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CFNL > SEC Filings for CFNL > Form 10-K on 14-Mar-2014All Recent SEC Filings

Show all filings for CARDINAL FINANCIAL CORP

Form 10-K for CARDINAL FINANCIAL CORP


14-Mar-2014

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 consolidated financial condition at December 31, 2013 and 2012 and the results of our operations for the years ended December 31, 2013, 2012 and 2011. The discussion should be read in conjunction with the consolidated financial statements and related notes included in this report.

Caution About Forward-Looking Statements

We make certain forward-looking statements in this Form 10-K that are subject to risks and uncertainties. These forward-looking statements include statements regarding our profitability, liquidity, allowance for loan losses, interest rate sensitivity, market risk, growth strategy, and financial and other goals. The words "believes," "expects," "may," "will," "should," "projects," "contemplates," "anticipates," "forecasts," "intends," or other similar words or terms are intended to identify forward-looking statements.

These forward-looking statements are subject to significant uncertainties because they are based upon or are affected by factors including:


the risks of changes in interest rates on levels, composition and costs of deposits, loan demand, and the values and liquidity of loan collateral, securities, and interest sensitive assets and liabilities;


changes in assumptions underlying the establishment of reserves for possible loan losses, reserves for repurchases of mortgage loans sold and other estimates;


changes in market conditions, specifically declines in the residential and commercial real estate market, volatility and disruption of the capital and credit markets, soundness of other financial institutions we do business with;


decrease in the volume of loan originations at our mortgage banking subsidiary as a result of the cyclical nature of mortgage banking, changes in interest rates, economic conditions, decreased economic activity, and slowdowns in the housing market which would negatively impact the income recorded on the sales of loans held for sale.


risks inherent in making loans such as repayment risks and fluctuating collateral values;


declines in the prices of assets and market illiquidity may cause us to record an other-than-temporary impairment or other losses, specifically in our pooled trust preferred securities portfolio resulting from increases in underlying issuers' defaulting or deferring payments;


changes in operations within the wealth management services segment, its customer base and assets under management;


changes in operations of George Mason Mortgage, LLC as a result of the activity in the residential real estate market and any associated impact on the fair value of goodwill in the future;


legislative and regulatory changes, including the Financial Reform Act and implementation of the Volcker Rule, and other changes in banking, securities, and tax laws and regulations and their application by our regulators, and changes in scope and cost of FDIC insurance and other coverages;


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exposure to repurchase loans sold to investors for which borrowers failed to provide full and accurate information on or related to their loan application or for which appraisals have not been acceptable or when the loan was not underwritten in accordance with the loan program specified by the loan investor;


the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and possible failures to achieve expected gains, revenue growth and/or expense savings from such transactions;


the ability to successfully manage our growth or implement our growth strategies as we implement new or change internal operating systems or if we are unable to identify attractive markets, locations or opportunities to expand in the future;


the effects of future economic, business and market conditions;


governmental monetary and fiscal policies;


changes in accounting policies, rules and practices;


maintaining cost controls and asset quality as we open or acquire new branches;


maintaining capital levels adequate to support our growth;


reliance on our management team, including our ability to attract and retain key personnel;


competition with other banks and financial institutions, and companies outside of the banking industry, including those companies that have substantially greater access to capital and other resources;


risks and uncertainties related to trust operations;


demand, development and acceptance of new products and services;


problems with technology utilized by us;


changing trends in customer profiles and behavior; and


other factors described from time to time in our reports filed with the SEC.

Because of these uncertainties, our actual future results may be materially different from the results indicated by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results.

In addition, this section should be read in conjunction with the description of our "Risk Factors" in Item 1A above.

Overview

We are a financial holding company formed in 1997 and headquartered in Fairfax County, Virginia. We were formed principally in response to opportunities resulting from the consolidation of several Virginia-based banks. These bank consolidations were typically accompanied by the dissolution of local boards of directors and relocation or termination of management and customer service professionals and a general deterioration of personalized customer service.

On January 16, 2014, we announced the completion of our acquisition of United Financial Banking Companies, Inc. ("UFBC"), the holding company of The Business Bank ("TBB"), pursuant to a previously announced definitive merger agreement. The merger of UFBC into Cardinal was effective January 16, 2014. Under the terms of the merger agreement, UFBC shareholders received $19.13 in cash and 1.154 shares of our common stock in exchange for each share of UFBC common stock they


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owned immediately prior to the merger. TBB, which was headquartered in Vienna, Virginia, merged into Cardinal Bank effective March 8, 2014 adding eight
(8) banking locations in northern Virginia, one of the Company's target markets.

We own Cardinal Bank (the "Bank"), a Virginia state-chartered community bank with 29 banking offices located in Northern Virginia and the greater Washington, D.C. metropolitan area. The Bank offers a wide range of traditional bank loan and deposit products and services to both our commercial and retail customers. Our commercial relationship managers focus on attracting small and medium sized businesses as well as government contractors, commercial real estate developers and builders and professionals, such as physicians, accountants and attorneys.

Additionally, we complement our core banking operations by offering a wide range of services through our various subsidiaries, including mortgage banking through George Mason Mortgage, LLC ("George Mason") and retail securities brokerage though Cardinal Wealth Services, Inc. ("CWS").

Prior to June 30, 2013, the Bank had a trust division, Cardinal Trust and Investment Services. This division merged its remaining operations as of June 30, 2013 into CWS. In addition, as of June 30, 2013, Wilson/Bennett Capital Management, Inc., formerly the Company's second nonbank subsidiary, merged its operations into CWS. During the second quarter of 2013, we exited the third party institutional custody and trustee component of our trust services division due to our limited opportunity to leverage this platform. As a result of our reorganization of the wealth management business segment, the remaining personal and commercial trust area of this business consolidated into CWS. In addition, the remaining Wilson/Bennett clients begin to be serviced on the CWS platform in the third quarter of 2013. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries.

We had a second mortgage subsidiary, Cardinal First Mortgage, LLC ("Cardinal First") based in Fairfax, Virginia, but as of June 30, 2013, this subsidiary merged into George Mason to improve operational efficiency. Results for the year ended December 31, 2013 include six months of operations of these subsidiaries.

George Mason, based in Fairfax, Virginia, engages primarily in the origination and acquisition of residential mortgages for sale into the secondary market on a best efforts basis through 20 offices located throughout the metropolitan Washington region. George Mason does business in eight states, primarily Virginia and Maryland, and the District of Columbia. George Mason is one of the largest residential mortgage originators in the greater Washington, D.C. metropolitan area, generating originations of approximately $5.8 billion in 2013 and $6.6 billion in 2012, excluding advances on construction loans and including loans purchased from other mortgage banking companies which are owned by local home builders but managed by George Mason (the "managed companies"). George Mason's primary sources of revenue include loan origination fees, net interest income earned on loans held for sale, gains on sales of loans and contractual management fees earned relating to services provided to other mortgage companies owned by local home builders. At the time we enter into an interest rate lock arrangement with the borrower, we enter into a loan forward sale commitment with a third party. Our mortgage loans are then sold servicing released.

George Mason also offers a construction-to-permanent loan program. This program provides variable rate financing for customers to construct their residences. Once the home has been completed, the loan converts to fixed rate financing and is sold into the secondary market. These construction-to-permanent loans generate fee income as well as net interest income for George Mason and are classified as loans held for sale.

The mortgage banking segment's business is both cyclical and seasonal. The cyclical nature of its business is influenced by, among other factors, the levels of and trends in mortgage interest rates, national and local economic conditions and consumer confidence in the economy. Historically, the


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mortgage banking segment has its lowest levels of quarterly loan closings during the first quarter of the year. However, due to a significant increase in interest rates during the third quarter of 2013 and subsequent increase in competition with other mortgage banking entities for loan originations, we saw a decrease in mortgage loan originations during the third and fourth quarters of 2013 as compared to prior quarters. In addition, the increase in mortgage interest rates decreased refinancing activity for George Mason as it did for other mortgage banking entities, and contributed to our decreased loan origination activity for the full 2013 year as compared to 2012.

Wilson/Bennett provided asset management services to certain of our customers. Wilson/Bennett's primary source of revenue was management fees earned on the assets it managed for its customers. These management fees were generally based upon the market value of managed and custodial assets. As part of our reorganization of the wealth management services business segment, we merged Wilson/Bennett operations into CWS as of June 30, 2013.

We formed a wholly-owned subsidiary, Cardinal Statutory Trust I, for the purpose of issuing $20.0 million of floating rate junior subordinated deferrable interest debentures ("trust preferred securities"). These trust preferred securities are due in 2034 and pay interest at a rate equal to LIBOR (London Interbank Offered Rate) plus 2.40%, which adjusts quarterly. These securities are redeemable at par. The interest rate on this debt was 2.64% at December 31, 2013. We have guaranteed payment of these securities. The $20.6 million payable by us to Cardinal Statutory Trust I is included in other borrowed funds in the consolidated statements of condition since Cardinal Statutory Trust I is an unconsolidated subsidiary as we are not the primary beneficiary of this entity. We utilized the proceeds from the issuance of the trust preferred securities to make a capital contribution into the Bank.

Net interest income is our primary source of revenue. We define revenue as net interest income plus non-interest income. As discussed further in the interest rate sensitivity section, we manage our balance sheet and interest rate risk exposure to maximize, and concurrently stabilize, net interest income. We do this by monitoring our liquidity position and the spread between the interest rates earned on interest-earning assets and the interest rates paid on interest-bearing liabilities. We attempt to minimize our exposure to interest rate risk, but are unable to eliminate it entirely. In addition to managing interest rate risk, we also analyze our loan portfolio for exposure to credit risk. Loan defaults and foreclosures are inherent risks in the banking industry, and we attempt to limit our exposure to these risks by carefully underwriting and then monitoring our extensions of credit. In addition to net interest income, non-interest income is an important source of revenue for us and includes, among other things, service charges on deposits and loans, investment fee income, gains and losses on sales of investment securities available-for-sale, gains on sales of mortgage loans, and management fee income. Realized and unrealized gains on mortgage banking activities has become a larger component of our non-interest income as we have added offices throughout the Washington metropolitan region and increased the number of loan originators in our mortgage banking segment over the past year.

Net interest income and non-interest income represented the following percentages of total revenue, which is calculated as net interest income plus non-interest income, for the three years ended December 31, 2013:

                               Net Interest     Non-Interest
                                  Income           Income
                       2013             75.5 %           24.5 %
                       2012             58.9 %           41.1 %
                       2011             69.8 %           30.2 %

Net interest income represented a larger portion of our total revenue for 2013 relative to 2012 as a result of steady net interest income, combined with the decrease in mortgage loan origination activity and the margin compression we experienced on mortgage loans sold, primarily due to the increase in mortgage interest rates during the latter half of 2013. Non-interest income was a larger percentage of


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our total revenue for 2012 than in 2011 because of the increase in realized and unrealized gains from mortgage banking activities. During 2012 and 2011, we strategically increased the number of loan originators and mortgage banking offices to increase the revenues from the business line.

2013 Economic Environment

The banking environment and the markets in which we conduct our businesses will continue to be strongly influenced by developments in the U.S. and global economies, as well as the continued implementation of rulemaking from recent financial reforms. U.S. economic growth continued in 2013, the fifth consecutive year of recovery. Employment gains were generally steady as the unemployment rate fell to 6.7% by year end. However, most of the improvement in the unemployment rate was attributable to a decrease in the labor force participation rate. Nationally, home prices rose approximately 12% during 2013, and equity markets surged. Even though we experienced a federal government shutdown during October 2013, the U.S. economy saw minimal impact and by year end, Congress had agreed to a two-year budget framework which reduced fiscal uncertainty.

U.S. Treasury yields increased during 2013 as a result of market expectations that the Federal Reserve will moderate its qualitative easing ("QE") programs. This increase in interest rates impacted the results of our mortgage banking segment. Typically, during periods of increasing interest rates, mortgage originations decrease. The degree of the impact is dependent upon the duration and severity of the aforementioned conditions.

Although economic conditions remain unsettled, the metropolitan Washington, D.C. area, the region we operate in, continued to perform relatively well, compared to other regions. The unemployment rate in the Washington, D.C. metropolitan area did not increase to the same level as the national unemployment rate, and commercial and residential real estate values held up well compared to other regions. However, as the federal government continues with announced spending cuts, which is a principal economic driver in our region, we expect growth in the local economy to be slower than that of the U.S.

Our credit quality continues to remain strong despite the challenging economic environment. At December 31, 2013, we had nonaccrual loans totaling $2.3 million and no loans contractually past due 90 days or more as to principal or interest and still accruing. We recorded annualized net recoveries of 0.03% of our average loans receivable for the year ended December 31, 2013. As a result of a rapid increase in mortgage interest rates during the third quarter of 2013, refinancing originations from our mortgage banking segment decreased significantly to 33% of total originations for the full year 2013 compared to 63% of total originations for 2012. Additionally, the margin on loans sold to investors decreased from 2.07% for the second quarter of 2013 to 1.77% for the third quarter of 2013, reflecting industry overcapacity and increased competition. Margins returned to 2.24% during the fourth quarter of 2013, but originations for George Mason decreased to $886 million for the fourth quarter of 2013, the lowest level seen since 2011.

Market illiquidity and concerns over credit risk continue to impact the ratings of our pooled trust preferred securities. We hold investments of $7.1 million in par value of pooled trust preferred securities, which are significantly below book value as of December 31, 2013 due to the lack of liquidity in the market, deferrals and defaults of issuers, and continued investor apprehension for investing in these types of investments. As a result of the issuance of the Final Rules required by the Financial Reform Act which were released by federal banking agencies in late 2013, two of these investments are considered to be "covered funds" and are now required to be divested by us before July 2015. These investment have a par value of $3.1 million at December 31, 2013. We recorded an other-than-temporary-impairment of $300,000 during 2013 as a result of this new regulatory requirement as we no longer have the ability to hold until recovery.


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We expect challenging economic and operating conditions and an evolving regulatory regime to continue for the foreseeable future. These conditions could continue to affect the markets in which we do business and could adversely impact our results for 2014. The degree of the impact is dependent upon the duration and severity of the aforementioned conditions and the nature of new banking regulations.

While our loan growth has continued to be strong, continued uncertainty and sluggish economic growth could adversely affect our loan portfolio, including causing increases in delinquencies and default rates, which would adversely impact our charge-offs and provision for loan losses. Deterioration in real estate values and household incomes may also result in higher credit losses for us. Also, in the ordinary course of business, we may be subject to a concentration of credit risk to a particular industry, counterparty, borrower or issuer. A deterioration in the financial condition or prospects of a particular industry or a failure or downgrade of, or default by, any particular entity or group of entities could negatively impact our businesses, perhaps materially. The systems by which we set limits and monitor the level of our credit exposure to individual entities and industries also may not function as we have anticipated.

Liquidity is essential to our business. The primary sources of funding for our Bank include customer deposits and wholesale funding. Our liquidity could be impaired by an inability to access the capital markets or by unforeseen outflows of cash, including deposits. This situation may arise due to circumstances that we may be unable to control, such as general market disruption, negative views about the financial services industry generally, or an operational problem that affects a third party or us. Our ability to borrow from other financial institutions on favorable terms or at all could be adversely affected by further disruptions in the capital markets or other events. While we believe we have a healthy liquidity position, any of the above factors could materially impact our liquidity position in the future.

The U.S. government continues to enact legislation and develop various programs and initiatives designed to stabilize the financial services industry, stabilize the housing markets and stimulate the economy. The banking industry is awaiting many of the regulations resulting from the implementation of the Financial Reform Act. We remain unsure of the full impact this legislation will have on our business, operations or our financial condition.

Critical Accounting Policies

General

U.S. generally accepted accounting principles are complex and require management to apply significant judgment to various accounting, reporting, and disclosure matters. Management must use assumptions, judgments, and estimates when applying these principles where precise measurements are not possible or practical. These policies are critical because they are highly dependent upon subjective or complex judgments, assumptions and estimates. Changes in such judgments, assumptions and estimates may have a significant impact on the consolidated financial statements. Actual results, in fact, could differ from initial estimates.

The accounting policies we view as critical are those relating to judgments, assumptions and estimates regarding the determination of the allowance for loan losses, the fair value measurements of certain assets and liabilities, accounting for economic hedging activities, accounting for impairment testing of goodwill, accounting for the impairment of amortizing intangible assets and other long-lived assets, and the valuation of deferred tax assets.


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Allowance for Loan Losses

We maintain the allowance for loan losses at a level that represents management's best estimate of known and inherent losses in our loan portfolio. Both the amount of the provision expense and the level of the allowance for loan losses are impacted by many factors, including general and industry-specific economic conditions, actual and expected credit losses, historical trends and specific conditions of individual borrowers. Unusual and infrequently occurring events, such as weather-related disasters, may impact our assessment of possible credit losses. As a part of our analysis, we use comparative peer group data and qualitative factors such as levels of and trends in delinquencies, nonaccrual loans, charged-off loans, changes in volume and term of loans, effects of changes in lending policy, experience and ability and depth of management, national and local economic trends and conditions, and concentrations of credit, competition, and loan review results to support our estimates.

For purposes of our analysis, we categorize our loans into one of five categories: commercial and industrial, commercial real estate (including construction), home equity lines of credit, residential mortgages, and consumer loans. Typically, financial institutions use their historical loss experience and trends in losses for each loan category and are then adjusted for portfolio trends and economical and environmental factors in determining their allowance for loan losses. Prior to 2008, we experienced minimal loss history within our loan portfolio and it has only been since the economic downturn that we have recorded a higher level of loan losses. Because of this, our allowance model uses the average loss rates of similar institutions (our custom peer group) as a baseline which is then adjusted based on our particular loan portfolio characteristics and environmental factors. The indicated loss factors resulting from this analysis are applied for each of the five categories of loans.

Our peer groups are defined by selecting commercial banking institutions of similar size within Virginia, Maryland, and the District of Columbia. This is known as our custom peer group. The commercial banking institutions comprising our custom peer group can change based on certain factors including but not limited to that characteristics, size, and geographic footprint of the institution. We have identified 20 banks for our custom peer group which are within $500 million to $5 billion in total assets, the majority of whom are geographically concentrated in the Washington metropolitan area in which we operate as this area has seen less of an economic downturn than other areas of the country. We evaluate the loan quality indicators of our custom peer group to those within our national FDIC peer group, all banks in Virginia, and all banks in Maryland. These baseline peer group loss rates are then adjusted by an estimated loss emergence factor in order to determine loss coverage for pass-level credits. Finally, we make adjustments to these loss factors based on an analysis of our loan portfolio characteristics, trends, economic considerations and other conditions that should be considered in assessing our credit risk. Our peer loss rates are updated on at least an annual basis.

In addition, we individually assign loss factors to all loans that have been identified as having loss attributes, as indicated by deterioration in the financial condition of the borrower or a decline in underlying collateral value if the loan is collateral dependent. In certain cases, we apply, in accordance with regulatory guidelines, a 5% loss factor to loans classified as special mention, a 15% loss factor to loans classified as substandard and a 50% loss factor to loans classified as doubtful. Loans classified as loss loans are fully reserved or charged-off. However, in most instances, we evaluate the impairment of certain loans on a loan by loan basis for those loans that are adversely risk rated. For these loans, we analyze the fair value of the collateral underlying the loan and consider estimated costs to sell the collateral on a discounted basis. If the net collateral value is less than the loan balance (including accrued interest and any unamortized premium or discount associated with the loan) we recognize an impairment and establish a specific reserve for the . . .

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