sources of income include interest on loans, interest on MBS, interest on investment securities, customer service fees, and mortgage banking fees. Its primary expenses are interest payments on customer deposit accounts and borrowings and normal operating costs. FINANCIAL CONDITION Assets The Company's total assets as of December 31, 2013 were $1,181.3 million, an increase of $37.1 million from September 30, 2013, the prior fiscal year end. Loans receivable held for investment were $736.6 million as of December 31, 2013, an increase of $20.9 million during the three month period. This increase was primarily due to the origination of new loans in the Bank's construction and land development portfolios. The weighted average rate on total loans receivable held for investment as of December 31, 2013, was 5.20%, a decrease from 5.73% as of December 31, 2012. Loans receivable held for sale as of December 31, 2013, were $66.3 million, a decrease of $2.8 million from September 30, 2013. This portfolio consists of residential mortgage loans originated by the Bank's mortgage banking division that will be sold with servicing released. The Company has elected to carry loans held for sale at fair value, as permitted under GAAP. As the Bank originates mortgage loans each month, management evaluates the existing market conditions to determine which loans will be held in the Bank's portfolio and which loans will be sold in the secondary market. Loans sold in the secondary market can be sold with servicing released or sold with the loan servicing retained by the Bank. At the time of each loan commitment, a decision is made to either hold the loan for investment, hold it for sale with servicing retained, or hold it for sale with servicing released. Management monitors market conditions to decide whether loans should be held in portfolio or sold and if sold, which method of sale is appropriate. During the three months ended December 31, 2013, the Bank originated and purchased $290.6 million in mortgage loans held for sale, $67.2 million in mortgage loans held for investment, and $505,000 in other loans. This total of $358.3 million in loans compares to $569.0 million in loans originated and purchased during the three months ended December 31, 2012. The Bank classifies problem assets as "substandard," "doubtful" or "loss." Substandard assets have one or more defined weaknesses, and it is possible that the Bank will sustain some loss unless the deficiencies are corrected. Doubtful assets have the same defects as substandard assets plus other weaknesses that make collection or full liquidation improbable. Assets classified as loss are considered uncollectible and of little value. The following table summarizes the Bank's classified assets, including foreclosed assets held for sale, as reported to their primary regulator, plus any classified assets of the holding company. Dollar amounts are expressed in thousands. 12/31/13 9/30/13 12/31/12 Asset Classification: Substandard $ 55,451 82,760 132,431 Doubtful 124 168 575 Loss - - - 55,575 82,928 133,006 Allowance for loan losses (21,270 ) (20,383 ) (27,853 ) $ 34,305 62,545 105,153 34 -------------------------------------------------------------------------------- The following table summarizes non-performing assets, troubled debt restructurings, and real estate acquired through foreclosure, net of specific loss allowances. Dollar amounts are expressed in thousands. 12/31/13 9/30/13 12/31/12 Total Assets $ 1,181,290 1,144,155 1,252,524 Non-accrual loans 25,159 31,622 61,076 Performing troubled debt restructurings 33,429 32,637 34,469 Net real estate and other assets acquired through foreclosure 10,596 11,252 15,314 Total 69,184 75,511 110,859 Percent of total assets $ 5.86 % 6.60 % 8.85 % Management records a provision for loan losses in amounts sufficient to cover current net charge-offs and an estimate of probable losses based on an analysis of risks that management believes to be inherent in the loan portfolio. The Allowance for Loan and Lease Losses recognizes the inherent risks associated with lending activities for individually identified problem assets as well as the entire homogenous and non-homogenous loan portfolios. Management believes that the specific loss allowances and ALLL are adequate. While management uses available information to determine these allowances, future provisions may be necessary because of changes in economic conditions or changes in the information available to management. Also, regulatory agencies review the Bank's allowance for losses as part of their examinations, and they may require the Bank to recognize additional loss provisions based on the information available at the time of their examinations. With the exception of certain residential loans, which are not deemed impaired until they reach 180 days past due, loans in non-accrual status are considered impaired. (At December 31, 2013, loans of $1.6 million in non-accrual status were not deemed impaired.) Once a loan has been deemed impaired, the impairment must be measured by comparing the recorded investment in the loan to the present value of the estimated future cash flows discounted at the loan's effective rate, or to the fair value of the loan based on the loan's observable market price, or to the fair value of the collateral if the loan is collateral dependent. Any measured impairment that is deemed a "confirmed loss" is charged off and netted from the respective loan balance. For collateral dependent loans, which make up the majority of the Bank's impaired loans, a "confirmed loss" is generally the amount by which the loan's recorded investment exceeds the fair value of its collateral. Therefore, risks associated with non-accrual loans have been addressed within Bank's quarterly analysis of the adequacy of its ALLL, as essentially all were individually analyzed for impairment. If loans classified as substandard are also impaired, they are individually analyzed for impairment, as noted above. At December 31, 2013, $34.1 million of loans classified as substandard have also been deemed impaired. In addition, the Bank utilizes a qualitative adjustment related to changes and trends in past due, non-accrual, and adversely classified loans. This adjustment is applied to the various pools of unimpaired loans when determining adequacy of the Bank's ALLL. Investment securities were $272.4 million as of December 31, 2013, an increase of $19.7 million from September 30, 2013. During the three month period, the Bank purchased $61.4 million and sold $40.4 million of securities available for sale. The average yield on the investment securities portfolio was 2.21% at December 31, 2013, an increase from 1.56% at December 31, 2012. Mortgage-backed securities were $43.0 million as of December 31, 2013, a decrease of $547,000 million from the prior year end. The Bank did not purchase or sell any mortgage-backed securities during the three month period ended December 31, 2013. The average yield on the mortgage-backed securities portfolio was 3.55% at December 31, 2013, a decrease from 4.51% at December 31, 2012. The Company's investment in LLCs, which is accounted for using the equity method, was $16.5 million at December 31, 2013, an increase of $43,000 from September 30, 2013. There have been no events subsequent to September 30, 2013, that would indicate an additional impairment in value of the Company's investment in LLCs at December 31, 2013. 35-------------------------------------------------------------------------------- Liabilities and Equity Customer deposit accounts decreased $12.5 million during the three months ended December 31, 2013. This decrease was due to an $8.1 million decrease in certificates of deposits and a $4.4 million decrease in money market accounts during the period. The weighted average rate on customer and brokered deposits as of December 31, 2013, was 0.49%, a decrease from 0.76% as of December 31, 2012. Advances from the FHLB were $210.0 million as of December 31, 2013, an increase of $55.0 million from September 30, 2013. During the three month period, the Bank borrowed $110.0 million of new advances and repaid $55.0 million. Management regularly uses FHLB advances as an alternate funding source to provide operating liquidity and to fund the origination and purchase of mortgage loans. Subordinated debentures were $25.8 million as of December 31, 2013. Such debentures resulted from the issuance of Trust Preferred Securities through the Company's wholly-owned statutory trust, NASB Preferred Trust I. The Trust used the proceeds from the offering to purchase a like amount of the Company's subordinated debentures. The debentures, which have a variable rate of 1.65% over the 3-month LIBOR and a 30-year term, are the sole assets of the Trust. Escrows were $4.3 million as of December 31, 2013, a decrease of $4.1 million from September 30, 2013. This decrease is due to amounts paid for borrowers' taxes during the fourth calendar quarter of 2013. Total stockholders' equity as of December 31, 2013, was $192.0 million (16.3% of total assets). This compares to $195.5 million (17.1% of total assets) at September 30, 2013. On a per share basis, stockholders' equity was $24.40 on December 31, 2013, compared to $24.85 on September 30, 2013. The Company did not pay any cash dividends to its stockholders during the three month period ended December 31, 2013. In accordance with the regulatory written agreement, which is described more fully in Footnote 15, Regulatory Agreements, the Company is restricted from paying dividends or making other capital distributions without the prior written non-objection from its primary regulator. Upon receipt of written non-objection from the FRB, the Company's Board of Directors declared a special cash dividend of $0.60 per share on December 20, 2013, payable on January 17, 2014, to shareholders of record as of January 3, 2014. The special dividend, which amounted to $4.7 million, was accrued within the December quarter. In addition, the Company received regulatory written non-objection to pay all accrued interest on its outstanding Trust Preferred Securities at the January 30, 2014, payment date, which amounted to $893,000. The Board intends to continue making quarterly interest payments on the Company's Trust Preferred Securities and to consider some level of quarterly cash dividend to the Company's shareholders; however, while the Company is operating under the regulatory written agreement, each interest payment on Trust Preferred Securities and dividend distribution to shareholders must first receive prior written non-objection from regulators. The Company will not declare future distributions of capital until it receives written non-objection from regulators. Total stockholders' equity as of December 31, 2013, includes an unrealized loss, net of deferred income taxes, on available for sale securities of $2.1 million. This amount is reflected in the line item "Accumulated other comprehensive income." Ratios The following table illustrates the Company's return on assets (annualized net income divided by average total assets); return on equity (annualized net income divided by average total equity); equity-to-assets ratio (ending total equity divided by ending total assets); and dividend payout ratio (dividends paid divided by net income). Three months ended 12/31/13 12/31/12 Return on assets 0.69 % 2.67 % Return on equity 4.13 % 18.94 % Equity-to-assets ratio 16.25 % 14.36 % Dividend payout ratio - % - % 36 -------------------------------------------------------------------------------- RESULTS OF OPERATIONS - Comparison of three ended December 31, 2013 and 2012. For the three months ended December 31, 2013, the Company had net income of $2.0 million or $0.25 per share. This compares to a net income of $8.3 million or $1.06 per share for the three month period ended December 31, 2012. Net Interest Margin The Company's net interest margin is comprised of the difference ("spread") between interest income on loans, MBS and investments and the interest cost of customer and brokered deposits and other borrowings. Management monitors net interest spreads and, although constrained by certain market, economic, and competition factors, it establishes loan rates and customer deposit rates that maximize net interest margin. The following table presents the total dollar amounts of interest income and expense on the indicated amounts of average interest-earning assets or interest-costing liabilities for the three months ended December 31, 2013 and 2012. Average yields reflect reductions due to non-accrual loans. Once a loan becomes 90 days delinquent, or when full payment of interest and principal is not expected, any interest that has accrued up to that time is reversed and no further interest income is recognized unless the loan is paid current. Average balances and weighted average yields for the periods include all accrual and non-accrual loans. The table also presents the interest-earning assets and yields for each respective period. Dollar amounts are expressed in thousands. As of As of Three months ended 12/31/13 12/31/13 Three months ended 12/31/12 12/31/12 Average Yield/ Yield/ Average Yield/ Yield/ Balance Interest Rate Rate Balance Interest Rate Rate Interest-earning assets Loans $ 767,807 10,600 5.52 % 5.10 % $ 862,292 12,334 5.72 % 5.28 % Mortgage-backed securities 45,609 411 3.60 % 3.55 % 28,649 294 4.10 % 4.51 % Securities 262,941 1,421 2.16 % 2.21 % 244,369 963 1.58 % 1.56 % Bank deposits 3,777 2 0.21 % 0.20 % 19,766 2 0.04 % 0.01 % Total earning assets 1,080,134 12,434 4.60 % 4.31 % 1,155,076 13,593 4.71 % 4.37 % Non-earning assets 64,238 74,662 Total $ 1,144,372 $ 1,229,738 Interest-costing liabilities Customer checking and savings deposit accounts $ 370,959 333 0.36 % 0.32 % $ 297,848 344 0.46 % 0.41 % Customer and brokered certificates of deposit 366,605 612 0.67 % 0.66 % 583,967 1,405 0.96 % 0.94 % FHLB Advances 172,506 470 1.09 % 0.91 % 131,755 531 1.61 % 1.42 % Subordinated debentures 25,000 125 2.00 % 1.89 % 25,000 129 2.06 % 1.96 % Other borrowings 421 5 4.75 % 5.00 % 210 3 5.71 % 5.00 % Total costing liabilities 935,491 1,545 0.66 % 0.62 % 1,038,780 2,412 0.93 % 0.88 % Non-costing liabilities 11,839 15,966 Stockholders' equity 197,042 174,992 Total $ 1,144,372 $ 1,229,738 Net earning balance 144,643 116,296 Earning yield less costing rate 3.94 % 3.69 % 3.78 % 3.49 % Average interest-earning assets, net interest, and net yield spread on average interest -earning assets $ 1,080,134 10,889 4.03 % $ 1,155,076 11,181 3.87 % 37 -------------------------------------------------------------------------------- The following table provides information regarding changes in interest income and interest expense. For each category of interest-earning asset and interest-costing liability, information is provided on changes attributable to (1) changes in rates (change in rate multiplied by the old volume), and (2) changes in volume (change in volume multiplied by the old rate), and (3) changes in rate and volume (change in rate multiplied by the change in volume). Average balances, yields and rates used in the preparation of this analysis come from the preceding table. Dollar amounts are expressed in thousands. Three months endedDecember 31, 2013, compared to three months ended December 31, 2012 Yield/ Yield Volume Volume Total Components of interest income: Loans $ (431 ) (1,351 ) 48 (1,734 ) Mortgage-backed securities (36 ) 174 (21 ) 117 Securities 354 73 31 458 Bank deposits 8 (2 ) (6 ) - Net change in interest income (105 ) (1,106 ) 52 (1,159 ) Components of interest expense: Customer and brokered deposit accounts (617 ) (285 ) 98 (804 ) FHLB Advances (171 ) 164 (54 ) (61 ) Subordinated debentures (4 ) - - (4 ) Other borrowings (1 ) 3 - 2 Net change in interest expense (793 ) (118 ) 44 (867 ) Increase (decrease) in net interest margin $ 688 (988 ) 8 (292 ) Net interest margin before loan loss provision for the three months ended December 31, 2013, decreased $292,000 from the same period in the prior year. Specifically, interest income decreased $1.2 million, which was offset by a $867,000 decrease in interest expense for the period. Interest on loans decreased $1.7 million as the result of a $94.5 million decrease in the average balance of loans receivable outstanding during the period and a 20 basis point decrease in the average rate earned on such loans during the period. Interest on mortgage-backed securities increased $117,000 due to a $17.0 million increase in the average balance during the period, the effect of which was partially offset by a 50 basis point decrease in the average rate earned on such securities during the period. Interest earned on investment securities increased $458,000 resulting from a 58 basis point increase in the average rate and an $18.6 million increase in the average balance of such securities during the period. Interest expense on customer and brokered deposit accounts decreased $804,000 due to a 28 basis point decrease in the average rate paid on such liabilities and a $144.3 million decrease in the average balance of customer and brokered deposits during the period. Interest expense on FHLB advances decreased $61,000 as the result a 52 basis point decrease in the average rate paid on such liabilities, the effect of which was largely offset by a $40.8 million increase in the average balance of advances outstanding during the period. Provision for Loan Losses The Company recorded no provision for loan losses during the current quarter. Management determined that the increase in the ALLL, resulting from net recoveries of $887,000 during the quarter, was appropriate due to increases in the Bank's portfolio of higher risk loans. Specifically, the construction and land development portfolio increased $19.9 million due to the origination of residential construction loans during the period. In addition, the residential portfolio increased $7.7 million due primarily to the origination of non-agency-conforming loans and loans secured by investment properties. Based upon management's analysis, the resulting allowance for loan losses of $21.3 million is adequate at December 31, 2013. The Company recorded a negative provision for loan losses of $4.0 million during the three month period ended December 31, 2012. The negative provision for loan loss for the quarter was based upon the Bank's ALLL methodology, which contains both qualitative and quantitative factors. Specifically, activity during the quarter ended December 31, 2012, reflected in quantitative factors included the following: • The Bank's portfolio of loans held to maturity decreased $43.9 million during the quarter ended December 31, 2012, to $722.7 million. This decrease consisted almost entirely of declines within the Bank's commercial real estate and construction and land development portfolios, which historically have experienced higher credit losses than the Bank's other portfolios. 38 -------------------------------------------------------------------------------- • The level of criticized loans (those classified as special mention, substandard, or doubtful) decreased $22.1 million during the three month period. Of this decline, $16.5 million related to loans within the Bank's commercial real estate and construction and land development portfolios. • The Bank's loss experience during the current quarter was much better than the previous 36 months. During the three month period ended December 31, 2012, the Bank recorded net recoveries of $24,000. • The level of nonperforming loans decreased $13.7 million during the three month period. Similar to the decrease in gross loan balances, this decline consisted almost entirely of loans within the Bank's commercial real estate and construction and land development portfolios. In addition to the quantitative factors noted above, management observed the following qualitative factors when determining the appropriate level of the Bank's ALLL at December 31, 2012: • The housing market in the Kansas City metropolitan area, where all of the Bank's construction and land development lending is concentrated, has shown renewed strength during the current period. In terms of new building permits, the market experienced its best fourth calendar quarter since 2008, and the supply of new housing inventory has dropped below the equilibrium level, resulting in an increase in new housing starts. • During the current period, an independent third party review was completed, which included approximately 80% of the loans within the Bank's commercial real estate and construction and land development portfolios. This review resulted in no loan classification discrepancies, validating the effectiveness of the Bank's internal asset review process.On a consolidated basis, the allowance for losses on loans and real estate owned was 38.3% of total classified assets at December 31, 2013, 24.6% at September 30, 2013, and 20.9% at December 31, 2012. Management believes that the allowance for losses on loans and real estate owned is adequate. The provision can fluctuate based on changes in economic conditions, changes in the level of classified assets, changes in the amount of loan charge-offs and recoveries, or changes in other information available to management. Also, regulatory agencies review the Company's allowances for losses as a part of their examination process, and they may require changes in loss provision based on information available at the time of their examination. Other Income Other income for the three months ended December 31, 2013, decreased $9.2 million from the same period in the prior year. Specifically, gain on sale of loans held for sale decreased $9.6 million from the same period in the prior year due to decreased mortgage banking volume and spreads. Customer service fees decreased $594,000 due primarily to a decrease in miscellaneous loan fees. These decreases were partially offset by a $460,000 decrease in the provision for loss on real estate owned due to fewer declines in the fair value of properties within the Bank's portfolio of foreclosed assets held for sale during the period. In addition, other income increased $396,000 due primarily to the effect of recording the net fair value of certain loan-related commitments in accordance with GAAP and a decrease in expenses related to foreclosed assets held for sale during the period. Gain on sale of securities increased $98,000 from the prior year, resulting from the sale of four U. S. government sponsored agency securities during the three months ended December 31, 2013. General and Administrative Expenses Total general and administrative expenses for the three months ended December 31, 2013, decreased $3.0 million from the same period in the prior year. Specifically, commission-based mortgage banking compensation decreased $2.7 million due to a decrease in residential mortgage loan origination volume from the same period in the prior year. Compensation and fringe benefits decreased $213,000 due primarily to fewer personnel in the Company's mortgage banking division. Federal deposit insurance premiums decreased $278,000, due primarily to a reduction in premium rates from the same period in the prior year, based upon the Bank's improved risk rating. Other expense decreased $551,000 due primarily to decreases in credit and appraisal expense, legal fees, processing fees, and temporary employment fees, related to the decreased in residential mortgage origination volume. In addition telecom expense decreased during the period due primarily to the settlement of billing disputes. These decreases were partially offset by a $638,000 increase in advertising and business promotion expense, due primarily to increased advertising costs related to the Company's mortgage banking division. In addition, premises and equipment expense increased $99,000 due primarily to the lease of additional office space for certain information technology and mortgage banking employees. 39-------------------------------------------------------------------------------- REGULATION Regulation of the Company NASB Financial, Inc. is a unitary savings and loan holding company of North American Savings Bank, F.S.B. On July 21, 2011, supervisory responsibility for the Company was transferred from the Office of Thrift Supervision (the "OTS") to the Board of Governors of the Federal Reserve System ("Federal Reserve Board" or "FRB"), as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). Accordingly, the Company is required to register and file reports with the Federal Reserve Board and is subject to regulation and examination by the Federal Reserve Board. In addition, the Federal Reserve Board has enforcement authority over the Company, which also permits the Federal Reserve Board to restrict or prohibit activities that are determined to present a serious risk to the Bank. Regulation of the Bank The Bank is a federally chartered stock savings bank, formed under the authority provided in the Home Owners' Loan Act (as amended, "HOLA"). On July 21, 2011, supervisory responsibility for the Bank was transferred from the OTS to the Office of the Comptroller of the Currency ("OCC"), as required by the Dodd-Frank Act. Although the Bank remains subject to regulations previously promulgated by the OTS, in general, those regulations are now enforced by the OCC. Capital Requirements Regulations require that thrifts meet three minimum capital ratios. Leverage Limit. The leverage limit requires that thrift maintain "core capital" of at least 4% of its adjusted tangible assets. "Core capital" includes (i) common stockholders' equity, including retained earnings; non-cumulative preferred stock and related earnings; and minority interest in the equity accounts of consolidated subsidiaries, minus (ii) those intangibles (including goodwill) and investments in and loans to subsidiaries not permitted in computing capital for national banks, plus (iii) certain purchased mortgage servicing rights and certain qualifying supervisory goodwill. Tangible Capital Requirement. The tangible capital requirement mandates that a thrift maintain tangible capital of at least 1.5% of tangible assets. For the purposes of this requirement, adjusted total assets are generally calculated on the same basis as for the leverage ratio requirement. Tangible capital is defined in the same manner as core capital, except that all goodwill and certain other intangible assets must be deducted. Risk-Based Capital Requirement. OCC standards require that institutions maintain risk-based capital equal to at least 8% of risk-weighted assets. Total risk-based capital includes core capital plus supplementary capital. In determining risk-weighted assets, all assets including certain off-balance-sheet items are multiplied by a risk weight factor from 0% to 100%, based on risk categories assigned by the OCC. Banking regulations categorize banks with risk-based capital ratios over 10% as well capitalized, 8% to 10% as adequately capitalized, and under 8% as undercapitalized. At December 31, 2013, the Bank exceeds all capital requirements prescribed by the OCC. To calculate these requirements, a thrift must deduct any investments in and loans to subsidiaries that are engaged in activities not permissible for a national bank. As of December 31, 2013, the Bank did not have any investments in or loans to subsidiaries engaged in activities not permissible for national banks. On May 22, 2012, the Board of Directors of the Bank agreed to a Consent Order with the OCC, which is described more fully in Footnote 14, Regulatory Agreements. Among other items, the Consent Order requires that the Bank maintain a Tier 1 leverage capital ratio equal to or greater than 10% and a risk-based capital ratio equal to or greater than 13%. As of December 31, 2013, the Bank's actual Tier 1 leverage capital and total risk-based capital ratios were 16.8% and 24.0%, respectively. The existence of individual minimum capital requirements means that the Bank may not be deemed well capitalized. 40-------------------------------------------------------------------------------- The following tables summarize the relationship between the Bank's capital and regulatory requirements. Dollar amounts are expressed in thousands. At December 31, 2013 Amount GAAP capital (Bank only) $ 195,844 Adjustment for regulatory capital: Intangible assets (2,246 ) Reverse the effect of SFAS No. 115 2,106 Tangible capital 195,704 Qualifying intangible assets - Tier 1 capital (core capital) 195,704 Qualifying general valuation allowance 10,893 Risk-based capital $ 206,597 As of December 31, 2013 Minimum Required for Minimum Required to be Actual Capital Adequacy Well Capitalized Amount Ratio Amount Ratio Amount Ratio Total risk-based capital to risk-weighted assets $ 206,597 24.0 % 68,888 ³8 % 86,110 ³10 % Tier 1 capital to adjusted tangible assets 195,704 16.8 % 46,498 ³4 % 58,123 ³5 % Tangible capital to tangible assets 195,704 16.8 % 17,437 ³1.5 % - - Tier 1 capital to risk-weighted assets 195,704 22.7 % - - 51,666 ³6 % Recent Legislation On July 21, 2010, the Dodd-Frank Act was signed into law. The Dodd-Frank Act implements far-reaching changes across the financial regulatory landscape, including provisions that, among other things: • Centralize responsibility for consumer financial protection by creating the Bureau of Consumer Financial Protection, with broad rulemaking, supervision and enforcement authority for a wide range of consumer protection laws that would apply to all banks and thrifts. Smaller financial institutions, including the Bank, will be subject to the supervision and enforcement of their primary federal banking regulator with respect to the federal consumer financial protection laws. • Require new capital rules that apply the same leverage and risk-based capital requirements applicable to insured depository institutions to savings and loan holding companies. • Require the federal banking regulators to seek to make their capital requirements countercyclical, so that capital requirements increase in times of economic expansion and decrease in times of economic contraction. • Provide for new disclosure and other requirements relating to executive compensation and corporate governance. • Make permanent the $250,000 limit for federal deposit insurance and provide unlimited federal deposit insurance until January 1, 2013 for non-interest bearing demand transaction accounts at all insured depository institutions. • Effective July 21, 2011, repealed the federal prohibitions on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts. • Require all depository institution holding companies to serve as a source of financial strength to their depository institution subsidiaries in the event such subsidiaries suffer from financial distress. 41 -------------------------------------------------------------------------------- Many aspects of the Dodd-Frank Act are subject to rulemaking and will take effect over several years, making it difficult to anticipate the overall financial impact on the Company and the financial services industry more generally. The elimination of the prohibition on the payment of interest on demand deposits could materially increase our interest expense, depending on how the marketplace responds. Provisions in the legislation that require revisions to the capital requirements of the Company and the Bank could require the Company and the Bank to seek additional sources of capital in the future. On January 10, 2013, the Consumer Finance Protection Bureau ("CFPB") issued a final rule that implements certain provision of the Dodd-Frank Act which prohibit creditors from making residential mortgage loans without regard to the borrower's repayment ability. The rule sets forth specific verification requirements, product features, and underwriting criteria that a lender must follow for residential mortgage loans to be treated as "qualified mortgages" and, therefore, subject to certain protections from liability. The final rule is effective for residential mortgage loan applications received on or after January 10, 2014. In July 2013, the federal banking agencies announced new risk-based capital and leverage ratios to conform to the Basel III framework and address provisions of the Dodd-Frank Act. With respect to the Company and the Bank, these requirements will become effective on January 1, 2015. See "Recent Amendments to Regulatory Capital Requirements" below for a discussion of these new Basel III requirements. On December 10, 2013, the federal banking agencies adopted the final version of the Volcker Rule which implements certain provision of the Dodd-Frank Act. The rule prohibits an insured depository institution and its affiliates from engaging in "proprietary trading;" acquiring or retaining an equity, partnership, or other ownership interest in a hedge fund or private equity fund; or sponsoring a hedge fund or private equity fund. The final rule will become effective on April 1, 2014. However, the conformance period was extended, and banks have until July 21, 2015, to bring their activities into compliance with the rule. Recent Amendments to Regulatory Capital Requirements In July 2013, the federal banking agencies approved amendments to their regulatory capital rules to conform them to the international regulatory standards agreed to by the Basel Committee on Banking Supervision in the accord often referred to as "Basel III". The revisions establish new higher capital ratio requirements, tighten the definitions of capital, impose new operating restrictions on banking organizations with insufficient capital buffers and increase the risk weighting of certain assets. The new capital requirements will apply to all banks and savings associations, bank holding companies with more than $500 million in assets and all savings and loan holding companies (other than certain savings and loan holding companies engaged in insurance underwriting and grandfathered diversified holding companies) regardless of asset size. The rules will become effective for the institutions with assets over $250 billion and internationally active institutions starting in January 2014 and will become effective for all other institutions beginning in January 2015. The following discussion summarizes the changes which are believed most likely to affect the Company and the Bank. New and Higher Capital Requirements. The regulations establish a new capital measure called "Common Equity Tier 1 Capital" which will consist of common stock instruments and related surplus (net of treasury stock), retained earnings, accumulated other comprehensive income and, subject to certain adjustments, minority common equity interests in subsidiaries. Unlike the current rules which exclude unrealized gains and losses on available-for-sale debt securities from regulatory capital, the amended rules would require accumulated other comprehensive income to flow through to regulatory capital unless a one-time, irrevocable opt-out election is made in the first regulatory reporting period under the new rule. Depository institutions and their holding companies will be required to maintain Common Equity Tier 1 Capital equal to 4.5% of risk-weighted assets by 2015. The regulations increase the required ratio of Tier 1 Capital to risk-weighted assets from the current 4% to 6% by 2015. Tier 1 Capital will consist of Common Equity Tier 1 Capital plus Additional Tier 1 Capital elements which would include non-cumulative perpetual preferred stock. Cumulative preferred stock (other than cumulative preferred stock issued to the U.S. Treasury under the TARP Capital Purchase Program or the Small Business Lending Fund) will no longer qualify as Additional Tier 1 Capital. Trust preferred securities and other non-qualifying capital instruments issued prior to May 19, 2010 by bank and savings and loan holding companies with less than $15 billion in assets as of December 31, 2009 or by mutual holding companies may continue to be included in Tier 1 Capital but will be phased out over 10 years beginning in 2016 for all other banking organizations. These non-qualifying capital instruments, however, may be included in Tier 2 Capital which could also include qualifying subordinated debt. The amended regulations also require a minimum Tier 1 leverage ratio of 4% for all institutions, eliminating the 3% option for institutions with the highest supervisory ratings. The minimum required ratio of total capital to risk-weighted assets will remain at 8%. 42 -------------------------------------------------------------------------------- Capital Conservation Buffer Requirement. In addition to higher capital requirements, depository institutions and their holding companies will be required to maintain a common equity Tier 1 capital conservation buffer of at least 2.5% of risk-weighted assets over and above the minimum risk-based capital requirements. Institutions that do not maintain the required capital buffer will become subject to progressively more stringent limitations on the percentage of earnings that can be paid out in dividends or used for stock repurchases and on the payment of discretionary bonuses to senior executive management. The capital conservation buffer requirement will be phased in over four years beginning in 2016. The capital conservation buffer requirement effectively raises the minimum required risk-based capital ratios to 7% Common Equity Tier 1 Capital, 8.5% Tier 1 Capital and 10.5% Total Capital on a fully phased-in basis. Changes to Prompt Corrective Action Capital Categories. The Prompt Corrective Action rules will be amended effective January 1, 2015 to incorporate a Common Equity Tier 1 Capital requirement and to raise the capital requirements for certain capital categories. In order to be adequately capitalized for purposes of the prompt corrective action rules, a banking organization will be required to have at least an 8% Total Risk-Based Capital Ratio, a 6% Tier 1 Risk-Based Capital Ratio, a 4.5% Common Equity Tier 1 Risk Based Capital Ratio and a 4% Tier 1 Leverage Ratio. To be well capitalized, a banking organization will be required to have at least a 10% Total Risk-Based Capital Ratio, an 8% Tier 1 Risk-Based Capital Ratio, a 6.5% Common Equity Tier 1 Risk Based Capital Ratio and a 5% Tier 1 Leverage Ratio. Federal savings associations will be required to calculate their prompt corrective action capital ratios in the same manner as national banks. Accordingly, tangible equity ratios will be based on average total assets rather than period-end total assets. Additional Deductions from Capital. Banking organizations will be required to deduct goodwill and other intangible assets (other than certain mortgage servicing assets), net of associated deferred tax liabilities, from Common Equity Tier 1 Capital. Deferred tax assets arising from temporary timing differences that cannot be realized through net operating loss carrybacks will continue to be deducted. Deferred tax assets that can be realized through NOL carrybacks will not be deducted but will be subject to 100% risk weighting. Defined benefit pension fund assets, net of any associated deferred tax liability, will be deducted from Common Equity Tier 1 Capital unless the banking organization has unrestricted and unfettered access to such assets. Reciprocal cross-holdings of capital instruments in any other financial institutions will now be deducted from capital, not just holdings in other depository institutions. For this purpose, financial institutions are broadly defined to include securities and commodities firms, hedge and private equity funds and non-depository lenders. Banking organizations will also be required to deduct non-significant investments (less than 10% of outstanding stock) in the capital of other financial institutions (including investments in trust preferred securities) to the extent these exceed 10% of Common Equity Tier 1 Capital subject to a 15% of Common Equity Tier 1 Capital cap. Greater than 10% investments must be deducted if they exceed 10% of Common Equity Tier 1 Capital. If the aggregate amount of certain items excluded from capital deduction due to a 10% threshold exceeds 17.65% of Common Equity Tier 1 Capital, the excess must be deducted. Savings associations will continue to be required to deduct investments in subsidiaries engaged in activities not permitted for national banks. Changes in Risk-Weightings. The federal banking agencies did not adopt a proposed rule that would have significantly changed the risk-weighting for residential mortgages. Instead, the amended regulations will continue to follow the current capital rules which assign a 50% risk-weighting to "qualifying mortgage loans" which generally consist of residential first mortgages with an 80% loan-to-value ratio (or which carry mortgage insurance that reduces the bank's exposure to 80%) that are not more than 90 days past due. All other mortgage loans will have a 100% risk weight. The revised regulations apply a 250% risk-weighting to mortgage servicing rights, deferred tax assets that cannot be realized through NOL carrybacks and investments in the capital instruments of other financial institutions that are not deducted from capital. The revised regulations also create a new 150% risk-weighting category for "high volatility commercial real estate loans" which are credit facilities for the acquisition, construction or development of real property other than for certain community development projects, agricultural land and one- to four-family residential properties or commercial real projects where: (i) the loan-to-value ratio is not in excess of interagency real estate lending standards; and (ii) the borrower has contributed capital equal to not less than 15% of the real estate's "as completed" value before the loan is made. LIQUIDITY AND CAPITAL RESOURCES Management believes that the Bank maintains sufficient liquidity to ensure safe and sound operation and that North American maintains a level of liquid assets adequate to meet the requirements of normal banking activities, including the repayment of maturing debt and potential deposit withdrawals. The Bank's primary sources of liquidity are cash and cash equivalents, the sale and repayment of loans, the retention of existing or newly acquired retail deposits, and FHLB advances. Additional sources of liquidity include the sale of investment securities available for sale, reverse repurchase agreements, FRB advances, and the acquisition of deposits through a nationwide internet listing service. 43-------------------------------------------------------------------------------- Management continues to use FHLB advances as a primary source of short-term funding. FHLB advances are secured by a blanket pledge agreement covering portions of the loan and securities portfolio as collateral, supported by quarterly reporting of eligible collateral to FHLB. FHLB borrowings are limited based upon a percentage of the Bank's assets and eligible collateral, as adjusted by collateral eligibility and maintenance levels. Management continually monitors the balance of eligible collateral relative to the amount of advances outstanding to determine the availability of additional FHLB advances. At December 31, 2013, the Bank had a total borrowing capacity at FHLB of $281.2 million, and outstanding advances of $210.0 million. As an additional source of liquidity, the Bank has $60.4 million of highly liquid short term U.S. Government sponsored agency securities in its portfolio at December 31, 2013. In accordance with the Consent Order with the OCC, which is described more fully in Footnote 15, Regulatory Agreements, the Bank is required to meet and maintain specific capital levels. This requirement prohibits the Bank from accepting, renewing, or rolling over any brokered deposits. Fluctuations in the level of interest rates typically impact prepayments on mortgage loans and mortgage related securities. During periods of falling rates, these prepayments increase and a greater demand exists for new loans. The Bank's ability to attract and retain customer deposits is partially impacted by area competition and by other alternative investment sources that may be available to the Bank's customers in various interest rate environments. Management believes that the Bank will retain most of its maturing time deposits in the foreseeable future. However, any material funding needs that may arise in the future can be reasonably satisfied through the use of the Bank's primary and additional liquidity sources, described above. Management is not currently aware of any other trends, market conditions, or other economic factors that could materially impact the Bank's primary sources of funding or affect its future ability to meet obligations as they come due. Although future changes to the level of market interest rates are uncertain, management believes its sources of funding will continue to remain stable during upward and downward interest rate environments. |