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BKOR > SEC Filings for BKOR > Form 10-K on 25-Mar-2013All Recent SEC Filings

Show all filings for OAK RIDGE FINANCIAL SERVICES, INC. | Request a Trial to NEW EDGAR Online Pro

Form 10-K for OAK RIDGE FINANCIAL SERVICES, INC.


25-Mar-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

The following presents management's discussion and analysis of our financial condition and results of operations and should be read in conjunction with the financial statements and related notes combined in Item 8 of this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ significantly from those anticipated in these forward-looking statements as a result of various factors. The following discussion is intended to assist in understanding the financial condition and results of operations of the Company. Because the Company has no material operations and conducts no business on its own other than owning its subsidiary, the Bank, the discussion contained in this Management's Discussion and Analysis concerns primarily the business of the Bank. However, for ease of reading and because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the Company unless otherwise noted.

The following Management's Discussion and Analysis of Financial Condition and Results of Operations describes our results of operations for the year ended December 31, 2012 as compared to the year ended December 31, 2011, and also analyzes our financial condition as of December 31, 2012 as compared to December 31, 2011. Like most financial institutions, we derive most of our income from interest we receive on our loans and investments. Our primary source of funds for making these loans and investments is our deposits, on most of which we pay interest. Consequently, one of the key measures of our success is the amount of net interest income, or the difference between the income on our interest-earning assets, such as loans and investments, and the expense on our interest-bearing liabilities, such as deposits. Another key measure is the spread between the yield we earn on these interest-earning assets and the rate we pay on our interest-bearing liabilities.

There are risks inherent in all loans, so we maintain an allowance for loan losses to absorb our estimate of probable losses on existing loans that may become uncollectible. We establish and maintain this allowance by charging a provision for loan losses against our operating earnings. In the following section, we have included a detailed discussion of this process.

In addition to earning interest on our loans and investments, we earn income through fees and other expenses we charge to our customers. We describe the various components of this noninterest income, as well as our noninterest expense, in the following discussion.

Markets in the United States and elsewhere have experienced extreme volatility and disruption for more than 12 months. These circumstances have exerted significant downward pressure on prices of equity securities and virtually all other asset classes, and have resulted in substantially increased market volatility, severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. Loan portfolio performances have deteriorated at many institutions resulting from, among other factors, a weak economy and a decline in the value of the collateral supporting their loans. Dramatic slowdowns in the housing industry with falling home prices and increasing foreclosures and unemployment have created strains on financial institutions. Many borrowers are now unable to repay their loans, and the value of the collateral securing these loans has, in some cases, declined below the loan balance. The following discussion and analysis describes our performance in this challenging economic environment.

The following discussion and analysis also identifies significant factors that have affected our financial position and operating results during the periods included in the accompanying financial statements. We encourage you to read this discussion and analysis in conjunction with our financial statements and the other statistical information included in this report.


Comparison of Results of Operations for the Years Ended December 31, 2012 and 2011

Net Income (loss)

In 2012, the Company had a net loss of $2.6 million or $1.45 basic and diluted earnings per share, compared to a net loss of $289 thousand or $0.16 basic and diluted earnings per share for the year ended December 31, 2011. The increase in our net loss is primarily attributable to increases in our provisions for loan losses.

The following table shows return on assets (net loss divided by average assets), return on equity (net income (loss) available to common shareholders divided by average common shareholders' equity) and shareholders' equity to assets ratio (average total shareholders' equity divided by average total assets) for each of the years presented.

                                     Year Ended December 31,
                                   2012         2011        2010
Return on assets                    (0.56 )%      0.10 %     0.21 %
Return (loss) on equity            (12.83 )      (1.85 )     2.59
Shareholders' equity to assets       7.58         7.97       7.97

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. The level of net interest income is determined primarily by the average balances (volume) of interest-earning assets and our interest-bearing liabilities and the various rate spreads between our interest-earning assets and interest-bearing liabilities. Changes in net interest income from period to period result from increases or decreases in the volume of interest-earning assets and interest-bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest-earning asset portfolio, and the availability of particular sources of funds, such as non-interest-bearing deposits.

The banking industry uses two key ratios to measure profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities. The net interest rate spread does not consider the impact of non-interest-bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing non-interest-bearing deposits in earning assets.

Our net interest income for the year ended December 31, 2012 was $13.4 million, a decrease of $731 thousand or 5.2% when compared to net interest income of $14.2 million for the year ended December 31, 2011. Our net interest margin for 2012 was 4.11% compared to 4.33% for 2011. The decrease in our net interest margin is mainly the result of a decline in yields on interest-earning assets offset by decreased rates paid on our interest bearing liabilities. Our net interest rate spread for 2012 was 3.98% compared to a 4.19% for 2011.

Total interest income decreased $1.8 million or 10.1% to $15.8 million in 2012 compared to $17.5 million in interest income in 2011. A decrease in the yield on interest-earning assets in 2012 when compared to 2011 resulted in a decline in interest income from 2011 to 2012. The yield on average earning assets decreased 56 basis points during 2012 compared to 2011.

The effect of variances in volume and rate on interest income and interest expense is illustrated in the table titled "Change in Interest Income and Expense" on page 27 of this Annual Report on Form 10-K. We attribute the majority of the decrease in the yield on our earning assets to a decline in the yield on our investment securities and loan portfolios, which was due to a decline in yields on new investment purchases and new and renewed loans during the year, respectively, in a lower interest rate environment.

Our average cost of funds for 2012 was 0.82%, a decrease of 35 basis points when compared to 1.17% for 2011. The average cost on interest bearing deposit accounts decreased 38 basis points from 1.16% paid in 2011 to 0.78% paid in 2012, while our average cost of borrowed funds also increased 78 basis points during 2012 compared to 2011.

Total interest expense decreased $1.1 million or 32.6% to $2.3 million in 2012 from $3.4 million in 2011, primarily the result of decreased market rates paid on Bank certificates of deposit as well as decreases in other interest-bearing deposit accounts. The volume of average interest-bearing deposits increased approximately $1.0 million when comparing 2012 with that of 2011. The decrease to interest expense resulting from decreased rates on all interest-bearing liabilities was $1.0 million and the decrease attributable to lower volumes of interest-bearing liabilities was $12 thousand.

Our net interest income for the year ended December 31, 2011 was $14.2 million, an increase of $801 thousand or 6.0% when compared to net interest income of $13.3 million for the year ended December 31, 2010. Our net interest margin for 2011 was 4.33% compared to 4.13% for 2010. The increase in our net interest margin is mainly the result of decreased rates paid on our interest bearing liabilities, offset by a decline in yields on interest-earning assets. Our net interest rate spread, on a tax-equivalent basis, for 2011 was 4.19% compared to a 3.97% for 2010.


Total interest income decreased $579 thousand or 3.2% to $17.5 million in 2011 compared to $18.1 million in interest income in 2010. A decrease in the yield on interest-earning assets in 2011 when compared to 2010 resulted in a decline in interest income from 2010 to 2011, but the decline in yield was partially offset by increases in average earning assets of $4.0 million in 2011 when compared to 2010. We funded the increases in interest-earning assets primarily with interest-bearing checking, savings, and money market deposit growth. The yield on average earning assets decreased 24 basis points during 2011 compared to 2010.

The effect of variances in volume and rate on interest income and interest expense is illustrated in the table titled "Change in Interest Income and Expense" on page 27 of this Annual Report on Form 10-K. We attribute the majority of the decrease in the yield on our earning assets to a decline in the yield on our taxable investment securities portfolio, which was due to a decline in yields on new investment purchases during the year. To a lesser extent, some of the decline in the total yield on interest-earning assets was caused by new and renewing fixed rate loans originated in a lower interest rate environment.

Our average cost of funds for 2011 was 1.17%, a decrease of 46 basis points when compared to 1.63% for 2010. The average cost on interest bearing deposit accounts decreased 50 basis points from 1.66% paid in 2010 to 1.16% paid in 2011, while our average cost of borrowed funds also increased 18 basis points during 2011 compared to 2010.

Total interest expense decreased $1.4 million or 29.2% to $3.4 million in 2011 from $4.8 million in 2010, primarily the result of decreased market rates paid on Bank certificates of deposit as well as decreases in other interest-bearing deposit accounts. The volume of average interest-bearing deposits increased approximately $986 thousand when comparing 2011 with that of 2010. The decrease to interest expense resulting from decreased rates on all interest-bearing liabilities was $1.3 million and the increase attributable to higher volumes of interest-bearing liabilities was $32 thousand.


Average Balances and Average Rates Earned and Paid

The following table presents an analysis of average interest-earning assets and interest-bearing liabilities, the interest income or expense applicable to each asset or liability category and the resulting yield or rate paid.

Net Interest Income and Average Balances (dollars in thousands)

                                                                               Years Ended December 31,
                                                2012                                     2011                                     2010
                                                            Average                                  Average                                  Average
                                 Average                     Yield/       Average                     Yield/       Average                     Yield/
                                 Balance      Interest        Rate        Balance      Interest        Rate        Balance      Interest        Rate
Interest-earning assets:
Federal funds sold and
interest bearing bank
deposits                        $  15,582     $      52         0.33 %   $  15,917     $      69         0.43 %   $  22,159     $      80         0.36 %
Investment securities and
restricted equity securities       57,174         2,267         4.36        57,174         2,922         5.11        48,176         3,006         6.24
Loans receivable and loans
held for sale(1)(2)               259,447        13,433         5.16       254,039        14,535         5.72       252,800        15,019         5.94

Total interest-earning assets     332,203        15,752         4.80       327,130        17,526         5.36       323,135        18,105         5.60
Non-interest-earning assets        22,213                                   21,985                                   22,308
Total assets                    $ 354,416                                $ 349,115                                $ 345,443

Interest-bearing liabilities:
Deposit accounts                $ 274,074     $   2,151         0.78 %   $ 275,087     $   3,191         1.16 %   $ 274,101     $   4,551         1.66 %
Borrowings                          8,367           179         2.13        13,451           182         1.35        17,256           202         1.17
Total interest-bearing
liabilities                       282,441         2,330         0.82       288,538         3,373         1.17       291,357         4,753         1.63
Non-interest-bearing
liabilities                        39,049                                   32,609                                   25,849
Stockholders' equity               27,663                                   27,968                                   28,237
Total liabilities and
stockholders' equity            $ 349,153                                $ 349,115                                $ 345,443
Net interest income and
interest rate spread                          $  13,422         3.98 %                 $  14,153         4.19 %                 $  13,352         3.97 %
Net interest-earning assets
and net interest margin(3)      $  44,499                       4.11 %   $  31,778                       4.33 %   $  31,778                       4.13 %
Ratio of interest-earning
assets to interest-bearing
liabilities                                                   115.76 %                                 113.38 %                                 110.91 %



(1) Average loan balances include nonaccrual loans.

(2) Deferred loan fees are included in interest income.

(3) Net interest margin is net interest income divided by average interest earning assets.


The following table presents the relative impact on net interest income of the volume of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.

Change in Interest Income and Expense

                                       Year Ended                                   Year Ended
                               December 31, 2012 vs. 2011                   December 31, 2011 vs. 2010
                               Increase (Decrease) Due to                   Increase (Decrease) Due to
                          Total           Rate          Volume          Total           Rate          Volume
                                                        (dollars in thousands)
Interest income:
Federal funds sold
and interest-bearing
bank deposits           $      (17 )    $     (16 )   $       (1 )   $       (11 )    $      14     $      (25 )
Taxable investment
and restricted equity
securities                    (655 )         (403 )         (252 )           (84 )         (594 )          510
Loans receivable            (1,102 )       (1,413 )          311            (484 )         (557 )           73
Total interest income       (1,774 )       (1,832 )           58            (579 )       (1,137 )          558

Interest expense:
Deposit accounts            (1,040 )       (1,028 )          (12 )        (1,360 )       (1,376 )           16
Borrowings                      (3 )           81            (84 )           (20 )           28            (48 )
Total interest
expense                     (1,043 )         (947 )          (96 )        (1,380 )       (1,348 )          (32 )
Net interest income
increase (decrease)     $     (731 )    $    (885 )   $      154     $       801      $     211     $      590

Rate Sensitivity Management

Rate sensitivity management, an important aspect of achieving satisfactory levels of net interest income, is the management of the composition and maturities of rate-sensitive assets and liabilities. The following table sets forth our interest sensitivity analysis at December 31, 2012 and describes, at various cumulative maturity intervals, the gap-ratios (ratios of rate-sensitive assets to rate-sensitive liabilities) for assets and liabilities that we consider to be rate sensitive. The interest-sensitivity position has meaning only as of the date for which it was prepared. Variable rate loans are considered to be highly sensitive to rate changes and are assumed to reprice within 12 months.

The difference between interest-sensitive asset and interest-sensitive liability repricing within time periods is referred to as the interest-rate-sensitivity gap. Gaps are identified as either positive (interest-sensitive assets in excess of interest-sensitive liabilities) or negative (interest-sensitive liabilities in excess of interest-sensitive assets).

As of December 31, 2012, we had a negative one year cumulative gap of 17.5%. We have interest-earning assets of $171.6 million maturing or repricing within one year and interest-bearing liabilities of $227.6 million repricing or maturing within one year. This is primarily the result of short-term interest sensitive liabilities being used to fund longer term interest-earning assets, such as loans and investment securities. A negative gap position implies that interest-bearing liabilities (deposits and other borrowings) will reprice at a faster rate than interest-earning assets (loans and investments). In a falling rate environment, a negative gap position will generally have a positive effect on earnings, while in a rising rate environment this will generally have a negative effect on earnings.

On December 31, 2012, savings, NOW and Money Market accounts totaled $143.1 million. In our rate sensitivity analysis, these deposits are considered as repricing in the earliest period (3 months or less) because the rate we pay on these interest-bearing deposits can be changed weekly. However, our historical experience has shown that changes in market interest rates have little, if any, effect on those deposits within a given time period and, for that reason, those liabilities could be considered non-rate sensitive. If those deposits were excluded from rate sensitive liabilities, our rate sensitive assets and liabilities would be more closely matched at the end of the one year period.


Rate Sensitivity Analysis as of December 31, 2012


                                                                    Total
                                   3 Months          4-12         Within 12        Over 12
                                   Or Less          Months          Months          Months         Total
                                                           (Dollars in thousands)
Earning assets:
Loans held for sale               $    1,787      $        -      $    1,787      $        -     $    1,787
Loans-gross                          103,770          44,732         148,502         111,345        259,847
Investment securities at
amortized cost                         4,179           4,650           8,829          36,570         45,399
Interest bearing deposits             11,909               -          11,909               -         11,909
FHLB stock                               528               -             528               -            528

Total earning assets              $  122,173      $   49,382      $  171,555      $  147,915     $  319,470

Percent of total earnings
assets                                  38.2 %          15.5 %          53.7 %          46.3 %        100.0 %
Cumulative percentage of total
earning assets                          38.2            53.7            53.7           100.0

Interest-bearing liabilities:
Savings, NOW and Money Market
deposits                          $  143,073      $        -      $  143,073      $        -     $  143,073
Time deposits                         31,609          44,687          76,296          45,270        121,566
Long-term obligations                  8,248               -           8,248               -          8,248

Total interest-bearing
liabilities                       $  182,930      $   44,687      $  227,617      $   45,270     $  272,887

Percent of total
interest-bearing liabilities            67.0 %          16.4 %          83.4 %          16.6 %        100.0 %
Cumulative percent of total
interest-bearing liabilities            67.0 %          83.4 %          83.4 %         100.0 %

Ratios:
Ratio of earning assets to
interest-bearing liabilities
(gap ratio)                             66.8 %         110.5 %          75.4 %         326.7 %        117.1 %
Cumulative ratio of earning
assets to interest-bearing
liabilities (cumulative gap
ratio)                                  66.8 %          75.4 %          75.4 %         117.1 %
Interest sensitivity gap           $ (60,757 )     $   4,695       $ (56,062 )     $ 102,645      $  46,583
Cumulative interest sensitivity
gap                                  (60,757 )       (56,062 )       (56,062 )        46,583         46,583
As a percent of total earnings
assets                                 (19.0 )%        (17.5 )%        (17.5 )%         14.6 %         14.6 %

Management believes that the simulation of net interest income in different interest rate environments provides a more meaningful measure of interest rate risk. Income simulation analysis captures not only the potential of all assets and liabilities to mature or reprice, but also the probability that they will do so. Income simulation also attends to the relative interest rate sensitivities of these items, and projects their behavior over an extended period of time. Finally, income simulation permits management to assess the probable effects on the balance sheet not only of changes in interest rates, but also of proposed strategies for responding to them.

The Company's income simulation model was developed by Profitstar, a financial-services consulting firm that provides asset/liability management solutions, product pricing solutions and other products and services to banks, thrifts, and credit unions nationwide. The model analyzes interest rate sensitivity by projecting net interest income and net income over the next 12 months in a flat rate scenario versus net interest income and net income in alternative interest rate scenarios. Management continually reviews and refines its interest rate risk management process in response to the changing economic climate.

The Company's ALCO (Asset Liability Committee) policy has established that interest income sensitivity will be considered acceptable if net interest income does not decline from the flat rate scenario more than 5.0%, 12.0%, 22.0%, and 34.0% in the plus and minus 100, 200, 300 and 400 basis point scenarios, respectively. These interest rate scenarios assume that rates increase immediately and permanently. At December 31, 2012, the Company's income simulation model projects that net interest income would increase 2.8%, 4.7%, 6.1% and 7.3% in the plus 100, 200, 300 and 400 basis point change scenarios. All of these forecasts are within an acceptable level of interest rate risk per the policies established by ALCO. ALCO did not consider the minus 100, 200, 300 and 400 basis point change scenarios relevant at December 31, 2012 due to the current low rate environment.


The ALCO policy also has established that interest income sensitivity will be considered acceptable if economic value of equity does not decline from the flat rate scenario more than 9.0%, 19.0%, 33.0%, and 51.0% in the plus and minus 100, 200, 300 and 400 basis point scenarios, respectively. These interest rate scenarios assume that rates increase immediately and permanently. At December 31, 2012, the Company's income simulation model projects that economic value of equity would increase 12.7%, 15.1%, 13.6%, and 7.1% in the plus 100, 200, 300, and 400 basis point change scenarios, respectively. All of these forecasts are within an acceptable level of interest rate risk per the policies established by ALCO. ALCO did not consider the minus 100, 200, 300 and 400 basis point change scenarios relevant at December 31, 2012 due to the current low rate environment.

In the event the model indicates an unacceptable level of risk, management could undertake a number of actions that would reduce this risk, including the sale of a portion of the Company's available-for-sale investment portfolio, the use of risk management strategies such as interest rate swaps and caps, or the extension of the maturities of its short-term borrowings.

Noninterest Income
Noninterest income, principally charges and fees assessed for the use of our services, is a significant contributor to our total revenue. The following table presents the components of noninterest income for 2012 and 2011.

Noninterest Income

                                                   For the                                                     For the
                                                Twelve Months                                               Twelve Months
                                                    Ended              Changes from the Prior Year              Ended
                                                December 31,                                                December 31,
                                                     2012            Amount                    %                 2011
                                                                         (dollars in thousands)
Service charges on deposit accounts             $         556     $          88                    18.8     $         468
. . .
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