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MREE > SEC Filings for MREE > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for MAINSTREET BANKSHARES INC


15-Mar-2013

Annual Report


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

The following discussion is intended to assist in understanding and evaluating the financial condition and results of operations of MainStreet BankShares, Inc. ("MainStreet", "BankShares", or "Corporation") on a consolidated basis. This discussion and analysis should be read in conjunction with BankShares' consolidated financial statements and related notes included in Item 8 of this report on Form 10-K.

Forward-Looking Statements

This report contains forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those reflected in such forward-looking statements which are representative only on the date hereof. Readers of this report should not rely solely on the forward-looking statements and should consider all uncertainties and risks discussed throughout this report. MainStreet takes no obligation to update any forward-looking statements contained herein. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) competitive pressures among depository and other financial institutions may increase significantly; (2) changes in the interest rate environment may reduce margins;
(3) general economic conditions, either nationally or regionally, may be less favorable than expected that could result in a deterioration of credit quality or a reduced demand for credit; and (4) legislative or regulatory changes including changes in accounting standards, may adversely affect the business.

General

MainStreet was incorporated on January 14, 1999 in the Commonwealth of Virginia. MainStreet was primarily formed to serve as a bank holding company. Its first wholly-owned subsidiary was located in Martinsville, Virginia, and was sold on March 23, 2005. In 2002, MainStreet organized a second bank subsidiary, Franklin Community Bank, National Association ("Franklin Bank') to serve the Franklin County area of Virginia. MainStreet provides a wide variety of banking services through Franklin Bank. Franklin Bank operates as a locally-owned and operated commercial bank emphasizing personal customer service and other advantages incident to banking with a locally owned community bank. It relies on local advertising and the personal contacts of its directors, employees, and shareholders to attract customers and business to the Bank. Franklin Bank has three banking offices in Rocky Mount and Franklin County. On February 8, 2007, MainStreet formed a wholly-owned real estate company, MainStreet RealEstate, Inc. for the sole purpose of owning the real estate of the Corporation. MainStreet RealEstate, Inc. owns the Union Hall (Southlake) branch of Franklin Bank.

On April 16, 2009, Franklin Bank entered into a formal agreement ("Agreement") with The Comptroller of the Currency ("OCC"). The Agreement required Franklin Bank to perform certain actions within designated time frames. The Bank must comply with the Agreement while it is outstanding. The Bank submitted the responses required in the respective time frames described below.

Within 30 days, Franklin Bank was required to adopt sublimits for concentrations in acquisition and development loans, speculative lot loans, and speculative single-family housing construction loans and determine if any action is necessary to reduce these concentrations. Franklin Bank reviewed and amended these limits and certain concentrations were lowered.

Within 60 days, Franklin Bank was required to do the following:

Franklin Bank was required to establish an effective program for early identification of emerging and potential problem credits to include accurate ratings, accrual status, continued financial analyses, and formal work out plans. Franklin Bank developed an attestation process monthly for loan officers to include risk rating and the accrual status of their loan portfolios. Franklin Bank has a Problem Loan Committee made up of senior management and one Board Loan Committee director that meets monthly. Criticized loan worksheets were enhanced and expanded to include a summary of the most recent financial analysis; most recent collateral valuation factoring possible liquidation and timing discount; and enhanced action plans with target dates. Primary and secondary repayment sources are detailed on the worksheets. Our internal loan review function now reports to the loan committee of the board of directors rather than to management. This committee of the board meets quarterly and reporting was enhanced to include the overall quality of the loan portfolio; the identification, type, rating, and amount of problem loans; the identification and amount of delinquent loans; credit and collateral documentation exceptions; the identification and status of credit-related violations of law; the identification of the loan officer who originated each loan reported; concentrations of credit; and loans to executive officers and directors.

Franklin Bank was required to develop a written underwriting program to include reasonable amortization of speculative lot and single family housing construction loans and ensure updated appraisals are documented. Our credit policy was amended to address the amortization periods. Personnel were designated to ensure the reporting system has updated appraisals and evaluations. All files were reviewed to ensure correct appraisal information. A credit analyst position was added in December 2008 that performs required financial analysis on all loans $100,000 and over at origination or renewal and at the receipt of new financial statements. In addition, new software was purchased to assist with this process and to assist the credit analyst and lenders in the risk rating of each loan.

The Bank also had to eliminate the basis of criticism of assets criticized by the OCC. Franklin Bank has dedicated an experienced employee to work through problem assets. The other actions described above also assist in achieving compliance with this requirement. The Bank continually strives to lower its problem assets.

Franklin Bank was required to enhance its asset liability management policy to ensure monitoring of the Bank's liquidity position which included more detailed reporting to the Board. The Agreement also required Franklin Bank to increase its liquidity immediately and to take action to ensure adequate sources of liquidity. Franklin Bank increased its sources by adding correspondent bank lines; becoming a member of QwickRate (an internet certificate of deposit program); becoming a member of the Certificate of Deposit Account Registry Service ("CDARS"); and partnering with certain institutions to acquire brokered deposits. According to the Agreement, brokered deposits cannot exceed 15% of total deposits. At December 31, 2012 and 2011, brokered deposits were $5.3 million and $6.9 million, respectively, and were less than 5% of total deposits in both years. Franklin Bank also participated loans during the first half of 2009 which improved our liquidity. Franklin Bank revised its Contingency Liquidity Plan to include crises relevant to current balance sheet composition. New reports created to assist with monitoring asset liability and liquidity include a maturity schedule of certificates of deposit; the volatility of demand deposits; loan commitments and letters of credit; borrowing lines and continued availability; an analysis of the impact of decreased cash flow from the loss of income from nonperforming loans and loans sold or participated; rolling sources and uses report; rollover risk analysis; and prioritization of funding sources and uses. Franklin Bank was required to review and enhance the analysis of the allowance for loan losses. The Bank has continued to review and enhance the process.

Within 90 days, Franklin Bank was required to develop and implement a three-year detailed capital plan. The Plan was put in place and is continually updated. The plan includes detailed projections for growth and capital requirements; projections for primary sources and secondary sources of capital; and a revised dividend policy. The Agreement prohibits the Bank from paying dividends until compliance with the program and certain other conditions are met.

Under the Agreement, a Compliance Committee of three members of the Franklin Bank's Board of Directors was formed to monitor the progress and make regular reports to the OCC. Failure to comply with the provisions of the Agreement could subject Franklin Bank and its directors to additional enforcement actions. The Compliance Committee of Franklin Bank continues to meet monthly to ensure adherence and compliance with the Agreement. The Compliance Committee reviews the Agreement by article in detail at each meeting along with the corresponding actions of Franklin Bank within each article. The Compliance Committee reports monthly to the full board of directors. While Franklin Bank intends to continue to take such actions as may be necessary to enable it to comply with the requirements of the Agreement, there can be no assurance that it will be able to comply fully with the provisions of the Agreement. Such compliance is costly and affects the operations of Franklin Bank and the Corporation. Franklin Bank met all of the required time lines for submission of information to the OCC along with regular reporting. Franklin Bank must demonstrate sustained performance under the Agreement.

On June 17, 2009, MainStreet BankShares, Inc. entered into a Memorandum of Understanding ("MOU") with the Federal Reserve Bank of Richmond ("Federal Reserve"). The MOU required the bank holding company to utilize its financial and managerial resources to assist Franklin Bank in functioning in a safe and sound manner. The MOU restricted MainStreet from declaring or paying any dividends without the prior written approval of the Federal Reserve. Under the MOU, MainStreet cannot incur or guarantee any debt or redeem or purchase any shares of its common stock without the prior written consent of the Federal Reserve. Since then, MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. On January 26, 2011, the MOU with the Federal Reserve was amended to include additional requirements. The bank holding company must comply with the restrictions on indemnification and severance payments of section 18(k) of the FDI Act (12 U.S.C. 1828(k)) and Part 359 of the Federal Deposit Insurance Corporation's regulations (12 C.F.R. Part 359). Also, the Corporation shall not appoint any individual to the board or employ or change the responsibilities of any individual as senior executive officer if the Federal Reserve notifies the Corporation of disapproval within the required time limits. MainStreet has not paid or declared any dividends or incurred or guaranteed any debt. Management believes the holding company is appropriately using its financial and managerial resources to assist Franklin Bank to function in a safe and sound manner.

MainStreet and Franklin Bank's President and CEO, Larry A. Heaton, was tragically killed in a car accident on Sunday, December 9, 2012. On Monday, December 10, 2012, the Board of Directors named Brenda H. Smith, Acting President and Chief Executive Officer. Mrs. Smith has been with the Corporation since its inception and is also the Executive Vice President and Chief Financial Officer. A search committee has been formed and is actively pursuing a permanent President and Chief Executive Officer.

Critical Accounting Policies

MainStreet's financial statements are prepared in accordance with accounting principles generally accepted in the United States (GAAP). The financial information contained within our statements is, to a significant extent, based on measures of the financial effects of transactions and events that have already occurred. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. We use historical loss factors, peer comparisons, regulatory factors, concentrations of credit, past dues, and the trend in the economy as factors in determining the inherent loss that may be present in our loan portfolio. Actual losses could differ significantly from the historical factors that we use in estimating risk.

The allowance for loan losses reflects our best estimate of the losses inherent in our loan portfolio. The allowance is based on two basic principles of accounting: (i) losses are accrued when they are probable of occurring and are capable of estimation and (ii) losses are accrued based on the differences between the value of collateral, present value of future cash flows or values that are observable in the secondary market and the loan balance. The allowance for loan losses is maintained at a level, which, reflects management's best estimate of probable credit losses inherent in the loan portfolio and is, therefore, believed to be appropriate.

The amount of the allowance is based on management's evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions and other risks inherent in the portfolio. Management reviews the past due reports and risk-rated loans and discusses individually the loans on these reports with the responsible loan officers. Management uses these tools and provides a quarterly analysis of the allowance based on our historical loan loss experience, risk-rated loans, past dues, concentrations of credit, unsecured loans, loan exceptions, and the economic trend. These are generally grouped by homogeneous loan pools. Impaired loans are reviewed individually to determine possible impairment based on one of three recognized methods which are fair value of collateral, present value of expected cash flows, or observable market price. A specific reserve is then allocated for the amount of the impairment. Although management uses available information to recognize losses on loans, the substantial uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, make it possible that a material change in the allowance for loan losses in the near term may be appropriate. However, the amount of the change cannot be estimated. The allowance is increased by a provision for loan losses, which is charged to expense, and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses. Past due status is determined based on contractual terms.

Overview

Total assets at December 31, 2012 and 2011 were $183,110,988 and $203,855,311, respectively, a decline of $20,744,323, or 10.18%. The composition of the balance sheet has also changed. The largest components of change were in cash and cash equivalents and loans, net of unearned deferred fees and costs. Total cash and cash equivalents declined $6.4 million from year-end 2011 while loans, net of unearned deferred fees and costs declined $8.7 million. Loan demand has remained soft during 2012 and we have aggressively continued to work through our problem loans, which has resulted in additional payouts and foreclosures. Please refer to Footnote #4 for a discussion of our criticized assets. We continue to monitor our asset quality closely and we have had great improvement in the level of our criticized assets. Securities available for sale declined to $18.8 million at year-end 2012 from $21.2 million at year-end 2011 primarily from pay downs on mortgage backed securities and called agency securities. Our total deposits declined $16.5 million from year-end 2011 to year-end 2012. With the continued focus on lowering our overall deposit costs and soft loan demand, this was an anticipated and appropriate result. Our loan to deposit ratio was 89.32% and 85.72% at December 31, 2012 and 2011, respectively. Overall costs of our interest bearing deposits declined 30 basis points in 2012 compared to 2011. We maintained our relationships as can be evidenced by the increase in demand deposits which are our non-interest bearing funds. We also had $7.5 million in repurchase agreements mature in September 2012 for which certain securities available for sale were utilized as collateral. At maturity, we paid off the $7.5 million and now have additional securities that can be utilized and pledged for other purposes, as needed.

Total shareholders' equity at December 31, 2012 and 2011 was $24,250,373 and $22,240,789, respectively. MainStreet and Franklin Bank were considered well capitalized at December 31, 2012 and 2011 under the standards of regulatory capital classification. The book value of shareholders' equity at December 31, 2012 and 2011 was $14.15 and $12.98 per share, respectively.

MainStreet had net income of $1,970,776 for the twelve months ending December 31, 2012 compared to a net loss of $(146,445) for the twelve month period ending December 31, 2011. Net income for 2012 was impacted substantially by reduced provision expense and income from bank owned life insurance as discussed below. Basic and diluted net income (loss) per share was $1.15 and $(.09) for 2012 and 2011, respectively. Return on average assets in 2012 and 2011 was 1.02% and (.07%), respectively while return on average shareholders' equity was 8.69% and (.66%) for 2012 and 2011, respectively. The return on average assets and average equity for 2010 was .36% and 3.57%, respectively. Year 2012 continued to be impacted by our level of criticized assets. As we worked through these assets and they moved through the cycle, we experienced losses on the sales of other real estate, write downs associated with lower appraisals and selling prices, and had expenses associated with holding these assets. Our overall losses and expenses associated with our other real estate properties were $1.4 million and $1.2 million for the years ending December 31, 2012 and 2011, respectively. Provision expense in 2012 was lower than 2011 as we worked through our problem loans. Provision expense for the periods ending December 31, 2012 and 2011 was $486,257 and $1,660,783, respectively.

Franklin Bank has bank owned life insurance on the lives of its executive officers. Upon the tragic death of CEO, Larry A. Heaton, Franklin Bank collected a death benefit of which approximately $2.4 million was attributed to income on bank owned life insurance. Also, Franklin Bank has a supplemental executive retirement plan in place for its executives. Upon Mr. Heaton's death, the present value of the payout of this benefit was accrued and expensed totaling approximately $1 million.

Results of Operations

Net Interest Income

The low interest rate environment continued during 2012 with the Federal Reserve leaving the short-term interest rates within a range of 0% - .25% which has been effective since 2008. At the most recent meeting of the Federal Reserve, the Board of Governors indicated a continued willingness to keep rates at low levels thru mid-2015. By employing the QE 3 strategy the Federal Reserve plans to continue purchasing assets to affect what is called a "twist". The decision to "twist" will drive the yield curve up for short term rates and lower long term rates. The net effect is to keep mortgage rates low for an extended period of time to help spur the housing industry and economic growth. It is also designed to maintain inflation at low levels.

As interest rates have remained low, our borrowers have extended pressure to move to more fixed rate interest products; however, interest rates on variable rate loans make up approximately 24% of Franklin Bank's loan portfolio. In a rising interest rate environment, this initially would have a positive impact on the net interest margin because deposit rates are slower to reprice at the higher rates. In a declining interest rate environment such as we have been in, asset sensitivity initially has had a negative impact on the net interest margin until deposit rates have an opportunity to reprice. Throughout our history, our overall deposit maturity has been short which has benefited us by allowing us to reprice our deposits downward as they have matured in the lower interest rate environment. On the other hand, in an environment of increasing interest rates, short deposit maturity would reduce the benefit of rising interest rates on loans. Furthermore, even though lower interest rates have been beneficial for our cost of deposits, with prime at 3.25% which is the interest rate basis for many of our loans, MainStreet's net interest margin has been adversely affected by the prolonged, recessionary low interest rate environment. In addition, competition for deposits remains fierce in our market; however, our goal is to continue to lower our cost of deposits during 2013. The maturity of our repurchase agreement in September 2012 had a positive impact on our net interest margin for the last quarter of 2012 and will continue in 2013. In addition, the remaining $6 million in repurchase agreements will mature in January 2013 which will also have a positive impact on our net interest margin going forward.

Net interest income is the difference between total interest income and total interest expense. The amount of net interest income is determined by the volume of interest-earning assets, the level of interest rates earned on those assets and the cost of supporting funds. The difference between rates earned on interest-earning assets and the cost of supporting funds is measured as the net interest margin. MainStreet's principal source of income is from the net interest margin. The distribution of assets, liabilities, and equity along with the related interest income and interest expense is presented in the following table. The statistical information in the table is based on daily average balances.

Distribution of Assets, Liabilities, and Shareholders' Equity: Interest Rates and Interest Differentials

                                                  2012                                             2011                                              2010
                                Average                          Yield/          Average                          Yield/          Average                           Yield/
                                Balance         Interest          Rate           Balance         Interest          Rate           Balance          Interest          Rate

Loans, net of unearned (1)   $ 138,184,714     $ 7,782,200           5.63 %   $ 153,201,363     $ 8,608,985           5.62 %   $ 162,931,745     $  9,588,767           5.89 %
Loans held for sale                244,544           7,613           3.11             8,016             270           3.37                 -                -              -
Securities
available-for-sale-taxable      18,863,608         468,374           2.48        24,103,456         753,407           3.13        25,650,372          963,875           3.76
Securities
available-for-sale-non
taxable                          3,717,392          56,838           2.25            96,835           2,029           3.08                 -                -              -
Restricted equity
securities                         778,190          32,098           4.12           927,000          30,280           3.27         1,042,853           28,215           2.71
Interest-bearing deposits
in banks                        13,450,334          29,526            .22        11,857,846          25,757            .22        15,387,260           34,501            .22
Federal funds sold               7,074,748          12,634            .18         6,820,273          11,497            .17         5,597,638           11,650            .21
Total Interest Earning
Assets                         182,313,530       8,389,283           4.62 %     197,014,789       9,432,225           4.79 %     210,609,868       10,627,008           5.05 %
Cash and due from banks          2,877,211                                        2,746,269                                        2,596,935
Other assets                    10,182,472                                       12,119,036                                       12,324,767
Allowance for loan losses       (2,755,936 )                                     (3,280,304 )                                     (3,328,725 )

Total Assets                 $ 192,617,277                                    $ 208,599,790                                    $ 222,202,845
Interest checking deposits   $   7,475,890     $     3,687            .05 %   $   6,928,098     $     6,720            .10 %   $   8,023,116     $     16,356            .20 %
Money market deposits           23,419,522          49,132            .21        24,678,500         105,840            .43        21,916,385          217,881            .99
Savings deposits                13,324,572           7,318            .05        12,231,895          26,004            .21        11,072,683           37,411            .34
Time deposits $100,000 and
over                            38,988,324         627,801           1.61        46,314,130         853,058           1.84        53,618,002        1,230,463           2.29
Other time deposits             51,597,511         684,629           1.33        61,126,990       1,000,582           1.64        72,304,687        1,584,464           2.19
Federal funds purchased                164               2           1.22               603               2            .33             5,781               41            .71
Corporate cash management                -               -              -                 -               -              -                 -                -              -
Repurchase agreements           11,348,361         447,233           3.94        13,500,000         538,071           3.99        13,500,000          538,071           3.99
Short-term borrowings                   55               -              -               712               3            .42             5,479               27            .49
Total interest-bearing
liabilities                    146,154,399       1,819,802           1.25 %     164,780,928       2,530,280           1.54 %     180,446,133        3,624,714           2.01 %
Demand deposits                 22,899,719                                       20,680,934                                       18,904,678
Other liabilities                  878,634                                          870,010                                          655,347
Total Liabilities              169,932,752                                      186,331,872                                      200,006,158
Shareholders' Equity            22,684,525                                       22,267,918                                       22,196,687

Total Liabilities and
Shareholders' Equity         $ 192,617,277                                    $ 208,599,790                                    $ 222,202,845

Net Interest Earnings                          $ 6,569,481           3.37 %                     $ 6,901,945           3.25 %                     $  7,002,294           3.04 %

Net Yield on Interest
Earning Assets                                                       3.62 %                                           3.50 %                                            3.20 %

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