UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-K

 

Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2013

Commission File Number 001-32968

 

Hampton Roads Bankshares, Inc.

(Exact name of registrant as specified in its charter)

 

 

(757) 217-1000

(Registrant's telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

Title of each className of each exchange on which registered

Common Stock, par value $0.01 per share                     The NASDAQ Global Select Market

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ☐    No   ☒

 

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 ☒    

 

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 ☒   No☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).   Yes ☒    No ☐

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K 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, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Large accelerated filer  Accelerated filer  

Non-accelerated filer  Smaller reporting company ☒

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes ☐    No ☒

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter:  $27,469,052

 

The number of shares outstanding of the issuer's Common Stock as of March 1, 2014 was 170,265,154 shares, par value $0.01 per share.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

Portions of the registrant’s Proxy Statement for the 2014 Annual Meeting of Shareholders are incorporated by reference into Part III hereof.

 

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Hampton Roads Bankshares, Inc.

Form 10-K Annual Report

For the Year Ended December 31, 2013

Table of Contents

 

 

 

 

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PART 1

 

ITEM 1 - BUSINESS

 

Overview

 

Unless indicated otherwise, the terms “we,” “us,” or “our” refer to Hampton Roads Bankshares, Inc. and its consolidated subsidiaries.

 

Hampton Roads Bankshares, Inc. (the “Company”), a Virginia corporation, incorporated under the laws of the Commonwealth of Virginia on February 28, 2001, serves as a multi-bank holding company for Bank of Hampton Roads (“BOHR”) and Shore Bank (“Shore” and collectively, the “Banks”). 

 

On June 1, 2008, the Company acquired via merger all the outstanding shares of Shore Financial Corporation, making Shore a wholly-owned subsidiary of the Company.  Included in this merger was Shore Investments, Inc. which provides securities, brokerage, and investment advisory services, which was sold on December 31, 2013.

 

On December 31, 2008, the Company acquired via merger all of the outstanding shares of Gateway Financial Holdings, Inc. (“GFH”) making Gateway Bank & Trust Co. (“Gateway”) a wholly-owned subsidiary of the Company.  At the time of acquisition, Gateway had four wholly-owned subsidiaries:  Gateway Title Company; Gateway Insurance Services, Inc.; Gateway Investment Services, Inc.; and Gateway Bank Mortgage, Inc.  On May 11, 2009, Gateway was dissolved and merged into BOHR; the subsidiaries became wholly-owned subsidiaries of BOHR.  On October 29, 2010, Gateway Title Company was sold, and on August 1, 2011, Gateway Insurance Services, Inc. was sold.  Gateway Investment Services, Inc. is inactive.

 

BOHR is a Virginia state-chartered commercial bank with 17 full-service offices in the Hampton Roads region of southeastern Virginia, including six offices in the city of Chesapeake, three offices in the city of Norfolk, six offices in the city of Virginia Beach, one office in Emporia, and one office in the city of Suffolk.  In addition, BOHR has 10 full-service offices located in Richmond, Virginia and the Northeastern and Research Triangle regions of North Carolina that do business as Gateway.  BOHR has three wholly-owned operating subsidiaries: Harbour Asset Servicing, Inc., which is inactive; Gateway Investment Services, Inc., which is intended to assist customers in their securities brokerage activities through an arrangement with an unaffiliated broker-dealer earning revenue through a commission sharing arrangement with the unaffiliated broker-dealer, is currently inactive; and Gateway Bank Mortgage, Inc., which provides mortgage banking services such as originating and processing mortgage loans for sale into the secondary market.   

Shore is a Virginia state-chartered commercial bank with 6 full-service offices located on the Delmarva Peninsula, otherwise known as the Eastern Shore.  Shore operates on the Virginia and Maryland portions of the Eastern Shore, including the counties of Accomack and Northampton in Virginia and the Pocomoke City and Salisbury market areas in Maryland.  Shore has an investment in a Virginia title insurance agency that enables Shore to offer title insurance policies to its real estate loan customers.  On July 7, 2011, Shore expanded its Maryland banking operations into the West Ocean City, Maryland area with the opening of a Loan Production Office.  Additionally, a Loan Production Office was opened in Rehoboth Beach, Delaware on June 1, 2012.

 

During 2011, 2012, and 2013 one of our priorities was to return our focus to core community banking by making choices to reduce branches in close proximity with one another, which would improve overall efficiency, and enable us to shift capital towards investments in mobile and online technologies.  On December 31, 2010, we had 58 branches, and by December 31, 2013, we had reduced our branches to 33.

 

Our principal executive office is located at 641 Lynnhaven Parkway, Virginia Beach, Virginia 23452 and our telephone number is (757) 217-1000.  The Company’s common stock, par value $0.01 per share (the “Common Stock”), trades on the NASDAQ Global Select Market under the symbol “HMPR.”  A significant portion of our outstanding Common Stock is owned by three institutional investors.

 

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Business

 

Principal Products or Services

 

Hampton Roads Bankshares, Inc. engages in a general community and commercial banking business, targeting the banking needs of individuals and small- to medium-sized businesses in its primary service areas, which include the Hampton Roads region of southeastern Virginia, the Northeastern and Research Triangle regions of North Carolina, the Eastern Shore of Virginia, Maryland, and Delaware and Richmond, Virginia.  The Company’s primary products are traditional loan and deposit banking services.

 

We offer a broad range of interest-bearing and noninterest-bearing deposit accounts, including commercial and retail checking accounts, Negotiable Order of Withdrawal accounts, savings accounts, and individual retirement accounts as well as certificates of deposit with a range of maturity date options.  The primary sources of deposits are small- and medium-sized businesses and individuals within our target markets.  Additionally, we may obtain both national certificates of deposit and brokered certificates of deposit

All deposit accounts are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum allowed by law of $250,000.  We offer a range of commercial, real estate, and consumer loans.  Our loan portfolio is comprised of the following categories:  commercial and industrial, construction, real estate-commercial mortgage, real estate-residential mortgage, and installment.  Commercial and industrial loans are loans to businesses that are typically not collateralized by real estate.  Generally, the purpose of commercial and industrial loans is for the financing of accounts receivable, inventory, or equipment and machinery.  Construction loans are made to individuals and businesses for the purpose of construction of single family residential properties, multi-family properties, and commercial projects as well as the development of residential neighborhoods and commercial office parks.  We have continued to decrease our exposure to this category of loans within our portfolio.  Commercial mortgage loans are made for the purchase and re-financing of owner occupied commercial properties as well as non-owner occupied income producing properties.  Our residential mortgage portfolio includes first and junior lien mortgage loans, home equity lines of credit, and other term loans secured by first and junior lien mortgages.  Installment loans are made on a regular basis for personal, family, and general household purposes.  More specifically, we make automobile loans, home improvement loans, loans for vacations, and debt consolidation loans.

 

Our primary lending objective is to enhance customer relationships by meeting business and consumer needs in our market areas, while maintaining our standards of profitability and credit quality.  All lending decisions are based upon an evaluation of the financial strength and credit history of the borrower and the quality and value of the collateral securing the loan.  With few exceptions, personal guarantees are required on all loans.

 

The direct lending activities in which the Company engages carry the risk that the borrowers will be unable to perform on their obligations. As such, interest rate policies of the Board of Governors of the Federal Reserve System (the "Federal Reserve") and general economic conditions, nationally and in the Company's primary market areas, have a significant impact on the Company's results of operations. To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Company in full, in a timely manner, resulting in decreased earnings or losses to the Company. To the extent the Company makes fixed rate loans, general increases in interest rates will tend to reduce the Company's spread as the interest rates the Company must pay for deposits may increase while interest income may be unchanged. Economic conditions may also adversely affect the value of property pledged as security for loans and the ability to liquidate that property to satisfy a loan if necessary.

 

The Company's goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures and modifying those policies on occasion to account for changing or emerging risks or changing market conditions, evaluating each borrower's business plan and financial condition during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and maintaining sufficient collateral to mitigate economic loss in the event of liquidation. An allowance for loan losses has been established which consists of general, specific, and unallocated components. A risk rating system is employed to estimate loss exposure and provide a measuring system for setting general reserve allocations.  The general component relates to groups of homogeneous loans not designated for specific impairment analysis and are collectively evaluated for potential loss.  The specific component relates to

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loans that are determined to be impaired and, therefore, individually evaluated for impairment.  The specific allowance for loan losses is based on a loan-by-loan analysis and varies between impaired loans largely due to the value of the loan’s underlying collateral.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses and considers internal portfolio management effectiveness and external macroeconomic factors.

 

The composition of the Company's loan portfolio is weighted toward commercial real estate and real estate construction.  At December 31, 2013, commercial real estate and real estate construction represented approximately 54.1% of the loan portfolio.  These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow, and general economic conditions. The Company typically requires a maximum loan to value of 80% or less and minimum cash flow debt service coverage at the time of origination of 1.25 to 1.0. Personal guarantees are required by policy, with a limited number of exceptions being granted due to mitigating factors.

 

The general terms and underwriting standards for each type of commercial real estate and construction loan are incorporated into the Company's lending policies. These policies are analyzed periodically by management, and the policies are reviewed and approved by a designated subcommittee of the Board on an annual basis. The Company's loan policies and practices described in this report are subject to periodic change, and each guideline or standard is subject to waiver or exception in the case of any particular loan, with approval by the appropriate officer or committee, in accordance with the Company's loan policies. Policy standards are often stated in mandatory terms, such as "shall" or "must", but these provisions are subject to exception where appropriately mitigated. Policy requires that loan value not exceed a percentage of "market value" or "fair value" based upon appraisals or evaluations obtained in the ordinary course of the Company's underwriting practices.

 

Loans are secured primarily by duly recorded first deeds of trust. In some cases, the Company may accept a recorded second lien position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is required. Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Company. Guaranteed, fixed price construction contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

 

Commercial land acquisition and construction loans are secured by real property where loan proceeds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are required to contribute equity into each project at levels determined by Loan Policy. Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.  Loan-to-value ("LTV") ratios, with few exceptions, are maintained consistent with or below supervisory guidelines.

 

All construction draw requests must be presented in writing on American Institute of Architects documents and certified by the contractor, the borrower and the borrower's architect. Each draw request shall also include the borrower's soft cost breakdown certified by the borrower or its Chief Financial Officer. Prior to an advance, the Company or its contractor inspects the project to determine that the work has been completed in order to justify the draw requisition.

 

Commercial permanent loans are secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. At the time of origination, the debt service coverage ratio is ordinarily at least 1.25 to 1.0.  As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

 

Personal guarantees are generally received from the principals on commercial real estate loans, and only in instances where the loan-to-value is sufficiently low and the debt service is sufficiently high is consideration given to either limiting or not requiring personal recourse.

 

Updated appraisals for real estate secured loans are obtained as necessary and appropriate to borrower financial condition, project status, loan terms, and market conditions.

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The Company is also an active traditional commercial lender providing loans for a variety of purposes, including cash flow, equipment and accounts receivable financing. This loan category represents approximately 16.3% of the Company's loan portfolio at December 31, 2013 and is generally priced at a variable or adjustable rate. Commercial loans must meet reasonable underwriting standards, including appropriate collateral, and cash flow necessary to support debt service.  Residential home mortgage loans, including home equity lines and loans, make up 25.6% of the loan portfolio. These credits represent both first and second liens on residential property almost exclusively located in the Company’s primary market areas. The remaining 4.0% of the loan portfolio consists of retail consumer installment loans.

 

The risk of nonpayment (or deferred payment) of loans is inherent in commercial lending. The Company's marketing focus on small to medium-sized businesses may result in the assumption by the Company of certain lending risks that are different from those inherent in loans to larger companies. The policies and procedures of the Company dictate that all loan applications are to be carefully evaluated and attempt to minimize credit risk exposure by use of extensive loan application data, due diligence, and approval and monitoring procedures; however, there can be no assurance that such procedures can eliminate such lending risks.

 

We offer other banking-related specialized products and services to our customers, such as travelers’ checks, coin counters, wire services, online banking, and safe deposit box services. Additionally, we offer our commercial customers various cash management products including remote deposit. Remote Deposit Capture allows our customers to make check deposits conveniently from their office with a small desktop scanner for faster funds availability and to begin earning interest sooner. Our  merchant services offers a suite of payment processing solutions tailored to retailers and other specific industries allowing processing of all major credit cards 24 hours a day 365 days a year  We issue letters of credit and standby letters of credit, most of which are related to real estate construction loans, for some of our commercial customers.  We also facilitate the use of back-to-back swaps to help us and our customers manage interest rate risk.  We have not engaged in any securitizations of loans.

Additional Services

In addition to its banking operations, the Company has two other reportable segments:  Mortgage and Other.  Gateway Bank Mortgage, Inc. comprises our Mortgage segment and provides mortgage banking services such as originating and processing mortgage loans for sale to the secondary market.  Our Other segment includes two of our wholly-owned subsidiaries, Shore Investments, Inc. (sold on December 31, 2013) and Gateway Investment Services, Inc., which provide securities, brokerage, and investment advisory services and are capable of handling many aspects of wealth management including stocks, bonds, annuities, mutual funds, financial consultations, and insurance products.  At the end of the third quarter of 2011, the Company sold Gateway Insurance Services, Inc., a wholly-owned subsidiary.  As a result of the sale, the Company’s insurance segment was combined with the investment segment and holding company into the reportable segment “Other.”  For financial information about our business segments, see Note 17, Business Segment Reporting, of the Notes to Consolidated Financial Statements.

We offer telephone, internet, and mobile banking to our customers. These services allow both commercial and retail customers to access detailed account information and execute a wide variety of banking transactions, including balance transfers and bill payment, by means other than a traditional teller or automated teller machine (“ATM”). We believe these services are particularly attractive to our customers, as these services enable them to conduct their banking business and monitor their accounts at any time. Telephone, internet, and mobile banking assist us in attracting and retaining customers and encourage our existing customers to consider us for all of their banking and financial needs.

Throughout our markets, we have a network of thirty-seven ATMs, which are also accessible by the customers of our subsidiary banks.  Our customers can also access ATMs not owned by the Banks.

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Competition

 

The financial services industry in our market area remains highly competitive and is constantly evolving.  We experience strong competition from other financial services organizations, some of which are not subject to the same degree of regulation that is imposed on us.  Many of them have broader geographic markets and substantially greater resources, and therefore, can offer more diversified products and services. 

In our market areas, we compete with large national and regional financial institutions, savings banks, and other independent community banks, as well as credit unions, consumer finance companies, mortgage companies, and loan production offices.  Competition for deposits and loans is affected by factors such as interest rates and terms offered, the number and location of branches, types of products offered, and reputation of the institution.  We believe that our pricing and structure of products has remained competitive, but our historical success is primarily attributable to high quality service and community involvement.

 

Market

 

Our primary service area is encompassed by the Virginia Beach – Norfolk – Newport News, VA-NC Metropolitan Statistical Area, the 36th largest metropolitan area in the United States, with a population of approximately 1.7 million.  The Company’s market area includes the Hampton Roads region including the cities of Chesapeake, Norfolk, Virginia Beach, Portsmouth, and Suffolk, Virginia; the Northeastern and Research Triangle regions of North Carolina; the Eastern Shore of Virginia and Maryland; Richmond, Virginia; Ocean City, Maryland; and Rehoboth Beach, Delaware.  The Hampton Roads region is recognized as the eighth largest metro area in the Southeast U.S. and the second largest between Atlanta and Washington D.C.  Six of the 10 largest population centers in the U.S. are located within 750 miles of Hampton Roads.  This region has a diverse, well-rounded economy supported by a solid manufacturing base.  However, due to a substantial military presence, the U.S. government has a significant impact on the economy of our region. 

 

The U.S. Navy’s Atlantic Fleet is headquartered at the Norfolk Naval Base, which is the largest Navy base in the world.  Additionally, Portsmouth is the home of the Norfolk Naval Shipyard, which is the U.S. Navy’s largest ship repair yard, and the Portsmouth Naval Medical Center, the U.S. Navy’s largest hospital.  In Newport News, Newport News Shipbuilding, a division of Huntington Ingalls Industries, is the nation’s sole designer, builder, and refueler of nuclear-powered aircraft carriers and one of only two shipyards capable of designing and building nuclear-powered submarines.  The area is also home to the National Aeronautics and Space Administration / Langley Research Center in Hampton, the Colonial Williamsburg Foundation (hotels and museums), three marine terminals owned by the Virginia Port Authority (shipping), and the Anheuser-Busch Williamsburg Brewery (beverage).  Furthermore, the U.S. Army, Air Force, and Coast Guard each have a significant presence in the Greater Hampton Roads area with bases in the region.

 

Leading employers in the private sector include Stihl, Inc. (chain saws), Sumitomo Machinery Corporation of America (industrial motor drives), Canon Virginia, Inc. (copiers, laser printers, and supplies), Dollar Tree Stores, Inc. (retail), Lumber Liquidators, Inc. (hardwood flooring retailer), Norfolk Southern Corporation (transportation), and Mitsubishi Corporation (various manufacturing operations).

 

Virginia Markets

According to the Federal Reserve Bank of Richmond’s update on the economy in the Fifth district (which includes our major market areas), the labor market conditions have shown modest year-over-year growth in 2013.  During 2013, the Virginia Beach-Norfolk MSA grew payrolls by 1.2%, Richmond MSA grew by 1.5% and Virginia in total grew 0.8%.  Unemployment in Virginia was at 5.2% in December 2013 down from 5.6% in December 2012.  Virginia residents reported a 1.2% increase in personal income over the prior year; however, median family incomes in the Virginia Beach-Norfolk MSA saw year-over-year growth of 3.4%, while the Richmond MSA saw declines of 2.6%.  Non-business bankruptcies in 2013 in Virginia declined 4.9% compared to 2012.

 

Regarding mortgage delinquencies in the fourth quarter of 2013 compared to the fourth quarter of 2012, the share of all mortgages with payments more than 90 days late declined to 2.0% from 2.3%; the prime delinquency rate dropped to 0.9% from 1.1%.  According to CoreLogic Information Solutions, home prices in the state fell 0.3% in December 2013 but values appreciated 5.7% since December 2012. 

 

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North Carolina Markets

During 2013, the Durham MSA grew payrolls by 2.3%, Greensboro-High Point MSA grew by 1.6%, Raleigh-Cary MSA grew 2.4%, and North Carolina in total grew 1.6%.  Unemployment in North Carolina was at 6.9% in December 2013 down from 9.4% in December 2012.  North Carolina residents reported a 2.0% increase in personal income over the prior year; however, median family incomes in the markets we serve in North Carolina saw year-over-year declines ranging from 1.5% to 5.8%.  Non-business bankruptcies in 2013 declined 12.9% compared to 2012.

 

Regarding mortgage delinquencies in the fourth quarter of 2013 compared to the fourth quarter of 2012,  the share of all mortgages with payments more than 90 days late declined to 2.6% from 2.8%; the prime delinquency rate dropped to 1.2% from 1.4%.  According to CoreLogic Information Solutions, home prices in the state fell 0.3% in December 2013 but values appreciated 4.3% since December 2012. 

 

Concentrations

 

The majority of our depositors are located and doing business in our targeted market areas, and we lend a substantial portion of our capital and deposits to individual and business borrowers in these market areas.  Any factors adversely affecting the economy of the Greater Hampton Roads area could, in turn, adversely affect our performance.  The Company has no significant concentrations to any one customer. 

 

Government Supervision and Regulation

 

General

 

As a bank holding company, the Company is subject to regulation under the Bank Holding Company Act of 1956, as amended, and the examination and reporting requirements of the Federal Reserve.

 

Other federal and state laws govern the activities of our Banks, including the activities in which they may engage, the investments they may make, the aggregate amount of loans they may grant to one borrower, and the dividends they may declare and pay to us. Our banking subsidiaries are also subject to various consumer and compliance laws. As Virginia state-chartered banks, BOHR and Shore are primarily subject to regulation, supervision, and examination by the Bureau of Financial Institutions of the Virginia State Corporation Commission (“Bureau of Financial Institutions”).  In addition, we are regulated and supervised by the Federal Reserve through the Federal Reserve Bank of Richmond (“FRB”).  We must furnish to the Federal Reserve quarterly and annual reports containing detailed financial statements and schedules.  All aspects of our operations, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends, and establishment of branches are governed by these authorities.  These authorities are able to impose penalties, initiate civil and administrative actions, and take further steps to prevent us from engaging in unsafe or unsound practices.  In this regard, the Federal Reserve has adopted capital adequacy requirements. 

 

The following description summarizes the more significant federal and state laws applicable to us. To the extent that statutory or regulatory provisions are described, the description is qualified in its entirety by reference to that particular statutory or regulatory provision.

 

Bank Holding Company Act

 

Under the Bank Holding Company Act, we are subject to periodic examination by the Federal Reserve and required to file periodic reports regarding our operations and any additional information that the Federal Reserve may require. Our activities at the bank holding company level are limited to:

 

 

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Some of the activities that the Federal Reserve has determined by regulation to be closely related to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services, and acting in some circumstances as a fiduciary, investment, or financial adviser.

 

With some limited exceptions, the Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve before:

 

 

In addition, and subject to some exceptions, the Bank Holding Company Act and the Change in Bank Control Act (the “Acts”), together with their regulations, require Federal Reserve approval prior to any person or company acquiring “control” of a bank holding company, which is generally deemed to occur if an individual or company acquires 25% or more of any class of voting securities of the bank holding company. Under the Acts, prior notice to the Federal Reserve is required if a person acquires 10% or more, but less than 25%, of any class of voting securities and if the institution has registered securities under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or no other person owns a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenging this rebuttable control presumption.  CapGen Capital Group VI LP (“CapGen”) has received Federal Reserve approval as a bank holding company to “control” the Company and currently owns 29.97% of the outstanding Common Stock.  Our next two largest investors, Anchorage Capital Group, L.L.C. (“Anchorage”), and The Carlyle Group, L.P. (“Carlyle”) each own 24.90%, respectively, of the outstanding Common Stock, and are prohibited from owning 25% or more of the outstanding Common Stock of the Company.  None of our other investors currently owns 25% or more of the outstanding Common Stock of the Company.

 

Capital Requirements

 

The Federal Reserve has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises.  The federal capital standards define capital and establish minimum capital requirements in relation to assets and off-balance sheet exposure as adjusted for credit risk.  The risk-based capital standards currently in effect are designed to make regulatory capital requirements more sensitive to differences in risk profiles among bank holding companies and banks, to account for off-balance sheet exposure, and to minimize disincentives for holding liquid assets.  Assets and off-balance sheet items are assigned to broad risk categories, each with an appropriate risk weighting.  The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items.   

 

Under the risk-based capital requirements, the Company and our bank subsidiaries are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit).  At least half of the total capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings, qualifying perpetual preferred stock, and minority interests in common equity accounts of consolidated subsidiaries, less certain intangible assets. The remainder may consist of “Tier 2 Capital,” which is defined as subordinated debt, some hybrid capital instruments and other qualifying preferred stock, and a limited amount of the allowance for loan losses and pretax net unrealized holding gains on certain equity securities. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Under these requirements, banking organizations must maintain a minimum ratio of Tier 1 Capital to adjusted average quarterly assets equal to 4%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness. In summary, the capital measures used by the federal banking regulators are Total Risk-Based Capital ratio (the total of Tier 1 Capital and Tier 2 Capital as a percentage of total risk-weighted assets), Tier 1 Risk-Based Capital ratio (Tier 1 capital divided by total risk-weighted assets), and the Leverage ratio (Tier 1 capital divided by adjusted average total assets).  Generally, under these regulations, a bank will be:

 

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●  “well capitalized” if it has a Total Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capital ratio of 6% or greater, a Leverage ratio of 5% or greater,

●“adequately capitalized” if it has a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-Based Capital ratio of 4% or greater, and a Leverage ratio of 4% or greater (or 3% in certain circumstances) and is not well capitalized,

●“undercapitalized” if it has a Total Risk-Based Capital ratio of less than 8%, a Tier 1 Risk-Based Capital ratio of less than 4% (or 3% in certain circumstances), or a Leverage ratio of less than 4% (or 3% in certain circumstances),

●“significantly undercapitalized” if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1 Risk-Based Capital ratio of less than 3%, or a Leverage ratio of less than 3%, or

●“critically undercapitalized” if its tangible equity is equal to or less than 2% of tangible assets.

 

In addition, the Federal Reserve may require banks to maintain capital at levels higher than those required by general regulatory requirements.  BOHR and Shore were “well capitalized” at December 31, 2013.  

 

The risk-based capital standards of the FDIC and the FRB explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

 

Changes in Capital Requirements

 

In December 2010, the Basel Committee released its final framework for strengthening international capital and liquidity regulation on Banking Supervision in “Basel III:  A Global Regulatory Framework for More Resilient Banks and Banking Systems”. The Federal Reserve approved a final rule regarding capital requirements on July 2, 2013.  The rule will implement in the United States the Basel III regulatory capital reforms from the Basel Committee on Banking Supervision and certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Basel III will require bank holding companies and their bank subsidiaries to maintain more capital, with a greater emphasis on common equity.

 

The Basel III final capital framework, among other things, (i) introduces as a new capital measure “Common Equity Tier 1” (“CET1”), (ii) specifies that Tier 1 capital consists of CET1 and “Additional Tier 1 capital” instruments meeting specified requirements, (iii) defines CET1 narrowly by requiring that most adjustments to regulatory capital measures be made to CET1 and not to the other components of capital, and (iv) expands the scope of the adjustments as compared to existing regulations.

 

When fully phased-in, Basel III requires banks to maintain (i) as a newly adopted international standard, a minimum ratio of CET1 to risk-weighted assets of at least 4.5% plus a “capital conservation buffer” of 2.5%, (ii) a minimum ratio of Tier 1 capital to risk-weighted assets of at least 6.0% plus the capital conservation buffer, (iii) a minimum ratio of Total (Tier 1 plus Tier 2) capital to risk-weighted assets of at least 8.0% plus the capital conservation buffer, and (iv) as a newly adopted international standard, a minimum leverage ratio of 4%, calculated as the ratio of Tier 1 capital to balance sheet exposures plus certain off-balance sheet exposures (computed as the average for each quarter of the month-end ratios for the quarter).

 

Banking institutions with a ratio of CET1 to risk-weighted assets above the minimum but below the conservation buffer (or below the combined capital conservation buffer and countercyclical capital buffer, when the latter is applied) may face constraints on dividends, equity repurchases, and compensation based on the amount of the shortfall.

 

The Basel III final framework provides for a number of new deductions from and adjustments to CET1. These include, for example, the requirement that mortgage servicing assets, deferred tax assets related to temporary differences that could not be realized through net operating loss carrybacks, and significant investments in non-consolidated financial entities be deducted from CET1 to the extent that any one such category exceeds 10% of CET1 or all such categories in the aggregate exceed 15% of CET1.  The Company does not have any recognized mortgage servicing assets, deferred tax assets, or significant investments in non-consolidated entities as of December 31, 2013.

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The Basel III Capital Rules prescribe a standardized approach for risk weightings that expand the risk-weighting categories from the current four Basel I-derived categories (0%, 20%, 50% and 100%) to a much larger and more risk-sensitive number of categories, depending on the nature of the assets, generally ranging from 0% for U.S. government and agency securities, to 600% for certain equity exposures, and resulting in higher risk weights for a variety of asset categories. Specifics changes to current rules impacting the Company’s determination of risk-weighted assets include, among other things:

 

 

 

 

 

The new minimum capital requirements are effective January 1, 2015, whereas the capital conservation buffer and the deductions from common equity Tier 1 capital phase in between 2015 and 2019. 

 

The Basel III Notice also changes the prompt corrective action capital requirements effective in 2015. After the change, an institution would be deemed to be: (i) “well capitalized” if it has a total risk based capital ratio of 10.0% or more, a Tier 1 risk based capital ratio of 8.0% or more, a CET1 risk based capital ratio of 6.5% or more, and a leverage capital ratio of 5.0% or more, (ii) “adequately capitalized” if it has a total risk based capital ratio of 8.0% or more, a Tier 1 risk based capital ratio of 6.0% or more, a CET1 risk based capital ratio of 4.5% or more, and a leverage capital ratio of 4.0% or more, (iii) “undercapitalized” if it has a total risk based capital ratio of less than 8.0%, a Tier 1 risk based capital ratio of less than 6.0%, a CET1 risk based capital ratio of less than 4.5%, and a leverage capital ratio of less than 4.0%, (iv) “significantly undercapitalized” if it has a total risk based capital ratio of less than 6.0%, a Tier 1 risk based capital ratio of less than 4.0%, a CET1 risk based capital ratio of less than 3.0%, and a leverage capital ratio of less than 3.0%, and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is less than or equal to 2.0%. Tangible equity would be defined for this purpose as Tier 1 capital (common equity Tier 1 capital plus any additional Tier 1 capital elements) plus any outstanding perpetual preferred stock that is not already included in Tier 1 capital.

 

Payment of Dividends

 

The Company is a legal entity separate and distinct from the Banks and their subsidiaries. Substantially all of our cash revenues will result from dividends paid to us by our Banks and interest earned on short-term investments. Our Banks are subject to laws and regulations that limit the amount of dividends that they can pay. Under Virginia law, a bank may declare a dividend out of the bank’s net undivided profits, but not in excess of its accumulated retained earnings.  Additionally, our Banks may not declare a dividend, unless the dividend is approved by the Federal Reserve, if the total amount of all dividends, including the proposed dividend, declared by the bank in any calendar year exceeds the total of the bank’s retained net income of that year to date, combined with its retained net income of the two preceding years.  Federal Reserve regulations also provide that a bank may not declare a dividend in excess of its undivided profits without Federal Reserve approval.  Our Banks may not declare or pay any dividend if, after making the dividend, the bank would be “undercapitalized,” as defined in the banking regulations

 

The Federal Reserve and the Bureau of Financial Institutions have the general authority to limit the dividends paid by insured banks if the payment is deemed an unsafe and unsound practice. Both the Federal Reserve and the Bureau of Financial Institutions have indicated that paying dividends that deplete a bank’s capital base to an inadequate level would be an unsound and unsafe banking practice.

 

In addition, we are subject to certain regulatory requirements to maintain capital at or above regulatory minimums. These regulatory requirements regarding capital affect our dividend policies. Regulators have indicated that bank

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holding companies should generally pay dividends only if the organization’s net income attributable to Hampton Roads Bankshares, Inc.  over the past year has been sufficient to fully fund the dividends and the prospective rate of earnings retention appears consistent with the organization’s capital needs, asset quality, and overall financial condition.

 

Insurance of Accounts, Assessments, and Regulation by the FDIC

 

The deposits of our bank subsidiaries are insured by the FDIC up to the limits set forth under applicable law and are subject to the deposit insurance assessments of the Deposit Insurance Fund (“DIF”) of the FDIC.  Under the Dodd-Frank Act (refer to discussion below), a permanent increase in deposit insurance was authorized to $250,000.  The coverage limit is per depositor, per insured depository institution for each ownership category.

 

This system is intended to tie each bank’s deposit insurance assessments to the risk it poses to the FDIC’s DIF.  Under the risk-based assessment system, the FDIC evaluates each bank’s risk based on three primary factors:  (1) its supervisory rating, (2) its financial ratios, and (3) its long-term debt issuer rating, if applicable.  In addition to being influenced by the risk profile of the particular depository institution, FDIC premiums are also influenced by the size of the DIF in relation to total deposits in FDIC insured banks.  Rates vary between 2.5 and 45 basis points, depending on the insured institution’s Risk Category.  Initial base assessment rates range from 5-9 basis points for Risk Category I institutions to 35 basis points for Risk Category IV institutions.  In addition, premiums increase for institutions that rely on excessive amounts of brokered deposits to fund rapid growth, excluding Certificate of Deposit Account Registry Service (“CDARS”), and decrease for institutions’ unsecured debt.  After applying all possible adjustments, minimum and maximum total base assessment rates range from 2.5-9 basis points for Risk Category I institutions to 30-45 basis points for Risk Category IV institutions.  Either an increase in the Risk Category of our bank subsidiaries or adjustments to the base assessment rates could have a material adverse effect on our earnings.  As the DIF reserve ratio is replenished to certain thresholds in the future, these assessment rates will decrease without further action by the FDIC being required.  The FDIC also has authority to impose special assessments.

Assessments generally are based upon a depository institution’s average total consolidated assets minus the average tangible equity of the insured depository institution during the assessment period; whereas assessments were previously based on the amount of an institution’s insured deposits. Pursuant to the Dodd-Frank Act, the minimum deposit insurance fund ratio will increase from 1.15% to 1.35% by September 30, 2020, and the cost of the increase will be borne by depository institutions with assets of $10.0 billion or more.

The Dodd-Frank Act also provides the FDIC with discretion to determine whether to pay rebates to insured depository institutions when its deposit insurance reserves exceed certain thresholds. Previously, the FDIC was required to give rebates to depository institutions equal to the excess once the reserve ratio exceeded 1.50%, and was required to rebate 50% of the excess over 1.35% but not more than 1.50% of insured deposits. The FDIC adopted a final rule on February 7, 2011 that implemented these provisions of the Dodd-Frank Act. 

Additionally, by participating in the transaction account guarantee program under the FDIC Temporary Liquidity Guarantee Program (“TLGP”), banks temporarily become subject to an additional assessment on deposits in excess of $250,000 in certain transaction accounts and additionally for assessments from 50 basis points to 100 basis points per annum depending on the initial maturity of the debt. Further, all FDIC insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (“FICO”), an agency of the Federal Government established to recapitalize the predecessor to the DIF.  The FICO assessment rate, which is determined on a quarterly basis and computed on assets, was 0.0016% for the fourth quarter of 2013.  These assessments will continue until the FICO bonds mature in 2019. 

The FDIC is authorized to prohibit any insured institution from engaging in any activity that the FDIC determines by regulation or order to pose a serious threat to the DIF. Also, the FDIC may initiate enforcement actions against banks, after first giving the institution’s primary regulatory authority an opportunity to take such action. The FDIC may terminate the deposit insurance of any depository institution if it determines, after a hearing, that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed in writing by the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of

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insurance, if the institution has no tangible capital. If deposit insurance is terminated, the deposits at the institution at the time of termination, less subsequent withdrawals, shall continue to be insured for a period from six months to two years, as determined by the FDIC. We are unaware of any existing circumstances that could result in the termination of any of our bank subsidiaries’ deposit insurance.

Dodd-Frank Act

 

On July 21, 2010, the Dodd-Frank Act, which significantly changes the regulation of financial institutions and the financial services industry, was signed into law.  The Dodd-Frank Act, together with the regulations to be developed thereunder, includes provisions affecting large and small financial institutions alike, including several provisions that will affect how community banks, thrifts, and small bank and thrift holding companies will be regulated in the future.  The Dodd-Frank Act requires a number of federal agencies to adopt a broad range of new rules and regulations and to prepare various studies and reports for Congress.  The federal agencies are given significant discretion in drafting these rules and regulations, and consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for some time.

 

The Dodd-Frank Act, among other things, limits interchange fees payable on debit card transactions, includes provisions that affect corporate governance and executive compensation at all publicly-traded companies, and allows financial institutions to pay interest on business checking accounts.

 

On December 10, 2013, five financial regulatory agencies, including the Federal Reserve, Commodity Futures Trading Commission, FDIC, Office of the Comptroller of the Currency, and the Securities and Exchange Commission, adopted final rules implementing a provision of the Dodd-Frank Act, commonly referred to as the Volcker Rule.  The final rules generally would prohibit banking entities from:

 

On January 14, 2014, the five financial regulatory agencies approved an adjustment to the final rule by allowing banks to keep certain collateralized debt obligations (“CDOs”) acquired by the bank before the Volcker Rule was finalized, if the CDO was established before May 2010 and is backed primarily by trust preferred securities issued by banks with less than $15 billion in assets established.  The final rules are effective April 1, 2014, however, the Federal Reserve has extended the conformance period until July 21, 2015.  We are continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder. We own $26.9 million of collateralized loan obligation ("CLO") securities with a weighted average yield of 2.34% that are subject to the Volcker Rule. If we decide to sell or are required to sell these securities, our future net interest income could be adversely impacted if our alternative use for these funds yields a lower rate.

 

Consumer Financial Protection Bureau

 

The Dodd-Frank Act created a new, independent federal agency, the Consumer Financial Protection Bureau (“CFPB”) having broad rulemaking, supervisory, and enforcement powers under various federal consumer financial protection laws, including the Equal Credit Opportunity Act, Truth in Lending Act, Real Estate Settlement Procedures Act, Fair Credit Reporting Act, Fair Debt Collection Act, the Consumer Financial Privacy provisions of the Gramm-Leach-Bliley Act, and certain other statutes. The CFPB has examination and primary enforcement authority with respect to depository institutions with $10.0 billion or more in assets. Smaller institutions, including the Banks, are subject to rules promulgated by the CFPB but continue to be examined and supervised by federal banking regulators for consumer compliance purposes. The CFPB has authority to prevent unfair, deceptive, or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

 

In 2013, the CFPB adopted a rule, effective in January 2014, to implement certain sections of the Dodd-Frank Act requiring creditors to make a reasonable, good faith determination of a consumer’s ability to repay any closed-end consumer credit transaction secured by a 1-4 family dwelling.  The rule also establishes certain protections from

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liability under this requirement to ensure a borrower’s ability to repay for loans that meet the definition of “qualified mortgage.”  Loans that satisfy this “qualified mortgage” safe harbor will be presumed to have complied with the new ability-to-repay standard.  We have assessed our current lending practices and have determined that a large majority of mortgage loans that we originate are GSE eligible and are therefore qualified mortgages.  We have also determined that the Company’s lending policies comply with the requirement to consider certain underwriting factors under the ability-to-repay standard.

Emergency Economic Stabilization Act of 2008 (“EESA”)

The EESA, enacted on October 3, 2008, authorized the Secretary of the United States Department of the Treasury (the “Treasury”) to purchase or guarantee up to $700.0 billion in troubled assets from financial institutions under the Troubled Asset Relief Program (“TARP”).  Pursuant to authority granted under EESA, the Secretary of the Treasury created the TARP Capital Purchase Program (“TARP CPP”) under which the Treasury could invest up to $250.0 billion in senior preferred stock of U.S. banks and savings associations or their holding companies.

On December 31, 2008, the Company entered into a Letter Agreement and Securities Purchase Agreement with the Treasury under the Treasury’s TARP CPP, pursuant to which the Company sold 80,347 shares of our Fixed-Rate Cumulative Perpetual Preferred Stock, Series C, no par value per share, having a liquidation preference of $1,000 per share (the “Series C Preferred”)  and a warrant (the “Warrant”) to purchase 53,035 shares of our Common Stock at an initial exercise price of $227.25 per share, subject to certain anti-dilution and other adjustments, for an aggregate purchase price of $80.3 million in cash.

On August 12, 2010 the Company and Treasury executed the Exchange Agreement, which provided for (i) the exchange of 80,347 shares of Series C Preferred for 80,347 shares of a newly-created Series C-1 preferred stock (“Series C-1 Preferred”) with a liquidation preference of $1,000, (ii) the conversion of the Series C-1 Preferred at a discounted conversion value of $6,500 per share into 2,089,022 shares of the Company’s Common Stock at a conversion price of $10.00 per share, and (iii) the amendment of the terms of the Warrant to provide for the purchase of up to 53,035 shares of the Company’s Common Stock at an exercise price of $10.00 per share for a ten-year term following the issuance of the amended warrant to the Treasury (the “Amended TARP Warrant”).   The Company and Treasury consummated the transactions contemplated by the Exchange Agreement on September 30, 2010. 

On September 27, 2012, as a result of a capital raise and the Amended TARP Warrant not being excluded from the operation of the anti-dilution provisions, the number of shares purchasable was adjusted to 757,633 shares of the Company’s Common Stock and the exercise price to purchase such shares was adjusted to $0.70 per share.

As a result of the Company’s participation in the Treasury’s TARP CPP, it is required to meet certain standards for executive compensation and corporate governance set forth in EESA, as amended, by the American Recovery and Reinvestment Act of 2009 (the “ARRA”) and the Treasury’s implementing regulations thereunder.  On June 15, 2009, the Treasury published its standards for executive compensation and corporate governance.  These standards include, in part, (1) prohibitions on making golden parachute payments to senior executive officers and the next 5 most highly-compensated employees during such time as any obligation arising from financial assistance provided under the TARP remains outstanding (the “Restricted Period”), (2) prohibitions on paying or accruing bonuses or other incentive awards for certain senior executive officers and employees, except for awards of long-term restricted stock with a value equal to no greater than 1/3 of the subject employee’s annual compensation that do not fully vest during the Restricted Period unless such compensation is pursuant to a valid written employment contract prior to February 11, 2009, (3) requirements that TARP recipients provide for the recovery of any bonus or incentive compensation paid to senior executive officers and the next 20 most highly-compensated employees based on statements of earnings, revenues, gains, or other criteria later found to be materially inaccurate, with the Secretary of the Treasury having authority to negotiate for reimbursement, and (4) a review by the Secretary of the Treasury of all bonuses and other compensation paid by TARP recipients to senior executive employees and the next 20 most highly-compensated employees before the date of enactment of the ARRA to determine whether such payments were consistent with the purposes of the act.

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The Treasury’s standards also set forth additional corporate governance obligations for TARP recipients, including semi-annual meetings of compensation committees of the board of directors to discuss and evaluate employee compensation plans in light of an assessment of any risk posed from such compensation plans. TARP recipients are further required to have in place company-wide policies regarding excessive or luxury expenditures, permit non-binding shareholder “say-on-pay” proposals to be included in proxy materials, as well as require written certifications by the chief executive officer and chief financial officer with respect to compliance.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 comprehensively revised the laws affecting corporate governance, accounting obligations, and corporate reporting for companies with equity or debt securities registered under the Exchange Act, as amended. In particular, the Sarbanes-Oxley Act of 2002 established (1) requirements for audit committees, including independence, expertise, and responsibilities; (2) certification responsibilities for the chief executive officer and chief financial officer with respect to the Company’s financial statements; (3) standards for auditors and regulation of audits; (4) increased disclosure and reporting obligations for reporting companies and their directors and executive officers; and (5) increased civil and criminal penalties for violation of the federal securities laws.

Bank Secrecy Act (“BSA”)

 

Under the BSA, a financial institution is required to have systems in place to detect certain transactions, based on the size and nature of the transaction. Financial institutions are generally required to report cash transactions involving $10 thousand or more to the Treasury. In addition, financial institutions are required to file suspicious activity reports for transactions that involve $5 thousand or more and which the financial institution knows, suspects, or has reason to suspect involves illegal funds, is designed to evade the requirements of the BSA, or has no lawful purpose.

 

USA Patriot Act of 2001 (“Patriot Act”)

 

In October 2001, the Patriot Act was enacted in response to the terrorist attacks in New York, Pennsylvania, and Washington, D.C. that occurred on September 11, 2001.  The Patriot Act is intended to strengthen U.S. law enforcement and the intelligence communities’ abilities to work cohesively to combat terrorism on a variety of fronts.  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.  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.

 

Gramm-Leach-Bliley Act of 1999 (“GLBA”)

 

The GLBA covers a broad range of issues, including a repeal of most of the restrictions on affiliations among depository institutions, securities firms, and insurance companies. The following description summarizes some of its significant provisions.

 

The GLBA contains extensive customer privacy protection provisions. Under these provisions, a financial institution must provide to its customers, both at the inception of the customer relationship and on an annual basis, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information. The law provides that, except for specific limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure. An institution may not disclose to a non-affiliated third party, other than to a consumer credit reporting agency, customer account numbers or other similar account identifiers for marketing purposes. The GLBA also provides that the states may adopt customer privacy protections that are stricter than those contained in the act.

 

The GLBA repeals sections 20 and 32 of the Glass-Steagall Act, thus permitting unrestricted affiliations between banks and securities firms.

 

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Community Reinvestment Act of 1977 (“CRA”)

 

Under the CRA and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low- and moderate-income areas, consistent with safe and sound banking practice. The CRA requires the adoption by each institution of a CRA statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs. Depository institutions are periodically examined for compliance with the CRA and are periodically assigned ratings in this regard. Banking regulators consider a depository institution’s CRA rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiaries.

 

The GLBA and federal bank regulators have made various changes to the CRA. Among other changes, CRA agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulator. A bank holding company or any of its subsidiaries will not be permitted to engage in new activities authorized under the GLBA if any bank subsidiary received less than a “satisfactory” rating in its latest CRA examination.  During our last CRA exam, our rating was “satisfactory.”

 

Monetary Policy

 

The commercial banking business is affected not only by general economic conditions but also by the monetary policies of the Federal Reserve. The instruments of monetary policy employed by the Federal Reserve include open market operations in United States government securities, changes in the discount rate on member bank borrowings,  changes in reserve requirements against deposits held by federally insured banks, and quantitative easing. The Federal Reserve’s monetary policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. In view of changing conditions in the national and international economies and in the money markets, as well as the effect of actions by monetary and fiscal authorities, including the Federal Reserve, no prediction can be made as to possible future changes in interest rates, deposit levels, loan demand, or the business and earnings of our bank subsidiaries, their subsidiaries, or any of our other subsidiaries.

 

Transactions with Affiliates

 

Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by, or is under common control with such bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same as, or at least as favorable to those that, the bank has provided to a non-affiliate.

 

The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee, and similar other types of transactions. Section 23B applies to “covered transactions” as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same as, or at least as favorable to those that, the bank has provided to non-affiliates.

 

The Dodd-Frank Act changed the definition of “covered transaction” in Sections 23A and 23B and limitations on asset purchases from insiders. With respect to the definition of “covered transaction,” the Dodd-Frank Act defines that term to include the acceptance of debt obligations issued by an affiliate as collateral for a bank’s loan or extension of credit to another person or company. In addition, a “derivative transaction” with an affiliate is now deemed to be a “covered transaction” to the extent that such a transaction causes a bank or its subsidiary to have a credit exposure to the affiliate. A separate provision of the Dodd-Frank Act states that an insured depository institution may not “purchase an asset from or sell an asset to” a bank insider (or their related interests) unless (1) the transaction is conducted on market terms between the parties and (2) it has been approved in advance by the majority of the institution’s non-interested directors if the proposed transaction represents more than 10 percent of the capital stock and surplus of the insured institution.

 

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Loans to Insiders

 

The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers, and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act and Regulation O, loans to a director, an executive officer, and to a principal shareholder of a bank as well as to entities controlled by any of the foregoing may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the bank’s loan-to-one borrower limit. For this purpose, the bank’s loan-to-one borrower limit is 15% of the bank’s unimpaired capital and unimpaired surplus in the case of loans that are not fully secured and an additional 10% of the bank’s unimpaired capital and unimpaired surplus in the case of loans that are fully secured by readily marketable collateral having a market value at least equal to the amount of the loan.  Loans in the aggregate to insiders and their related interests as a class may not exceed the bank’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans above amounts prescribed by the appropriate federal banking agency to directors, executive officers, and principal shareholders of a bank or bank holding company and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. The Federal Reserve has prescribed the loan amount, which includes all other outstanding loans to such person as to which such prior board of director approval is required, as being the greater of $25 thousand or 5% of capital and surplus (up to $500 thousand). Section 22(h) requires that loans to directors, executive officers, and principal shareholders be made on terms and underwriting standards substantially the same as those offered in comparable transactions to other persons.  Violations of Section 22(h) of the Federal Reserve Act and Regulation O could subject the Company to civil penalties.  As of December 31, 2013, there were no loans to insiders and their related interests in the aggregate that exceeded the restrictions imposed by the Federal Reserve Act and related regulations.

 

Other Safety and Soundness Regulations    

 

There are significant obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance fund in the event that the depository institution is insolvent or is in danger of becoming insolvent. These obligations and restrictions are not for the benefit of investors. Regulators may pursue an administrative action against any bank holding company or bank that violates the law, engages in an unsafe or unsound banking practice, or is about to engage in an unsafe or unsound banking practice. The administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil monetary penalty action. A cease and desist order, in addition to prohibiting certain action, could also require that certain actions be undertaken. Under the Dodd-Frank Act and the policies of the Federal Reserve, we are required to serve as a source of financial strength to our subsidiary depository institutions and to commit resources to support the Banks in circumstances where we might not do so otherwise.

 

The federal banking agencies also have broad powers under current federal law to take prompt corrective action to resolve problems of insured depository institutions.  The extent of these powers depends upon whether the institution in question is well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized, as defined by the law.  As of December 31, 2013, BOHR and Shore were “well capitalized.”  

 

State banking regulators also have broad enforcement powers over the Banks, including the power to impose fines and other civil and criminal penalties and to appoint a conservator.

 

Consumer Laws Regarding Fair Lending

 

In addition to the CRA described above, other federal and state laws regulate various lending and consumer aspects of our business. Governmental agencies, including the United States Department of Housing and Urban Development, the Federal Trade Commission, and the United States Department of Justice, have become concerned that prospective borrowers may experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums of money, short of a full trial.

 

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These governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants but the practice had a discriminatory effect unless the practice could be justified as a business necessity.

 

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.

 

Future Regulatory Uncertainty

 

Because federal and state regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal and state regulation of financial institutions may change in the future and, as a result, impact our operations. As a result of the financial crisis, additional regulatory burden has been created, and we fully expect that the financial institution industry will remain heavily regulated going forward.

 

Recent Events

 

Written Agreement

 

The Company and BOHR entered into a Written Agreement with the FRB and the Bureau of Financial Institutions effective June 9, 2010.  Under the terms of the Written Agreement, BOHR agreed to certain actions and restrictions on its operations and could not declare or pay dividends to its shareholders without prior regulatory approval. The Written Agreement was terminated on February 20, 2014 and the Company and BOHR are no longer subject to its terms and conditions. The FRB and Bureau of Financial Institutions retain supervisory oversight following termination and have the ability to institute informal measures that could impose restrictions on the business activities of the company and its subsidiaries. Shore was not a party to the Written Agreement.

 

Employees

 

As of December 31, 2013, we employed 536 people, of whom 513 were full-time employees.  None of our employees are represented by any collective bargaining agreements.

 

Available Information

 

We maintain internet websites at www.bankofhamptonroads.com www.shorebank.com, and www.gatewaybankandtrust.com.  These websites contain a link to our filings with the Security Exchange Commission (“SEC”) on Form 10-K, Form 10-Q, and Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.  The reports are made available on this website as soon as practicable following the filing of the reports with the SEC.  The information is free of charge and may be reviewed, downloaded, and printed from the website at any time.

 

Any material we file with the SEC may be read and copied at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C.  20549.  You may obtain information on the operation of the SEC’s Public Reference Room by calling the SEC at 1-800-SEC-0330.  Copies of these materials may be obtained at prescribed rates from the SEC at such address.  These materials can also be inspected on the SEC’s web site at www.sec.gov.

 

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ITEM 1A – RISK FACTORS

 

An investment in our Common Stock involves risks.  You should carefully consider the risks described below in conjunction with the other information in this Form 10-K, including our consolidated financial statements and related notes, before investing in our Common Stock.  In addition to the other information contained in this report, the following risks may affect us.  This Form 10-K contains forward-looking statements that involve risks and uncertainties, including statements about our future plans, objectives, intentions, and expectations.  Past results are not a reliable indicator of future results, and historical trends should not be used to anticipate results or trends in future periods. Many factors, including those described below, could cause actual results to differ materially from those discussed in forward-looking statements.

 

Risks Relating to our Business

 

Our success is largely dependent on attracting and retaining key management team members.

 

We are a customer-focused and relationship-driven organization. Future growth is expected to be driven in large part by the relationships maintained with customers. While we have assembled an experienced and talented senior management team, maintaining this team, while at the same time developing other managers and/or attracting new talent in order that management succession can be achieved, is not assured. The unexpected loss of key employees could have a material adverse effect on our business and may result in lower revenues or reduced earnings.

 

We are not paying dividends on our Common Stock and currently are prevented from doing so.  The failure to resume paying dividends on our Common Stock may adversely affect the market price of our Common Stock.

 

We paid cash dividends on our Common Stock prior to the third quarter of 2009.  During the third quarter of 2009, we suspended dividend payments.  We are prevented by our regulators from paying dividends until our financial position improves.  In addition, the retained deficit of BOHR, our principal banking subsidiary, was $468.6 million as of December 31, 2013.  Absent permission from the Virginia State Corporation Commission, BOHR may pay dividends to us only to the extent of positive accumulated retained earnings.  It is unlikely in the foreseeable future that we would be able to pay dividends if BOHR cannot pay dividends to us.  Although we can seek to obtain a waiver of this prohibition, our regulators may choose not to grant such a waiver, and we would not expect to be granted a waiver or be released from this obligation until our financial performance and retained earnings improve significantly.  As a result, there is no assurance if or when we will be able to resume paying cash dividends. 

 

In addition, all dividends are declared and paid at the discretion of our Board of Directors and are dependent upon our liquidity, financial condition, results of operations, regulatory capital requirements, and such other factors as our Board of Directors may deem relevant.  The ability of our banking subsidiaries to pay dividends to us is also limited by obligations to maintain sufficient capital and by other general restrictions on dividends that are applicable to our banking subsidiaries.  If we do not satisfy these regulatory requirements, we are unable to pay dividends on our Common Stock. 

We have elected to defer the payment of interest on our outstanding trust preferred securities issued by trust subsidiaries of our holding company and expect to continue to defer the payment of interest for the foreseeable future.

Beginning in January 2010, we exercised our right to defer all quarterly distributions on our trust preferred securities.  Our deferral of interest payments for up to 20 consecutive quarters (through various dates during the first quarter of 2015 depending on the series of debt securities) does not constitute an event of default.  During the deferral period, the debt securities continue to accrue interest. To the extent applicable law permits interest on interest, the deferred interest payments also accrue interest at the rates specified in the corresponding indentures, compounded quarterly. At December 31, 2013 total accrued interest equaled $5.6 million. All of the deferred interest, including compounded interest, as to each series of debt securities is due in full at the end of the applicable deferral period. If we fail to pay the deferred and compounded interest at the end of the deferral period, the trustee of the corresponding trust, or in most cases the holders of as little as 25% of the aggregate liquidation amount of preferred securities, would have the right, after any applicable grace period, to exercise various remedies, including demanding immediate payment in full of the entire outstanding principal amount of such series of debt securities.  The aggregate principal amount of all such series of debt securities is $56.7 million.

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The retained deficit of BOHR, our principal banking subsidiary, was $468.6 million as of December 31, 2013.  Absent permission from the Virginia State Corporation Commission, BOHR may pay dividends to us only to the extent of positive accumulated retained earnings.  It is unlikely in the foreseeable future that we would be able to pay the interest accrued on our outstanding debt securities if BOHR cannot pay dividends to us.  Although we can seek to obtain a waiver of this prohibition, our regulators may choose not to grant such a waiver, and we would not expect to be granted a waiver of or be released from this obligation until our financial performance and retained earnings improve significantly.  As a result, if by January 17, 2015 we do not achieve sufficient profitability for BOHR so that our regulators would grant approval for BOHR to pay dividends, it is unlikely we will resume the payment of interest on the debt securities. Even if BOHR is able to resume paying dividends, we cannot be assured that the amount of dividends would be sufficient to pay the entire amount of interest due on the debt securities at the end of the deferral period.

 

The Volcker Rule collateralized loan obligation provisions could result in adverse consequences for us, including lower earnings, lower tangible capital and/or lower regulatory capital

The so-called “Volcker Rule” provisions of the Dodd-Frank Act restrict the ability of affiliates of insured depository institutions, such as the Banks, to sponsor or invest in private funds or to engage in certain types of proprietary trading. The Federal Reserve adopted final rules implementing the Volcker Rule in December 2013. We are continuing to evaluate the impact of the Volcker Rule and the final rules adopted thereunder. We own $26.9 million of CLO securities with a weighted average yield of 2.34% that are subject to the Volcker Rule. If we decide to sell or are required to sell these securities, our future net interest income could be adversely impacted if our alternative use for these funds yields a lower rate.

While there is a potential for additional regulatory guidance or a legislative ruling that would enable banks to continue to hold CLO securities under the Volcker Rule, to the extent this does not materialize nor do the regulators accept any structural solutions put forth by the financial services industry, we are currently subject to potentially significant price movements in these securities which could adversely impact our tangible capital. For instance, a hypothetical 10% reduction in current CLO market prices would result in a $5.0 million reduction to our current CLO securities valuation. Since these securities are currently held as available for sale, the resulting change in other comprehensive income (loss) would be approximately $5.0 million. Further, if we decide to sell these securities or if it is more likely than not that we will be required to sell such securities before recovery, we may recognize losses that could adversely impact our regulatory capital ratios. A loss of $5.0 million would lower regulatory capital by 23 basis points.

We incurred significant losses from 2009 to 2012.  While we returned to profitability in 2013, we can make no assurances that will continue.  An inability to improve our profitability could adversely affect our operations and our capital levels.

 

Since 2008, our loan customers have operated in an economically stressed environment.  While broader economic conditions have begun to gradually improve, economic conditions in the markets in which we operate remain somewhat constrained.  Consequently, the levels of loan delinquencies and defaults that we have experienced continue to be higher than historical levels and our net interest income, before the provision for loan losses, has not grown over this period

 

Our net income attributable to Hampton Roads Bankshares, Inc. for the year ended December 31, 2013 was $4.1 million but our net loss attributable to Hampton Roads Bankshares, Inc. for the years ended December 31, 2012 and December 31, 2011 was $25.1 million and $97.6 million, respectively.  There is no guarantee that we will be able to maintain this improvement in our net income. In addition to the risk that the broader economic conditions will stagnate or reverse their improvements, our mortgage banking earnings are particularly volatile due to their dependence upon the direction and level of mortgage interest rates, which have recently increased.

 

Our mortgage banking earnings are cyclical and sensitive to the level of interest rates, changes in economic conditions, decreased economic activity, and slowdowns in the housing market, any of which could adversely impact our results of operations.

 

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Our mortgage banking earnings are dependent upon our ability to originate loans and sell them to investors.  Loan production levels are sensitive to changes in the level of interest rates and changes in economic conditions.  A significant portion of recent increases in our mortgage banking earnings is due to the recent historically low interest rate environment that resulted in a high volume of mortgage loan refinancing activity. As the interest rate environment returns to more typical levels, mortgage loan refinancing activity has significantly reduced.  Loan production levels may also suffer if we experience a slowdown in the local housing market or tightening credit conditions.  Any sustained period of decreased activity caused by fewer refinancing transactions, higher interest rates, housing price pressure or loan underwriting restrictions would adversely affect our mortgage originations and, consequently, could significantly reduce our income from mortgage banking activities.  As a result, these conditions would also adversely affect our results of operations.

 

The formal investigation by the SEC may result in penalties, sanctions, or a restatement of our previously issued financial statements. 

 

Since April 2011, the SEC’s Division of Enforcement (the “Division”) has been conducting a formal investigation into the Company’s deferred tax asset valuation allowances, provision and allowance for loan losses, and other matters contained in its annual and quarterly reports for years 2008 through 2010.  The Company has fully cooperated with the Division and intends to continue to do so. However, the formal investigation continues.  At this time, we cannot predict when this investigation will be resolved or what form the eventual outcome will take.  It could result in material penalties, sanctions, or a restatement of our previously issued consolidated financial statements and may require significant time and attention from our management.

 

Economic, market, or operational developments may negatively impact our ability to maintain required capital levels or otherwise negatively impact our financial condition.

 

At December 31, 2013, BOHR and Shore were classified as “well capitalized” for regulatory capital purposes.  However, impairments to our loan or securities portfolio, declines in our earnings or a combination of these or other factors could change our capital position in a relatively short period of time.  If BOHR or Shore is unable to remain “well capitalized,” it will not be able to renew or accept brokered deposits without prior regulatory approval or offer interest rates on deposit accounts that are significantly higher than the average rates in its market area. As a result, it would be more difficult for us to attract new deposits as our existing brokered deposits mature and do not rollover and to retain or increase non-brokered deposits.  If we are not able to attract new deposits, our ability to fund our loan portfolio may be adversely affected.  In addition, we would be required to pay higher insurance premiums to the FDIC, which will reduce our earnings.

 

Virginia law and the provisions of our Articles of Incorporation and Bylaws could deter or prevent takeover attempts by a potential purchaser of our Common Stock that would be willing to pay you a premium for your shares of our Common Stock.

 

Our Articles of Incorporation, as well as the Company’s Bylaws (the “Bylaws”), contain provisions that may be deemed to have the effect of discouraging or delaying uninvited attempts by third parties to gain control of the Company. These provisions include the ability of our board to set the price, term, and rights of, and to issue, one or more series of our preferred stock. Our Articles of Incorporation and Bylaws do not provide for the ability of stockholders to call special meetings.

 

Similarly, the Virginia Stock Corporation Act contains provisions designed to protect Virginia corporations and employees from the adverse effects of hostile corporate takeovers. These provisions reduce the possibility that a third party could affect a change in control without the support of our incumbent directors. These provisions may also strengthen the position of current management by restricting the ability of shareholders to change the composition of the board, to affect its policies generally, and to benefit from actions that are opposed by the current board.

 

Our ability to maintain adequate sources of funding and liquidity may be negatively impacted by the economic environment which may, among other things, impact our ability to resume the payment of dividends or satisfy our obligations.

 

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The management of liquidity risk is critical to the management of our business and to our ability to service our customer base.  Our access to funding sources in amounts adequate to finance our activities on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general.  In managing our balance sheet, a primary source of funding is customer deposits. Our ability to continue to attract these deposits and other funding sources is subject to variability based upon a number of factors including volume and volatility in the securities markets and the relative interest rates that we are prepared to pay for these liabilities. Our potential inability to maintain adequate sources of funding may, among other things, impact our ability to resume the payment of dividends or satisfy our obligations.

 

An inability to raise funds through deposits, borrowings, the sale of investments or loans, the issuance of equity and debt securities, and other sources could have a substantial negative effect on our liquidity. Factors that could detrimentally impact our access to liquidity sources include operating losses; rising levels of non-performing assets; a decrease in the level of our business activity as a result of a downturn in the markets in which our loans or deposits are concentrated or as a result of a loss of confidence in us by our customers, lenders, and/or investors; or adverse regulatory action against us.  Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial industry.

 

The availability and level of deposits and other funding sources, including borrowings and the issuance of equity and debt securities, is highly dependent upon the perception of the liquidity and creditworthiness of the financial institution, and such perception can change quickly in response to market conditions or circumstances unique to a particular company. Concerns about our financial condition or concerns about our credit exposure to other persons could adversely impact our sources of liquidity, financial position, regulatory capital ratios, results of operations, and our business prospects.

 

Our future success is dependent on our ability to compete effectively in the highly competitive banking industry.

 

We face vigorous competition from other banks and other financial institutions, including savings and loan associations, savings banks, finance companies, and credit unions for deposits, loans, and other financial services that serve our market area.  A number of these banks and other financial institutions are significantly larger than we are and have substantially greater access to capital and other resources, as well as larger lending limits and branch systems, and offer a wider array of banking services.  Many of our non-bank competitors are not subject to the same extensive regulations that govern us. As a result, these non-bank competitors have advantages over us in providing certain services. While we believe we compete effectively with these other financial institutions serving our primary markets, we may face a competitive disadvantage to larger institutions.  If we have to raise interest rates paid on deposits or lower interest rates charged on loans to compete effectively, our net interest margin and income could be negatively affected. Failure to compete effectively to attract new, or to retain existing, clients may reduce or limit our margins and our market share and may adversely affect our results of operations, financial condition, growth, and the market price of our Common Stock.

 

Sales, or the perception that sales could occur, of large amounts of our Common Stock by our institutional investors may depress our stock price.

 

The market price of our Common Stock could drop if our existing shareholders decide to sell their shares.  As of December 31, 2013, Anchorage, CapGen, and Carlyle owned 24.90%, 29.97%, and 24.90%, respectively, of the outstanding shares of our Common Stock.  Pursuant to the various definitive investment agreements that we have entered into with these shareholders, the Company has an effective registration statement covering the resale of shares of our Common Stock by each of the shareholders listed above.  These shareholders could utilize this registration statement by reselling the shares of our Common Stock they currently hold.  If any of these shareholders sell large amounts of our Common Stock, or other investors perceive such sales to be imminent, the market price of our Common Stock could drop significantly.  In addition, sale of our Common Stock by Anchorage, CapGen, and Carlyle could adversely impact our ability to realize certain deferred tax benefits relating to prior losses, thereby increasing our effective tax rate in the future.

 

The concentration of our loan portfolio continues to be in real estate – commercial mortgage, equity line lending, and construction, which may expose us to greater risk of loss.

 

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Our business strategy centers, in part, on offering real estate - commercial mortgage and equity line loans secured by real estate in order to generate interest income.  These types of loans generally have higher yields due to an elevated risk profile compared to traditional one-to-four family residential mortgage loans.  At December 31, 2013 real estate – commercial mortgage and equity line lending totaled $590.5 million and $130.4 million, respectively.  These loan categories combined represented approximately 52.1% of total loans.  Such loans increase our credit risk profile relative to other financial institutions that have lower concentrations of real estate - commercial mortgage and equity line loans.

 

Loans secured by real estate – commercial mortgage properties are generally for larger amounts than one-to-four family residential mortgage loans.  Payments on loans secured by these properties generally are dependent on the income produced by the underlying properties which, in turn, depends on the successful operation and management of the properties.  Accordingly, repayment of these loans is subject to adverse conditions in the real estate market or the local economy.  While we seek to minimize these risks in a variety of ways, there can be no assurance that these measures will protect against credit-related losses.

 

Equity line lending allows a customer to access an amount up to their line of credit for the term specified in their agreement.  At the expiration of the term of an equity line, a customer may have the entire principal balance outstanding as opposed to a one-to-four family residential mortgage loan where the principal is disbursed entirely at closing and amortizes throughout the term of the loan.  We cannot predict when and to what extent our customers will access their equity lines.  While we seek to minimize this risk in a variety of ways, including attempting to employ conservative underwriting criteria, there can be no assurance that these measures will protect against credit-related losses.

 

Our loan portfolio contains loans used to finance construction and land development.  Construction financing typically involves a higher degree of credit risk than financing on improved, owner-occupied real estate.  Risk of loss on a construction loan is largely dependent upon the accuracy of the initial estimate of the property’s value at completion of construction, the marketability of the property, and the bid price and estimated cost (including interest) of construction.  If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project.  If the estimate of the value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project whose value is insufficient to assure full repayment.  When lending to builders, the cost of construction breakdown is provided by the builder, as well as supported by the appraisal.  Although our underwriting criteria were designed to evaluate and minimize the risks of each construction loan, there can be no guarantee that these practices will have safeguarded against material delinquencies and losses to our operations.

 

At December 31, 2013 we had loans of $158.5 million or 11.5% of total loans outstanding to finance construction and land development.  Construction and land development loans are dependent on the successful completion of the projects they finance, however, in many cases such construction and development projects in our primary market areas are not being completed in a timely manner, if at all.  A portion of our residential and real estate – commercial mortgage lending is secured by vacant or unimproved land.  Loans secured by vacant or unimproved land are generally more risky than loans secured by improved property for one-to-four family residential mortgage loans. Since vacant or unimproved land is generally held by the borrower for investment purposes or future use, payments on loans secured by vacant or unimproved land will typically rank lower in priority to the borrower than a loan the borrower may have on their primary residence or business.  These loans are more susceptible to adverse conditions in the real estate market and local economy.

 

If the value of real estate in the markets we serve were to decline materially, the value of our other real estate owned could decline or a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on our results of operations and financial condition.

 

With approximately three-fourths of our loans concentrated in the regions of Hampton Roads, Richmond, the Eastern Shore of Virginia, and the Triangle region of North Carolina, a decline in local economic conditions could adversely affect the value of the real estate collateral securing our loans.  A decline in property values could diminish our ability to recover on defaulted loans by selling the real estate collateral, making it more likely that we would suffer additional losses on defaulted loans and/or foreclosed properties by requiring additions to our allowance for loan losses through increased provisions for loan losses.  Also a decline in local economic conditions may have a greater effect on our earnings and capital than on the earnings and capital of financial institutions whose real estate portfolios are more

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geographically diverse.  The local economies where the Company does business are heavily reliant on military spending and may be adversely impacted by significant cuts to such spending that might result from recent Congressional budgetary enactments.  Real estate values are affected by various factors in addition to local economic conditions, including, among other things, changes in general or regional economic conditions, government rules or policies, and natural disasters.  While our policy is to obtain updated appraisals on a periodic basis, there are no assurances that we may be able to realize the amount indicated in the appraisal upon disposition of the underlying property.

 

We have had large numbers of problem loans.  Although problem loans have declined significantly, there is no assurance that they will continue to do so.

 

Our non-performing assets as a percentage of total assets decreased to 3.9% at December 31, 2013 from 6.4% at December 31, 2012.  On December 31, 2013, less than 1% of our loans was 30 to 89 days delinquent and treated as performing assets.  The administration of non-performing loans is an important function in attempting to mitigate any future losses related to our non-performing assets. 

 

The determination of the appropriate balance of our allowance for loan losses is merely an estimate of the inherent risk of loss in our existing loan portfolio and may prove to be incorrect.  If such estimate is proven to be materially incorrect and we are required to increase our allowance for loan losses, our results of operations, financial condition, and the market price of our Common Stock could be materially adversely affected. 

 

We maintain an allowance for loan losses, which is a reserve established through a provision for loan losses charged to our expenses that represents management’s best estimate of probable losses within our existing portfolio of loans.  Our allowance for loan losses was $35.0 million at December 31, 2013, which represented 2.53% of our total loans, as compared to $48.4 million, or 3.38% of total loans, at December 31, 2012.  The level of the allowance reflects management’s estimates and judgments as to specific credit risks, evaluation of industry concentrations, loan loss experience, current loan portfolio quality, present economic, political, and regulatory conditions, and incurred but unidentified losses inherent in the current loan portfolio.  For further discussion on the impact continued weak economic conditions have on the collateral underlying our loan portfolio, see above section “If the value of real estate in the markets we serve were to further decline materially, the value of our other real estate owned could decline or a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on our results of operations and financial condition.” 

 

The determination of the appropriate level of the allowance for loan losses inherently involves a high degree of subjectivity and requires management to make significant estimates of current credit risks and future trends, all of which may undergo material changes.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses of loans.  Such agencies may require us to recognize additional losses based on their judgments about information available to them at the time of their examination.  Furthermore, certain proposed changes to GAAP, if implemented as proposed, may require us to increase our estimate for losses embedded in our loan portfolio, resulting in an adverse impact to our results of operations and level of regulatory capital.  Accordingly, the allowance for loan losses may not be adequate to cover loan losses or significant increases to the allowance for loan losses may be required in the future if economic conditions should worsen.  Any such increases in the allowance for loan losses may have a material adverse effect on our results of operations, financial condition, and the market price of our Common Stock.

 

Our profitability will be jeopardized if we are unable to successfully manage interest rate risk.

 

Our profitability depends in substantial part upon the spread between the interest rates earned on investments and loans and the interest rates paid on deposits and other interest-bearing liabilities.  These rates are normally in line with general market rates and rise and fall based on management’s view of our needs.  Changes in interest rates will affect our operating performance and financial condition in diverse ways including the prices of securities, loans and deposits, and the volume of loan originations in our mortgage banking business, and could result in decreases to our earnings. Our net interest income will be adversely affected if market interest rates change so that the interest we pay on deposits and borrowings increases faster than the interest we earn on loans and investments.  This could, in turn, have a material adverse effect on the market price of our Common Stock.

 

We may face increasing deposit-pricing pressures, which may, among other things, reduce our profitability.

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Deposit pricing pressures may result from competition as well as changes to the interest rate environment. Under current conditions, pricing pressures also may arise from depositors who demand premium interest rates from what they perceive to be a troubled financial institution. There is intense competition for deposits. The competition has had an impact on interest rates paid to attract deposits as well as fees charged on deposit products. In addition to the competitive pressures from other depository institutions, we face heightened competition from non-depository financial products such as securities and other alternative investments.

 

Furthermore, technology and other market changes have made it more convenient for bank customers to transfer funds for investing purposes. Bank customers also have greater access to deposit vehicles that facilitate spreading deposit balances among different depository institutions to maximize FDIC insurance coverage. In addition to competitive forces, we also are at risk from market forces as they affect interest rates. It is not uncommon when interest rates transition from a low interest rate environment to a rising rate environment for deposit and other funding costs to rise in advance of yields on earning assets. In order to keep deposits required for funding purposes, it may be necessary to raise deposit rates without commensurate increases in asset pricing in the short term. Finally, we may see interest rate pricing pressure from depositors concerned about our financial condition and levels of non-performing assets.

 

We face a variety of threats from technology-based frauds and scams.

 

Financial institutions are a prime target of criminal activities through various channels of information technology. We attempt to mitigate risk from such activities through policies, procedures, and preventative and detective measures. In addition, we maintain insurance coverage designed to provide a level of financial protection to our business. However, risks posed by business interruption, fraud losses, business recovery expenses, and other potential losses or expenses that may be experienced from a significant event are not readily predictable and, therefore, could have an impact on our results of operations.

 

Our operations and customers might be affected by the occurrence of a natural disaster or other catastrophic event in our market area.

 

Because a substantial portion of our loans are with customers and businesses located in the central and coastal portions of Virginia, North Carolina, and Maryland, catastrophic events, including natural disasters such as hurricanes which have historically struck the east coast of the United States with some regularity, or terrorist attacks, could disrupt our operations. Any of these natural disasters or other catastrophic events could have a negative impact on our financial centers and customer base as well as collateral values and the strength of our loan portfolio. Any natural disaster or catastrophic event affecting us could have a material adverse impact on our operations and the market price of our Common Stock. 

 

The Company received a grand jury subpoena from the United States Department of Justice, Criminal Division (“DOJ”).  Although the Company has been advised that it is not a target or a subject of the investigation at this time and we do not believe we will become a target or a subject of the investigation, there can be no assurances as to the timing or eventual outcome of the related investigation. 

 

On November 2, 2010, the Company received from the DOJ a grand jury subpoena to produce information principally relating to the merger of GFH into the Company on December 31, 2008 and to loans made by GFH and its wholly-owned subsidiary, Gateway, before GFH’s merger with the Company. The DOJ has informed the Company that it is not a target or a subject of the investigation at this time, and we are fully cooperating.  Although we do not believe this matter will have a material adverse effect on the Company, we can give you no assurances as to the timing or eventual outcome of this investigation.  The Company is not aware of any recent developments in this matter and has not been notified of any developments in over a year.  The Company has not had contact with the DOJ related to the grand jury subpoena since April 2011.

 

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Risks Relating to Market, Legislative, and Regulatory Events

 

Our business, financial condition, and results of operations are highly regulated and could be adversely affected by new or changed regulations and by the manner in which such regulations are applied by regulatory authorities.

 

Current economic conditions, particularly in the financial markets, have resulted in government regulatory agencies placing increased focus and scrutiny on the financial services industry.  The U.S. Government has intervened on an unprecedented scale, responding to what has been commonly referred to as the financial crisis.  In addition to participating in the Treasury’s TARP CPP, the U.S. Government has taken steps that include enhancing the liquidity support available to financial institutions, establishing a commercial paper funding facility, temporarily guaranteeing money market funds and certain types of debt issuances, and increasing insured deposits.  These programs subject us and other financial institutions who have participated in these programs to additional restrictions, oversight and/or costs that may have an impact on our business, financial condition, results of operations, and the price of our Common Stock.

 

Compliance with such regulation and scrutiny may significantly increase our costs, impede the efficiency of our internal business processes, require us to increase our regulatory capital, and limit our ability to pursue business opportunities in an efficient manner.  We also will be required to pay significantly higher FDIC premiums because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.  The increased costs associated with anticipated regulatory and political scrutiny could adversely impact our results of operations.

 

New proposals for legislation continue to be introduced in the U.S. Congress that could further substantially increase regulation of the financial services industry.  Federal and state regulatory agencies also frequently adopt changes to their regulations and/or change the manner in which existing regulations are applied.  We cannot predict whether any pending or future legislation will be adopted or the substance and impact of any such new legislation on us.  Additional regulation could affect us in a substantial way and could have an adverse effect on our business, financial condition, and results of operations.

 

Banking regulators have broad enforcement power, but regulations are meant to protect depositors and not investors.

 

We are subject to supervision by several governmental regulatory agencies.  The regulators’ interpretation and application of relevant regulations, are beyond our control, may change rapidly and unpredictably, and can be expected to influence our earnings and growth.  In addition, if we do not comply with regulations that are applicable to us, we could be subject to regulatory penalties, which could have an adverse effect on our business, financial condition, and results of operations.  Until February 20, 2014 we were subject to a Written Agreement with the FRB and Bureau of Financial Institutions. Under the terms of the Written Agreement, BOHR agreed to certain actions and restrictions on its operations and could not declare or pay dividends to its shareholders without prior regulatory approval. We can give no assurance that our regulators will not impose similar restrictions and requirements on us in the future.

 

All such government regulations may limit our growth and the return to our investors by restricting activities such as the payment of dividends, mergers with, or acquisitions by, other institutions, investments, loans and interest rates, interest rates paid on deposits, the use of brokered deposits, and the creation of financial centers.  Although these regulations impose costs on us, they are intended to protect depositors.  The regulations to which we are subject may not always be in the best interests of investors. 

 

The fiscal, monetary, and regulatory policies of the Federal Government and its agencies could have a material adverse effect on our results of operations.

 

The Federal Reserve regulates the supply of money and credit in the United States.  Its policies determine, in large part, the cost of funds for lending and investing and the return earned on those loans and investments, both of which affect our net interest margin.  It also can materially decrease the value of financial assets we hold, such as debt securities.  Its policies also can adversely affect borrowers, potentially increasing the risk that they may fail to repay their loans. 

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In addition, as a public company we are subject to securities laws and standards imposed by the Sarbanes-Oxley Act of 2002. Because we are a relatively small company, the costs of compliance are disproportionate compared with much larger organizations.  Continued growth of legal and regulatory compliance mandates could adversely affect our expenses, future results of operations, and the market price of our Common Stock.  In addition, the government and regulatory authorities have the power to impose rules or other requirements, including requirements that we are unable to anticipate, that could have an adverse impact on our results of operations and the market price of our Common Stock. 

 

Government legislation and regulation may adversely affect our business, financial condition, and results of operations.

 

On July 21, 2010, President Obama signed the Dodd-Frank Act into law. The Dodd-Frank Act makes extensive changes to the laws regulating financial services firms and requires significant rule-making. In addition, the law mandates multiple studies, which could result in additional legislative or regulatory action.  The Dodd-Frank Act has and will continue to have a broad impact on the financial services industry, including significant regulatory and compliance changes designed to improve supervision and oversight of and strengthen safety and soundness for the financial services sector.  Many of the provisions of the Dodd-Frank Act have begun to be or will be implemented over the next few years and will be subject to further rulemaking and the discretion of applicable regulatory bodies.  Because the ultimate impact of the Dodd-Frank Act will depend on future regulatory rulemaking and interpretation, we cannot predict the full effect of this legislation on our business, financial condition, or results of operations.  

 

Although management does not expect the Dodd-Frank Act to have a material adverse effect on the Company, it is not possible to predict at this time all the effects the Dodd-Frank Act will have on the Company and the rest of our industry.  It is possible that the Company’s interest expense could increase and deposit insurance premiums could change and steps may need to be taken to increase qualifying capital.  The full impact of the Volcker Rule, a component of the Dodd-Frank Act, is yet to be determined.  However, should the Company have to divest itself of any investments deemed covered funds under the final rule, this may cause the recognition of current unrealized losses and negatively impact current operating results.

 

On June 6, 2012, the federal bank regulatory agencies issued a series of proposed rules to revise the risk-based and leverage capital requirements and the method for calculating risk-weighted assets to make them consistent with the agreements that were reached by the Basel Committee in Basel III.  These federal bank regulatory agencies approved final rules on July 2, 2013.  The rules apply to all depository institutions, top-tier bank holding companies with total consolidated assets of $500.0 million or more, and top-tier savings and loan holding companies (“banking organizations”).  Although the final rules contain significant revisions from the proposed rules intended to provide relief to community banks, such as BOHR and Shore, many of the Basel III rules will apply to these institutions.  Among other things, the rules establish a new common equity Tier 1 minimum capital requirement and a higher minimum Tier 1 capital requirement, changes in the treatment of unrealized gains and losses on available-for-sale securities in the calculation of regulatory capital, and assigns higher risk weightings (150%) to exposures that are more than 90 days past due or are on nonaccrual status and certain commercial real estate facilities that finance the acquisition, development, or construction of real property.  The rules also limit a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a “capital conservation buffer” consisting of a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements.  For community banking organizations, the rules will be phased in beginning in 2015 and 2016.  The Company is diligently assessing the impact of this rule making on our capital and the amount of capital required to support our business, which could adversely affect our results of operations and financial condition.

 

For further discussion of these issues, see the “Government Supervision and Regulation” section found in Item 1 of this document.

 

Proposed and final regulations could restrict our ability to originate loans.

 

The CFPB has issued a rule designed to clarify how lenders can avoid legal liability under the Dodd-Frank Act, which would hold lenders accountable for ensuring a borrower’s ability to repay a mortgage. Loans that meet this

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definition of “qualified mortgage” will be presumed to have complied with the new ability-to-repay standard. Under the CFPB’s rule, a “qualified mortgage” loan must not contain certain specified features, including:

 

 

Also, to qualify as a “qualified mortgage,” a borrower’s total monthly debt-to-income ratio may not exceed 43%. Lenders must also verify and document the income and financial resources relied upon to qualify the borrower for the loan and underwrite the loan based on a fully amortizing payment schedule and maximum interest rate during the first five years, taking into account all applicable taxes, insurance and assessments. The CFPB’s rule on qualified mortgages and similar rules could limit our ability to make certain types of loans or loans to certain borrowers, or could make it more expensive and time-consuming to make these loans, which could limit our growth or profitability.

 

The soundness of other financial institutions could adversely affect us.

 

Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions.  Financial services institutions are interrelated as a result of trading, clearing, counterparty, or other relationships.  As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry, generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions.  Many of these transactions expose us to credit risk in the event of default of our counterparty or client.  In addition, our credit risk may be exacerbated when the collateral held by us cannot be liquidated at prices sufficient to recover the full amount of the financial instrument exposure due to us.  There is no assurance that any such losses would not materially and adversely affect our results of operations and the value of, or market for, our Common Stock.

 

ITEM 1B – UNRESOLVED STAFF COMMENTS

 

Not applicable.

 

ITEM 2 - PROPERTIES

 

We own our executive office, which is located at 641 Lynnhaven Parkway, Virginia Beach, Virginia 23452.  As of December 31, 2013, we operated from the locations listed below:

 

 

 

All of our properties are in good operating condition and are adequate for our present and anticipated future needs.

 

ITEM 3 - LEGAL PROCEEDINGS

 

In the ordinary course of operations, the Company may become a party to legal proceedings.  Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on our business, financial condition, cash flows, or results of operations except as provided below.

 

In April 2011, the SEC informed the Company that it is conducting a formal investigation related to certain accounting matters.  For a further discussion of this matter, see section “Risk Factors – Risks Relating to our Business – The formal investigation by the SEC may result in penalties, sanctions, or a restatement of our previously issued financial statements.”

 

On November 2, 2010, the Company received a grand jury subpoena from the United States Department of Justice, Criminal Division.  For a discussion of this matter, see section “Risk Factors – Risks Relating to our Business – The Company received a grand jury subpoena from the United States Department of Justice, Criminal Division.  Although the Company has been advised that it is not a target or a subject of the investigation at this time and we do not believe we will become a target or a subject of the investigation, there can be no assurances as to the timing or the eventual outcome of the related investigation.”

 

On November 6, 2013, the Company received a notice of violation and intent to seek civil money penalty from the U.S. Department of Housing and Urban Development (“HUD”) stating that HUD is considering taking administrative action against and imposing civil money penalties on Gateway Mortgage for certain asserted

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violations of HUD and Federal Housing Administration requirements. We do not believe the outcome of this proceeding will have a material effect on our business, financial condition, cash flows, or results of operations.

 

ITEM 4 - MINE SAFETY DISCLOSURES

 

None.

 

PART II

 

ITEM 5 - MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED SHAREHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Price of Common Stock and Dividend Payments

 

Market Information

 

Our Common Stock began trading on the NASDAQ Global Select Market under the symbol “HMPR” on September 12, 2007.  Prior to listing on the NASDAQ Global Select Market, our Common Stock traded on the NASDAQ Capital Market starting on August 3, 2006.

 

 

The following table sets forth for the periods indicated the high and low prices per share of our Common Stock as reported on the NASDAQ Global Select Market along with the quarterly cash dividends per share declared.  Per share prices do not include adjustments for markups, markdowns, or commissions.

 

 

Number of Shareholders of Record

 

As of February 28, 2014, we had 170,263,264 shares of Common Stock outstanding, which were held by 2,866 shareholders of record.

 

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Dividend Policy

 

We have historically paid cash dividends on a quarterly basis.  However, on July 30, 2009, the Board of Directors voted to suspend the quarterly dividend on Common Stock of the Company in order to preserve capital and liquidity.  Our ability to distribute cash dividends in the future may be limited by negative regulatory restrictions and the need to maintain sufficient consolidated capital.  In addition, the retained deficit of BOHR, our principal banking subsidiary, was $468.6 million as of December 31, 2013.  Absent permission from the Virginia State Corporation Commission, BOHR may pay dividends to us only to the extent of positive accumulated retained earnings.  It is unlikely in the foreseeable future that we would be able to pay dividends if BOHR cannot pay dividends to us.  Although we can seek to obtain a waiver of this prohibition, our regulators may choose not to grant such a waiver, and we would not expect to be granted a waiver or be released from this obligation until our financial performance and retained earnings improve significantly.  As a result, there is no assurance if or when we will be able to resume paying cash dividends.

 

Recent Sales of Unregistered Securities

 

Not applicable.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

The Company announced an open ended program on August 13, 2003 by which management was authorized to repurchase an unlimited number of the Company’s shares of Common Stock in the open market and through privately negotiated transactions.  During 2013 the Company did not purchase any shares of its Common Stock.

 

ITEM 6 - SELECTED FINANCIAL DATA

 

Not applicable.

 

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

 

Executive Overview

 

The following commentary provides information about the major components of our results of operations, financial condition, liquidity, and capital resources.  This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements.

 

Hampton Roads Bankshares, Inc. (the “Company”) is a multi-bank holding company headquartered in Virginia Beach, Virginia.  The Company’s primary subsidiaries are Bank of Hampton Roads (“BOHR”) and Shore Bank (“Shore” collectively the “Banks”).  The Banks engage in general community and commercial banking business, targeting the needs of individuals and small- to medium-sized businesses in our primary service areas.  Currently, BOHR operates 17 full-service offices in the Hampton Roads region of southeastern Virginia and 10 full-service offices throughout Richmond, Virginia and the Northeastern and Research Triangle regions of North Carolina that do business as Gateway Bank & Trust Co. (“Gateway”).  Shore operates 6 full-service offices in the Eastern Shore of Virginia and Maryland.  Through various affiliates, the Banks also offer mortgage banking and investment services.  Our largest investor shareholders include Anchorage Capital Group, L.L.C. (“Anchorage”), CapGen Capital Group VI LP (“CapGen”), and The Carlyle Group, L.P. (“Carlyle”).  Anchorage, CapGen, and Carlyle own 24.90%, 29.97%, and 24.90%, respectively, of the outstanding shares of our Common Stock as of December 31, 2013. 

 

Our primary source of revenue is net interest income earned by our bank subsidiaries.  Net interest income represents interest and fees earned from lending and investment activities less the interest paid on deposits and borrowings.  Net interest income may be impacted by variations in the volume and mix of interest-earning assets and interest-bearing liabilities, changes in the yields earned and the rates paid, level of non-performing assets, and the level of noninterest-bearing liabilities available to support earning assets.  In addition to net interest income, noninterest income is another important source of revenue.  Noninterest income is derived primarily from service charges on deposits and mortgage banking revenue.  Gains and losses on the sale or impairment of our other real

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estate owned and repossessed assets are recognized in noninterest income.  Other significant factors that impact net income (loss) attributable to Hampton Roads Bankshares, Inc. are the provision for loan losses, noninterest expense, and income taxes.

 

The direct lending activities in which the Company engages carry the risk that the borrowers will be unable to perform on their obligations. As such, interest rate policies of the Board of Governors of the Federal Reserve System (the "Federal Reserve") and general economic conditions, nationally and in the Company's primary market areas, have a significant impact on the Company's results of operations. To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Company in full, in a timely manner, resulting in decreased earnings or losses to the Company. To the extent the Company makes fixed rate loans, general increases in interest rates will tend to reduce the Company's spread as the interest rates the Company must pay for deposits may increase while interest income may be unchanged. Economic conditions may also adversely affect the value of property pledged as security for loans and the ability to liquidate that property to satisfy a loan if necessary.

 

The Company's goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include: carefully enforcing loan policies and procedures and modifying those policies on occasion to account for changing or emerging risks or changing market conditions, evaluating each borrower's business plan and financial condition during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and maintaining sufficient collateral to mitigate economic loss in the event of liquidation. An allowance for loan losses has been established which consists of general, specific, and unallocated components. A risk rating system is employed to estimate loss exposure and provide a measuring system for setting general reserve allocations.  The general component relates to groups of homogeneous loans not designated for specific impairment analysis and are collectively evaluated for potential loss.  The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment.  The specific allowance for loan losses is based on a loan-by-loan analysis and varies between impaired loans largely due to the value of the loan’s underlying collateral.  An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses and considers internal portfolio management effectiveness and external macroeconomic factors.

 

The composition of the Company's loan portfolio is weighted toward commercial real estate and real estate construction.  At December 31, 2013, commercial real estate and real estate construction represented approximately 54.1% of the loan portfolio.  These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow, and general economic conditions. The Company typically requires a maximum loan to value of 80% or less and minimum cash flow debt service coverage at the time of origination of 1.25 to 1.0. Personal guarantees are required by policy, with a limited number of exceptions being granted due to mitigating factors.

 

The general terms and underwriting standards for each type of commercial real estate and construction loan are incorporated into the Company's lending policies. These policies are analyzed periodically by management, and the policies are reviewed and approved by a designated subcommittee of the Board on an annual basis. The Company's loan policies and practices described in this report are subject to periodic change, and each guideline or standard is subject to waiver or exception in the case of any particular loan, with approval by the appropriate officer or committee, in accordance with the Company's loan policies. Policy standards are often stated in mandatory terms, such as "shall" or "must", but these provisions are subject to exception where appropriately mitigated. Policy requires that loan value not exceed a percentage of "market value" or "fair value" based upon appraisals or evaluations obtained in the ordinary course of the Company's underwriting practices.

 

Loans are secured primarily by duly recorded first deeds of trust. In some cases, the Company may accept a recorded second lien position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is required. Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Company. Guaranteed, fixed price construction contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.

 

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Commercial land acquisition and construction loans are secured by real property where loan proceeds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are required to contribute equity into each project at levels determined by Loan Policy. Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months.  Loan-to-value ("LTV") ratios, with few exceptions, are maintained consistent with or below supervisory guidelines.

 

All construction draw requests must be presented in writing on American Institute of Architects documents and certified by the contractor, the borrower and the borrower's architect. Each draw request shall also include the borrower's soft cost breakdown certified by the borrower or its Chief Financial Officer. Prior to an advance, the Company or its contractor inspects the project to determine that the work has been completed in order to justify the draw requisition.

 

Commercial permanent loans are secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. At the time of origination, the debt service coverage ratio is ordinarily at least 1.25 to 1.0.  As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

 

Personal guarantees are generally received from the principals on commercial real estate loans, and only in instances where the loan-to-value is sufficiently low and the debt service is sufficiently high is consideration given to either limiting or not requiring personal recourse.

 

Updated appraisals for real estate secured loans are obtained as necessary and appropriate to borrower financial condition, project status, loan terms, and market conditions.

 

The Company is also an active traditional commercial lender providing loans for a variety of purposes, including cash flow, equipment and accounts receivable financing. This loan category represents approximately 16.3% of the Company's loan portfolio at December 31, 2013 and is generally priced at a variable or adjustable rate. Commercial loans must meet reasonable underwriting standards, including appropriate collateral, and cash flow necessary to support debt service.  Residential home mortgage loans, including home equity lines and loans, make up 25.6% of the loan portfolio. These credits represent both first and second liens on residential property almost exclusively located in the Company’s primary market areas. The remaining 4.0% of the loan portfolio consists of retail consumer installment loans.

 

The risk of nonpayment (or deferred payment) of loans is inherent in commercial lending. The Company's marketing focus on small to medium-sized businesses may result in the assumption by the Company of certain lending risks that are different from those inherent in loans to larger companies. The policies and procedures of the Company dictate that all loan applications are to be carefully evaluated and attempt to minimize credit risk exposure by use of extensive loan application data, due diligence, and approval and monitoring procedures; however, there can be no assurance that such procedures can eliminate such lending risks.

 

Material Trends and Uncertainties

Currently, the U.S. economy is slowly recovering from one of its longest and most severe economic recessions in recent history.  Continued improvements in general economic conditions and credit performance of the Company’s loan portfolio coupled with cost savings initiatives and performance from our mortgage subsidiary resulted in $4.1 million in net income attributable to Hampton Roads Bankshares, Inc. for 2013.  While the pace of economic growth remains slow and regulatory and legislative friction continues to hamper the recovery, we expect to continue to be profitable for the full year 2014, although such profitability is not assured. 

 

During 2012 and 2013, problem loans were reduced significantly from previous levels.  As a result of this improvement and continued declines in the loan portfolio due to pay-downs and charge-offs, our provision for loan losses during 2013 was $1.0 million compared to $15.0 million in 2012.  The increasing moderation of defaults from better asset quality and stabilized and improved collateral values has resulted in fewer impaired loans and a reduction in specific impairments.  Higher historical charge-offs taken in prior years are now rolling off of the weighted loss calculations we use to determine the reserves that are based, in part, on these historical loss trends. 

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We expect that the provision for loan losses will continue to be favorably impacted by these trends in addition to overall improvement in asset quality.  Additionally, during 2013, losses on other real estate owned and repossessed assets decreased $19.1 million compared to 2012.  During the latter part of 2013, the performance of our mortgage banking subsidiary was negatively impacted as interest rates rose, resulting in a significant decline of mortgage loan refinancing activity.  This negative impact may continue as interest rates rise to more typical levels.

 

Overview

Since 2008, our loan customers have operated in an economically stressed environment.  While broader economic conditions have begun to gradually improve, economic conditions in the markets in which we operate remain somewhat constrained.  Consequently, the levels of loan delinquencies and defaults that we experienced continue to be higher than historical levels and our net interest income, before the provision for loan losses, has not grown over this period.

 

The Company reported net income for 2013, compared to reporting net operating losses for 2010 to 2012, primarily resulting from improved general economic conditions and credit performance of the Company’s loan portfolio.  There is no guarantee that we will be able to maintain this improvement in our net income. In addition to the risk that the broader economic conditions will stagnate or reverse their improvements, our mortgage banking earnings are particularly volatile due to their dependence upon the direction and level of mortgage interest rates, which have recently increased.  As of December 31, 2013, the Company exceeded the regulatory capital minimums and BOHR and Shore were considered “well capitalized” under the risk-based capital standards.

 

The following is a summary of our financial condition as of December 31, 2013 and our financial performance for the year then ended.

 

 

 

 

 

 

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Critical Accounting Policies

U.S. generally accepted accounting principles (“GAAP”) are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex assumptions, judgments, and estimates.  Our assumptions, judgments, and estimates may be incorrect, and changes in such assumptions, judgments, and estimates may have a material impact on the consolidated financial statements.  Actual results, in fact, could differ materially from those estimates.  We consider our policies on allowance for loan losses, the valuation of deferred taxes, and the valuation of other real estate owned to be critical accounting policies.

 

Allowance for Loan Losses 

The purpose of the allowance for loan losses is to provide for potential losses inherent in our loan portfolio.  Management considers numerous factors in determining the allowance for loan losses, including historical loan loss experience, the size and composition of the portfolio, and the estimated value of collateral and guarantees securing the loans.  Management regularly reviews the loan portfolio to determine whether adjustments are necessary to maintain an allowance for loan losses sufficient to absorb losses.  Our review takes into consideration changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and review of current economic conditions that may affect the borrower’s ability to repay.  Some of the tools used in the credit review process to identify potential problem loans include past due reports, collateral valuations (primarily from third parties), cash flow analyses of borrowers, and risk ratings of loans.  In addition to the review of credit quality through ongoing credit review processes, we perform a comprehensive allowance analysis for our loan portfolio at least quarterly. 

 

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The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment.  The specific allowance for loan losses necessary for these loans is based on a loan-by-loan analysis and varies between impaired loans largely due to the value of the loan’s underlying collateral.

 

The general component relates to groups of homogeneous loans not designated for specific allowance and are collectively evaluated for impairment.  The general component is based on historical loss experience adjusted for qualitative factors.  To arrive at the general component, the loan portfolio is grouped by loan type.  Each loan type is further subdivided by risk level as determined in our loan grading process.  A weighted average historical loss rate is computed for each group of loans over the trailing thirty-six months with higher weightings assigned to the most recent months.  In addition, an adjustment factor may be applied.  The adjustment factor, which may be favorable or unfavorable, represents management’s judgment that inherent losses in a given group of loans are different from historical loss rates due to environmental factors unique to that specific group of loans.  These factors may relate to growth rate factors within the particular loan group; whether the recent loss history for a particular group of loans differs from its historical loss rate; the amount of loans in a particular group that have recently been designated as impaired and that may be indicative of future trends for this group; reported or observed difficulties that other banks are having with loans in the particular group; changes in the experience, ability, and depth of lending personnel; changes in the nature and volume of the loan portfolio and in the terms of loans; and changes in the volume and severity of past due loans, nonaccrual loans, and adversely classified loans.  The sum of the historical loss rate and the adjustment factor comprise the estimated annual loss rate.  To adjust for risk levels, a loss allocation factor is estimated based on the segmented risk levels for the loan group and is keyed off of a pass credit rating.  The loss allocation factor is applied to the estimated annual loss rate to determine the expected annual loss amount. 

 

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 and represents inherent losses that may not otherwise be captured in the specific or general components.  Additionally, we apply an economic factor to recognize external forces over which management has no control and to estimate inherent losses that may otherwise be omitted from the allowance calculation.  The factors used in this calculation include published data for the gross domestic product growth rate, interest rate levels as measured by the prime rate, changes in regional real estate indices, and regional unemployment statistics.  Additionally, the Company performs a self-diagnostic assessment to evaluate internal controls over the management of the credit process to derive an internal component to the unallocated portion of the allowance which is added to the aforementioned macroeconomic factors.

 

Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are adequate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment.  Credit losses are also impacted by real estate values.  To the extent possible, we use updated third party appraisals to assist us in determining the estimated fair value of our collateral dependent impaired loans.  While we believe our appraisal practices are consistent with industry norms, there can be no assurance that the fair values we estimate in determining how much impairment (if any) to recognize on our collateral dependent impaired loan portfolio will be realized in an actual sale of the property to a third party.  Additional provisions for such losses, if necessary, would negatively impact earnings.  As a result, our earnings could be adversely affected if our estimate of an adequate allowance is inaccurate by even a small amount.

 

Valuation of Deferred Taxes

Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis.  Deferred tax assets, including tax loss and credit carryforwards, and deferred tax liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  Deferred income tax expense (benefit) represents the change during the period in the deferred tax assets and deferred tax liabilities.

 

Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized.  Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years, and, as such, material changes could impact our

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financial condition and results of operations.  As of December 31, 2013, we have recorded a valuation allowance of $176.0 million on our net deferred tax assets.  Internal Revenue Code Section 382 (“Section 382”) limitations related to the capital raised and resulting change in control for tax purposes during the third and fourth quarters of 2010 add further uncertainty as to the realizability of the deferred tax assets in future periods.  In this regard, sale of our Common Stock by Anchorage, CapGen, or Carlyle could adversely impact our ability to realize certain deferred tax benefits relating to prior losses, thereby increasing our effective tax rate in the future.

 

While net operating losses incurred after our 2010 change in control are not limited, we have not recognized any benefit in our consolidated financial statements due to the continued uncertainty of our ability to realize such deferred tax assets.  We do not expect to reverse some or all of our valuation allowance established against our net deferred tax assets until such a time we return to profitability for three or more years and can reasonably expect to continue to be profitable in future periods (and thereby begin utilizing our available net operating loss carryforwards).

 

Valuation of Other Real Estate Owned

Other real estate owned and repossessed assets include real estate acquired in the settlement of loans and other repossessed collateral and is initially recorded at the lower of the recorded loan balance or estimated fair value less estimated disposal costs.  Although by policy, each property in Other Real Estate Owned is to receive an updated appraisal on an annual basis, we cannot be certain that the most recent appraisal represents current market conditions.  Similar to the discussion above under Allowance for Loan Losses, there can be no assurance that the fair values we estimate in determining how much impairment (if any) to recognize on our foreclosed real estate portfolio will be realized in an actual sale of the property to a third party.

 

At foreclosure, any excess of the loan balance over the fair value of the property (less estimated costs to sell) is charged to the allowance for loan losses.  Such carrying value is periodically reevaluated and written down if there is an indicated subsequent decline in fair value.  Costs to bring a property to salable condition are capitalized up to the fair value of the property while costs to maintain a property in salable condition are expensed as incurred.  Gains and losses on sales of other real estate owned upon disposition and write-downs of other real estate owned during the holding period are recognized in losses on other real estate owned and repossessed assets in noninterest income. 

 

Analysis of Results of Operations

During 2013, net income attributable to Hampton Roads Bankshares, Inc. was $4.1 million, as compared with net loss attributable to Hampton Roads Bankshares, Inc. of $25.1 million for 2012.  Net income for 2013 was primarily attributable to improved general economic conditions and credit performance of the Company’s loan portfolio.

 

Net Interest Income and Net Interest Margin

Net interest income, a major component of our earnings, is the difference between the income generated by interest-earning assets and the cost of interest-bearing liabilities.  Net interest margin, which is calculated by expressing annualized net interest income as a percentage of average interest-earning assets, is an indicator of effectiveness in generating income from earning assets.

 

Net interest income and net interest margin may be significantly impacted by the market interest rates (rate); the mix, duration, and volume of interest-earning assets and interest-bearing liabilities (volume); changes in the yields earned and rates paid; and the level of noninterest-bearing liabilities available to support interest-earning assets.  Our management team strives to maximize net interest income through prudent balance sheet administration and by maintaining appropriate risk levels as determined by our Asset / Liability Committee (“ALCO”) and the Board of Directors. 

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Table 1 presents the average interest-earning assets and average interest-bearing liabilities, the average yields earned on such assets and rates paid on such liabilities, and the net interest margin for the indicated periods.

 

Table 1:  Average Balance Sheet and Net Interest Margin Analysis

 

Our method for calculating net interest margin has been adjusted.  In prior years, we excluded nonaccrual loans from our calculation.  We now include nonaccrual loans in the calculations, and prior year amounts have been adjusted retroactively to reflect this method.    A reconciliation of the methods is below for the years ended December 31, 2013, 2012, and 2011.

 

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Table 2 below shows the variance in interest income and expense caused by differences in average balances and rates.

 

Table 2:  Effect of Changes in Rate and Volume on Net Interest Income

 

 

 

 

Net interest income for the year ended December 31, 2013 was $63.5 million, a decrease of $1.5 million or 2.3% as compared to the same period in 2012.  The 2013 decrease in net interest income primarily resulted from the decline in interest income from loans of $5.2 million, partially offset by a decrease of $3.2 million in interest expense on deposits.  Also a decline in the average level of nonaccrual loans helped improve total interest income as a higher percentage of the loan portfolio was generating interest income.  Changes in average yield and rate produced a net interest spread that increased to 3.30% in 2013 from 3.27% in 2012.  We changed the method by which net interest margin is calculated in 2013 to include nonaccrual loans.  On this basis, net interest margin increased by 4 basis points to 3.43% in 2013 compared to 3.39% in 2012.

 

Interest-earning assets consist of loans, investment securities, overnight funds sold and due from FRB, and interest-bearing deposits in other banks.  Interest income on loans, including fees, decreased $5.2 million to $69.0 million for the year ended December 31, 2013 compared to $74.2 million at year-end 2012.  This decrease was predominantly the result of a decline in the average yield on loans from 4.98% in 2012 to 4.80% in 2013, and the decline in average loan balances year over year by $51.7 million.  Interest income on investment securities decreased $183 thousand to $7.7 million for the year ended December 31, 2013 compared to $7.9 million for the year ended December 31, 2012.  This decrease was due to a $9.7 million decrease in average investment securities, offset by a 2-basis point increase in the average yield on investment securities to 2.50% in 2013 from 2.48% during 2012.  Interest income on overnight funds sold and due from FRB decreased modestly to $238 thousand for the year ended December 31, 2013 compared to $245 thousand for the year ended December 31, 2012.  This decrease was largely due to the $7.5 million decrease in average overnight funds sold and due from FRB.   

 

Interest-bearing liabilities consist of deposit accounts and borrowings.  Interest expense on deposits decreased $3.2 million to $9.3 million for the year ended December 31, 2013. This decrease resulted from a $138.3 million decrease in average interest-bearing deposits and a 15-basis point decrease in the average interest rate paid on interest-bearing deposits for the year ended December 31, 2013 compared to the year ended December 31, 2012.  A reduction in the average rate paid on time deposits to 1.05% for the year ended December 31, 2013 from 1.21% for the year ended

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December 31, 2012, coupled with a $181.5 million decrease in average time deposits, contributed significantly toward the decrease in overall interest expense on deposits.  Our average rate on savings deposits decreased to 0.06% in 2013 from 0.13% in 2012.  Interest expense on borrowings, which consisted of FHLB borrowings and other borrowings, decreased $637 thousand to $4.1 million for the year ended December 31, 2013 compared to $4.7 million for the year ended December 31, 2012.  The 23-basis point decrease in the average interest rate paid on borrowings and the $5.3 million decrease in average borrowings produced this result.  In 2011, following a review of the Company’s current level of assumed interest rate risk and to promote liquidity and enhance current earnings, the Company modified certain advances with the FHLB.  A majority of the Company’s existing fixed-rate advances were restructured as floating rate obligations at a fixed spread to three month LIBOR with maturities ranging from 2.75 to 4 years. 

 

Noninterest Income

Noninterest income comprised 24.9% of total revenue in 2013 and 8.5% in 2012 and 4.0% in 2011.  The primary cause of this increase in noninterest income as a percentage of total revenue was a reduction in other than temporary impairment of other real estate owned and repossessed assets.  Table 3 provides a summary of noninterest income for the years ended December 31, 2013, 2012, and 2011.

 

Table 3:  Noninterest Income

 

 

 

For year-end 2013 total noninterest income was $25.5 million, an increase of $17.8 million or 232.8% as compared to $7.7 million at year-end 2012.  Total noninterest income was $4.2 million at year-end 2011.  Mortgage banking revenue decreased $2.6 million or 14.0% to $15.8 million for the year ended December 31, 2013 compared to $18.4 million in the same period in 2012 due to declining loan origination activity in the latter part of 2013 as market

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interest rates rose.  Mortgage banking revenue was $8.4 million in the same period in 2011.  Service charges on deposit accounts decreased $172 thousand to $5.0 million in 2013 from $5.2 million in 2012 as a result of certain changes in our fee structure as well as a lower level of deposits due to certain branch sales in 2012.  We generated net gains on sales of investment securities of $781 thousand in 2013, $627 thousand in 2012, and $1.5 million in 2011.  In August 2011 we sold our insurance company for a gain of $1.3 million.  Continued declines in certain real estate values caused losses on other real estate owned and repossessed assets of $3.9 million during 2013. During 2012 and 2011, the Company incurred losses on other real estate owned and repossessed assets of $14.1 million and $17.2 million, respectively.  The decrease in losses and other than temporary impairment of other real estate owned was primarily due to the stabilization of market values. The Company had no other-than-temporary impairments in our securities portfolios during 2013 and 2012.  As the Company closed down certain branches in 2013, it recorded impairments totaling $2.8 million to premises and equipment as those properties were transferred to other real estate and repossessed assets.

 

Noninterest Expense

Noninterest expense represents our operating and overhead expenses.  The efficiency ratio, calculated by dividing noninterest expense by the sum of net interest income and noninterest income excluding securities gains and gain on sale of insurance company was 93.3% in 2013 compared to 113.0% in 2012 and 140.1% in 2011.  Table 4 provides a summary of noninterest expense for the years ended December 31, 2013, 2012, and 2011. 

 

Table 4:  Noninterest Expense

 

 

 

Total noninterest expense for 2013 grew 1.1% compared to 2012, finishing at $82.3 million during the year ended December 31, 2013.  Total noninterest expense decreased $22.2 million or 21.5% during the year ended December 31, 2012 compared to the same period of 2011.  Salaries and employee benefits expense increased 4.8% to $41.2 million for the year ended December 31, 2013 compared to $39.3 million for the year ended December 31, 2012 as a direct result of increased commissions associated with mortgage volumes, merit adjustments for certain personnel, and the accrual of incentive compensation and restricted stock unit grants.  Professional and consultant fees were $5.8 million for the year ended December 31, 2013 compared to $7.6 million for the comparative period in 2012 as the Company reduced its reliance on outside consultants and incurred lower legal fees in connection with its non-

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performing loans.  Occupancy expense increased by $1.5 million for the year ended December 31, 2013 compared to the year ended December 31, 2012 due to accelerated amortization of leasehold improvements at a closed branch and the fair value measurement of the Dominion Tower lease in connection with the move of our headquarters from Norfolk, VA to its current location in Virginia Beach, VA.  FDIC insurance was $4.8 million for the year ended December 31, 2013 compared with $4.6 million for the same period in 2012.  The year over year increase in FDIC expense is attributable to a change in accounting methodology which was partially offset by a reduction in the assessment rate.  Problem loan and repossessed asset costs decreased $1.4 million to $2.4 million for the year ended December 31, 2013 driven by the improvement in our overall loan quality.  For the year ended December 31, 2013, equipment expense was $1.7 million compared to $2.8 million for the comparative period in 2012. These improvements were due to cost cutting initiatives and our smaller branch network.  Directors’ and regional board fees increased $580 thousand to $1.5 million for the year ended December 31, 2013 compared to $0.9 million for the comparable period in 2012 due to share-based compensation costs for restricted stock unit grants to directors.  Advertising and marketing expenses increased $810 thousand to $1.4 million for the year ended December 31, 2013 due to the Company’s efforts to better promote its business services and products.

 

Analysis of Financial Condition

Assets were $2.0 billion at December 31, 2013.  Total assets decreased by $103.8 million or 5.1% from $2.1 billion at December 31, 2012.  The decrease in assets was primarily associated with a $59.0 million or 70.2% decrease in loans held for sale, a $47.7 million or 3.3% decrease in gross loans, a $41.0 million or 48.9% decrease in overnight funds sold and due from FRB, partially offset by a $49.0 million or 17.7% increase in investment securities available for sale.

Cash and Cash Equivalents

Cash and cash equivalents includes cash and due from banks, interest-bearing deposits in other banks, and overnight funds sold and due from FRB.  Cash and cash equivalents are used for daily cash management purposes, management of short-term interest rate opportunities, and liquidity.  Cash and cash equivalents as of December 31, 2013 were $62.3 million compared to $101.2 million at December 31, 2012 and consisted mainly of deposits with FRB.  As the risk profile of the Company improved commensurate with improvements in credit quality and earnings accretion to capital, the Company attempted to optimize the balance sheet by deploying excess funds into investment securities in 2013 rather than holding them as cash and cash equivalents.  In the future, the Company expects to utilize its cash on hand to support loan origination activity.

Investment Securities

Our investment portfolio at December 31, 2013 consisted primarily of U.S. agency, mortgage-backed, and asset-backed securities.  The Company allotted a percentage of its investment portfolio to Asset Backed Securities (“ABS”) during 2013. This allocation provides the Company with a floating rate asset, which mitigates the interest rate risk inherent in certain other asset classes, e.g., Mortgage Backed Securities (“MBS”).  Repayment of principal and interest of the ABS security is dependent upon the performance of the underlying loan collateral.  The Company performs due diligence of each security on a pre- and post-purchase basis to evaluate the underlying collateral and invests in the investment grade tranches of securitizations.  However, should defaults or loss severities exceed the credit enhancement in the structure, payment of principal or interest may be impacted.

 

Our available-for-sale securities are reported at fair value and are used primarily for liquidity, pledging, earnings, and asset / liability management purposes and are reviewed quarterly for possible impairment.  At year-end 2013 the fair value of our available-for-sale investment securities was $325.5 million, an increase of 17.7% over the $276.5 million at year-end 2012.

 

Table 5 displays the contractual maturities and weighted average yields of investment securities at year-end 2013.  Actual maturities may differ from contractual maturities because certain issuers may have the right to call or prepay obligations with or without call or prepayment penalties.  In addition, the effective life or duration of mortgage-backed and asset-backed securities is also less than the contractual maturity since these securities pay principal and interest monthly.

 

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Table 5:  Investment Maturities and Yields

 

 

 

Table 6 provides information regarding the composition of our securities portfolio showing selected maturities and yields.  For more information on investment securities, refer to Note 6, Investment Securities, of the Notes to Consolidated Financial Statements.

 

Table 6:  Composition of Securities Portfolio

 

 

 

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Loans

 

As a holding company of two community banks, we have a primary objective of meeting the business and consumer credit needs within our markets where standards of profitability, client relationships, and credit quality intersect.  Our loan portfolio is comprised of commercial and industrial, construction, real estate-commercial mortgage, real estate-residential mortgage, and installment loans.  Lending decisions are based upon evaluation of the financial strength and credit history of the borrower and the quality and value of the collateral securing the loan.  With few exceptions, personal guarantees are required on all loans.  As shown in Table 7, the overall loan portfolio decreased $47.7 million or 3.3% to $1.4 billion at year-end 2013 from $1.4 billion at year-end 2012. 

 

Table 7:  Loans by Classification

 

 

 

Overall our loan trends during 2013 have been influenced by decreased demand for loans in nearly all our loan categories with the exception of real estate – commercial mortgage loans.  Our commercial and industrial loan portfolio decreased $41.6 million to the 2013 year-end balance of $225.5 million from the 2012 year-end balance of $267.1 million.  Construction loans decreased $47.9 million to the 2013 year-end balance of $158.5 million from the year-end 2012 balance of $206.4 million, thus lowering the concentration of construction loans to 11.4% of the total loan portfolio at December 31, 2013 compared with 14.4% at December 31, 2012.  Our real estate-commercial mortgage loan portfolio increased $60.4 million to the 2013 year-end balance of $590.5 million from the 2012 year-end balance.  The real estate-residential mortgage loan portfolio decreased $18.6 million to the 2013 year-end balance of $354.0 million from the 2012 year-end balance of $372.6 million.  The installment loan portfolio increased $1.3 million to the 2013 year-end balance of $57.6 million from the 2012 year-end balance. 

 

In addition to the aforementioned weaker demand for credit, the contraction seen in loans stems from the continued resolution of problem loans.  Origination volumes were offset by principal pay-downs and scheduled amortization in the portfolio.  In the future, our continued focus will be on managing the entire loan portfolio through the current challenging economic conditions.  Additionally, our prudent business practices and internal guidelines and underwriting standards will continue to be followed in making lending decisions in order to manage exposure to credit-related losses.

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Table 8 indicates our loans by geographic area as of December 31, 2013. 

 

Table 8:  Loans by Geographic Location

 

 

 

 

Table 9 sets forth the maturity periods of our loan portfolio as of December 31, 2013.  Demand loans are reported as due within one year. 

 

Table 9:  Loan Maturities Schedule

 

 

 

 

Allowance for Loan Losses and Provision for Loan Losses

 

The allowance for loan losses decreased significantly during 2013, both in dollars and as a percentage of total loans as credit trends in the loan portfolio continues to show improvement.  The allowance for loan losses was $35.0 million or 2.53% of outstanding loans as of December 31, 2013 compared with $48.4 million or 3.38% of outstanding loans as of December 31, 2012.

 

We decreased the allowance for loan losses $13.4 million (net of charge-offs and recoveries) during 2013 as a result of net charge-offs exceeding additional provisions for loan losses.  Net charge-offs were $14.4 million in 2013 compared with $41.6 million during 2012.  Our provision for loan losses was $1.0 million in 2013 compared to $15.0 million in 2012 and $67.9 million in 2011.  We did not change our methodology or model for estimating the allowance for loan losses during any of the past three years.

 

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An analysis of the allowance for loans losses for the years ended December 31, 2013, 2012, 2011, 2010, and 2009 is shown in Table 10.  Additional information about the allowance for loan losses can be found in Note 1, Basis of Financial Statement Presentation and Summary of Significant Accounting Policies, and Note 7, Loans and Allowance for Loan Losses, of the Notes to Consolidated Financial Statements.

 

Table 10:  Allowance for Loan Losses Analysis

 

 

 

 

The allowance consists of specific, general, and unallocated components.  Table 11 provides an allocation of the allowance for loan losses and other related information at December 31, 2013 and 2012.

 

Table 11:  Allowance for Loan Losses Components and Related Data

 

 

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The specific component of our allowance for loan losses relates to loans that are determined to be impaired and, therefore, are individually evaluated for impairment.  The specific component decreased during 2013, primarily due to the charge-off of loans with specific reserves.  Specific loan loss allocations decreased $1.6 million to $13.1 million at December 31, 2013 from $14.8 million at December 31, 2012.  The decrease is commensurate with the significant decrease in impaired loans to $67.6 million at December 31, 2013 from $141.0 million at December 31, 2012.  Of these loans, $39.9 million were on nonaccrual status at December 31, 2013 as compared with $97.4 million at December 31, 2012, a decrease of 59.1%.

 

The general or pooled component relates to groups of homogeneous loans not designated for a specific allowance and are collectively evaluated for impairment.  The pooled component of the allowance decreased $10.3 million during 2013, from $27.9 million at December 31, 2012 to $17.6 million at December 31, 2013. The decrease in the pooled component is the result of (i) lower historical loss factors applied in our models, as higher charge-offs in older periods are replaced with lower charge-offs in more recent periods, (ii) changes in portfolio mix, as categories with higher pooled reserve levels such as construction loans have continued to decline, and (iii) continued improvement in credit quality as evidenced by improved internal weighted average loan grades.

 

An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses.  The unallocated portion of the loan loss allowance decreased $1.4 million to $4.3 million at December 31, 2013 from $5.7 million at December 31, 2012 due to a combination of factors.  Macroeconomic indicators such as GDP, unemployment, and housing prices showed year-over-year improvement, resulting in a reduction in the portion of the unallocated component that considers external variables.  Additionally, the continued resolution of troubled assets during the year led to a reduction in the overall size of the loan portfolio and an improvement in the quality of the existing portfolio.  The portion of the unallocated component that considers internal variables has declined as a reflection of management’s assessment of the improved health of the portfolio and the credit process of the Company. 

 

Table 12 displays certain ratios used by management in assessing the adequacy of the allowance for loan losses at December 31, 2013 and 2012.

 

Table 12:  Adequacy of the Allowance for Loan Losses

 

 

 

 

At December 31, 2013, management believed the level of the allowance for loan losses to be commensurate with the risk existing in our portfolio.  However, the allowance is 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

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of the allowance in comparison to peer banks identified by regulatory agencies.  Such agencies may require us to recognize additions to the allowance for loan losses based on their judgments about information available at the time of the examinations.

 

We allocated the allowance for loan losses to the loan categories as shown in Table 13.  Notwithstanding these allocations, the entire allowance for loan losses is available to absorb charge-offs in any loan category.

 

Table 13:  Allocation of Allowance for Loan Losses

 

 

 

 

The decrease in the allocation of the allowance for loan losses associated with the commercial and industrial segment during 2013 is largely attributable to the charge off of one specific credit that became impaired during 2012 and was ultimately transferred to other real estate during 2013. The decrease in the allocation of the allowance for loan losses associated with the construction segment during 2013 was primarily due to a $5.7 million decrease in the pooled component of the reserve. This decrease in the pooled component is attributable to a continued decrease in our construction portfolio exposure (i.e., lower unpaid principal balances), as well as an improvement in the credit quality of the remaining portfolio (i.e., better mix and loan grades).

 

Non-Performing Assets

 

Management classifies non-performing assets as those loans on which payments have been delinquent 90 days and are still accruing interest, nonaccrual loans, and foreclosed real estate and repossessed assets.  Total non-performing assets were $76.5 million or 3.9% of total assets at year-end 2013 as compared to $130.7 million or 6.4% of total assets at year-end 2012.  At December 31, 2013 and 2012 we had loans totaling $0 and $1.0 million, respectively, categorized as 90 days or more past due and still accruing interest.  We had $36.7 million and $32.2 million of other real estate owned and repossessed assets at December 31, 2013 and 2012, respectively.  This growth was due to inflows into real estate owned outpacing sales and write-downs thereof.  Non-performing assets by geographic location at December 31, 2013 is shown in Table 14.

 

Table 14:  Non-performing Assets by Geographic Location

 

 

 

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Loans are placed in nonaccrual status when the collection of principal or interest becomes uncertain, part of the balance has been charged off and no restructuring has occurred, or the loans reach 90 days past due, whichever occurs first, unless there are extenuating circumstances.

 

As shown in Table 15, nonaccrual loans were $39.9 million at December 31, 2013 compared to $97.4 million at December 31, 2012.  If income on nonaccrual loans had been recorded under original terms, $2.0 million and $6.7 million of additional interest income would have been recorded in 2013 and 2012, respectively. 

 

Table 15:  Nonaccrual Loans

 

 

Deposits

Total deposits at December 31, 2013 were $1.5 billion, a decrease of $94.4 million or 5.8% from the $1.6 billion at December 31, 2012.  In recent years, our deposit composition has improved as a result of strategies to grow demand deposits, while de-emphasizing higher rate certificates of deposit.  Table 16 shows deposits by classification at December 31, 2013, 2012, and 2011.

 

Table 16:  Deposits by Classification

 

 

 

At December 31, 2013, noninterest-bearing demand deposits were $245.4 million, a decrease of $17.9 million from $263.3 million at December 31, 2012. 

 

Interest-bearing demand deposits at year-end 2013 were $600.3 million, an increase of $80.5 million from $519.8 million at year-end 2012.  Interest-bearing demand deposits included $7.7 million of brokered money market funds at December 31, 2013, which was $1.7 million lower than the balance of brokered money market funds of $9.4 million outstanding at December 31, 2012.

 

At year-end 2013 savings accounts were $62.3 million, an increase of $2.4 million from $59.9 million at year-end 2012.

 

Time deposits less than $100 thousand decreased $68.9 million or 17.5% at year-end 2013 from year-end 2012 while time deposits $100 thousand or more decreased $90.6 million or 23.8% at year-end 2013 over year-end 2012.  Brokered Certificate of Deposits (“CDs”) represented $43.6 million or 2.9% of the December 31, 2013 balance of total deposits, which was a decrease of $10.4 million from the $54.0 million balance of brokered CDs outstanding at December 31, 2012.  The decrease in time deposits was primarily due to run-off as maturity dates were reached and CDs were not renewed due to lower rates offered, particularly in the national market time deposit category.

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The Company continues to focus on core deposit growth as its primary source of funding.  Core deposits are non-brokered and consist of noninterest-bearing demand accounts, interest-bearing checking accounts, money market accounts, savings accounts, and time deposits of less than $100 thousand.  Core deposits totaled $1.2 billion or 80% of total deposits at year-end 2013 and $1.2 billion or 73% of total deposits at year-end 2012.

 

Borrowings

 

We use short-term and long-term borrowings from various sources including the FRB discount window, FHLB, reverse repurchase agreements, and trust preferred securities.  We manage the level of our borrowings to ensure that we have adequate sources of liquidity.  At December 31, 2013 and 2012, we had advances from the FHLB totaling $194.2 million and $195.1 million, respectively.

 

As shown in Table 17, maturities of FHLB borrowings at December 31, 2013 were as follows:

 

Table 17: FHLB Borrowings

 

 

The Company has four placements of trust preferred securities.  The carrying amount and par amount is shown in Table 18.

 

Table 18:  Trust Preferred Securities

 

 

 

LIBOR in the table above refers to three-month LIBOR.  In all four trusts, the trust issuer has invested the total proceeds from the sale of the trust preferred securities in junior subordinated deferrable interest debentures issued by the Company.  The trust preferred securities pay cumulative cash distributions quarterly at an annual rate, reset quarterly.  The dividends paid to holders of the trust preferred securities, which are recorded as interest expense, are deductible for income tax purposes.

 

In January 2010, the Company exercised its right to defer all quarterly distributions on the trust preferred securities.  Interest payable continues to accrue during the deferral period and interest on the deferred interest also accrues, both of which must be paid at the end of the deferral period and totaled $5.6 million at December 31, 2013.  Prior to the expiration of the deferral period, the Company has the right to further defer interest payments provided that no deferral period, together with all principal deferrals, exceeds 20 consecutive quarters and that no event of default (as defined by the terms of the applicable Trust Preferred Securities) has occurred and is continuing at the time of the deferral.  The Company was not in default with respect to the terms of the Trust Preferred Securities at the time the quarterly payments were deferred and such deferrals did not cause an event of default under the terms of the Trust Preferred Securities.  If we are not able to pay all accrued but unpaid interest prior to the end of the deferral period in January 2015, we could be in default under the terms of the trust preferred securities.

 

The Company has fully and unconditionally guaranteed the trust preferred securities through the combined operation of the debentures and other related documents.  The Company’s obligation under the guarantee is unsecured and subordinate to our senior and subordinated indebtedness.  The aggregate carrying value of these debentures as of December 31, 2013 was $29.0 million.  The difference between the par amounts and the carrying amounts of the

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debentures is amortized using the interest method as an adjustment to interest expense each period.  Effective interest rates used by the Company as of December 31, 2013 were between 5.61% and 7.09%.

 

Capital Resources and Liquidity

 

Capital Resources.  Total shareholders’ equity declined $3.3 million or 1.8% to $183.8 million at December 31, 2013.

 

To preserve capital, on July 30, 2009 the Board of Directors voted to suspend the quarterly dividends on our Common Stock.  We are currently prevented by our regulators from paying dividends on our Common Stock until our financial position improves.  Our ability to distribute cash dividends in the future may be limited by financial performance, regulatory restrictions, our desire or intent to reinvest our earnings, and the need to maintain sufficient consolidated capital.  

 

On September 27, 2012, the Company closed on the Capital Raise, which resulted in $95.0 million in gross proceeds for which the Company issued, in the aggregate, 135,717,307 shares of Common Stock at a price of $0.70 per share. 

 

The Company and the Banks are subject to regulatory capital guidelines that measure capital relative to risk-weighted assets and off-balance sheet financial instruments.  Failure to meet minimum capital requirements can cause certain mandatory and discretionary actions by regulators that, if undertaken, could have a material effect on our consolidated financial statements.  Under capital adequacy guidelines and the regulatory framework for prompt correction action, the Banks must meet specific capital guidelines that involve quantitative and qualitative measures to ensure capital adequacy.  Tier I capital is comprised of shareholders’ equity, net of unrealized gains or losses on available-for-sale securities, less intangible assets, while total risk-based capital adds certain debt instruments and qualifying allowances for loan losses.  As of December 31, 2013, our consolidated regulatory capital ratios were Tier 1 Leverage Ratio of 10.73%, Tier 1 Risk-Based Capital Ratio of 13.86%, and Total Risk-Based Capital of 15.13%.  As of December 31, 2013, the Company exceeded the regulatory capital minimums, and BOHR and Shore were considered “well capitalized” under the risk-based capital standards.  Their Tier 1 Leverage Ratio, Tier 1 Risk-Based Capital Ratio, and Total Risk-Based Capital Ratio were as follows: 9.58%, 12.21%, and 13.48%, respectively for BOHR and 9.99%, 13.80%, and 15.03%, respectively for Shore.   

 

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.  It is used by management to provide continuous access to sufficient, reasonably priced funds.  Funding requirements are impacted by loan originations and refinancing, deposit growth, liability issuances and settlements, and off-balance sheet funding commitments.  We consider and comply with various regulatory guidelines regarding required liquidity levels and routinely monitor our liquidity position in light of the changing economic environment and customer activity.  Based on our liquidity assessments, we may alter our asset, liability, and off-balance sheet positions.  The ALCO monitors sources and uses of funds and modifies asset and liability positions as liquidity requirements change.  This process, combined with our ability to raise funds in money and capital markets and through private placements, provides flexibility in managing the exposure to liquidity risk.  At December 31, 2013, cash and due from banks, interest-bearing deposits in other banks, overnight funds sold and due from FRB, and investment securities were $387.8 million or 19.9% of total assets. 

 

In an effort to satisfy our liquidity needs, we actively manage our assets and liabilities.  We have immediate liquid resources in cash and due from banks, interest-bearing deposits in other banks, and overnight funds sold and due from FRB.  The potential sources of short-term liquidity include interest-bearing deposits as well as the ability to pledge or sell certain assets including available-for-sale investment securities.  Short-term liquidity is further enhanced by our ability to pledge or sell loans in the secondary market and to secure borrowings from the FRB and FHLB.  Short-term liquidity is also generated from securities sold under agreements to repurchase, funds purchased, and short-term borrowings.  Deposits have historically provided us with a long-term source of stable and relatively lower cost funding.  Additional funding is available through the issuance of long-term debt.

 

At December 31, 2013, our Banks had credit lines in the amount of $227.6 million at the FHLB with advances of $194.2 million utilized.  These lines may be utilized for short- and/or long-term borrowing.  At December 31, 2013 and 2012, all our FHLB borrowings were long-term.  We also possess additional sources of liquidity through a variety of borrowing arrangements.  The Banks also maintain federal funds lines with two regional banking

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institutions and through the FRB Discount Window.  These available lines totaled approximately $38.9 million and $40.9 million at December 31, 2013 and 2012, respectively.  These lines were not utilized for borrowing purposes at December 31, 2013 or 2012.

 

Under normal conditions, our liquid assets and the ability to generate liquidity through normal operations and various liability funding mechanisms should be sufficient to satisfy our depositors’ requirements, meet our customers’ credit needs, and supply adequate funding for our other business needs.  As demonstrated by some of the nation’s largest financial institutions, liquidity may be adversely affected if the sources of liquidity suddenly become unavailable.  Such a situation may occur when the financial condition of an institution deteriorates as the result of operating losses and rising levels of credit problems.  In such circumstances, credit availability and other funding sources may diminish significantly.

 

Contractual Obligations

 

We have contractual obligations to make future payments on debt and lease agreements.  Additionally, in the normal course of business, we enter into contractual arrangements whereby we commit to future purchases of products or services from unaffiliated parties.  Our contractual obligations consist of time deposits, borrowings, and operating lease obligations.  Our operating lease obligations have significantly decreased as a result of the termination of leases due to branch closings.  Table 19 shows payment detail for these contractual obligations as of December 31, 2013.

 

Table 19:  Contractual Obligations

 

 

Off-Balance Sheet Arrangements

 

We are a party to financial instruments with off-balance sheet risk in the normal course of business to meet our customers’ financing needs.  For more information on our off-balance sheet arrangements, refer to Note 14, Financial Instruments with Off-Balance-Sheet Risk, of the Notes to Consolidated Financial Statements.

 

Legal Contingencies

 

Various legal actions arise from time to time in the normal course of our business.  For more information, refer to Item 3 “Legal Proceedings” in our 2013 Form 10-K.  Based upon information currently available, management believes that such legal proceedings, in the aggregate, will not have a material adverse effect on our business, financial condition, cash flows, or results of operations.  Management was not aware of any unasserted claims or assessments that may be probable of assertion at December 31, 2013.

 

Interest Rate Sensitivity

 

Market risk is the potential of loss arising from adverse changes in interest rates and prices.  We are exposed to market risk as a consequence of the normal course of conducting our business activities.  Management considers interest rate risk to be a significant market risk for the Company.  Fluctuations in interest rates will impact both the level of interest income and interest expense and the market value of the Company’s interest-earning assets and interest-bearing liabilities.

 

The primary goal of our asset/liability management strategy is to optimize net interest income while limiting exposure to fluctuations caused by changes in the interest rate environment.  Our ability to manage our interest rate risk depends generally on our ability to match the maturities and re-pricing characteristics of our assets and

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liabilities while taking into account the separate goals of maintaining asset quality and liquidity and achieving the desired level of net interest income.

 

Our management, guided by ALCO, determines the overall magnitude of interest sensitivity risk and then formulates policies 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 and regional economy, and other financial and business risk factors.

 

The primary method that we use to quantify and manage interest rate risk is simulation analysis, which is used to model net interest income from assets and liabilities over a specified time period under various interest rate scenarios and balance sheet structures.  This analysis measures the sensitivity of net interest income over a relatively short time horizon.  Key assumptions in the simulation analysis relate to the behavior of interest rates and spreads, the changes in product balances, and the behavior of loan and deposit customers in different rate environments.

 

Table 20 illustrates the expected effect on net interest income for the year following each of the years ended 2013 and 2012 due to an immediate change in interest rates.  Estimated changes set forth below are dependent on material assumptions, such as those previously discussed.

 

Table 20:  Effect on Net Interest Income

 

 

 

As of December 31, 2013, we project a decrease in net interest income in both increasing and decreasing interest rate environments.  As of December 31, 2012, we projected an increase in net interest income in an increasing interest rate environments and a decrease in net interest income in a decreasing interest rate environment.  Relative to 2012, rising rate scenarios are less favorable due to lower levels of assets with short-term re-pricing characteristics, as well as due to the variable rate structure on the majority of our borrowings and the floors on many loans that will cause a delay in any interest income improvement.

 

It should be noted, however, that the simulation analysis is based upon equivalent changes in interest rates for all categories of assets and liabilities.  In normal operating conditions, interest rate changes rarely occur in such a uniform manner.  Many factors affect the timing and magnitude of interest rate changes on financial instruments.  In addition, management may deploy strategies that offset some of the impact of changes in interest rates.  Consequently, variations should be expected from the projections resulting from the controlled conditions of the simulation analysis.  Management maintains a simulation model where it is assumed that interest rate changes occur gradually, that rate increases for interest-bearing liabilities lag behind the rate increases of interest-earning assets, and that the level of deposit rate increases will be less than the level of rate increases for interest-earning assets.

 

Caution About Forward-Looking Statements 

 

This Form 10-K contains “forward-looking statements” within the meaning of the U.S. Private Securities Litigation Reform Act of 1995.  When or if used in this annual report or any SEC filings, other public or shareholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases “anticipate,” “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “is estimated,” “is projected,” or similar expressions are intended to identify “forward-looking statements.”

 

Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy, and other future conditions.  Because forward-looking statements relate to the future, they are subject to

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inherent uncertainties, risks, and changes in circumstances that are difficult to predict.  Our actual results may differ materially from those contemplated by the forward-looking statements.  They are neither statements of historical fact nor guarantees or assurances of future performance.  Therefore, we caution you against relying on any of these forward-looking statements. 

 

For a discussion of the risks, uncertainties, and assumptions that could affect our future events, developments, or results, you should carefully review the risk factors summarized below and the more detailed discussion in the “Risk Factors” section in the 2013 Form 10-K.  Our risks include, without limitation, the following:

 

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Our forward-looking statements could be incorrect in light of these risks, uncertainties, and assumptions.  The future events, developments, or results described in this report could turn out to be materially different.  We have no obligation to publicly update or revise our forward-looking statements after the date of this report and you should not expect us to do so.

 

Use of Non-GAAP Financial Measures

 

The ratios “book value per common share-tangible,” “shareholders’ equity-tangible,” and “common shareholders’ equity-tangible” are non-GAAP financial measures.  The Company believes these measurements are useful in our press releases and other correspondence for investors, regulators, management, and others to evaluate capital adequacy and to compare against other financial institutions.  The following is a reconciliation of these non-GAAP financial measures with financial measures defined by GAAP.

 

 

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ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Interest Rate Sensitivity

Market risk is the potential of loss arising from adverse changes in interest rates and prices.  We are exposed to market risk as a consequence of the normal course of conducting our business activities.  Management considers interest rate risk to be a significant market risk for the Company.  Fluctuations in interest rates will impact both the level of interest income and interest expense and the market value of the Company’s interest-earning assets and interest-bearing liabilities.

 

The primary goal of our asset/liability management strategy is to optimize net interest income while limiting exposure to fluctuations caused by changes in the interest rate environment.  Our ability to manage our interest rate risk depends generally on our ability to match the maturities and re-pricing characteristics of our assets and liabilities while taking into account the separate goals of maintaining asset quality and liquidity and achieving the desired level of net interest income.

 

Our management, guided by ALCO, determines the overall magnitude of interest sensitivity risk and then formulates policies 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 and regional economy, and other financial and business risk factors.

 

The primary method that we use to quantify and manage interest rate risk is simulation analysis, which is used to model net interest income from assets and liabilities over a specified time period under various interest rate scenarios and balance sheet structures.  This analysis measures the sensitivity of net interest income over a relatively short time horizon.  Key assumptions in the simulation analysis relate to the behavior of interest rates and spreads, the changes in product balances, and the behavior of loan and deposit customers in different rate environments.

 

The table below illustrates the expected effect on net interest income for the year following each of the years ended 2013 and 2012 due to an immediate change in interest rates.  Estimated changes set forth below are dependent on material assumptions, such as those previously discussed.

 

Effect on Net Interest Income

 

As of December 31, 2013, we project a decrease in net interest income in both increasing and decreasing interest rate environments.  As of December 31, 2012, we projected an increase in net interest income in an increasing interest rate environments and a decrease in net interest income in a decreasing interest rate environment.  Relative to 2012, rising rate scenarios are less favorable due to lower levels of assets with short-term re-pricing characteristics, as well as due to the variable rate structure on the majority of our borrowings and the floors on many loans that will cause a delay in any interest income improvement.  

 

It should be noted, however, that the simulation analysis is based upon equivalent changes in interest rates for all categories of assets and liabilities.  In normal operating conditions, interest rate changes rarely occur in such a uniform manner.  Many factors affect the timing and magnitude of interest rate changes on financial instruments.  In addition, management may deploy strategies that offset some of the impact of changes in interest rates.  Consequently, variations should be expected from the projections resulting from the controlled conditions of the simulation analysis.  Management maintains a simulation model where it is assumed that interest rate changes occur gradually, that rate increases for interest-bearing liabilities lag behind the rate increases of interest-earning assets, and that the level of deposit rate increases will be less than the level of rate increases for interest-earning assets. 

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ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

The following report of independent registered public accounting firm, audited consolidated financial statements of the Company for the year ended December 31, 2013, and notes to consolidated financial statements of the Company are included as a part of this Form 10-K.

 

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2013 and December 31, 2012

Consolidated Statements of Operations for the years ended December 31, 2013, December 31, 2012 and December 31, 2011

 

Consolidated Statements of Comprehensive Income (Loss) for the years December 31, 2013, December 31, 2012 and December 31, 2011

Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2013, December 31, 2012 and December 31, 2011

Consolidated Statements of Cash Flows for the years ended December 31, 2013, December 31, 2012 and December 31, 2011

Notes to Consolidated Financial Statements