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VSBN > SEC Filings for VSBN > Form 10-Q on 12-Nov-2013All Recent SEC Filings

Show all filings for VSB BANCORP INC

Form 10-Q for VSB BANCORP INC


12-Nov-2013

Quarterly Report


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

Financial Condition at September 30, 2013

Total assets were $299,917,247 at September 30, 2013, an increase of $30,212,876, or 11.2%, from December 31, 2012. The increase resulted from the investment of funds available to us as the result of retained earnings and an increase in deposits. The deposit increase was caused generally by our efforts to grow our franchise and specifically by the deposit increases at our branch offices. We invested these funds primarily in the purchase of new investment securities. The principal changes resulting in the net increase in assets can be summarized as follows:

? a $50,045,408 net increase in investment securities, partially offset by

? a $14,471,228 net decrease in cash and cash equivalents and

? a $ 4,958,202 net decrease in loans receivable, net.

In addition to these changes in major asset categories, we also experienced changes in other asset categories due to normal fluctuations in operations.

Our deposits (including escrow deposits) were $271,090,463 at September 30, 2013, an increase of $30,389,257 or 12.6%, from December 31, 2012 as a result of our active solicitation of retail deposits to increase funds for investment. The aggregate increase in deposits resulted from increases of $15,616,216 in non-interest demand deposits, $8,542,069 in money market accounts, $2,375,920 in time deposits, $2,107,968 in NOW accounts, $1,719,777 in savings accounts and $27,307 in escrow deposits.

Total stockholders' equity was $27,535,233 at September 30, 2013, a decrease of $218,738, or 0.79%, from December 31, 2012. The decrease reflected: (i) a $453,829 increase in retained earnings due to net income of $774,178 for the nine months ended September 30, 2013, partially offset by $320,349 of dividends paid in 2013; (ii) a reduction of $126,809 in Unearned ESOP shares reflecting the gradual payment of the loan we made to fund the ESOP's purchase of our stock and (iii) a decrease in the net unrealized gain on securities of $863,521.

The unrealized gain or losses on the available for sale and held to maturity securities portfolios are excluded from the calculation of regulatory capital. Management does not anticipate selling securities in these portfolios, but changes in market interest rates or in the demand for funds may change management's plans with respect to the securities portfolios. If there is a material increase in interest rates, the market value of the securities portfolios may decline.. Management believes that the principal and interest payments on these portfolios, combined with the existing liquidity, will be sufficient to fund loan growth and potential deposit outflow.

The Current Economic Turmoil

The economy in the United States, including the economy in Staten Island, has recently come out of a recession, but the recovery has been slow and uneven. The extent and speed of the recovery is far from clear and the effects of low inflation, moderate job growth, and the Federal Reserve's decision to taper their purchase of mortgage-backed securities have created uncertainty not only on the pace of economic growth but on its sustainability. Some analysts continue to predict a darker road ahead. Substantial stress remains on many financial institutions and financial products due to the artificially maintained low interest rate environment, which directly places negative pressure on interest rate margins. We draw a substantial portion of our customer base from local businesses, especially those in the building trades and related industries, and we believe that there continue to be significant weaknesses in the business economy in our market area. Our customers have been adversely affected by the economic downturn and Superstorm Sandy. If adverse conditions in the local economy continue, it will become more difficult for us to conduct prudent and profitable business in our community.

Making permanent residential mortgage loans is not a material part of our business, and our investments in mortgage-backed securities and collateralized mortgage obligations have been made with a view towards avoiding the types of securities that are backed by low quality mortgage-related assets. However, one of the primary focuses of our local business is receiving deposits from, and making loans to, businesses involved in the construction and building trades industry on Staten Island. Construction loans represented a significant component of our loan portfolio, reaching 39.8% of total loans at year end 2005. As we monitored the economy and the strength of the local construction industry, we elected to reduce our portfolio of construction loans. By September 30, 2013, the percentage had declined to 4.2%. However, developers and builders provide not only a source of loans, but they also provide us with deposits and other business. The weakness in the economy and the uncertain pace of the recovery has had an adverse effect on some of our customers and potential customers, making it more difficult for us to find satisfactory loan opportunities. This compelled us to invest in lower yielding securities instead of higher-yielding loans. This has and may continue to reduce our net income.

Possible Adverse Effects on Our Net Income Due to Fluctuations in Market Rates

Our principal source of income is the difference between the interest income we earn on interest-earning assets, such as loans and securities, and our cost of funds, principally interest paid on deposits. These rates of interest change from time to time, depending upon a number of factors, including general market interest rates. However, the frequency of the changes varies among different types of assets and liabilities. For example, for a five-year loan with an interest rate based upon the prime rate, the interest rate may change every time the prime rate changes. In contrast, the rate of interest we pay on a five-year certificate of deposit adjusts only every five years, based upon changes in market interest rates.

In general, the interest rates we pay on deposits adjust more slowly than the interest rates we earn on loans because our loan portfolio consists primarily of loans with interest rates that fluctuate based upon the prime rate. In contrast, although many of our deposit categories have interest rates that could adjust immediately, such as interest checking accounts and savings accounts, changes in the interest rates on those accounts are at our discretion. Thus, the rates on those accounts, as well as the rates we pay on certificates of deposit, tend to adjust more slowly. As a result, the declines in market interest rates that occurred through the end of 2008 initially had an adverse effect on our net income because the yields we earn on our loans declined more rapidly than our cost of funds. However, many of our prime-based loans have minimum interest rates, or floors, below which the interest rate does not decline despite further decreases in the prime rate. As our loans reached their interest rate floors, our loan yields stabilized while our deposit costs continued to decline. This had a positive effect on our net interest income.

When market interest rates begin increasing, which we expect will occur at some point in the future, we anticipate an initial adverse effect on our net income. We anticipate that this will occur because our deposit rates should begin to rise, while loan yields remain relatively steady until the prime rate increases sufficiently that our loans begin to reprice above their interest rate floors. For most of our prime-rate based loans, this will not occur until the prime rate increases above 6%. Once our loan rates exceed the interest rate floors, increases in market interest rates should increase our net interest income because our cost of deposits should probably increase more slowly than the yields on our loans. However, customer preferences and competitive pressures may negate this positive effect because customers may choose to move funds into higher-earning deposit types as higher interest rates make them more attractive, or competitors offer premium rates to attract deposits.

We have a substantial amount of investment securities with fixed rates of interest, most of which are mortgage-backed securities with an estimated average life of not more than 7 years. We receive regular cash flows from the repayment of our securities portfolios. These repayments had averaged in excess of $8 million per quarter for over two years but declined to $7 million in the third quarter of 2013. As securities purchased in past years gradually repaid and were replaced with purchases of new investment securities, our cash flows from those securities did and will decline in the immediate future because prepayments tend to be lower on recently-issued securities. We also have a significant level of overnight and short term investments, The availability overnight funds and securities repayments should allow us to invest at higher yields as market rates increase, thus blunting the effect of the delay in repricing our loans with interest rate floors.

Transfer of Some Available For Sale Securities to Held to Maturity

During the second quarter of 2013, Senior Management and the Board decided to transfer some securities that we pledge to secure borrowings and deposits (GNMA MBS, GNMA CMOs, and FNMA balloon MBS with final maturities of ten years or less) from available for sale portfolio to the held to maturity portfolio to align those securities with the Bank's ability and intent to hold until maturity. As the securities are backed by GNMA, FNMA or FHLMC, we will recover the recorded investment and thus realize no gains or losses when the issuer pays the amount promised through maturity. Each transfer was done at fair value and any unrealized gain or loss is being amortized or accreted as the security pays down.

Delays in Foreclosure Proceedings

The length of time it takes to prosecute a foreclosure action and be able to sell real estate collateral in New York has substantially lengthened. It is not unusual for it to take more than two years from the date a foreclosure action is commenced until the property is sold even in uncontested cases, and some uncontested cases can take longer. This problem, if it continues or gets worse, could have a substantial adverse effect on the value of our collateral for loans in default. The inability to realize upon collateral promptly, increases our loss in the event of a default due to the property value deterioration during a lengthy foreclosure.

Effects of Superstorm Sandy

Superstorm Sandy has had a devastating effect on the homes and businesses of New York City, especially Staten Island. We opened four of five locations (all located in Richmond County) the day after the Hurricane and they are in full operation. We re-opened the fifth location in February 2013 and all retail banking services are fully operational. While Superstorm Sandy did not have a significant effect on our operations, we incurred expenses of approximately $300,000 to remediate and reconstruct one of our branches that suffered sewer backup, water and wind driven rain damage. We have received insurance proceeds of $275,333 to help defray those costs. In the aftermath of Sandy, we had waived deposit service charges and late fees to those affected customers.

After Superstorm Sandy, we immediately embarked an outreach program to determine the extent that our borrowers were affected by Superstorm Sandy. We contacted 58 customers that we identified as being located in areas affected by the Superstorm who sustained some of, or a combination of, the following issues:
substantial water and sewage damage to the business' physical plant, machinery and equipment; extended power loss causing business interruptions; displaced tenants due to the flood and sewage backup; employees unable to report to work due to the loss/damage of their personal homes or cars and the loss of mass transit. We individually assessed their condition and access to resources. The majority of our customers were able to restart their business with little assistance from us.

As we are primarily a commercial lender, we did not have residential loans that were negatively affected. We received 12 requests for either one or two month payment deferrals on commercial loans, which we granted. All twelve resumed their payments.

We operate primarily in Richmond County (Staten Island) and that is where we had the highest impact. We had one loan in Kings County that was affected but has since been current on payments. We had sufficient liquidity and resources to handle the effects of Superstorm Sandy. Our operations center was up and running the day Superstorm Sandy left the region and had full access to all of our resources.

We have assessed the short term impact of Superstorm Sandy, including the effects on the allowance for loan losses and the loan portfolio, but the sustainability and the viability of some businesses may take longer to evaluate. We will address any of the associated issues as they arise.

Results of Operations for the Three Months Ended September 30, 2013 and September 30, 2012

Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer 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 changes in market interest rates, government policies and actions of regulatory authorities.

General. We had net income of $341,238 for the three months ended September 30, 2013, compared to net income of $357,460 for the comparable period in 2012. The principal categories which make up the 2013 net income are:

? Interest income of $2,169,482

? Reduced by interest expense of $205,691

? Reduced by a provision for loan losses of $45,000

? Increased by non-interest income of $714,367

? Reduced by non-interest expense of $2,004,136

? Reduced by income tax expense of $287,784

We discuss each of these categories individually and the reasons for the differences between the three months ended September 30, 2013 and 2012 in the following paragraphs.

Interest Income. Interest income was $2,169,482 for the three months ended September 30, 2013, compared to $2,251,883 for the three months ended September 30, 2012, a decrease of $82,401 or 3.7%. The main reason for the decline was a $7,764,984 decrease in the average loan balance and a 14 basis point decrease in the yield on loans, between the periods, which combined to cause a $172,782 decline in interest income on loans.

Interest income on loans decreased by $172,782 as a result of a decrease of $7.8 million in the average balance of loans and a 14 basis point decrease in the average yield, from the three months ended September 30, 2012 to the three months ended September 30, 2013. There was a $225,582 decrease in our average non-performing loans, from $6.1 million in the three months ended September 30, 2012 to $5.9 million in the same period ended 2013. During the period in which interest is not being paid, non-performing loans continue to be included in the calculation of average loan yield, but with an effective yield of zero. We estimate that if all non-performing loans were performing according to their contractual terms during the three months ended September 30, 2013, our average loan yield would have been approximately 41 basis points higher. In contrast, we estimate that the comparable effect in 2012 period would have been approximately a 55 basis point increase in average loan yield. Substantially all of the non-accrual loans are secured by mortgages on real estate.

Interest rate floors on most of our loans have helped to stabilize interest income from the loan portfolio, but these floors will have the effect of limiting increases in our income until the prime rate rises above 6%.

We had an increase of $80,918, or 11.0%, in income on investment securities when comparing the third quarter of 2012 to the third quarter of 2013. We experienced a 35 basis point decrease in the average yield on our investment securities portfolios, from 2.55% to 2.20%, due to the purchase of new investment securities at lower market rates than the rates we had been earning on the investment securities previously purchased that were gradually being repaid. The combined average balance of our investment portfolios increased by $32.4 million, or 28.2%, between the periods, as market conditions gave us opportunities to purchase investment securities at more favorable yields with terms similar to those we had purchased in the past. This increase in average balance was the reason for the overall increase in interest income on securities. The investment securities portfolios represented 68.9% of average non-loan interest earning assets in the 2013 period compared to 68.1% in the 2012 period.

Interest income from other interest earning assets (principally overnight investments) increased by $9,463 due to an increase in the yield of 2 basis point from 0.22% for the three months ended September 30, 2012 to 0.24% for the same period ended September 30, 2013. In addition, the average balance of our other interest earning assets increased by $12.6 million between the periods because we elected to invest most of the available funds in overnight investments rather than tie them up in longer term investment securities which were available only at relatively low yields.

Interest Expense. Interest expense was $205,691 for the three months ended September 30, 2013, compared to $200,612 for the three months ended September 30, 2012, an increase of $5,079 or 2.5%. The principal reason for the increase was an increase in the average balance of interest-bearing deposits as we sought to increase our total deposits, partially offset by a decline in average cost of funds as we were able to reprice some deposits downward as market interest rates remained low. The components of this increase included a $7,985 increase in interest on time deposits due to a $10.3 million increase in the average balance between the periods, even as the average cost declined by 5 basis point, and a $3,537 increase in the cost of savings accounts due to 3 basis point increase in the average cost and the $2.5 million increase in the average balance between the periods. The increase in interest expense was partially offset by an $2,139 decrease in the cost of money market accounts, as the average cost declined by 16 basis points, while the average balance increased by $7.5 million and a $4,304 decrease in the cost of NOW accounts, as the average cost declined by 6 basis points, while the average balance increased by $1.5 million. We decided to reprice money market and NOW accounts downward due to a continuation of low market interest rates. As a result, our average cost of funds, excluding the effect of interest-free demand deposits, decreased to 0.47% from 0.53% between the periods.

Net Interest Income Before Provision for Loan Losses. Net interest income before the provision for loan losses was $1,963,791 for the three months ended September 30, 2013, compared to $2,051,271 for the three months ended September 30, 2012, a decrease of $87,480, or 4.3%. The decrease was because the reduction in our interest income was greater than the reduction in our cost of funds when comparing the three months ended September 30, 2013 to the same period ended 2012. The average yield on interest earning assets declined by 55 basis points, while the average cost of funds declined by 6 basis points. The reduction in the yield on assets was principally due to the 35 basis points drop in the yield on investment securities and the 14 basis points drop in the yield on loans, partially offset by an increase of 2 basis points in the low yielding overnight investments. In addition, loans, our highest yielding asset category, declined from 33.1% of earning assets in the 2012 quarter to 26.2% in the 2013 quarter, which also contributed to the decline in average yield. Overall, our interest rate spread declined 49 basis points, from 2.97% to 2.48% between the periods. Correspondingly, our net interest margin decreased to 2.67% for the three months ended September 30, 2013 from 3.18% in the same period of 2012. The margin is higher than the spread because it takes into account the effect of interest free demand deposits and capital. We are working to reverse the trend of declining spread by seeking to increase our loan portfolio and by taking advantage of opportunities to purchase investment securities at favorable yields that presented themselves during the third quarter of 2013.

The spread and margin both decreased because of the combined effect of the decline in earnings we were able to obtain on our investments securities and the larger average balances of our lowest yielding category, other interest earning assets. These declines could not be offset by corresponding declines in the cost of deposits because the rates we paid on deposits were already low due to low markets rates so that we could not reduce them as much as the decline in the earnings on investment securities. In addition, we continued to incur interest expense on deposits that funded the non-performing loans that did not earn interest and on other interest earning assets, our lowest yielding asset class.

Provision for Loan Losses. The provision for loan losses in any period depends upon the amount necessary to bring the allowance for loan losses to the level management believes is appropriate, after taking into account charge offs and recoveries. We took a provision for loan losses of $45,000 for the three months ended September 30, 2013 compared to a provision for loan losses of $40,000 for the same period in 2012. The $5,000 increase in the provision was a result of a higher level of charge-offs despite a lower level of non-performing loans and total loans.

We experienced a decrease of $953,866 in non-performing loans from $6,090,239 at September 30, 2012 to $5,136,373 at September 30, 2013. Most of those loans are secured by real estate. We individually evaluated the non-performing mortgage loans based primarily upon updated appraisals as part of our analysis of the appropriate level of our allowance for loan and lease losses. We charged-off $50,000 of loans for the three months ended September 30, 2013 as compared to charge-offs of $10,917 for the same period in 2012. We also had recoveries (which are added back to the allowance for loan losses) of $13,867 for the three months ended September 30, 2013 as compared to $55,436 in the same period of 2012.

After considering other matters that increased or decreased the allowance, we determined that the level of our allowance at September 30, 2013 was appropriate to address inherent losses. Overall, our allowance for loan losses decreased from $1,666,916 or 2.03% of total loans, at September 30, 2012 to $1,260,454 or 1.64% of total loans, at September 30, 2013. There can be no assurance that a higher level, or a higher provision for loan losses, will not be necessary in the future.

Non-interest Income. Non-interest income was $714,367 for the three months ended September 30, 2013, compared to $607,828 during the same period last year. The $106,539, or 17.5%, increase in non-interest income was a direct result of an increase of $105,845 in service charges on deposits primarily due to a recent increase in the per item insufficient fund fee we charge. Service charges on deposits consist mainly of insufficient fund fees, which are inherently volatile, and are based upon the number of items being presented for payment against insufficient funds.

Non-interest Expense. Non-interest expense was $2,004,136 for the three months ended September 30, 2013, compared to $1,960,211 for the three months ended September 30, 2012, an increase of $43,925 or 2.2%. The principal shifts in the individual categories were:

? a $26,185 increase in legal expense due to general corporate needs in 2013 and a recovery of legal expense on a past due loan in the third quarter of 2012 which legal fees had been previously expensed;

? a $21,156 increase in professional fees due to the engagement of a consulting firm;

? a $13,419 increase in salaries and benefits due to termination expenses;

? a $10,049 increase in other non-interest expenses due to a $4,255 increase in the costs of operating our ATM, a $2,571 increase in regulatory filing costs and increases other normal operating expenses;

? a $4,261 increase in computer expense due to a recent rise in software contract expense, partially offset by;

? a $27,245 decrease in occupancy expense due to reduced fixed asset costs; and

? a $7,400 decrease in directors fees due to fewer meetings in 2013.

In addition to these changes, we also experienced changes in the various other non-interest expenses categories due to normal fluctuations in operations.

Income Tax Expense. Income tax expense was $287,784 for the three months ended September 30, 2013, compared to income tax expense of $301,428 for the same period ended 2012. The decrease in income tax expense was due to the $29,866 decrease in income before income taxes in the 2013 period. Our effective tax rate for the three months ended September 30, 2013 and 2012 was 45.8%.

Results of Operations for the Nine Months Ended September 30, 2013 and September 30, 2012

Our results of operations depend primarily on net interest income, which is the difference between the income we earn on our loan and investment portfolios and our cost of funds, consisting primarily of interest we pay on customer 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 changes in market interest rates, government policies and actions of regulatory authorities.

General. We had net income of $774,178 for the nine months ended September 30, 2013, compared to net income of $1,010,945 for the comparable period in 2012. The principal categories which make up the 2013 net income are:

? Interest income of $6,355,289

? Reduced by interest expense of $621,755

? Reduced by a provision for loan losses of $180,000

? Increased by non-interest income of $1,965,906

? Reduced by non-interest expense of $6,092,304

? Reduced by income tax expense of $652,958

We discuss each of these categories individually and the reasons for the differences between the nine months ended September 30, 2013 and 2012 in the following paragraphs.

Interest Income. Interest income was $6,355,289 for the nine months ended September 30, 2013, compared to $6,886,588 for the nine months ended September 30, 2012, a decrease of $531,299 or 7.7%. The main reason for the decline was a $5,346,704 decrease in the average loan balance and a 9 basis point decrease in the yield on loans between the periods, which combined to cause a $351,283 decline in interest income on loans. There was also an increase of $225,466 in investment securities.

Interest income on loans decreased by $351,283 as a result of a decrease of $5.3 million in the average balance of loans and a 9 basis point decrease in the average yield, from the nine months ended September 30, 2012 to the nine months ended September 30, 2013. There was a $1,926,874 decrease in our average non-performing loans, from $7.7 million in the nine months ended September 30, 2012 to $5.8 million in the same period ended 2013. During the period in which interest is not being paid, non-performing loans continue to be included in the calculation of average loan yield, but with an effective yield of zero. We estimate that if all non-performing loans were performing according to their contractual terms during the nine months ended September 30, 2013, our average loan yield would have been approximately 37 basis points higher. In contrast, we estimate that the comparable effect in 2012 period would have been approximately a 34 basis point increase in average loan yield. Substantially all of the non-accrual loans are secured by mortgages on real estate.

Interest rate floors on most of our loans have helped to stabilize interest income from the loan portfolio, but these floors will have the effect of . . .

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