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

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Form 10-K for VSB BANCORP INC


15-Mar-2013

Annual Report


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

General

VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company") is the holding company for Victory State Bank (the "Bank"), a New York State chartered commercial bank. Our primary business is owning all of the issued and outstanding stock of the Bank. Victory State Bank is a New York State chartered commercial bank, founded in November 1997. The Bank is supervised by the New York State Department of Financial Services ("NYSDFS") and the Federal Deposit Insurance Corporation ("FDIC"). The Bank gathers deposits from individuals and businesses primarily in Staten Island and makes loans throughout that community. The Bank invests funds that are not used for lending primarily in government securities, mortgage backed securities and collateralized mortgage obligations. Customer deposits are insured, up to the applicable limit, by the FDIC. VSB Bancorp, Inc. common stock is quoted on the NASDAQ Global Market ("NASDAQ GM") under the symbol "VSBN".

Our results of operations are dependent primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our costs of funds, consisting primarily of interest paid on our 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 the general strength of the local economy, changes in market interest rates, government policies and actions of regulatory authorities.

Since the Bank opened for business in 1997, the Board of Directors and management have pursued a strategy of growth and expansion in order to enhance the long term value of our banking franchise. The Board of Directors and management anticipate that an increase in customer deposits, and the resulting increase in funds we would have available to fund asset growth, will generate an increase in net interest income.

In order to support branch expansion and asset growth, we had not paid cash dividends prior to the fourth quarter of 2007. Our Board of Directors approved our first $0.06 cash dividend to stockholders of record on November 29, 2007, payable on January 2, 2008 and we paid quarterly dividends of $0.06 per share with respect to each calendar quarter thereafter through the end of 2012. We paid $426,571 of dividends out of net income of $1,188,200, for a dividend payout ratio of 36% in 2012 and we paid $433,235 of dividends out of net income of $1,444,451, for a dividend payout ratio of 30% in 2011. Thus, we retained the majority of our net income to increase our capital base to support our efforts to expand our franchise in the future.

During 2012, we continued to face challenges from our level of non-accrual loans and a continuation of low market interest rates that pushed down our yields on assets. Although non-accrual loans declined from 2011 to 2012, they still totaled $6.4 million, or 7.8% of total loans, at December 31, 2012.

Our cost of funds, due to the downward pressure of deposit rates, declined but not as fast as our yield on assets. The real estate market continued to soften, which reduced deposit balances and loan originations from real estate attorneys who form a segment of our customer base. We incurred additional provisions for loan loss due to the increased level of delinquencies.

Management intends to exert efforts to continue growing our company in the future. However, both internal and external factors could adversely affect our future growth. The down turn in the economy has made it more difficult for us to originate new loans that meet our underwriting standards. Not only does that cause us to invest available funds in lower-yielding securities and deposits with other banks, but it also slows the development of non-loan relationships which sometimes flow from cross-selling to loan customers.

A continuation of adverse general economic conditions could make it difficult for us to execute our growth plans. Additionally, an increase in market rates may have a negative impact on our net interest income. Furthermore, regulatory capital requirements could have a negative effect on our ability to grow if growth outpaces our ability to support that growth with increased capital.

Critical Accounting Policies

We are required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the amounts of revenues and expenses during the reporting period. The allowance for loan losses, the measurement of loan impairment, prepayment estimates on the mortgage-backed securities and collateralized mortgage obligation portfolios, contingencies and fair values of financial instruments are particularly subject to change and to management's estimates. Actual results or values can differ from those estimates and may have an impact on our financial statements.

Asset/Liability Management

We maintain the interest rate sensitivity of our assets by investing primarily in CMOs and MBSs with short and intermediate average lives to generate cash flows and by originating and retaining primarily loans with interest rates that adjust based on the prime rate. As of December 31, 2012, prime based loans totaled $59,359,893, or 69.8% of total loans. Many of these prime based loans are subject to interest rate floors of 7.00% to 8.00%. We anticipate that we will continue to concentrate on originating prime based loans in our principal market areas. We also expect to continue to invest other available funds that we cannot invest in loans in short-term investment grade securities.

Cash Flow Sensitivity Analysis. The matching of assets and liabilities may be analyzed by examining our cash flow sensitivity "gap." An asset or liability is said to be cash flow sensitive within a specific time period if it will mature or reprice within that time period. The cash flow sensitivity gap is defined as the difference between the amount of interest-earning assets maturing within a specific time period and the amount of interest-bearing liabilities maturing within that time period. A gap is considered positive when the amount of interest earning assets exceeds the amount of interest bearing liabilities. A gap is considered negative when the amount of interest bearing liabilities exceeds the amount of interest earning assets.

During a period of falling interest rates, the net income of an institution with a positive gap can be expected to be adversely affected because the yield on its interest-earning assets should reprice downward faster than the decline in its cost of funds. Conversely, during a period of rising interest rates, the net income of an institution with a positive gap position can be expected to increase as it is able to invest in higher yielding interest-earning assets at a more rapid rate than its interest-earning liabilities reprice. A positive gap may not protect an institution with a large portfolio of adjustable rate based loans or mortgage-backed securities from increases in interest rates for extended time periods if such loans or securities have annual and lifetime interest rate caps. In a low interest rate environment, such as the one that we are experiencing, once the yields on assets reach their interest rate floors, the yields do not further decline even if the index used to determine the interest rate continues to decline. When market interest rates then increase, the assets that have floors will not reprice upwards until the index rises sufficiently to cause the interest rates to exceed their floors. This delay in the upward adjustment of the interest rate may negatively affect net interest income. Our prime rate based loans and our securities investments generally do not have any annual or lifetime maximum interest rates, or caps. Caps can adversely affect net interest income if market interest rates rise substantially.

In the current interest rate environment, we generally have been investing available funds not needed for lending in CMOs and MBSs with estimated average lives of five years or less and we invested the increase in funds resulting from our growth in deposits in overnight liquid investments to the extent not needed to fund an increase in loans. As a result of this strategy, and based upon the assumptions used in the following table at December 31, 2012, our total interest-bearing assets maturing within one year exceeded our total interest-bearing liabilities maturing in the same period by $26,603,537, representing a one year cumulative positive gap ratio of 10.53%. In many cases, a positive gap ratio means that in an increasing rate environment, the interest that we earn on assets will reprice upward faster than the rates we pay on deposits. However, for a number of important reasons, that may not be the results we will experience if market interest rates begin to rise.

As explained above, an increase in the target federal funds rate, which normally presages an immediate increase in the prime rate, will not have an immediate positive effect on most of our adjustable rate loans because they have interest rate floors that must be surpassed before yields on those assets begin to increase. However, the increase in the prime rate is likely to put prompt upward pressure on the rates we pay to depositors, at least in the case of certificates of deposit.
The gap table does not consider the effects of customer discretion. When market interest rates are very low, the difference between the rates paid on different deposit types is relatively small, and customers may elect to keep funds in very liquid deposits with the lowest interest rates because those deposits provide the greatest flexibility when market rates increase. Those customers may elect to switch a deposit to a higher cost category, such as from NOW accounts to a time deposit, if the increase in market rates makes the difference in rates between those two deposit types more meaningful. Our cost of a specific customer's deposit could go up faster than market rates are rising if the customer decides to do so.
The gap table does not take into account discretion by the Bank in making deposit pricing decisions. Other external factors, such as changes in competition or the decision by a local competitor to aggressively seek local deposits by offering premium rates on deposits, may cause the Bank to increase deposit rates more rapidly to match competitors.

We closely monitor our interest rate risk as such risk relates to our operational strategies. The Company and the Victory State Bank Boards of Directors have established Asset/Liability Committees, responsible for reviewing our asset/liability policies and interest rate risk position, which generally meets quarterly and reports back to the Boards on interest rate risk and trends on a quarterly basis. In light of the current interest rate environment, we are attempting to maintain a position in which our assets reprice more quickly than our liabilities. There can be no assurance, however, that we will be able to achieve that result or that we will be able to avoid further spread compression or avoid negative consequences from interest rate fluctuations. Although we have not experienced a material runoff in our core deposits, there can be no assurances that such a runoff will not occur in the future if depositors seek higher yielding investments.

Our substantial level of non-interest-bearing demand deposits also furthers our goal of maintaining a positive gap because the interest cost of those deposits will not increase as market rates increase. However an increase in market interest rates could cause our customers to shift funds from demand deposits into interest earning deposits if interest rates are high enough to justify maintaining multiple accounts. Furthermore, effective July 2011, banks were permitted to pay interest on commercial demand deposits. This could have a significant effect on our net income by forcing us to pay interest on business demand deposits to maintain parity with our competitors.

The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 2012 which we estimate, based upon certain assumptions, will mature in each of the future time periods shown. Except as stated below, the amount of assets and liabilities shown which mature during a particular period were determined in accordance with the earlier of estimated repayment or runoff or the contractual terms of the asset or liability. There can be no assurance that deposits would reprice to peer bank's historical levels if interest rates were to increase. Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities, they may react in different degrees to changes in market interest rates. The table reflects only whether a yield or cost is expected to adjust without measuring whether the magnitude of the adjustment is the same for different types of assets or liabilities. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets may have features which restrict changes in interest rates on a short-term basis and over the life of the asset. For example, if a prime rate loan has a minimum interest rate of 7.0%, an increase in a very low prime rate might not be sufficient to increase the interest rate on the loan to more than the minimum. Further, in the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly, in a manner we cannot predict, from those assumed in calculating the table. Finally, the ability of many borrowers to service their prime rate loans may decrease in the event of interest rate increases.

                                                                         At December 31, 2012
                                                                             More than One
                                         Three months         Four to         year to five        More than
                                           or less         twelve months         years           five years           Total
Interest-earning assets:
Commercial loans (1)                    $   59,425,745     $   1,027,010     $    5,117,777     $   6,003,846     $  71,574,378
Consumer loans (1)                             808,316         2,427,108            869,628           128,148         4,233,200
Mortgage-backed securities                  10,308,014        30,924,042         61,580,776                 -       102,812,832
Other interest-earning assets               74,005,295                 -                  -                 -        74,005,295
Total interest-earning assets              144,547,370        34,378,160         67,568,181         6,131,994       252,625,705

Unamortized premium , unearned
(discount) and deferred fees(2)                 76,889           230,666            797,417                 -         1,104,972

Net interest-earning assets                144,624,259        34,608,826         68,365,598         6,131,994       253,730,677

Interest-bearing liabilities:
Savings accounts                            20,871,593                 -                  -                 -        20,871,593
NOW accounts                                33,394,785                 -                  -                 -        33,394,785
Money market accounts                       33,814,712                 -                  -                 -        33,814,712
Certificate accounts                        40,654,269        23,894,189          6,904,246                 -        71,452,704
Total interest-bearing liabilities         128,735,359        23,894,189          6,904,246                 -       159,533,794

Interest sensitivity gap                $   15,888,900     $  10,714,637     $   61,461,352     $   6,131,994     $  94,196,883
Cumulative gap                          $   15,888,900     $  26,603,537     $   88,064,889     $  94,196,883     $  94,196,883
Cumulative gap as a percentage of
total interest-earning assets                     6.29 %           10.53 %            34.86 %           37.29 %           37.29 %
Cumulative net interest-earning
assets as a percentage of total
interest-bearing liabilities                    112.34 %          117.43 %           155.20 %          159.05 %          159.05 %

(1) For purposes of the gap analysis, mortgage and other loans are reduced by non-performing loans but are not reduced by the allowance for possible loan losses. For purposes of the gap analysis, unearned discount and deferred fees are
(2) pro-rated.

Analysis of Net Interest Income

Our profitability is primarily dependent upon net interest income. Net interest income represents the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities. Net interest income depends primarily upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.

Average Balance Sheet

The following table sets forth certain information relating to our consolidated statements of financial condition and the consolidated statements of earnings for the fiscal years ended December 31, 2012, 2011 and 2010 and reflects the average yield on assets and average cost of liabilities for the period indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods shown. Average balances are derived from average daily balances. The average balance of loans receivable include loans on which we have discontinued accruing interest. The yields and costs include net fees, which are considered adjustments to yields. No tax equivalent adjustments have been made.

                                Year Ended December 31,                       Year Ended December 31,                      Year Ended December 31,
                                         2012                                          2011                                          2010
                          Average                        Yield/         Average                        Yield/         Average            Yield/
                          Balance         Interest1       Cost          Balance         Interest1       Cost          Balance          Interest1      Cost
Assets:
Interest-earning
assets:
Loans receivable       $  83,241,277     $ 5,902,637        7.09 %   $  81,755,097     $ 5,683,399        6.95 %   $  78,995,376     $  5,800,691      7.34 %
Other interest
earning assets            52,090,223         115,098        0.22        36,675,684          66,713        0.18        39,091,176           61,124      0.16
Investment
securities               113,305,714       2,988,980        2.64       116,211,595       3,797,049        3.27       114,319,832        4,401,547      3.85
Total
interest-earning
assets                   248,637,214       9,006,715        3.62       234,642,376       9,547,161        4.07       232,406,384       10,263,362      4.42

Non-interest earning
assets                     6,667,017                                     6,757,109                                     8,380,147
Total assets           $ 255,304,231                                 $ 241,399,485                                 $ 240,786,531

Liabilities and
equity:
Interest-bearing
liabilities:
Savings accounts       $  19,111,205          53,318        0.28     $  16,803,092          46,719        0.28     $  15,262,470           47,445      0.31
Time accounts             64,519,056         436,374        0.68        64,184,904         479,705        0.75        65,196,898          572,292      0.88
Money market
accounts                  31,362,621         226,515        0.72        27,865,123         235,581        0.85        27,820,065          240,461      0.86
Now accounts              32,885,018          79,818        0.24        29,411,515          96,761        0.33        35,273,971          160,865      0.46
Total
interest-bearing
liabilities              147,877,900         796,025        0.54       138,264,634         858,766        0.62       143,553,404        1,021,063      0.71
Checking accounts         78,286,944                                    73,971,400                                    68,686,944
Escrow Deposits              364,996                                       384,468                                       437,880
Total                    226,529,840                                   212,620,502                                   212,678,228
Other liabilities          1,234,657                                     1,784,938                                     2,169,130
Total liabilities        227,764,497                                   214,405,440                                   214,847,358
Equity                    27,539,734                                    26,994,045                                    25,939,173
Total liabilities
and equity             $ 255,304,231                                 $ 241,399,485                                 $ 240,786,531
Net interest
income/net interest
rate spread                              $ 8,210,690        3.08 %                     $ 8,688,395        3.45 %                     $  9,242,299      3.71 %
Net interest earning
assets/net interest
margin                 $ 100,759,314                        3.30 %   $  96,377,742                        3.70 %   $  88,852,980                       3.98 %
Ratio of
interest-earning
assets to
interest-bearing
liabilities                     1.68 x                                        1.70 x                                        1.62 x

Return On Average
Assets:                                                     0.47 %                                        0.60 %                                       0.78 %
Return On Average
Equity:                                                     4.31 %                                        5.35 %                                       7.25 %
Equity To Assets:                                          10.29 %                                       11.21 %                                      11.07 %
Dividend Payout
Ratio                                                      35.90 %                                       29.99 %                                      22.86 %

1 - Interest on loans includes $201,071 in 2012, $130,341 in 2011 and $25,261 in 2010 representing interest received during the year on non-accrual loans that is attributable to prior years. Those amounts were excluded in calculating the average loan yield for the year in which they were received but were not added to the prior period interest in calculating the yield in the prior period.

Rate/Volume Analysis

The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.

                                           Year Ended December 31, 2012                  Year Ended December 31, 2011                   Year Ended December 31, 2010
                                                   Compared to                                    Compared to                                   Compared to
                                                December 31, 2011                              December 31, 2010                             December 31, 2009
                                               Increase/(Decrease)                            Increase/(Decrease)                           Increase/(Decrease)
                                              In Net Interest Income                        In Net Interest Income                         In Net Interest Income
                                              Due to                                         Due to                                        Due to
                                      Volume          Rate             Net          Volume          Rate             Net           Volume          Rate             Net

Interest-earning assets:
Loans receivable                    $  103,290     $   115,948     $   219,238     $ 202,564     ($  319,856 )   ($  117,292 )   $  560,019     ($  224,696 )   $   335,323
Other interest-earning assets           27,746          20,639          48,385        (3,865 )         9,454           5,589         13,981          14,093          28,074
Investment securities, afs             (95,022 )      (713,047 )      (808,069 )      72,833        (677,331 )      (604,498 )     (180,771 )      (567,452 )      (748,223 )
Total                                   36,013        (576,459 )      (540,446 )     271,532        (987,733 )      (716,201 )      393,229        (778,055 )      (384,826 )

Interest-bearing liabilities:
Savings accounts                         6,463             136           6,599         4,776          (5,502 )          (726 )        5,655          (8,355 )        (2,700 )
Time accounts                            2,506         (45,837 )       (43,331 )      (8,906 )       (83,681 )       (92,587 )      (14,740 )      (338,761 )      (353,501 )
Money market accounts                   29,729         (38,795 )        (9,066 )         387          (5,267 )        (4,880 )       23,599         (30,004 )        (6,405 )
Now accounts                            11,463         (28,406 )       (16,943 )     (26,967 )       (37,137 )       (64,104 )       29,250         (10,790 )        18,460
Total                                   50,160        (112,901 )       (62,741 )     (30,709 )      (131,588 )      (162,297 )       43,765        (387,911 )      (344,146 )
Net change in net interest income   ($  14,147 )   ($  463,558 )   ($  477,705 )   $ 302,241     ($  856,145 )   ($  553,904 )   $  349,464     ($  390,144 )   ($   40,680 )

Effect of Adverse Conditions in the Real Estate Market

We rarely make residential mortgage loans to consumers to finance or refinance their home ownership. At December 31, 2012, we owned $102.8 million of securities that are either collateralized by residential mortgage loans or that represent shares in pools of such loans. However, 99.5% of those securities are issued or guaranteed by FNMA, GNMA or FHLMC. The remainder of the securities' portfolio consist of investment grade securities rated AAA. None of those securities have experienced ratings downgrades. We do not hold any loans in our portfolio of the type that are commonly known as subprime residential mortgage loans.

However, many of our customers, both loan and deposit customers, are involved in the residential construction business in Staten Island. We believe that the turmoil in the national housing and residential mortgage markets has had an adverse effect on some of our customers and has contributed to the increase in our level of past due loans. Weaknesses in the real estate market in general have also reduced the value of real estate collateral for some of our loans, which reduces our ability to recover loans in full when customers default in making regular payments.

The previous slowdown in the local housing market, which now may have stabilized but at lower value levels, seems to have reduced the business activity of our customers. We believe that this, in turn, has caused a reduction in their demand for loans from us, such as construction loans to build new homes. It also appears to have reduced the level of deposits they maintain. Furthermore, as the housing market has slumped, we have become more selective in our origination of construction loans, making it more difficult to deploy funds from lower yielding . . .

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