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FBNC > SEC Filings for FBNC > Form 10-Q on 10-May-2013All Recent SEC Filings

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Form 10-Q for FIRST BANCORP /NC/


10-May-2013

Quarterly Report


Item 2 - Management's Discussion and Analysis of Consolidated Results of Operations and Financial Condition

Critical Accounting Policies

The accounting principles we follow and our methods of applying these principles conform with accounting principles generally accepted in the United States of America and with general practices followed by the banking industry. Certain of these principles involve a significant amount of judgment and may involve the use of estimates based on our best assumptions at the time of the estimation. The allowance for loan losses, intangible assets, and the fair value and discount accretion of loans acquired in FDIC-assisted transactions

are three policies we have identified as being more sensitive in terms of judgments and estimates, taking into account their overall potential impact to our consolidated financial statements.

Allowance for Loan Losses

Due to the estimation process and the potential materiality of the amounts involved, we have identified the accounting for the allowance for loan losses and the related provision for loan losses as an accounting policy critical to our consolidated financial statements. The provision for loan losses charged to operations is an amount sufficient to bring the allowance for loan losses to an estimated balance considered adequate to absorb losses inherent in the portfolio.

Our determination of the adequacy of the allowance is based primarily on a mathematical model that estimates the appropriate allowance for loan losses. This model has two components. The first component involves the estimation of losses on "impaired loans" that are individually evaluated. A loan is considered to be impaired when, based on current information and events, it is probable we will be unable to collect all amounts due according to the contractual terms of the loan agreement. A loan is individually evaluated for an appropriate valuation allowance if the loan balance is above a prescribed evaluation threshold (which varies based on credit quality, accruing status, and type of collateral) and the loan is determined to be impaired. The estimated valuation allowance is the difference, if any, between the loan balance outstanding and the value of the impaired loan as determined by either 1) an estimate of the cash flows that we expect to receive from the borrower discounted at the loan's effective rate, or 2) in the case of a collateral-dependent loan, the fair value of the collateral.

The second component of the allowance model is an estimate of losses for impaired loans collectively evaluated and all loans not considered to be impaired loans. Impaired loans collectively evaluated and loans not considered to be impaired are segregated by loan type, and estimated loss percentages are assigned to each loan type, based on the historical losses, current economic conditions, and operational conditions specific to each loan type. For impaired loans collectively evaluated and loans with more than standard risk but not considered to be impaired, loss percentages are based on a multiple of the estimated loss rate for loans of a similar loan type with normal risk. The multiples assigned vary by type of loan, depending on risk, and we have consulted with an external credit review firm in assigning those multiples.

The reserve estimated for impaired loans is then added to the reserve estimated for all other loans. This becomes our "allocated allowance." In addition to the allocated allowance derived from the model, we also evaluate other data such as the ratio of the allowance for loan losses to total loans, net loan growth information, nonperforming asset levels and trends in such data. Based on this additional analysis, we may determine that an additional amount of allowance for loan losses is necessary to reserve for probable losses. This additional amount, if any, is our "unallocated allowance." The sum of the allocated allowance and the unallocated allowance is compared to the actual allowance for loan losses recorded on our books and any adjustment necessary for the recorded allowance to equal the computed allowance is recorded as a provision for loan losses. The provision for loan losses is a direct charge to earnings in the period recorded.

Loans covered under loss share agreements are recorded at fair value at acquisition date. Therefore, amounts deemed uncollectible at acquisition date become a part of the fair value calculation and are excluded from the allowance for loan losses. Subsequent decreases in the amount expected to be collected result in a provision for loan losses with a corresponding increase in the allowance for loan losses. Subsequent increases in the amount expected to be collected are accreted into income over the life of the loan. Proportional adjustments are also recorded to the FDIC indemnification asset.

Although we use the best information available to make evaluations, future material adjustments may be necessary if economic, operational, or other conditions change. In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require us to recognize additions to the allowance based on the examiners' judgment about information available to them at the time of their examinations.

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For further discussion, see "Nonperforming Assets" and "Summary of Loan Loss Experience" below.

Intangible Assets

Due to the estimation process and the potential materiality of the amounts involved, we have also identified the accounting for intangible assets as an accounting policy critical to our consolidated financial statements.

When we complete an acquisition transaction, the excess of the purchase price over the amount by which the fair market value of assets acquired exceeds the fair market value of liabilities assumed represents an intangible asset. We must then determine the identifiable portions of the intangible asset, with any remaining amount classified as goodwill. Identifiable intangible assets associated with these acquisitions are generally amortized over the estimated life of the related asset, whereas goodwill is tested annually for impairment, but not systematically amortized. Assuming no goodwill impairment, it is beneficial to our future earnings to have a lower amount assigned to identifiable intangible assets and higher amount of goodwill as opposed to having a higher amount considered to be identifiable intangible assets and a lower amount classified as goodwill.

The primary identifiable intangible asset we typically record in connection with a whole bank or bank branch acquisition is the value of the core deposit intangible, whereas when we acquire an insurance agency, the primary identifiable intangible asset is the value of the acquired customer list. Determining the amount of identifiable intangible assets and their average lives involves multiple assumptions and estimates and is typically determined by performing a discounted cash flow analysis, which involves a combination of any or all of the following assumptions: customer attrition/runoff, alternative funding costs, deposit servicing costs, and discount rates. We typically engage a third party consultant to assist in each analysis. For the whole bank and bank branch transactions recorded to date, the core deposit intangibles have generally been estimated to have a life ranging from seven to ten years, with an accelerated rate of amortization. For insurance agency acquisitions, the identifiable intangible assets related to the customer lists were determined to have a life of ten to fifteen years, with amortization occurring on a straight-line basis.

Subsequent to the initial recording of the identifiable intangible assets and goodwill, we amortize the identifiable intangible assets over their estimated average lives, as discussed above. In addition, on at least an annual basis, goodwill is evaluated for impairment by comparing the fair value of our reporting units to their related carrying value, including goodwill (our community banking operation is our only material reporting unit). If the carrying value of a reporting unit were ever to exceed its fair value, we would determine whether the implied fair value of the goodwill, using a discounted cash flow analysis, exceeded the carrying value of the goodwill. If the carrying value of the goodwill exceeded the implied fair value of the goodwill, an impairment loss would be recorded in an amount equal to that excess. Performing such a discounted cash flow analysis would involve the significant use of estimates and assumptions.

In our October 2012 goodwill impairment evaluation, we determined the fair value of our community banking operation was approximately $17.20 per common share, or 5% higher, than the $16.43 stated book value of our common stock at the date of valuation. To assist us in computing the fair value of our community banking operation, we engaged a consulting firm that used various valuation techniques as part of its analysis, which resulted in the conclusion of the $17.20 value.

We review identifiable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Our policy is that an impairment loss is recognized, equal to the difference between the asset's carrying amount and its fair value, if the sum of the expected undiscounted future cash flows is less than the carrying amount of the asset. Estimating future cash flows involves the use of multiple estimates and assumptions, such as those listed above.

Fair Value and Discount Accretion of Loans Acquired in FDIC-Assisted Transactions

We consider the determination of the initial fair value of loans acquired in FDIC-assisted transactions, the initial fair value of the related FDIC indemnification asset, and the subsequent discount accretion of the purchased loans to involve a high degree of judgment and complexity. We determine fair value accounting estimates of newly assumed assets and liabilities in accordance with relevant accounting guidance. However, the amount that we realize on these assets could differ materially from the carrying value reflected in our financial statements, based upon the timing of collections on the acquired loans in future periods. To the extent the actual values realized for the acquired loans are different from the estimates, the FDIC indemnification asset will generally be impacted in an offsetting manner due to the loss-sharing support from the FDIC.

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Because of the inherent credit losses associated with the acquired loans in a failed bank acquisition, the amount that we record as the fair values for the loans is generally less than the contractual unpaid principal balance due from the borrowers, with the difference being referred to as the "discount" on the acquired loans. We have applied the cost recovery method of accounting to all purchased impaired loans due to the uncertainty as to the timing of expected cash flows. This will result in the recognition of interest income on these impaired loans only when the cash payments received from the borrower exceed the recorded net book value of the related loans.

For nonimpaired purchased loans, we accrete the discount over the lives of the loans in a manner consistent with the guidance for accounting for loan origination fees and costs.

FDIC Indemnification Asset

The FDIC indemnification asset is the estimated amount that the Company will receive from the FDIC under loss share agreements associated with two FDIC-assisted failed bank acquisitions. See page 40 of the Company's 2012 Annual Report on Form 10-K for a detailed explanation of this asset.

The following table presents additional information regarding our covered loans, loan discounts, allowances for loan losses and the corresponding FDIC indemnification asset:

($ in thousands)
                                              Cooperative        Cooperative         Bank of Asheville        Bank of Asheville
                                             Single Family       Non-Single            Single Family             Non-Single
                                              Loss Share         Family Loss             Loss Share              Family Loss
            At March 31, 2013                    Loans           Share Loans               Loans                 Share Loans           Total
Expiration of loss share agreement                6/19/2019         6/19/2014                  1/21/2021               1/21/2016

Nonaccrual covered loans
   Unpaid principal balance                 $        15,992            71,039                      1,022                   6,779        94,832
   Carrying value prior to loan discount*            15,881            46,325                        885                   5,061        68,152
   Loan discount                                      3,088            11,999                        497                   1,347        16,931
   Net carrying value                                12,793            34,326                        388                   3,714        51,221
   Allowance for loan losses                          2,125               870                         17                       -         3,012
   Indemnification asset recorded                     4,170            10,295                        411                   1,078        15,954

All other covered loans
   Unpaid principal balance                         141,358            59,049                     13,830                  48,845       263,082
   Carrying value prior to loan discount*           141,230            55,412                     13,802                  48,600       259,044
   Loan discount                                     20,031             8,803                      4,411                  13,552        46,797
   Net carrying value                               121,199            46,609                      9,391                  35,048       212,247
   Allowance for loan losses                            451             1,565                          -                       -         2,016
   Indemnification asset recorded                    16,025             7,042                      3,529                  10,842        37,438

All covered loans
   Unpaid principal balance                         157,350           130,088                     14,852                  55,624       357,914
   Carrying value prior to loan discount*           157,111           101,737                     14,687                  53,661       327,196
   Loan discount                                     23,119            20,802                      4,908                  14,899        63,728
   Net carrying value                               133,992            80,935                      9,779                  38,762       263,468
   Allowance for loan losses                          2,576             2,435                         17                       -         5,028
   Indemnification asset recorded                    20,195            17,337                      3,940                  11,920        53,392

                                                                                                        Present Value Adjustment          (338 )

* Reflects partial charge-offs Total indemnification asset recorded related to loans $ 53,054

As noted in the table above, our commercial loss share agreement related to Cooperative Bank's non-single family loans expires in June 2014. As it relates to that portion of covered loans, we expect accelerated amounts of loan discount accretion and corresponding indemnification asset expense until the expiration date as the loss share attributes of the loan portfolio are resolved.

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Current Accounting Matters

See Note 2 to the Consolidated Financial Statements above for information about accounting standards that we have recently adopted.

RESULTS OF OPERATIONS

Overview

Net income available to common shareholders for the first quarter of 2013 amounted to $2.9 million, or $0.14 per diluted common share, compared to a net loss available to common shareholders of $5.9 million, or ($0.35) per diluted common share, reported in the first quarter of 2012. The higher earnings in 2013 were primarily a result of a lower provision for loan losses.

Net Interest Income and Net Interest Margin

Net interest income for the first quarter of 2013 amounted to $31.9 million in the first quarter of 2013 compared to $32.1 million in the first quarter of 2012.

Our net interest margin (tax-equivalent net interest income divided by average earning assets) in the first quarter of 2013 was 4.69% compared to 4.59% for the first quarter of 2012. The higher margin was primarily a result of a higher amount of discount accretion on loans purchased in failed bank acquisitions, as well as lower overall funding costs. The 4.69% net interest margin realized in the first quarter of 2013 was a 32 basis point decrease from the 5.01% margin realized in the fourth quarter of 2012. The decrease in margin was due primarily to a lower amount of loan discount accretion recognized during the first quarter of 2013 in comparison to the fourth quarter of 2012. Loan discount accretion amounted to $3.7 million in the first quarter of 2013, $6.0 million in the fourth quarter of 2012 and $2.6 million in the first quarter of 2012.

Our cost of funds has steadily declined from 0.67% in the first quarter of 2012 to 0.45% in the first quarter of 2013.

Provision for Loan Losses and Asset Quality

We recorded total provisions for loan losses of $11.1 million in the first quarter of 2013 compared to $21.6 million for the first quarter of 2012. The decrease in 2013 was primarily the result of an elevated provision for loan losses on non-covered loans recorded in the first quarter of 2012 - see explanation of the terms "covered" and "non-covered" in the section below entitled "Note Regarding Components of Earnings."

Total non-covered nonperforming assets amounted to $83.4 million at March 31, 2013 (2.79% of total non-covered assets), which compares to $106.1 million at December 31, 2012 and $117.1 million at March 31, 2012. The decrease in 2013 was due primarily to a combination of loan sales and foreclosed property write-downs that occurred in the fourth quarter of 2012 and the first quarter of 2013, as discussed in the following paragraph.

In the fourth quarter of 2012, we identified approximately $68 million of non-covered higher-risk loans that we targeted for sale to a third-party investor. Based on an offer to purchase these loans that was received in December, we wrote the loans down by approximately $38 million in the fourth quarter of 2012 to their estimated liquidation value of approximately $30 million and reclassified them as "loans held for sale." The sale of these loans was completed on January 23, 2013. Of the $68 million in loans targeted for sale, approximately $38.2 million had been classified as nonaccrual loans, and $10.5 million had been classified as accruing troubled debt restructurings. Additionally, in the fourth quarter of 2012, we recorded write-downs totaling $10.6 million on substantially all of our non-covered foreclosed properties in connection with efforts to accelerate the sale of these assets.

Non-covered nonaccrual loans increased from $33.0 million at December 31, 2012 to $38.9 million at March 31, 2013 due primarily to four larger credits that deteriorated during the first quarter of 2013. Non-covered foreclosed real estate decreased from $26.3 million at December 31, 2012 to $20.1 million at March 31, 2013 as a result of strong sales activity during the quarter, which was consistent with our intent discussed above to accelerate the disposition of foreclosed properties.

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Total covered nonperforming assets have steadily declined in the past year, amounting to $92.0 million at March 31, 2013 compared to $135.1 million at March 31, 2012. Within this category, foreclosed real estate declined from $79.5 million at March 31, 2012 to $30.2 million at March 31, 2013. The Company is experiencing increased property sales activity, particularly along the North Carolina coast, which is where most of our covered foreclosed properties are located. Covered nonaccrual loans increased from $33.5 million at December 31, 2012 to $51.2 million at March 31, 2013, due primarily to several large loans that deteriorated during the quarter.

Noninterest Income

Total noninterest income for the three months ended March 31, 2013 was $7.1 million compared to $5.3 million for the comparable period of 2012.

Core noninterest income for the first quarter of 2013 was $6.5 million, an increase of 10.6% over the $5.8 million reported for the first quarter of 2012. Core noninterest income includes i) service charges on deposit accounts, ii) other service charges, commissions, and fees, iii) fees from presold mortgages,
iv) commissions from financial product sales, and v) bank-owned life insurance income. The largest component of the increase in core noninterest income was in the amount of fees from presold mortgages we recorded. The increase in these fees was due to high mortgage loan refinancing activity, as well as increased volume resulting from additional mortgage loan personnel that the Company has added in recent quarters.

Noncore components of noninterest income resulted in net gains of $0.6 million in the first quarter of 2013 compared to net losses of $0.5 million in the first quarter of 2012. The largest variance related to non-covered foreclosed property gains/losses, which amounted to a gain of $0.8 million in the first quarter of 2013 compared to a loss of $0.7 million in 2012. Also in 2013, we recorded "other losses" of $0.4 million related to the sale of a parcel of property that the Company had previously held for a future branch.

Noninterest Expenses

Noninterest expenses amounted to $23.2 million in the first quarter of 2013, a 4.7% decrease from the $24.4 million recorded in the first quarter of 2012. The decrease primarily relates to a decline in pension expense as a result of freezing the Company's two defined benefit pension plans on December 31, 2012. Pension expense was $1.0 million in the first quarter of 2012 compared to income of $0.1 million in the first quarter of 2013, which related to investment income from the pension plan's assets.

Balance Sheet and Capital

Total assets at March 31, 2013 amounted to $3.3 billion, a 1.7% decrease from a year earlier. Total loans at March 31, 2013 amounted to $2.4 billion, a 1.6% decrease from a year earlier, and total deposits amounted to $2.9 billion at March 31, 2013, a 0.9% increase from a year earlier.

The decrease in loans over the past year was a result of the loan sale previously discussed, as well as the progressive decline in the amount of covered loans. Partially offsetting the decrease was internal loan growth, as well as loans added in a branch acquisition discussed in the following paragraph. As it relates to deposits, the Company has experienced strong growth in transaction oriented deposits, while time deposits have declined.

As previously reported, during the first quarter of 2013, we completed the acquisition of two branches from Four Oaks Bank & Trust Company, which resulted in the addition of $16 million in loans and $57 million in deposits. Excluding the acquired growth, the Company's non-covered loans increased by $22 million, representing annualized growth of 4.3%.

We remain well-capitalized by all regulatory standards, with a Total Risk-Based Capital Ratio at March 31, 2013 of 16.82% compared to the 10.00% minimum to be considered well-capitalized. Our tangible common equity to tangible assets ratio was 6.76% at March 31, 2013, an increase of 47 basis points from a year earlier, which is primarily due to the Company's capital raise that occurred in the fourth quarter of 2012.

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Note Regarding Components of Earnings

Our results of operation are significantly affected by the on-going accounting for two FDIC-assisted failed bank acquisitions. In the discussion above and elsewhere in the document, the term "covered" is used to describe assets included as part of FDIC loss share agreements, which generally result in the FDIC reimbursing the Company for 80% of losses incurred on those assets. The term "non-covered" refers to the Company's legacy assets, which are not included in any type of loss share arrangement.

For covered loans that deteriorate in terms of repayment expectations, we record immediate allowances through the provision for loan losses. For covered loans that experience favorable changes in credit quality compared to what was expected at the acquisition date, including loans that payoff, we record positive adjustments to interest income over the life of the respective loan - also referred to as loan discount accretion. For foreclosed properties that are sold at gains or losses or that are written down to lower values, we record the gains/losses within noninterest income.

The adjustments discussed above are recorded within the income statement line items noted without consideration of the FDIC loss share agreements. Because favorable changes in covered assets result in lower expected FDIC claims, and unfavorable changes in covered assets result in higher expected FDIC claims, the FDIC indemnification asset is adjusted to reflect those expectations. The net increase or decrease in the indemnification asset is reflected within noninterest income.

The adjustments noted above can result in volatility within individual income statement line items. Because of the FDIC loss share agreements and the associated indemnification asset, pretax income resulting from amounts recorded as provisions for loan losses on covered loans, discount accretion, and losses from covered foreclosed properties is generally only impacted by 20% of these amounts due to the corresponding adjustments made to the indemnification asset.

Components of Earnings

Net interest income is the largest component of earnings, representing the difference between interest and fees generated from earning assets and the interest costs of deposits and other funds needed to support those assets. Net interest income for the three month period ended March 31, 2013 amounted to $31.9 million, a decrease of $0.2 million, or 0.5%, from the $32.1 million recorded in the first quarter of 2012. Net interest income on a tax-equivalent basis for the three month period ended March 31, 2013 amounted to $32.3 million, a decrease of $0.2 million, or 0.6%, from the $32.5 million recorded in the first quarter of 2012. We believe that analysis of net interest income on a tax-equivalent basis is useful and appropriate because it allows a comparison of net interest income amounts in different periods without taking into account the different mix of taxable versus non-taxable investments that may have existed during those periods.

                                         Three Months Ended March 31,
($ in thousands)                           2013                 2012
Net interest income, as reported      $       31,921               32,091
Tax-equivalent adjustment                        372                  387
Net interest income, tax-equivalent   $       32,293               32,478

There are two primary factors that cause changes in the amount of net interest income we record - 1) changes in our loans and deposits balances, and 2) our net interest margin (tax-equivalent net interest income divided by average interest-earning assets).

For the three months ended March 31, 2013, the slightly lower net interest income compared to the same period of 2012 was due to a decline in interest-earning assets (primarily average loan balances), which was partially offset by a slightly higher net interest margin (see discussion below).

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