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VSBN > SEC Filings for VSBN > Form 10-Q on 9-Nov-2011All Recent SEC Filings

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Form 10-Q for VSB BANCORP INC


9-Nov-2011

Quarterly Report

Management's Discussion and Analysis of Financial Condition and Results of Operations

Financial Condition at September 30, 2011

Total assets were $245,376,094 at September 30, 2011, an increase of $10,122,395, or 4.3%, from December 31, 2010. The increase resulted from the investment of funds available to us as the result of an increase in deposits and retained earnings. The deposit increase was caused generally by our efforts to grow our franchise and specifically by the deposit increases at our branch offices. We invested these funds primarily in cash and cash equivalents. The principal changes resulting in the net increase in assets can be summarized as follows:

? an $18,449,677 net increase in cash and cash equivalents ? an $8,300,285 net decrease in investment securities available for sale.

In addition to these changes in major asset categories, we also experienced changes in other asset categories due to normal fluctuations in operations.

Our deposits (including escrow deposits) were $215,862,536 at September 30, 2011, an increase of $8,455,879 or 4.1%, from December 31, 2010 as a result of our active solicitation of retail deposits to increase funds for investment. The increase in deposits resulted from increases of $11,815,602 in non-interest demand deposits, $2,125,408 in savings accounts, $1,134,206 in time deposits, $446,903 in money market accounts, and $107,611 in escrow deposits partially offset by a decrease of $7,173,851 in NOW accounts.

Total stockholders' equity was $27,641,640 at September 30, 2011, an increase of $1,596,784, or 6.13%, from December 31, 2010. The increase reflected: (i) $955,632 net increase in retained earnings due to net income of $1,281,783 for the nine months ended September 30, 2011 partially offset by $326,151 of dividends paid in 2011; (ii) an increase in the net unrealized gain on securities available for sale of $494,803; and (iii) a reduction of $126,809 in Unearned ESOP shares reflecting the gradual payment of the loan we made to fund the ESOP's purchase of our stock.

The unrealized gain on securities available for sale is excluded from the calculation of regulatory capital. Management does not anticipate selling securities in this portfolio, but changes in market interest rates or in the demand for funds may change management's plans with respect to the securities portfolio. If there is a material increase in interest rates, the market value of the available for sale portfolio may decline. Management believes that the principal and interest payments on this portfolio, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow.

The Dodd-Frank Wall Street Reform and Consumer Protection Law

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Law was adopted. It has been described as the greatest legislative change in the supervision of financial institutions since the 1930s. Its effect on Victory State Bank and VSB Bancorp, Inc. cannot now be judged with certainty because the interpretation and implementation of the law, as well as the numerous regulations and studies required or permitted by it, are still evolving. However, we believe that the following areas, among others, will be or may be significant to our future operations:

1. The law exempts smaller reporting companies filing with the Securities and Exchange Commission, such as our company, from the internal controls attestation rules of Section 404(b) of the Sarbanes-Oxley Act. Thus far, we have incurred expenses to prepare for compliance but we have not been governed by Section 404(b) due to temporary SEC extensions of the compliance deadline. The permanent exemption means that we will not be required to incur the expense of actual compliance as long as we continue to qualify as a smaller reporting company.


2. Securities brokers may not vote shares held in "street name" unless they receive instructions from their customers on the election of directors, executive compensation or any other significant matter, as determined by the SEC. This may increase our costs of holding annual stockholder meetings if it becomes necessary for us to retain the services of a proxy solicitor to increase shareholder participation in our meetings or to obtain approval of matters that the Board presents to stockholders. However, we did not experience any difficulties or additional expense related to this issue in connection with our 2011 annual meeting of stockholders.

3. At least every three years, we will be required to submit to our stockholders, for a non-binding vote, our executive compensation. This requirement may increase the cost of holding some stockholder meetings. The law also requires that the SEC implement other requirements for enhanced compensation disclosures. The SEC adopted a temporary exemption for smaller reporting companies, such as our company, until annual meetings occurring on or after January 21, 2013.

4. The law includes a number of changes to expand FDIC insurance coverage, as well as changes to the premiums banks must pay for insurance coverage, and the requirements applicable to the reserve ratio (the ratio of the deposit insurance fund to the amount of insured deposits). One important change is that, in the future, deposit insurance premiums we pay will be based upon total assets minus tangible capital, rather than based upon deposits. Since we do not use material borrowings to provide funds for asset growth, and we do not have material intangible assets that are excluded from capital such as goodwill, our share of the total deposit premiums paid by all banks appears to have declined. However, other factors, such as required replenishment of the current reserve fund, which must be increased to 1.35% of total insured deposits by September 30, 2020, as well as future failures of banks that may further deplete the fund, may result in an increase in our future deposit insurance premium. The FDIC must provide an offset for smaller banks negating the adverse effect of requiring a reserve ratio in excess of 1.15%, but reaching even the 1.15% ratio may require additional burdens on smaller banks. The FDIC approved final regulations implementing these changes on February 25, 2011, effective April 1, 2011. According to the FDIC, the substantial majority of banks will see reduced deposit insurance premiums as a result of the new rules. We believe that will be the case for us as long as all other relevant factors remain unchanged.

5. The law increases the amount of each customer's deposits that are subject to FDIC insurance. The general limit has been permanently increased from $100,000 to $250,000. In addition, non-interest bearing transaction accounts will be fully insured, without limit, from December 31, 2010 to December 31, 2012.

6. The law repeals the prohibition on paying interest on demand deposit accounts, effective in July 2011. Interest-free demand deposits represent a substantial portion of our deposit base. We are not currently offering a demand deposit product that pays interest. If other banks offer interest-bearing demand deposits in our community, that competitive pressure may require that we offer interest checking accounts to businesses in order to retain deposits. That could have a direct adverse effect on our cost of funds. Although current market interest rates are very low, and such deposits are unlikely to carry high rates of interest, an increase in market interest rates could result in significant additional costs in order to maintain the level of such deposits.

7. The law makes interstate branching by banks much easier than in the past. We have no plans to branch outside New York State, but the law facilitates out of state banks branching into our market area, thus potentially increasing competition.

8. The law creates a new federal agency - the Consumer Financial Protection Bureau ("Bureau") - which has substantial authority to regulate consumer financial transactions, effective July 21, 2011. Our loans are primarily made to businesses rather than individual consumers, so the Bureau will not have a direct effect on many of our loan transactions. However, the Bureau also has authority to regulate other non-loan consumer transactions, such as deposits and electronic banking transactions. The implementation of new consumer regulations may increase our operating costs in a manner we cannot predict until regulations are adopted.


The Current Economic Turmoil

The economy in the United States, including the economy in Staten Island, was and may still be in a recession. Although some analysts report that the economy is recovering, the extent and speed of the recovery is far from clear and some analysts predict a darker road ahead. There is substantial stress on many financial institutions and financial products. The federal government has intervened by making hundreds of billions of dollars in capital contributions to the banking industry. We draw a substantial portion of our customer base from local businesses, especially those in the building trades and related industries, and we believe that there continue to be substantial weaknesses in the business economy in our market area. Our customers have been adversely affected by the economic downturn, and if adverse conditions in the local economy continue, it will become more difficult for us to conduct prudent and profitable business in our community.

Making permanent residential mortgage loans is not a material part of our business, and our investments in mortgage-backed securities and collateralized mortgage obligations have been made with a view towards avoiding the types of securities that are backed by low quality mortgage-related assets. However, one of the primary focuses of our local business is receiving deposits from, and making loans to, businesses involved in the construction and building trades industry on Staten Island. Construction loans represented a significant component of our loan portfolio, reaching 39.8% of total loans at year end 2005. As we monitored the economy and the strength of the local construction industry, we elected to reduce our portfolio of construction loans. By September 30, 2011, the percentage had declined to 5.7%. However, developers and builders provide not only a source of loans, but they also provide us with deposits and other business. If the weakness in the economy continues or worsens, then that could have a substantial adverse effect on our customers and potential customers, making it more difficult for us to find satisfactory loan opportunities and low-cost deposits. This could compel us to invest in lower yielding securities instead of higher-yielding loans and could also reduce low cost funding sources such as checking accounts and require that we replace them with higher cost deposits such as time deposits. Either or both of those shifts could reduce our net income.

Changes in FDIC Assessment Rates

The Bank is a member of the FDIC. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-­insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC.

In the past three years, there have been many failures and near-failures among financial institutions. The number of FDIC-insured banks that have failed has increased, and the FDIC insurance fund reserve ratio, representing the ratio of the fund to the level of insured deposits, declined dramatically due to losses caused by bank failures. As a result, the FDIC increased its deposit insurance premiums on remaining institutions, including well-capitalized institutions like Victory State Bank, in order to replenish the insurance fund. If bank failures continue to occur, and more so if the level of failures increases, the FDIC insurance fund may further decline, and the FDIC would be required to continue to impose higher premiums on healthy banks. Thus, despite the prudent steps we may take to avoid the mistakes made by other banks, our costs of operations may increase as a result of those mistakes by others.

Our FDIC regular insurance premium was $41,218 in the third quarter of 2011 compared to $98,359 in the third quarter of 2010, a decrease of 58.1%. As required by The Dodd -Frank Wall Street Reform and Consumer Protection Law (the "Dodd-Frank" Act), the FDIC has recently revised its deposit insurance premium assessment rates. Our Bank, even though we are in the lowest regulatory risk category, is subject to an assessment rate between five (5) and nine (9) basis points per annum. In general, the rates are applied to our bank's total assets less tangible capital, in contrast to the former rule which applied the assessment rate to our level of deposits.


The deposit insurance premium change and the special assessment have begun to replenish the fund created to pay the cost of resolving failed banks and the fund no longer has a negative balance. The Dodd-Frank Act requires that the FDIC must increase the ratio of the FDIC insurance fund to estimated total insured deposits to 1.35% by September 30, 2020. The FDIC believes that most banks will pay a lower total assessment under the new system than under the former system, and Victory State Bank has paid lower premiums under the new system than under the former system. However, if bank failures in the future exceed FDIC estimates, or other estimates that the FDIC makes turn out to be incorrect, and the losses to the insurance fund increase, the FDIC could be forced to increase insurance premiums. Such an increase would increase our non-interest expense.

As a result of the Dodd-Frank Act, non-interest bearing demand deposits, together with certain attorney trust account deposits commonly known in New York as IOLA accounts, will have the benefit of unlimited federal deposit insurance until December 31, 2012. Since the Dodd-Frank Act also authorized banks to pay interest on commercial demand deposits beginning in July 2011, commercial depositors will have to choose between earning interest on their demand deposits or having the benefit of unlimited deposit insurance coverage. In addition, the increase in the general FDIC insurance limit from $100,000 to $250,000 was made permanent.

The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, 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 by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances that would result in termination of the Bank's deposit insurance.

Possible Adverse Effects on Our Net Income Due to Fluctuations in Market Rates

Our principal source of income is the difference between the interest income we earn on interest-earning assets, such as loans and securities, and our cost of funds, principally interest paid on deposits. These rates of interest change from time to time, depending upon a number of factors, including general market interest rates. However, the frequency of the changes varies among different types of assets and liabilities. For example, for a five-year loan with an interest rate based upon the prime rate, the interest rate may change every time the prime rate changes. In contrast, the rate of interest we pay on a five-year certificate of deposit adjusts only every five years, based upon changes in market interest rates.

In general, the interest rates we pay on deposits adjust more slowly than the interest rates we earn on loans because our loan portfolio consists primarily of loans with interest rates that fluctuate based upon the prime rate. In contrast, although many of our deposit categories have interest rates that could adjust immediately, such as interest checking accounts and savings accounts, changes in the interest rates on those accounts are at our discretion. Thus, the rates on those accounts, as well as the rates we pay on certificates of deposit, tend to adjust more slowly. As a result, the declines in market interest rates that occurred through the end of 2008 initially had an adverse effect on our net income because the yields we earn on our loans declined more rapidly than our cost of funds. However, many of our prime-based loans have minimum interest rates, or floors, below which the interest rate does not decline despite further decreases in the prime rate. As our loans reached their interest rate floors, our loan yields stabilized while our deposit costs continued to decline. This had a positive effect on our net interest income.


When market interest rates begin increasing, which we expect will occur at some point in the future, we anticipate an initial adverse effect on our net income. We anticipate that this will occur because our deposit rates should begin to rise, while loan yields remain relatively steady until the prime rate increases sufficiently that our loans begin to reprice above their interest rate floors. For most of our prime-rate based loans, this will not occur until the prime rate increases above 6%. Once our loan rates exceed the interest rate floors, increases in market interest rates should increase our net interest income because our cost of deposits should probably increase more slowly than the yields on our loans. However, customer preferences and competitive pressures may negate this positive effect because customers may choose to move funds into higher-earning deposit types as higher interest rates make them more attractive, or competitors offer premium rates to attract deposits. We also have a substantial portfolio of investment securities with fixed rates of interest, most of which are mortgage-backed securities with an estimated average life of not more than 5 years.

Results of Operations for the Three Months Ended September 30, 2011 and September 30, 2010

Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer deposits. Our operating expenses principally consist of employee compensation and benefits, occupancy expenses, professional fees, advertising and marketing expenses and other general and administrative expenses. Our results of operations are significantly affected by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities.

General. We had net income of $422,288 for the quarter ended September 30, 2011, compared to net income of $506,861 for the comparable quarter in 2010. The principal categories which make up the 2011 net income are:

? Interest income of $2,494,086
? Reduced by interest expense of $210,382 ? Reduced by a provision for loan losses of $90,000 ? Increased by non-interest income of $602,505 ? Reduced by non-interest expense of $2,017,676 ? Reduced by income tax expense of $356,245

We discuss each of these categories individually and the reasons for the differences between the quarters ended September 30, 2011 and 2010 in the following paragraphs.

Interest Income. Interest income was $2,494,086 for the quarter ended September 30, 2011, compared to $2,598,016 for the quarter ended September 30, 2010, a decrease of $103,930, or 4.0%. The main reason for the decline was a 57 basis point decrease in the yield on investment securities, partially offset by a $1,989,150 increase in average balance of investment securities between the periods, which combined to cause a $149,851 decline in interest income on investment securities. Interest income on loans increased by $45,392, due to the collection of interest of $103,881 on a non-accrual loan, partially offset by a reversal of $40,438 of accrued but uncollected interest income on loans that we categorized as non-accrual in the third quarter and a 38 basis point decrease in average yield from the third quarter of 2010 to the third quarter of 2011.

We had a $3,025,521 increase in average balance of loans, which partially offset a 38 basis point decrease in the average yield, on loans, from 7.43% to 7.05%, from the quarter ended September 30, 2010 to the quarter ended September 30, 2011. The increase in the average balance was the result of our efforts to increase our loan portfolio. The average balance of non-accrual loans increased by $1.3 million from the third quarter of 2010 to the third quarter of 2011, the balance of non-accrual loans for which we received interest and recognized it on a cash basis decreased by $2.4 million in that period. This shift in non-accrual loans was the principal cause to the 38 basis point drop in our average loan yield. Substantially all of the new non-accrual loans are secured by mortgages on real estate located on Staten Island. Interest rate floors on most of our loans have helped to stabilize interest income from the loan portfolio, but these floors will have the effect of limiting increases in our income until the prime rate rises above 6%.


We experienced a 57 basis point decrease in the average yield on our investment securities portfolio, from 3.75% to 3.18%. The average balance of our investment portfolio increased by $1,989,150, or 1.7%, between the periods. The investment securities portfolio represented 75.7% of average non-loan interest earning assets in the 2011 period compared to 73.8% in the 2010 period.

The average yield on other interest earning assets (principally overnight investments) increased 2 basis points from 0.16% for the quarter ended September 30, 2010 to 0.18% for the quarter ended September 30, 2011, partially offset by a decrease in average balance of other interest earning assets of $3,366,167 from the quarter ended September 30, 2010 to the quarter ended September 30, 2011.

Interest Expense. Interest expense was $210,382 for the quarter ended September 30, 2011, compared to $249,476 for the quarter ended September 30, 2010, a decrease of $39,094 or 15.7%. The decrease was primarily the result of a reduction in the rates we paid on deposits, principally on NOW and time account deposits. There was a 19 basis point decrease in the cost of NOW account deposits between the periods, and an 8 basis point decrease in the cost of time deposits, due to the continuing low market interest rates. As a result, our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 0.61% from 0.68% between the periods.

Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $2,283,704 for the quarter ended September 30, 2011, compared to $2,348,540 for the quarter ended September 30, 2010, a decrease of $64,836, or 2.7%. The decrease was primarily because the reduction in our interest income was greater than the reduction in our cost of funds when comparing the quarter ended September 30, 2011 to the same period ended 2010. The average yield on interest earning assets declined by 32 basis points, while the average cost of funds declined by 7 basis points. The decline in average yield resulted when we were required to reinvest the proceeds from payments on investment securities at lower rates because of the continuation of low market interest rates. Also contributing to the decline in average yield was the 38 basis point decrease in the average yield on loans, our highest earning asset, as we experienced an increase in non-performing loans. Interest rate floors on our loans have helped to stabilize interest income from the loan portfolio, but these floors also have the effect of limiting increases in our income when market rates increase until the prime rate rises above 6%. The 7 basis point decline in the cost of funds was driven principally by the 19 basis point drop in the cost of NOW account deposits and the 8 basis point drop in the cost of time deposits. Overall, our interest rate spread declined 25 basis points, from 3.69% to 3.44% between the periods.

Our net interest margin decreased to 3.70% for the quarter ended September 30, 2011 from 3.95% in the same period of 2010. The interest rate margin decreased for substantially the same reasons as the decrease in our interest rate spread. The margin is higher than the spread because it takes into account the effect of interest free demand deposits and capital.

Provision for Loan Losses. We took a provision for loan losses of $90,000 for the quarter ended September 30, 2011 compared to a provision for loan losses of $15,000 for the quarter ended September 30, 2010. The $75,000 increase in the provision was a result of our evaluation of our loan portfolio. We use the following framework to evaluate the appropriateness of our allowance for loan losses. We conduct a loan by loan evaluation of inherent losses in all non-performing or classified loans and we conduct a collective analysis of homogenous groups of performing loans to estimate inherent losses in those loans on a group by group basis. Our individual evaluation of non-performing mortgage loans, which represent most of our non-performing loans, is based primarily upon updated appraisals. Our evaluation of homogenous groups of performing loans takes into account historical charge off rates we have experienced, as adjusted for pertinent current factors that may affect the extent to which we should rely upon our charge off history.


We experienced an increase of $2,046,085 in non-performing loans from $6,459,626 at September 30, 2010 to $8,505,711 at September 30, 2011. Most of those loans are secured by real estate. We individually evaluated the non-performing mortgage loans based primarily upon updated appraisals as part of our analysis of the appropriate level of our allowance for loan and lease losses. We had charge-offs of $1,942 for the quarter ended September 30, 2011 as compared to $6,426 for the quarter ended September 30, 2010. We also had recoveries (which are added back to the allowance for loan losses) of $31,877 for the quarter ended September 30, 2011 as compared to $23,484 in the third quarter of 2010. After increasing the provision for loan losses in the third quarter of 2011 compared to the third quarter of 2010, and considering other matters that increased or decreased the allowance, we determined that the level of our allowance at September 30, 2011 was appropriate to address inherent losses. We are aggressively collecting charged-off loans in an effort to recover the amounts charged off whenever we believe that collection efforts are likely to be fruitful.

The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. Our allowance for loan losses is based on management's evaluation of the risks inherent in our loan portfolio and the general economy. Management periodically evaluates both broad categories of performing loans and problem loans individually to assess the appropriate level of the allowance.

Although management uses available information to assess the appropriateness of the allowance on a quarterly basis in consultation with outside advisors and the board of directors, changes in national or local economic conditions, the circumstances of individual borrowers, or other factors, may change, increasing the level of problem loans and requiring an increase in the level of the . . .

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