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MBRG > SEC Filings for MBRG > Form 10-Q on 8-Nov-2013All Recent SEC Filings

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Form 10-Q for MIDDLEBURG FINANCIAL CORP


8-Nov-2013

Quarterly Report


Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of the financial condition at September 30, 2013 and results of operations of the Company for the three and nine months ended September 30, 2013 should be read in conjunction with the Company's Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements included in this report and in the 2012 Form 10-K. It should also be read in conjunction with the "Caution About Forward Looking Statements" section at the end of this discussion.

Overview

The Company is headquartered in Middleburg, Virginia and conducts its primary operations through two wholly owned subsidiaries, Middleburg Bank and Middleburg Investment Group, Inc., and a majority owned subsidiary, Southern Trust Mortgage, LLC. Middleburg Bank is a community bank serving the Virginia counties of Loudoun, Fairfax, Fauquier and western Prince William as well as the Town of Williamsburg, Virginia and the City of Richmond, Virginia. The Bank operates twelve financial service centers and one limited service facility. Middleburg Investment Group is a non-bank holding company that was formed in the fourth quarter of 2005. It has one wholly-owned subsidiary, Middleburg Trust Company which is headquartered in Richmond, Virginia, and maintains offices in Williamsburg, Virginia and in several of Middleburg Bank's facilities. Southern Trust Mortgage is a regional mortgage company headquartered in Virginia Beach, Virginia and maintains offices in Virginia, Maryland, Georgia, North Carolina and South Carolina.

The Company operates under a business model that makes all of its financial and wealth management services available to its clients at all of its financial service centers. Financial service centers are larger than most traditional retail banking branches in order to allow commercial, mortgage, retail and wealth management personnel and services to be readily available to serve clients. By working together in the financial service center and the market, the team at each financial service center becomes more effective in expanding relationships with current clients and new clients. The Company's goal is to assist in the creation, preservation and ultimate transfer of the wealth of its clients.

The Company generates a significant amount of its income from the net interest income earned by Middleburg Bank. Net interest income is the difference between interest income and interest expense. Interest income depends on the amount of interest-earning assets outstanding during the period and the interest rates earned thereon. Middleburg Bank's cost of money is a function of the average amount of deposits and borrowed money outstanding during the period and the interest rates paid thereon. The quality of the assets further influences the amount of interest income lost on non-accrual loans and the amount of additions to the allowance for loan losses. Middleburg Bank also generates income from fees on deposits and loans.

Middleburg Investment Group's subsidiary, Middleburg Trust Company, generates fee income by providing trust and investment management services to its clients. Investment management and trust fees are generally based upon the value of assets under administration and, therefore, can be significantly affected by fluctuation in the values of securities caused by changes in the capital markets.

Southern Trust Mortgage generates fees from the origination and sale of mortgage loans. Southern Trust Mortgage also maintains a real estate construction portfolio and receives interest and fee income from these loans, which, net of interest expense, is included in net interest income.

Net income attributable to Middleburg Financial Corporation for the three months ended September 30, 2013 decreased 6.0% to $1.6 million from $1.7 million over the same period in 2012. Earnings per fully diluted share for the three months ended September 30, 2013 was $0.23 per share compared to $0.24 per share for the same period in 2012.

Annualized return on total average assets for the three months ended September 30, 2013 was 0.52%, compared to 0.55% for the same period in 2012. Annualized return on total average equity of Middleburg Financial Corporation for the three months ended September 30, 2013 was 5.71%, compared to 6.11% for the same period in 2012.

As a result of improving trends in non-accrual loans and improved risk ratings for several loans during the quarter, the Company recorded a loan loss provision of $3,000 for the three months ended September 30, 2013, compared to $635,000 for the three months ended September 30, 2012. The reserve ratio decreased to 1.87% of portfolio loans at September 30, 2013 from 2.02% at December 31, 2012. As of the end of the quarter, the coverage ratio for non-performing assets (allowance for loan losses balance divided by non-performing assets) increased to 43.9% of nonperforming assets from 37.9% at December 31, 2012.

Net interest income before provision for loan losses for the three months ended September 30, 2013 was $9.3 million compared to $9.2 million for the three months ended September 30, 2012. Total non-interest income decreased to $6.1 million for the three


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months ended September 30, 2013 compared to $8.3 million for the three months ended September 30, 2012. Total non-interest expense decreased approximately $531,000 to $13.3 million for the three months ended September 30, 2013 from $13.8 million for the same period in 2012.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was signed into law. The Dodd-Frank Act contains significant modifications to the current bank regulatory structure and requires various federal agencies to adopt a broad range of new rules and regulations. While not fully determinable at this time, the impact of the Dodd-Frank Act and the rules and regulations that will be promulgated thereunder could significantly affect our operations, increase our operating costs and divert management resources.

Under the changes to the regulatory capital framework that were approved on July 9, 2013 by the federal banking agencies (Basel III Final Rule), the Company's subordinated notes will continue to be included in Tier 1 Capital until they mature, pursuant to a "grandfathering" provision that exempts the Company's trust preferred securities from the more stringent regulatory capital treatment contained in the Basel III Final Rule for trust preferred securities. In addition to "grandfathering" certain previously outstanding trust preferred securities for bank holding companies with total assets less than $15 billion (as of December 31, 2009), the Basel III Final Rule introduces a new Common Equity Tier 1 Capital measure, increases the applicable minimum regulatory capital levels and certain prompt corrective action capital levels, establishes a capital conservation buffer and new risk weights for certain types of assets. The Basel III Final Rule also permits a one-time Accumulated Other Comprehensive Income ("AOCI") opt out for banking organizations not subject to advanced approaches rule (those with greater than $250 billion in assets). Election must be made in the first call report filed by a banking organization after January 1, 2015, when it becomes subject to the final rule. The Basel III Final Rule is effective on January 1, 2015 for banking organizations not subject to the advanced approaches rules and has a transition period applicable to certain regulatory capital changes until January 1, 2019. The Company is not subject to the advanced approaches rules and plans on making the one-time AOCI opt-out election in the first quarter of 2015.

Critical Accounting Policies

General

The financial condition and results of operations presented in the Consolidated Financial Statements, the accompanying Notes to Consolidated Financial Statements and this section are, to a large degree, dependent upon the accounting policies of the Company. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change.

Presented below is discussion of those accounting policies that management believes are the most important ("Critical Accounting Policies") to the portrayal and understanding of the Company's financial condition and results of operations. The Critical Accounting Policies require management's most difficult, subjective and complex judgments about matters that are inherently uncertain. In the event that different assumptions or conditions were to prevail, and depending upon the severity of such changes, the possibility of materially different financial condition or results of operations is a reasonable likelihood.

Allowance for Loan Losses

Middleburg Bank monitors and maintains an allowance for loan losses to absorb an estimate of probable losses inherent in the loan portfolio. Middleburg Bank maintains policies and procedures that address the systems of controls over the following areas: the systematic methodology used to determine the appropriate level of the allowance to provide assurance they are maintained in accordance with accounting principles generally accepted in the United States of America; the accounting policies for loan charge-offs and recoveries; the assessment and measurement of impairment in the loan portfolio; and the loan grading system.

Middleburg Bank evaluates various loans individually for impairment as required by applicable accounting standards. Loans evaluated individually for impairment include non-performing loans, such as loans on non-accrual, loans past due by 90 days or more, restructured loans and other loans selected by management. The evaluations are based upon discounted expected cash flows or collateral valuations. If the evaluation shows that a loan is individually impaired, then a specific reserve is established for the amount of impairment. If a loan evaluated individually is not impaired, then the loan is assessed for impairment with a group of loans that have similar characteristics.

For loans without individual measures of impairment, Middleburg Bank makes estimates of losses for groups of loans as required by applicable accounting standards. Loans are grouped by similar characteristics, including the type of loan, the assigned loan grade and the general collateral type. A loss rate reflecting the expected loss inherent in a group of loans is derived based upon estimates of default rates for a given loan grade, the predominant collateral type for the group and the terms of the loan. The


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resulting estimate of losses for groups of loans are adjusted for relevant environmental factors and other conditions of the portfolio of loans, including: borrower and industry concentrations; levels and trends in delinquencies, charge-offs and recoveries; changes in underwriting standards and risk selection; level of experience, ability and depth of lending management; and national and local economic conditions.

The amount of estimated impairment for individually evaluated loans and groups of loans is added together for a total estimate of loan losses. This estimate of losses is compared to the allowance for loan losses of Middleburg Bank as of the evaluation date and, if the estimate of losses is greater than the allowance, an additional provision to the allowance would be made. If the estimate of losses is less than the allowance, the degree to which the allowance exceeds the estimate is evaluated to determine whether the allowance falls outside a range of estimates. If the estimate of losses is below the range of reasonable estimates, the allowance would be reduced by way of a credit to the provision for loan losses. Middleburg Bank recognizes the inherent imprecision in estimates of losses due to various uncertainties and variability related to the factors used, and therefore a reasonable range around the estimate of losses is derived and used to ascertain whether the allowance is too high. If different assumptions or conditions were to prevail and it is determined that the allowance is not adequate to absorb the new estimate of probable losses, an additional provision for loan losses would be made, which amount may be material to the Consolidated Financial Statements.

Intangibles and Goodwill

The Company had approximately $5.9 million in intangible assets and goodwill at September 30, 2013, a decrease of $128,000 or 2.1% since December 31, 2012, which is attributable to regular amortization of intangible assets.

On April 1, 2002, the Company acquired Middleburg Investment Advisors for $6.0 million. Approximately $5.9 million of the purchase price was allocated to intangible assets and goodwill. In connection with this investment, a purchase price valuation was completed to determine the appropriate allocation to identified intangibles. The valuation concluded that approximately 42% of the purchase price was related to the acquisition of customer relationships with an amortizable life of 15 years. Another 19% of the purchase price was allocated to a non-compete agreement with an amortizable life of seven years. The remainder of the purchase price has been allocated to goodwill. On January 3, 2011, Middleburg Investment Advisors was merged into Middleburg Trust Company and its goodwill balance is reflected in the total goodwill balance reported for Middleburg Investment Group of $3.4 million. The remaining balance of unamortized identified intangible assets related to the acquisition of Middleburg Investment Advisors is approximately $600,000. Approximately $1.0 million of the $5.9 million in total intangible assets and goodwill at September 30, 2013 was attributable directly to the Company's investment in Middleburg Trust Company exclusive of the goodwill related to the former Middleburg Investment Advisors. With the consolidation of Southern Trust Mortgage, the Company recognized $1.9 million in goodwill as part of its equity investment.

The purchase price allocation process requires management estimates and judgment as to expectations for the life span of various customer relationships as well as the value that key members of management add to the success of the Company. For example, customer attrition rates were determined based upon assumptions that the past five years may predict the future. If the actual attrition rates, among other assumptions, differed from the estimates and judgments used in the purchase price allocation, the amounts recorded in the Consolidated Financial Statements could result in a possible impairment of the intangible assets and goodwill or require acceleration in the amortization expense.

In addition, current accounting standards permit an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform a two step goodwill impairment test. If a two step process is necessary, the first step is to identify whether or not any impairment exists. The second step measures the amount of the impairment loss, if any. The most recent evaluation of the Company's goodwill balance was conducted as of December 31, 2012.

As of September 30, 2013, the Company recognized two consolidated subsidiaries as reporting units for the purpose of goodwill evaluation and reporting: Southern Trust Mortgage ("STM") and Middleburg Investment Group ("MIG"). MIG is the parent company of Middleburg Trust Company and the former Middleburg Investment Advisors. The following table shows the allocation of goodwill between the two reporting units and the percentage by which the fair value of each reporting unit as of December 31, 2012 (the most recent fair value evaluation date) exceeded the carrying value as of that date. Management does not believe the estimated fair values have changed significantly from December 31, 2012 to September 30, 2013.


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                                           Allocation of Goodwill to Reporting Units
                                                     (Dollars in Thousands)
                                                                                             (1) Percentage
                                                                                               by which
                                                                                            Estimated Fair
                                                                                               Value of
                                          (1) Carrying               (1) Estimated Fair     Reporting Unit
                  Carrying Value of    Value of Reporting            Value of Reporting         Exceeds
                       Goodwill               Unit                          Unit            Carrying Value
Reporting Unit    December 31, 2012    December 31, 2012             December 31, 2012
STM               $          1,867     $          7,880            $             10,040             27.41 %
MIG                          3,422                6,244     (2)                   9,167             46.81 %
Total             $          5,289     $         14,124            $             19,207             35.99 %

(1) Reported amounts reflect only Middleburg Financial Corporation shareholders' ownership interests. Estimated fair values are as of December 31, 2012.

(2) Includes $728,000 of amortizing intangible assets at December 31, 2012.

Management estimates fair value utilizing multiple methodologies which include discounted cash flows, comparable companies, third-party sale and assets under management analysis. Determining the fair value of the Company's reporting units requires management to make judgments and assumptions related to various items, including estimates of future operating results, allocations of indirect expenses, and discount rates. Management believes its estimates and assumptions are reasonable; however, the fair value of each reporting unit could be different in the future if actual results or market conditions differ from the estimates and assumptions used.

The Company's forecasted cash flows for its reporting units assume a stable economic environment and consistent long-term growth in loan originations and assets under management over the projected periods. Additionally, expenses are assumed to be consistently correlated with projected asset and revenue growth over the time periods projected. Although we believe the key assumptions underlying the financial forecasts to be reasonable, they are inherently uncertain and involve a number of risks and uncertainties that are beyond the control of the Company. Accordingly, there can be no assurance that the forecasted results will be realized and variations from the forecast may be material. If weak economic conditions continue or worsen for a prolonged period of time, or if the reporting unit loses key personnel, the fair value of the reporting unit may be adversely affected which may result in impairment of goodwill or other intangible assets in the future. Any changes in the key management estimates or judgments could result in an impairment charge, and such a charge could have an adverse effect on the Company's financial condition and results of operations.

Financial Condition

Assets, Liabilities and Shareholders' Equity

Total assets for the Company were $1.2 billion at September 30, 2013, a decrease of $21.5 million or 1.7% compared to total assets at December 31, 2012. Total average assets and total average liabilities remained relatively unchanged for the nine months ended September 30, 2013 compared to the the nine months ended September 30, 2012. Total liabilities were $1.10 billion at September 30, 2013, compared to $1.12 billion at December 31, 2012. Average shareholders' equity increased 4.3% or $4.7 million over the same periods.

Loans

Total loans, including loans held for sale, at September 30, 2013 were $758.0 million, a decrease of $33.6 million from the December 31, 2012 amount of $791.6 million, primarily as a result of a decrease in loans held for sale. Portfolio loans were $716.1 million at September 30, 2013, an increase of $6.6 million from the December 31, 2012 balance of $709.5 million. Loans held for sale were $41.9 million at September 30, 2013, compared to $82.1 million at December 31, 2012, a decrease of $40.3 million during the period. Southern Trust Mortgage originated $590.4 million in loans for the nine months ended September 30, 2013, compared to $444.6 million for the nine months ended September 30, 2012. The Company experienced a decrease in real estate construction loans, which were $37.2 million at September 30, 2013, compared to $50.2 million at December 31, 2012. Real estate mortgage loans of $531.1 million at September 30, 2013 increased from the December 31, 2012 amount of $515.6 million. Commercial loans, which are primarily loans to businesses, increased to $123.3 million at September 30, 2013, compared to $118.6 million at December 31, 2012. Net charge-offs were $928,000 for the nine months ended September 30, 2013 versus $2.8 million for the same period in 2012. The provision for loan losses for the three months ended September 30, 2013 was $3,000 compared to $635,000 for the same period in 2012. As a result of the decline in non-performing assets and charge-offs and improving credit quality trends, the Company recorded a negative loan loss provision of $1,000 for the nine months ended


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September 30, 2013 compared to a provision of $2.2 million for the same period in 2012. The allowance for loan losses at September 30, 2013 was $13.4 million or 1.87% of portfolio loans outstanding (excluding loans held for sale) compared to $14.3 million and 2.02% at December 31, 2012.

The following table presents information on the Company's nonperforming assets as of the dates indicated:

                                                          Nonperforming Assets
                                  September 30,                        December 31,
                                      2013            2012          2011          2010          2009
                                                             (In thousands)
Non-performing assets:
Non-accrual loans                $      20,525     $  21,664     $  25,346     $  29,386     $   8,606
Restructured loans (1)                   4,820         5,132         3,853         1,254         2,096
Accruing loans greater than 90
days past due                              636         1,044         1,233           909           908
Total non-performing loans       $      25,981     $  27,840     $  30,432     $  31,549     $  11,610
Foreclosed property                      4,530         9,929         8,535         8,394         6,511
Total non-performing assets      $      30,511     $  37,769     $  38,967     $  39,943     $  18,121

Allowance for loan losses        $      13,382     $  14,311     $  14,623     $  14,967     $   9,185

Non-performing loans to period
end portfolio loans                       3.63 %        3.92 %        4.53 %        4.79 %        1.80 %
Allowance for loan losses to
non-performing loans                     51.51 %       51.40 %       48.05 %       47.44 %       79.11 %
Non-performing assets to period
end assets                                2.51 %        3.05 %        3.27 %        3.62 %        1.86 %

(1) Amount reflects restructured loans that are performing as agreed to the restructured terms and are not included in non-accrual loans.

The Company utilizes the ratios included in the above table to evaluate the relative level of non-performing assets included in the Company's balance sheet. Changes in the ratios assist management in evaluating the overall adequacy of the allowance for loan losses and any reserve against other real estate owned.

Our accounting policy for foreclosed property does not include any allowance for loan loss amounts subsequent to the reclassification event which adjusts the loan balance to fair value when moved into foreclosed property.

The following table depicts the transactions, in summary form, that occurred to the allowance for loan losses in each period presented:


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                                   Allowance for Loan Losses
                                                    Nine Months Ended          Year Ended
                                                    September 30, 2013     December 31, 2012
Balance, beginning of year                         $           14,311     $           14,623
Provision for (recovery of) loan losses                            (1 )                3,438
Charge-offs:
Real estate construction                                          194                  2,152
Real estate secured by 1-4 family residential                     783                    893
Other real estate loans                                            97                    760
Commercial loans                                                   38                    394
Consumer loans                                                     28                     72
Total charge-offs                                  $            1,140     $            4,271
Recoveries:
Real estate construction                           $               47     $                2
Real estate secured by 1-4 family residential                     109                    388
Other real estate loans                                            30                     86
Commercial loans                                                    7                     12
Consumer loans                                                     19                     33
Total recoveries                                   $              212     $              521
Net charge-offs                                                   928                  3,750
Balance, end of period                             $           13,382     $           14,311

Ratio of allowance for loan losses to portfolio
loans outstanding at end of period                               1.87 %                 2.02 %
Annualized ratio of net charge-offs to average
portfolio loans outstanding during the period                    0.16 %                 0.54 %

The following table shows the balance of the allowance for loan losses allocated to each major loan type and the percent of loans in each category to total loans as of September 30, 2013 and December 31, 2012:

                                  Allocation of Allowance for Loan Losses
                                                      Percent of                               Percent of
                                                    loans in each                            loans in each
                                                     category to                              category to
                             September 30, 2013      total loans       December 31, 2012      total loans
Commercial, financial and
agricultural               $              1,790             17.2 %   $             2,233             18.4 %
Real estate construction                  1,368              5.2 %                 1,258              7.1 %
Real estate mortgage                     10,017             75.8 %                10,624             72.7 %
Consumer loans                              207              1.8 %                   196              1.9 %
Totals                     $             13,382            100.0 %   $            14,311            100.0 %

. . .

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