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

Show all filings for HAMPTON ROADS BANKSHARES INC

Form 10-K for HAMPTON ROADS BANKSHARES INC


14-Mar-2014

Annual Report


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

Executive Overview

The following commentary provides information about the major components of our results of operations, financial condition, liquidity, and capital resources. This discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements.

Hampton Roads Bankshares, Inc. (the "Company") is a multi-bank holding company headquartered in Virginia Beach, Virginia. The Company's primary subsidiaries are Bank of Hampton Roads ("BOHR") and Shore Bank ("Shore" collectively the "Banks"). The Banks engage in general community and commercial banking business, targeting the needs of individuals and small- to medium-sized businesses in our primary service areas. Currently, BOHR operates 17 full-service offices in the Hampton Roads region of southeastern Virginia and 10 full-service offices throughout Richmond, Virginia and the Northeastern and Research Triangle regions of North Carolina that do business as Gateway Bank & Trust Co. ("Gateway"). Shore operates 6 full-service offices in the Eastern Shore of Virginia and Maryland. Through various affiliates, the Banks also offer mortgage banking and investment services. Our largest investor shareholders include Anchorage Capital Group, L.L.C. ("Anchorage"), CapGen Capital Group VI LP ("CapGen"), and The Carlyle Group, L.P. ("Carlyle"). Anchorage, CapGen, and Carlyle own 24.90%, 29.97%, and 24.90%, respectively, of the outstanding shares of our Common Stock as of December 31, 2013.

Our primary source of revenue is net interest income earned by our bank subsidiaries. Net interest income represents interest and fees earned from lending and investment activities less the interest paid on deposits and borrowings. Net interest income may be impacted by variations in the volume and mix of interest-earning assets and interest-bearing liabilities, changes in the yields earned and the rates paid, level of non-performing assets, and the level of noninterest-bearing liabilities available to support earning assets. In addition to net interest income, noninterest income is another important source of revenue. Noninterest income is derived primarily from service charges on deposits and mortgage banking revenue. Gains and losses on the sale or impairment of our other real


HAMPTON ROADS BANKSHARES, INC.

estate owned and repossessed assets are recognized in noninterest income. Other significant factors that impact net income (loss) attributable to Hampton Roads Bankshares, Inc. are the provision for loan losses, noninterest expense, and income taxes.

The direct lending activities in which the Company engages carry the risk that the borrowers will be unable to perform on their obligations. As such, interest rate policies of the Board of Governors of the Federal Reserve System (the "Federal Reserve") and general economic conditions, nationally and in the Company's primary market areas, have a significant impact on the Company's results of operations. To the extent that economic conditions deteriorate, business and individual borrowers may be less able to meet their obligations to the Company in full, in a timely manner, resulting in decreased earnings or losses to the Company. To the extent the Company makes fixed rate loans, general increases in interest rates will tend to reduce the Company's spread as the interest rates the Company must pay for deposits may increase while interest income may be unchanged. Economic conditions may also adversely affect the value of property pledged as security for loans and the ability to liquidate that property to satisfy a loan if necessary.

The Company's goal is to mitigate risks in the event of unforeseen threats to the loan portfolio as a result of economic downturn or other negative influences. Plans for mitigating inherent risks in managing loan assets include:
carefully enforcing loan policies and procedures and modifying those policies on occasion to account for changing or emerging risks or changing market conditions, evaluating each borrower's business plan and financial condition during the underwriting process and throughout the loan term, identifying and monitoring primary and alternative sources for loan repayment, and maintaining sufficient collateral to mitigate economic loss in the event of liquidation. An allowance for loan losses has been established which consists of general, specific, and unallocated components. A risk rating system is employed to estimate loss exposure and provide a measuring system for setting general reserve allocations. The general component relates to groups of homogeneous loans not designated for specific impairment analysis and are collectively evaluated for potential loss. The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment. The specific allowance for loan losses is based on a loan-by-loan analysis and varies between impaired loans largely due to the value of the loan's underlying collateral. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses and considers internal portfolio management effectiveness and external macroeconomic factors.

The composition of the Company's loan portfolio is weighted toward commercial real estate and real estate construction. At December 31, 2013, commercial real estate and real estate construction represented approximately 54.1% of the loan portfolio. These loans are underwritten to mitigate lending risks typical of this type of loan such as declines in real estate values, changes in borrower cash flow, and general economic conditions. The Company typically requires a maximum loan to value of 80% or less and minimum cash flow debt service coverage at the time of origination of 1.25 to 1.0. Personal guarantees are required by policy, with a limited number of exceptions being granted due to mitigating factors.

The general terms and underwriting standards for each type of commercial real estate and construction loan are incorporated into the Company's lending policies. These policies are analyzed periodically by management, and the policies are reviewed and approved by a designated subcommittee of the Board on an annual basis. The Company's loan policies and practices described in this report are subject to periodic change, and each guideline or standard is subject to waiver or exception in the case of any particular loan, with approval by the appropriate officer or committee, in accordance with the Company's loan policies. Policy standards are often stated in mandatory terms, such as "shall" or "must", but these provisions are subject to exception where appropriately mitigated. Policy requires that loan value not exceed a percentage of "market value" or "fair value" based upon appraisals or evaluations obtained in the ordinary course of the Company's underwriting practices.

Loans are secured primarily by duly recorded first deeds of trust. In some cases, the Company may accept a recorded second lien position. In general, borrowers will have a proven ability to build, lease, manage and/or sell a commercial or residential project and demonstrate satisfactory financial condition. Additionally, an equity contribution toward the project is required. Construction loans require that the financial condition and experience of the general contractor and major subcontractors be satisfactory to the Company. Guaranteed, fixed price construction contracts are required whenever appropriate, along with payment and performance bonds or completion bonds for larger scale projects.


HAMPTON ROADS BANKSHARES, INC.

Commercial land acquisition and construction loans are secured by real property where loan proceeds will be used to acquire land and to construct or improve appropriately zoned real property for the creation of income producing or owner user commercial properties. Borrowers are required to contribute equity into each project at levels determined by Loan Policy. Commercial land acquisition and construction loans generally are underwritten with a maximum term of 24 months. Loan-to-value ("LTV") ratios, with few exceptions, are maintained consistent with or below supervisory guidelines.

All construction draw requests must be presented in writing on American Institute of Architects documents and certified by the contractor, the borrower and the borrower's architect. Each draw request shall also include the borrower's soft cost breakdown certified by the borrower or its Chief Financial Officer. Prior to an advance, the Company or its contractor inspects the project to determine that the work has been completed in order to justify the draw requisition.

Commercial permanent loans are secured by improved real property which is generating income in the normal course of operation. Debt service coverage, assuming stabilized occupancy, must be satisfactory to support a permanent loan. At the time of origination, the debt service coverage ratio is ordinarily at least 1.25 to 1.0. As part of the underwriting process, debt service coverage ratios are stress tested assuming a 200 basis point increase in interest rates from their current levels.

Personal guarantees are generally received from the principals on commercial real estate loans, and only in instances where the loan-to-value is sufficiently low and the debt service is sufficiently high is consideration given to either limiting or not requiring personal recourse.

Updated appraisals for real estate secured loans are obtained as necessary and appropriate to borrower financial condition, project status, loan terms, and market conditions.

The Company is also an active traditional commercial lender providing loans for a variety of purposes, including cash flow, equipment and accounts receivable financing. This loan category represents approximately 16.3% of the Company's loan portfolio at December 31, 2013 and is generally priced at a variable or adjustable rate. Commercial loans must meet reasonable underwriting standards, including appropriate collateral, and cash flow necessary to support debt service. Residential home mortgage loans, including home equity lines and loans, make up 25.6% of the loan portfolio. These credits represent both first and second liens on residential property almost exclusively located in the Company's primary market areas. The remaining 4.0% of the loan portfolio consists of retail consumer installment loans.

The risk of nonpayment (or deferred payment) of loans is inherent in commercial lending. The Company's marketing focus on small to medium-sized businesses may result in the assumption by the Company of certain lending risks that are different from those inherent in loans to larger companies. The policies and procedures of the Company dictate that all loan applications are to be carefully evaluated and attempt to minimize credit risk exposure by use of extensive loan application data, due diligence, and approval and monitoring procedures; however, there can be no assurance that such procedures can eliminate such lending risks.

Material Trends and Uncertainties

Currently, the U.S. economy is slowly recovering from one of its longest and most severe economic recessions in recent history. Continued improvements in general economic conditions and credit performance of the Company's loan portfolio coupled with cost savings initiatives and performance from our mortgage subsidiary resulted in $4.1 million in net income attributable to Hampton Roads Bankshares, Inc. for 2013. While the pace of economic growth remains slow and regulatory and legislative friction continues to hamper the recovery, we expect to continue to be profitable for the full year 2014, although such profitability is not assured.

During 2012 and 2013, problem loans were reduced significantly from previous levels. As a result of this improvement and continued declines in the loan portfolio due to pay-downs and charge-offs, our provision for loan losses during 2013 was $1.0 million compared to $15.0 million in 2012. The increasing moderation of defaults from better asset quality and stabilized and improved collateral values has resulted in fewer impaired loans and a reduction in specific impairments. Higher historical charge-offs taken in prior years are now rolling off of the weighted loss calculations we use to determine the reserves that are based, in part, on these historical loss trends.


HAMPTON ROADS BANKSHARES, INC.

We expect that the provision for loan losses will continue to be favorably impacted by these trends in addition to overall improvement in asset quality. Additionally, during 2013, losses on other real estate owned and repossessed assets decreased $19.1 million compared to 2012. During the latter part of 2013, the performance of our mortgage banking subsidiary was negatively impacted as interest rates rose, resulting in a significant decline of mortgage loan refinancing activity. This negative impact may continue as interest rates rise to more typical levels.

Overview

Since 2008, our loan customers have operated in an economically stressed environment. While broader economic conditions have begun to gradually improve, economic conditions in the markets in which we operate remain somewhat constrained. Consequently, the levels of loan delinquencies and defaults that we experienced continue to be higher than historical levels and our net interest income, before the provision for loan losses, has not grown over this period.

The Company reported net income for 2013, compared to reporting net operating losses for 2010 to 2012, primarily resulting from improved general economic conditions and credit performance of the Company's loan portfolio. There is no guarantee that we will be able to maintain this improvement in our net income. In addition to the risk that the broader economic conditions will stagnate or reverse their improvements, our mortgage banking earnings are particularly volatile due to their dependence upon the direction and level of mortgage interest rates, which have recently increased. As of December 31, 2013, the Company exceeded the regulatory capital minimums and BOHR and Shore were considered "well capitalized" under the risk-based capital standards.

The following is a summary of our financial condition as of December 31, 2013 and our financial performance for the year then ended.

Assets were $2.0 billion at December 31, 2013. Total assets decreased by $103.8 million or 5.1% from $2.1 billion at December 31, 2012. The decrease in assets was primarily associated with a $59.0 million or 70.2% decrease in loans held for sale, a $47.7 million or 3.3% decrease in gross loans, a $41.0 million or 48.9% decrease in overnight funds sold and due from FRB, partially offset by a $49.0 million or 17.7% increase in investment securities available for sale.

Investment securities available for sale increased $49.0 million to $325.5 million as of December 31, 2013 from $276.5 million at December 31, 2012. The increase primarily resulted from the addition of asset-backed securities to our portfolio, partially offset by the sales and settlements of our mortgage-backed securities and the decrease in net unrealized gains in our portfolio. During 2013, the Company sold securities generating net gains of $781 thousand. Those dispositions, in conjunction with a general increase in interest rates during the quarter, contributed to a decrease in the net unrealized gains in our portfolio.

Gross loans decreased by $47.7 million or 3.3% during 2013, primarily through reductions in non-performing loans. The majority of the recent loan demand within our markets has come from the real estate - commercial mortgage category.

Impaired loans decreased by $73.4 million during 2013 to $67.6 million at December 31, 2013. The majority of the decrease is due to charge-offs and resolutions, coupled with payoffs received in the general course of business in the overall portfolio, including a $20.5 million decrease in impaired commercial and industrial loans, a $21.0 million decrease in impaired construction loans, a $20.3 million decrease in impaired real estate-commercial mortgage loans, and an $11.4 million decrease in impaired real estate-residential mortgage loans.

Allowance for loan losses at December 31, 2013 decreased 27.6% to $35.0 million from $48.4 million at December 31, 2012 as net charge-offs exceeded additional provisions for loan losses. Both the absolute and relative levels of non-performing loans, particularly newly identified problem credits, decreased during 2013.

Deposits decreased $94.4 million or 5.8% from December 31, 2012 as a result of decreases of $68.9 million in time deposits under $100 thousand and $90.6 million in time deposits over $100 thousand, partially offset by increases of $82.9 million in interest-bearing demand and savings deposits. The decline in time deposits is a result of the Company's efforts to improve both the average cost and mix of funds.


HAMPTON ROADS BANKSHARES, INC.

Net income attributable to Hampton Roads Bankshares, Inc. for 2013 was $4.1 million, as compared with net loss attributable to Hampton Roads Bankshares, Inc. of $25.1 million for 2012. Net income for 2013 was primarily attributable to improved general economic conditions and credit performance of the Company's loan portfolio.

Net interest income decreased $1.5 million in 2013 as compared to 2012. The decrease was due primarily to the decreases in average interest-earning assets, partially offset by an increase in net interest margin. We changed the method by which net interest margin is calculated in 2013 to include nonaccrual loans. On this basis, net interest margin increased by 4 basis points to 3.43% in 2013 compared to 3.39% in 2012.

We had $1.0 million in provision for loan losses for 2013 compared to $15.0 million for 2012. The increasing moderation of defaults from better asset quality and stabilized and improved collateral values has resulted in fewer impaired loans and a reduction in specific impairments. Additionally, larger historical charge-offs taken in prior quarters are now rolling off of the weighted loss calculations we use to determine the component of general reserves that are based on these historical loss trends.

Noninterest income for 2013 was $25.5 million, a 232.8% increase over 2012. This was largely due to a decline in losses on other real estate owned and repossessed assets. Mortgage income decreased during 2013 compared to 2012 due to declines in both origination volume and margin, driven by rising market interest rates.

Income from bank-owned life insurance increased $1.7 million during 2013 to $3.3 million compared to $1.6 million for 2012. The increase was due to a life insurance benefit from a death of a former executive.

Noninterest expense in 2013 grew 1.1% compared to 2012, finishing at $82.3 million. Higher expenses related to salary and employee benefits and occupancy were partially offset by a decrease in problem loan and repossessed asset costs.

Our effective tax rate was (1.6%) for 2013 compared to 9.2% for 2012. These taxes related to state income taxes owed. These rates differ from the statutory rate due primarily to the valuation allowance against the Company's deferred tax assets.

Critical Accounting Policies

U.S. generally accepted accounting principles ("GAAP") 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 assumptions, judgments, and estimates. Our assumptions, judgments, and estimates may be incorrect, and changes in such assumptions, judgments, and estimates may have a material impact on the consolidated financial statements. Actual results, in fact, could differ materially from those estimates. We consider our policies on allowance for loan losses, the valuation of deferred taxes, and the valuation of other real estate owned to be critical accounting policies.

Allowance for Loan Losses

The purpose of the allowance for loan losses is to provide for potential losses inherent in our loan portfolio. Management considers numerous factors in determining the allowance for loan losses, including historical loan loss experience, the size and composition of the portfolio, and the estimated value of collateral and guarantees securing the loans. Management regularly reviews the loan portfolio to determine whether adjustments are necessary to maintain an allowance for loan losses sufficient to absorb losses. Our review takes into consideration changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans, and review of current economic conditions that may affect the borrower's ability to repay. Some of the tools used in the credit review process to identify potential problem loans include past due reports, collateral valuations (primarily from third parties), cash flow analyses of borrowers, and risk ratings of loans. In addition to the review of credit quality through ongoing credit review processes, we perform a comprehensive allowance analysis for our loan portfolio at least quarterly.


HAMPTON ROADS BANKSHARES, INC.

The allowance consists of specific, general, and unallocated components. The specific component relates to loans that are determined to be impaired and, therefore, individually evaluated for impairment. The specific allowance for loan losses necessary for these loans is based on a loan-by-loan analysis and varies between impaired loans largely due to the value of the loan's underlying collateral.

The general component relates to groups of homogeneous loans not designated for specific allowance and are collectively evaluated for impairment. The general component is based on historical loss experience adjusted for qualitative factors. To arrive at the general component, the loan portfolio is grouped by loan type. Each loan type is further subdivided by risk level as determined in our loan grading process. A weighted average historical loss rate is computed for each group of loans over the trailing thirty-six months with higher weightings assigned to the most recent months. In addition, an adjustment factor may be applied. The adjustment factor, which may be favorable or unfavorable, represents management's judgment that inherent losses in a given group of loans are different from historical loss rates due to environmental factors unique to that specific group of loans. These factors may relate to growth rate factors within the particular loan group; whether the recent loss history for a particular group of loans differs from its historical loss rate; the amount of loans in a particular group that have recently been designated as impaired and that may be indicative of future trends for this group; reported or observed difficulties that other banks are having with loans in the particular group; changes in the experience, ability, and depth of lending personnel; changes in the nature and volume of the loan portfolio and in the terms of loans; and changes in the volume and severity of past due loans, nonaccrual loans, and adversely classified loans. The sum of the historical loss rate and the adjustment factor comprise the estimated annual loss rate. To adjust for risk levels, a loss allocation factor is estimated based on the segmented risk levels for the loan group and is keyed off of a pass credit rating. The loss allocation factor is applied to the estimated annual loss rate to determine the expected annual loss amount.

An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio and represents inherent losses that may not otherwise be captured in the specific or general components. Additionally, we apply an economic factor to recognize external forces over which management has no control and to estimate inherent losses that may otherwise be omitted from the allowance calculation. The factors used in this calculation include published data for the gross domestic product growth rate, interest rate levels as measured by the prime rate, changes in regional real estate indices, and regional unemployment statistics. Additionally, the Company performs a self-diagnostic assessment to evaluate internal controls over the management of the credit process to derive an internal component to the unallocated portion of the allowance which is added to the aforementioned macroeconomic factors.

Credit losses are an inherent part of our business and, although we believe the methodologies for determining the allowance for loan losses and the current level of the allowance are adequate, it is possible that there may be unidentified losses in the portfolio at any particular time that may become evident at a future date pursuant to additional internal analysis or regulatory comment. Credit losses are also impacted by real estate values. To the extent possible, we use updated third party appraisals to assist us in determining the estimated fair value of our collateral dependent impaired loans. While we believe our appraisal practices are consistent with industry norms, there can be no assurance that the fair values we estimate in determining how much impairment (if any) to recognize on our collateral dependent impaired loan portfolio will be realized in an actual sale of the property to a third party. Additional provisions for such losses, if necessary, would negatively impact earnings. As a result, our earnings could be adversely affected if our estimate of an adequate allowance is inaccurate by even a small amount.

Valuation of Deferred Taxes

Deferred tax assets and liabilities are recognized for future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets, including tax loss and credit carryforwards, and deferred tax liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Deferred income tax expense (benefit) represents the change during the period in the deferred tax assets and deferred tax liabilities.

Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Realization of the deferred tax asset is dependent on generating sufficient taxable income in future years, and, as such, material changes could impact our


HAMPTON ROADS BANKSHARES, INC.

financial condition and results of operations. As of December 31, 2013, we have recorded a valuation allowance of $176.0 million on our net deferred tax assets. Internal Revenue Code Section 382 ("Section 382") limitations related to the capital raised and resulting change in control for tax purposes during the third and fourth quarters of 2010 add further uncertainty as to the realizability of the deferred tax assets in future periods. In this regard, sale of our Common Stock by Anchorage, CapGen, or Carlyle could adversely impact our ability to realize certain deferred tax benefits relating to prior losses, . . .

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