Southern National Bancorp
Southern National Bancorp of Virginia Inc (Form: 10-K, Received: 03/08/2010 11:58:43)
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2009

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 001-33037

SOUTHERN NATIONAL BANCORP OF VIRGINIA, INC.

(Exact name of registrant as specified in its charter)

 

VIRGINIA   20-1417448

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employee

Identification No.)

6830 Old Dominion Drive

McLean, Virginia 22101

(Address or principal executive offices) (Zip code)

(703) 893-7400

(Registrant’s telephone number including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Common Stock, $0.01 par value   Nasdaq Global Market
(Title of each class)   (Name of each exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.    Yes   ¨     No   x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes   ¨     No   x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   ¨     No   ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b – 2 of the Exchange Act. (Check one):

 

Large accelerated filer   ¨   Accelerated filer   ¨   Non-accelerated filer   x   Smaller reporting company   ¨
    (Do not check if a smaller reporting company)  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes   ¨     No   x

The aggregate market value of voting stock held by non-affiliates of the registrant as of June 30, 2009 was approximately $50,352,518 based on the closing price of the common stock on such date.

The number of shares of common stock outstanding as of March 2, 2010 was 11,590,212.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive proxy statement to be used in conjunction with the registrant’s 2010 Annual Meeting of Shareholders are incorporated into Part III, Items 10-14 of this Form 10-K.

 

 

 


Table of Contents

SOUTHERN NATIONAL BANCORP OF VIRGINIA, INC.

FORM 10-K

INDEX

 

PART I
          Page

Item 1.

  

Business

   1

Item 1A.

  

Risk Factors

   20

Item 1B.

  

Unresolved Staff Comments

   30

Item 2.

  

Properties

   31

Item 3.

  

Legal Proceedings

   32

Item 4.

  

Reserved

   32
PART II

Item 5.

  

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   33

Item 6.

  

Selected Financial Data

   36

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   37

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   65

Item 8.

  

Financial Statements and Supplementary Data

   66

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   102

Item 9A.

  

Controls and Procedures

   102

Item 9B.

  

Other Information

   102
PART III

Item 10.

  

Directors, Executive Officers and Corporate Governance of the Registrant

   103

Item 11.

  

Executive Compensation

   103

Item 12.

  

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   103

Item 13.

  

Certain Relationships, Related Transactions and Director Independence

   103

Item 14.

  

Principal Accounting Fees and Services

   103
PART IV

Item 15.

  

Exhibits and Financial Statement Schedules

   104

 

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PART I

Item 1.—Business

Overview

Southern National Bancorp of Virginia, Inc. (“SNBV”, “we” or “our”) is the bank holding company for Sonabank (“Sonabank” or the “Bank”), a Virginia state chartered bank which commenced operations on April 14, 2005. Sonabank conducts full-service community banking operations from locations in Fairfax County (Reston, McLean and Fairfax), Charlottesville, Warrenton, Leesburg, New Market, Front Royal, South Riding and Clifton Forge, Virginia and in Rockville, Maryland and maintains loan production offices in Richmond, Charlottesville, Warrenton and Fredericksburg. As of December 31, 2009, we reported, on a consolidated basis, total assets of $610.7 million, total loans, net of unearned income, of $462.3 million, total deposits of $455.8 million and shareholders’ equity of $97.1 million.

While we offer a wide range of commercial banking services, we focus on making loans secured primarily by commercial real estate and other types of secured and unsecured commercial loans to small and medium-sized businesses in a number of industries, as well as loans to individuals for a variety of purposes. We are the leading Small Business Administration (SBA) lender among Virginia community banks. We also invest in real estate-related securities, including collateralized mortgage obligations and agency mortgage backed securities. Our principal sources of funds for loans and investing in securities are deposits and, to a lesser extent, borrowings. We offer a broad range of deposit products, including checking (NOW), savings, money market accounts and certificates of deposit. We actively pursue business relationships by utilizing the business contacts of our directors, senior management and local bank officers, thereby capitalizing on our knowledge of our local market areas.

Effective December 4, 2009, Sonabank assumed certain deposits and liabilities and acquired certain assets of Greater Atlantic from the FDIC as receiver for Greater Atlantic Bank, pursuant to the terms of a purchase and assumption agreement entered into by the Bank and the FDIC on December 4, 2009 (the “Agreement”). On December 5, 2009, the former Greater Atlantic offices, located in Reston, New Market, Front Royal and South Riding, Virginia and Rockville, Maryland opened as Sonabank branches.

The Bank acquired substantially all of the assets of Greater Atlantic Bank, including all loans, and assumed substantially all of its liabilities, including the insured and uninsured deposits. Pursuant to the terms of the Agreement, the Bank (a) acquired at fair value $113.6 million in loans, $1.0 million in foreclosed assets, $28.1 million in securities available-for-sale and $73.0 million in cash and other assets, and (b) assumed at fair value $178.7 million in deposits, $25.4 million in borrowings and $407 thousand in other liabilities and recorded a deferred tax liability of $3.8 million. The Bank also recorded a core deposit intangible asset in the amount of $1.2 million and recorded a pre-tax gain on the transaction of $11.2 million. In connection with the Greater Atlantic acquisition, the FDIC made a cash payment to the Bank of approximately $27.0 million. The foregoing amounts are estimates and subject to adjustment based upon final settlement with the FDIC. The terms of the Agreement provide for the FDIC to indemnify the Bank against claims with respect to liabilities of Greater Atlantic not assumed by the Bank and certain other types of claims listed in the Agreement.

The Bank paid no cash or other consideration to acquire Greater Atlantic Bank. As part of the Greater Atlantic acquisition, the Bank and the FDIC entered into a loss sharing agreement (the “loss sharing agreement”) on approximately $143.4 million (cost basis) of Greater Atlantic Bank’s assets. The Bank will share in the losses on the loans and foreclosed loan collateral with the FDIC as specified in the loss sharing agreement; we refer to these assets collectively as “covered assets.” Pursuant to the terms of the loss sharing agreement, the FDIC is obligated to reimburse the Bank for 80% of losses of up to $19 million with respect to the covered assets. The FDIC will reimburse the Bank for 95% of losses in excess of $19 million with respect to the covered assets. The Bank will reimburse the FDIC for 80% of recoveries with respect to losses for which the FDIC paid the Bank 80% reimbursement under the loss sharing agreement, and for 95% of recoveries with respect to losses for which the FDIC paid the Bank 95% reimbursement under the loss sharing agreement.

 

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On September 28, 2009, Southern National Bancorp of Virginia, Inc. completed the purchase of the Warrenton branch office, acquired at fair value selected loans in the amount of $23.8 million and assumed at fair value approximately $26.8 million of deposits from Millennium Bank, N.A.

SNBV completed a public offering of its common stock in an underwritten public offering. FIG Partners, LLC acted as the sole manager for the offering. SNBV closed on the offering on November 4, 2009, selling 4,791,665 shares of common stock, including 624,999 shares sold pursuant to an over-allotment option granted to the underwriter, at a price of $6.00 per share. The gross proceeds from the shares sold were $28.7 million. The net proceeds to SNBV from the offering were approximately $26.9 million after deducting $1.3 million in underwriting commission and an estimated $486 thousand in other expenses incurred in connection with the offering.

SNBV expects to use the net proceeds from the offering to provide capital to Sonabank to support its anticipated organic growth, to support potential future acquisitions of branches or whole banks, including the possible acquisitions of failed financial institutions in FDIC assisted transactions, and for other general corporate purposes.

We primarily market our products and services to small and medium-sized businesses and to retail consumers. Our strategy is to provide superior service through our employees, who are relationship-oriented and committed to their respective customers. Through this strategy, we intend to grow our business, expand our customer base and improve our profitability. The key elements of our strategy are to:

 

   

Utilize the Strength of our Management Team . The experience and market knowledge of our management team is one of our greatest strengths and competitive advantages. Our chairman, Georgia S. Derrico, was the founder, chairman of the board and chief executive officer, and our president, R. Roderick Porter, was the president and chief operating officer, of Southern Financial Bancorp, Inc., a publicly traded bank holding company. At the time of its sale to Provident Bankshares, Inc. in April of 2004, Southern Financial had $1.5 billion in assets and operated 34 full-service banking offices of Southern Financial Bank, which was founded in Fairfax County and subsequently expanded into Central and Southern Virginia. Including the members of our current senior management team, 38 of our employees previously worked with our chairman and president at Southern Financial Bank.

 

   

Leverage Our Existing Foundation for Additional Growth. Based on our management’s depth of experience and certain infrastructure investments, we believe that we will be able to take advantage of certain economies of scale typically enjoyed by larger organizations to expand our operations both organically and through strategic cost-effective branch or bank acquisitions. We believe that the investments we have made in our data processing, staff and branch network will be able to support a much larger asset base. We are committed, however, to control any additional growth in a manner designed to minimize the risk and to maintain strong capital ratios. We believe that the net proceeds raised in this offering will assist us in implementing our growth strategies by providing the capital necessary to support future asset growth, both organically and through strategic acquisitions.

 

   

Continue to Pursue Selective Acquisition Opportunities . Historically, acquisitions have been a key part of our growth. Since our formation, we have completed the acquisition and assumption of certain assets and liabilities of Greater Atlantic Bank from the FDIC on December 4, 2009, the acquisition of a branch of Millennium Bank in Warrenton, Virginia on September 28, 2009, the acquisition of the Leesburg branch location from Founders Corporation which opened on February 11, 2008, the acquisition of 1 st Service Bank in December of 2006 and the acquisition of the Clifton Forge branch of First Community Bancorp, Inc. in December of 2005. We intend to continue to review branch and whole bank acquisition opportunities, including possible acquisitions of failed financial institutions in FDIC assisted transactions, and will pursue these opportunities if they represent the most efficient use of our capital under the circumstances. We believe that we have demonstrated that we have the skill set and experience to acquire and integrate successfully both bank and branch acquisitions, and that with the stronger capital position we expect to have following this offering, we will be well-positioned to

 

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take advantage of acquisition opportunities as they may arise. We intend to focus on targets in our market areas or other attractive areas with significant core deposits and/or a potential customer base compatible with our growth strategy.

 

   

Focus on the Business Owner . It is our goal to be the bank that business owners in our markets turn to first for commercial banking needs as a result of our superior personal service and the tailored products and services that we provide. To help achieve this goal, we:

 

   

have a standing credit committee that meets as often as necessary on a “when needed” basis to review completed loan applications, making extensive use of technology to facilitate our internal communications and thereby enabling us to respond to our customers promptly;

 

   

are an SBA approved “Preferred” lender, which permits us to make SBA loan decisions at Sonabank rather than waiting for SBA processing. We offer a number of different types of SBA loans designed for the small and medium-sized business owner and some of our SBA loan customers also have other relationships with Sonabank. This product group is complex and “paper intensive” and not well utilized by some of our competitors;

 

   

provide Internet business banking at www.sonabank.com which allows our business customers 24-hour web-based access to their accounts so they can confirm or transfer balances, pay bills, download statements and use our “Web Lockbox” or “Sona Cash Manager;”

 

   

provide our business customers with “Sona In-House,” a service that utilizes Check 21 technology to allow customers to make remote deposits from their business locations and gives them access to those funds within 24 to 48 hours; and

 

   

provide our business customers with access to SABL, our recently developed state-of-the-art asset-based lending system. Unlike most asset-based lending systems, which are based on manual processes or software that certifies a company’s borrowing base periodically, SABL provides a real time capability to analyze and adjust borrowing availability based on actual collateral levels. SABL is predicated on a link between any kind of accounting software used by the customer and Sonabank’s server. SABL is now fully operational, with seven users.

 

   

Maintain Local Decision-Making and Accountability . We believe that we have a competitive advantage over larger national and regional financial institutions by providing superior customer service with experienced, knowledgeable management, localized decision-making capabilities and prompt credit decisions. We believe that our customers want to deal directly with the persons who make the credit decisions.

 

   

Focus on Asset Quality and Strong Underwriting . We consider asset quality to be of primary importance and have taken measures in an effort to ensure that, despite the growth in our loan portfolio, we consistently maintain strong asset quality.

 

   

Build a Stable Core Deposit Base . We intend to continue to grow a stable core deposit base of business and retail customers. To the extent that our asset growth outpaces this local deposit funding source, we plan to continue to borrow and raise deposits in the national market using deposit intermediaries. We intend to continue our practice of developing a deposit relationship with each of our loan customers.

General

Our principal business is the acquisition of deposits from the general public through our branch offices and deposit intermediaries and the use of these deposits to fund our loan and investment portfolios. We seek to be a full service community bank that provides a wide variety of financial services to our middle market corporate clients as well as to our retail clients. We are an active commercial lender, have been designated as a “Preferred SBA Lender” and participate in the Virginia Small Business Financing Authority lending program. In addition, we are an active commercial real estate lender. We also invest funds in mortgage-backed securities, securities sold with an agreement to repurchase, reverse repurchase agreements and securities issued by agencies of the federal government.

 

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The principal sources of funds for our lending and investment activities are deposits, amortization and repayment of loans, prepayments from mortgage-backed securities, repayments of maturing investment securities, Federal Home Loan Bank advances and other borrowed money.

Principal sources of revenue are interest and fees on loans and investment securities, as well as fee income derived from the maintenance of deposit accounts and income from bank-owned life insurance policies. Our principal expenses include interest paid on deposits and advances from the Federal Home Loan Bank of Atlanta (“FHLB”) and other borrowings, and operating expenses.

Available Information

SNBV files annual, quarterly and other reports under the Securities Exchange Act of 1934 with the Securities and Exchange Commission (“SEC”). These reports are posted and are available at no cost on our website, www.sonabank.com , through the Investor Relations link, as soon as reasonably practicable after we file such documents with the SEC. Our filings are also available through the SEC’s website at www.sec.gov.

Lending Activities

Our primary strategic objective is to serve small to medium-sized businesses in our market with a variety of unique and useful services, including a full array of commercial mortgage and non-mortgage loans. These loans include commercial real estate loans, construction to permanent loans, development and builder loans, accounts receivable financing, lines of credit, equipment and vehicle loans, leasing, and commercial overdraft protection. We strive to do business in the areas served by our branches, which is also where our marketing is focused, and the vast majority of our loan customers are located in existing market areas. Virtually all of our loans are from Virginia, Maryland, West Virginia, or Washington D.C. The Small Business Administration may from time to time come to us because of our reputation and expertise as an SBA lender and ask us to review a loan outside of our core counties but within our market area. Prior to making a loan, we obtain loan applications to determine a borrower’s ability to repay, and the more significant items on these applications are verified through the use of credit reports, financial statements and confirmations.

The following is a discussion of each of the major types of lending:

Commercial Real Estate Lending

Permanent. Commercial real estate lending includes loans for permanent financing. Commercial real estate lending typically involves higher loan principal amounts and the repayment of loans is dependent, in large part, on sufficient income from the properties securing the loans to cover operating expenses and debt service. As a general practice, we require our commercial real estate loans to be secured by well-managed income producing properties with adequate margins and to be guaranteed by responsible parties. We look for opportunities where cash flow from the collateral properties provides adequate debt service coverage and the guarantor’s net worth is strong. At December 31, 2009, our commercial real estate loans for permanent financing totaled $167.7 million, of which $21.4 million was acquired in the Greater Atlantic transaction.

Our underwriting guidelines for commercial real estate loans reflect all relevant credit factors, including, among other things, the income generated from the underlying property to adequately service the debt, the availability of secondary sources of repayment and the overall creditworthiness of the borrower. In addition, we look to the value of the collateral, while maintaining the level of equity invested by the borrower.

All valuations on property which will secure loans over $250 thousand are performed by independent outside appraisers who are reviewed by our executive vice president of risk management and/or an officer independent of the transaction. We retain a valid lien on real estate and obtain a title insurance policy (on first trust loans only) that insures the property is free of encumbrances. In addition, we do title searches on all loans secured by real estate.

 

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Construction. We recognize that construction loans for commercial, multifamily and other non-residential properties can involve risk due to the length of time it may take to bring a finished real estate product to market. As a result, we will only make these types of loans when pre-leasing or pre-sales or other credit factors suggest that the borrower can carry the debt if the anticipated market and property cash flow projections change during the construction phase.

Income producing property loans are supported by evidence of the borrower’s capacity to service the debt. All of our commercial construction loans are guaranteed by the principals or general partners. At December 31, 2009, we had $53.8 million of construction, land and development loans, of which $5.8 million was acquired in the Greater Atlantic transaction.

Construction loan borrowers are generally pre-qualified for the permanent loan by us or a third party. We obtain a copy of the contract with the general contractor who must be acceptable to us. All plans, specifications and surveys must include proposed improvements. We review feasibility studies and risk analyses showing sensitivity of the project to variables such as interest rates, vacancy rates, lease rates and operating expenses.

Commercial Business Lending

These loans consist of lines of credit, revolving credit facilities, demand loans, term loans, equipment loans, SBA loans, stand-by letters of credit and unsecured loans. Commercial business loans are generally secured by accounts receivable, equipment, inventory and other collateral, such as readily marketable stocks and bonds with adequate margins, cash value in life insurance policies and savings and time deposits at Sonabank. At December 31, 2009, our commercial business loans totaled $74.7 million, of which $4.0 million was acquired in the Greater Atlantic transaction.

In general, commercial business loans involve more credit risk than residential mortgage loans and real estate-backed commercial loans and, therefore, usually yield a higher return to us. The increased risk for commercial business loans is due to the type of collateral securing these loans. The increased risk also derives from the expectation that commercial loans will be serviced principally from the operations of the business, and that those operations may not be successful. Historical trends have shown that these types of loans do have higher delinquencies than mortgage loans. Because of this, we often utilize the SBA 7(a) program (which guarantees the repayment of up to 90% of the principal and accrued interest to us) to reduce the inherent risk associated with commercial business lending.

Another way that we reduce risk in the commercial loan portfolio is by taking accounts receivable as collateral. Our accounts receivable financing facilities, which provide a relatively high yield with considerable collateral control, are lines of credit under which a company can borrow up to the amount of a borrowing base which covers a certain percentage of the company’s receivables. From our customer’s point of view, accounts receivable financing is an efficient way to finance expanding operations because borrowing capacity expands as sales increase. Customers can borrow from 75% to 90% of qualified receivables. In most cases, the borrower’s customers pay us directly. For borrowers with a good track record for earnings and quality receivables, we will consider pricing based on an increment above the prime rate for transactions in which we lend up to a percentage of qualified outstanding receivables based on reported aging of the receivables portfolio.

We also actively pursue for our customers equipment lease financing opportunities. We provide financing and use a third party to service the leases. Payment is derived from the cash flow of the borrower, so credit quality may not be any lower than it would be in the case of an unsecured loan for a similar amount and term.

SBA Lending

We have developed an expertise in the federally guaranteed SBA program. The SBA program is an economic development program which finances the expansion of small businesses. We are a Preferred Lender in the Washington D.C. and Richmond Districts of the SBA. As an SBA Preferred lender, our pre-approved status

 

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allows us to quickly respond to customers’ needs. Under the SBA program, we originate and fund SBA 7(a) loans which qualify for guarantees up to 90% of principal and accrued interest. We also originate 504 chapter loans in which we generally provide 50% of the financing, taking a first lien on the real property as collateral.

We provide SBA loans to potential borrowers who are proposing a business venture, often with existing cash flow and a reasonable chance of success. We do not treat the SBA guarantee as a substitute for a borrower meeting our credit standards, and, except for minimum capital levels or maximum loan terms, the borrower must meet our other credit standards as applicable to loans outside the SBA process.

Residential Mortgage Lending

Permanent. To a limited extent, we make fixed and adjustable rate first mortgage loans on residential properties with terms up to 30 years. In the case of conventional loans, we typically lend up to 80% of the appraised value of single-family residences and require mortgage insurance for loans exceeding that amount. We have no sub-prime loans. At December 31, 2009, we had $94.8 million of permanent residential mortgage loans. Of that amount, $34.5 million remain from the purchase of 1 st Service Bank, and $33.8 million was acquired in the Greater Atlantic transaction.

We retain a valid lien on real estate and obtain a title insurance policy that insures the property is free of encumbrances. We also require hazard insurance and flood insurance for all loans secured by real property if the real property is in a flood plain as designated by the Department of Housing and Urban Development. We also require most borrowers to advance funds on a monthly basis from which we make disbursements for items such as real estate taxes, private mortgage insurance and hazard insurance.

Construction. We typically make single family residential construction loans to builders/developers in our market areas. Construction loans generally have interest rates of prime plus one to two percent and fees of one to three points, loan-to-value ratios of 80% or less based on current appraisals and terms of generally nine months or less. In most cases, when we make a residential construction loan to a builder, the residence is pre-sold. All plans, specifications and surveys must include proposed improvements. Borrowers must evidence the capacity to service the debt.

Home Equity Lines of Credit. Sonabank rarely originates home equity lines of credit. At December 31, 2009, we had outstanding balances totaling $54.8 million, of which $44.2 million was acquired in the Greater Atlantic transaction. We had previously acquired outstanding balances of home equity lines of credit in the amount of $8.0 million in the acquisition of 1 st Service Bank in 2006.

Consumer Lending

To a limited extent, we offer various types of secured and unsecured consumer loans. We make consumer loans primarily for personal, family or household purposes as a convenience to our customer base since these loans are not the focus of our lending activities. As a general guideline, a consumer’s debt service should not exceed 40% of his gross income or 45% of net income. For purposes of this calculation, debt includes house payment or rent, fixed installment payments, the estimated payment for the loan being requested and the minimum required payment on any revolving debt. At December 31, 2009, we had $3.7 million of consumer loans.

Credit Approval and Collection Policies

Because future loan losses are so closely intertwined with our underwriting policy, we have instituted what management believes is a stringent loan underwriting policy. Our underwriting guidelines are tailored for particular credit types, including lines of credit, revolving credit facilities, demand loans, term loans, equipment loans, real estate loans, SBA loans, stand-by letters or credit and unsecured loans. We will make extensions of credit based, among other factors, on the potential borrower’s creditworthiness, likelihood of repayment and proximity to market areas served.

 

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We have a standing Credit Committee comprised of certain officers, each of whom has a defined lending authority in combination with other officers. These individual lending authorities are determined by our Chief Executive Officer and certain directors and are based on the individual’s technical ability and experience. These authorities must be approved by our board of directors and our Credit Committee. Our Credit Committee is comprised of four levels of members: junior, regular, senior, and executive, based on experience. Our executive members are Ms. Derrico and Messrs. Porter and Wallace. Mr. Stevens, Chief Risk Officer, must approve risk ratings for loans over $1.5 million. Loans over a certain size must be approved by outside director, Neil Call. (See “Management.”) Under our loan approval process, the sponsoring loan officer’s approval is required on all credit submissions. This approval must be included in or added to the individual and joining authorities outlined below. The sponsoring loan officer is primarily responsible for the customer’s relationship with us, including, among other things, obtaining and maintaining adequate credit file information. We require each loan officer to maintain loan files in an order and detail that would enable a disinterested third party to review the file and determine the current status and quality of the credit.

In addition to approval of the sponsoring loan officer, we require approvals from one or more members of the Credit Committee on all loans. The approvals required differ based on the size of the borrowing relationship. At least one senior or one executive member must approve all loans in the amount of $100,000 or more. All three of the executive members of the committee must approve all loans of $1 million or more. Regardless of the number of approvals needed, we encourage each member not to rely on another member’s approval as a basis for approval and to treat his approval as if it were the only approval necessary to approve the loan. Our legal lending limit to one borrower is limited to 15% of our unimpaired capital and surplus. We have an internal guidance line of 75% of the legal lending limit. As of December 31, 2009, our legal lending limit was approximately $13.3 million, although we have no loans to one borrower that approach our legal lending limit to date. Our largest group credit is $8.5 million.

The following collection actions are the minimal procedures which management believes are necessary to properly monitor past due loans and leases. When a borrower fails to make a payment, we contact the borrower in person, in writing or on the telephone. At a minimum, all borrowers are notified by mail when payments of principal and/or interest are 10 days past due. Real estate and commercial loan borrowers are assessed a late charge when payments are 10-15 days past due. Customers are contacted by a loan officer before the loan becomes 60 days delinquent. After 90 days, if the loan has not been brought current or an acceptable arrangement is not worked out with the borrower, we will institute measures to remedy the default, including commencing foreclosure action with respect to mortgage loans and repossessions of collateral in the case of consumer loans.

If foreclosure is effected, the property is sold at a public auction in which we may participate as a bidder. If we are the successful bidder, we include the acquired real estate property in our real estate owned account until it is sold. These assets are carried at the lower of cost or the fair value net of estimated selling costs. To the extent there is a decline in value, that amount is charged to operating expense. At December 31, 2009, we had other real estate owned totaling $3.5 million, of which $740 thousand, net of discount, was acquired in the Greater Atlantic transaction.

Special Products and Services

To complement our array of loans, we also provide the following special products and services to our commercial customers:

Cash Management Services

Cash Management services are offered that enable the Bank’s business customer to maximize the efficiency of their cash management. Specific products offered in our cash management services program include the following:

 

   

Investment/sweep accounts

 

   

Wire Transfer services

 

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Employer Services/Payroll processing services

 

   

Zero balance accounts

 

   

Night depository services

 

   

Lockbox services

 

   

Depository transfers

 

   

Merchant services (third party)

 

   

ACH originations

 

   

Business debit cards

 

   

Controlled disbursement accounts

 

   

SONA 24/7 (Check 21 processing)

 

   

Sonabank asset based lending (SABL)

Some of the products listed above are described in-depth below.

 

 

SONA 24/7/Check 21: SONA 24/7 is ideal for landlords, property managers, medical professionals, and any other businesses that accept checks. Sonabank is a market leader in banking technology, and has created SONA 24/7 to empower its business customers. Now the customers of Sonabank can have total control over how, when, and where their checks will be deposited. SONA 24/7 uses the new Check Truncation technology outlined by the “Check Clearing for the 21st Century Act”, passed in October 2004 (Check 21). This act allows banks to have a universal technique for processing checks. With Check Truncation, paper checks can now be converted to electronic images and processed between participating banks, vastly speeding up the check clearing process. SONA In-House passes on the benefits of Check Truncation directly to Sonabank’s business customers.

 

 

Lockbox Services: Sonabank will open a lockbox, retrieve and scan incoming checks, and deposit them directly into the customer’s account. The images of the checks will then be available to view online. This makes bookkeeping for the customer fast and easy, and because Sonabank is checking the lockbox daily, funds will often be available sooner. Big businesses have been using lockboxes for decades as a cash management tool. Sonabank makes this service cost effective for all small and medium sized businesses as well.

 

 

Employer Services: Sonabank will provide its business clients with software that allows them to generate ACH payroll transactions to their employees’ accounts.

 

 

SABL: Asset Based Lending is a form of “collateral-based” lending. It is a combination of secured lending and short-term business lending. It is a specialized form of financing that allows a bank’s commercial customers to pledge their working assets, typically inventory and account receivables as collateral to secure financing. Asset Based Lending borrowers are typically in the service, manufacturing or distribution fields.

SABL is an Asset Based Lending software system, built by Sonabank that allows the bank to monitor the collateral of its commercial borrowers who have pledged their working assets (accounts receivables and other qualifying assets such as inventory) as collateral. SABL will also have the ability to track other offsets (liabilities, e.g. other loans the customer has with the bank) to the line of credit. SABL will serve to provide the more stringent controls and supervision that this type of lending requires.

One control that is typical of Asset Based Lending is that the commercial borrower is required to have its customers remit invoice payments to a bank controlled lockbox. The bank retrieves these payments and the bank applies them directly to any outstanding balance on the line. SABL allows for this and can combine that service with remote capture (check 21) if warranted.

 

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Most Asset Based Lending systems are manual processes or software that certifies the borrowing base periodically. These certifications are usually provided in the form of manually created borrowing bases backed up with field exams. SABL will provide a real time capability to analyze and adjust borrowing availability based on the levels of collateral at the moment.

SABL also offers an automated collateral upload, taking receivable information directly from the clients accounting system. SABL also offers discretionary borrowings and pay offs, allowing clients to borrow on or pay down their line at their discretion, as long as they are compliant with the SABL system. Lastly, SABL offers superior reporting, offering reports to bank officers that provide all the information they need to monitor risk. Customized reports can also be built for clients.

 

 

Other Consumer/Retail Products and Services. Other products and services that are offered by the Bank are primarily directed toward the individual customer and include the following:

 

   

Debit cards

 

   

ATM services

 

   

Travelers Checks

 

   

Savings bonds

 

   

Money Orders

 

   

Notary service

 

   

Wire transfers

 

   

Telephone banking

 

   

Online banking with bill payment services

 

   

Credit Cards

Competition

The banking business is highly competitive, and our profitability depends principally on our ability to compete in the market areas in which our banking operations are located. We experience substantial competition in attracting and retaining savings deposits and in lending funds. The primary factors we encounter in competing for savings deposits are convenient office locations and rates offered. Direct competition for savings deposits comes from other commercial bank and thrift institutions, money market mutual funds and corporate and government securities which may offer more attractive rates than insured depository institutions are willing to pay. The primary factors we encounter in competing for loans include, among others, interest rate and loan origination fees and the range of services offered. Competition for origination of loans normally comes from other commercial banks, thrift institutions, mortgage bankers, mortgage brokers and insurance companies. We have been able to compete effectively with other financial institutions by:

 

   

emphasizing customer service and technology;

 

   

establishing long-term customer relationships and building customer loyalty; and

 

   

providing products and services designed to address the specific needs of our customers.

Employees

At December 31, 2009, we had 103 full-time equivalent employees, four of whom were executive officers. Management considers its relations with its employees to be good. Neither we nor Sonabank are a party to any collective bargaining agreement.

 

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SUPERVISION AND REGULATION

The business of SNBV and the Bank are subject to extensive regulation and supervision under federal banking laws and other federal and state laws and regulations. In general, these laws and regulations are intended for the protection of the customers and depositors of the Bank and not for the protection of SNBV or its shareholders. Set forth below are brief descriptions of selected laws and regulations applicable to SNBV and the Bank. These descriptions are not intended to be a comprehensive description of all laws and regulations to which SNBV and the Bank are subject or to be complete descriptions of the laws and regulations discussed. The descriptions of statutory and regulatory provisions are qualified in their entirety by reference to the particular statutes and regulations. Changes in applicable statutes, regulations or regulatory policy may have a material effect on SNBV, the Bank and their business.

The Bank Holding Company Act of 1956. Under the Bank Holding Company Act of 1956, as amended (“BHCA”), SNBV is subject to periodic examination by the Federal Reserve Board (“FRB”) and required to file periodic reports regarding its operations and any additional information that the FRB may require. Our activities at the bank holding company level are limited to:

 

   

banking, managing or controlling banks;

 

   

furnishing services to or performing services for our bank subsidiary; and

 

   

engaging in other activities that the FRB has determined by regulation or order to be so closely related to banking as to be a proper incident to these activities.

Some of the activities that the FRB has determined by regulation to be proper incidents to the business of a bank holding company include making or servicing loans and specific types of leases, performing specific data processing services and acting in some circumstances as a fiduciary or investment or financial adviser. SNBV does not currently plan to perform any of these activities, but may do so in the future.

With some limited exceptions, the BHCA requires every bank holding company to obtain the prior approval of the FRB before: (i) acquiring substantially all the assets of any bank; (ii) acquiring direct or indirect ownership or control of any voting shares of any bank if after such acquisition it would own or control more than 5% of the voting shares of such bank (unless it already owns or controls the majority of such shares); or (iii) merging or consolidating with another bank holding company.

In addition, and subject to some exceptions, the BHCA and the Change in Bank Control Act, together with their regulations, require FRB approval prior to any person or company acquiring “control” of a bank holding company. Control is conclusively presumed to exist if an individual or company acquires 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of voting securities of the bank holding company. Control is rebuttably presumed to exist if a person acquires 10% or more, of any class of voting securities and either has registered securities under Section 12 of the Exchange Act or no other person owns a greater percentage of that class of voting securities immediately after the transaction. The regulations provide a procedure for challenging this rebuttable control presumption. On September 22, 2008, the FRB issued a policy statement on equity investments in bank holding companies and banks, which allows the FRB to generally be able to conclude that an entity’s investment is not “controlling” if the entity does not own in excess of 15% of the voting power and 33% of the total equity of the bank holding company or bank. Depending on the nature of the overall investment and the capital structure of the banking organization, based on the policy statement, the FRB will permit noncontrolling investments in the form of voting and nonvoting shares that represent in the aggregate (i) less than one-third of the total equity of the banking organization (and less than one-third of any class of voting securities, assuming conversion of all convertible nonvoting securities held by the entity) and (ii) less than 15% of any class of voting securities of the banking organization.

In November 1999, Congress enacted the Gramm-Leach-Bliley Act (“GLBA”), which made substantial revisions to the statutory restrictions separating banking activities from other financial activities. Under the GLBA, bank holding companies that are well-capitalized and well-managed and meet other conditions can elect

 

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to become “financial holding companies.” As financial holding companies, they and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting and distribution, travel agency activities, insurance agency activities, merchant banking and other activities that the FRB determines to be financial in nature or complementary to these activities. Financial holding companies continue to be subject to the overall oversight and supervision of the FRB, but the GLBA applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. Although SNBV has not elected to become a financial holding company in order to exercise the broader activity powers provided by the GLBA, SNBV may elect to do so in the future.

Insurance of Deposits. The Bank’s deposit accounts have been insured by the FDIC up to a maximum of $100,000 per insured depositor ($250,000 for certain retirement accounts). On October 3, 2008, the FDIC temporarily increased deposit insurance from $100,000 per depositor to $250,000. This increase is effective until December 31, 2013. On October 14, 2008, the FDIC announced the Temporary Liquidity Guarantee Program (“TLG Program”) to strengthen confidence and encourage liquidity in the banking system. The program consists of two components: a temporary guarantee of newly-issued senior unsecured debt and a temporary unlimited guarantee of funds in noninterest-bearing transaction accounts at FDIC-insured institutions. Sonabank is participating in the Transaction Account Guarantee Program, but opted not to participate in the Debt Guarantee Program.

Under deposit insurance reform legislation which became effective in February 2006, deposit insurance coverage will be increased for inflation every five years beginning in 2011. The FDIC issues regulations, conducts periodic examinations, requires the filing of reports and generally supervises the operations of its insured banks. Any insured bank which is not operated in accordance with, or does not conform to FDIC regulations, policies and directives may be sanctioned for non-compliance. Proceedings may be instituted against any insured bank or any director, officer or employee of such bank engaging in unsafe and unsound practices including the violation of applicable laws and regulations. The FDIC has the authority to terminate insurance of accounts pursuant to procedures established for that purpose.

In February 2006, the Federal Deposit Insurance Reform Act of 2005 (“Deposit Reform Act”) was enacted. The Deposit Reform Act, among other things, consolidates the Bank Insurance Fund and Savings Association Insurance Fund into the Deposit Insurance Fund (“DIF”), establishes a range for reserves levels for the DIF of 1.15% to 1.50% and creates a mechanism for raising the ceiling on deposit insurance coverage to reflect future inflation.

If the reserve ratio falls below 1.15%, the FDIC must adopt a restoration plan that provides that the DIF will return to 1.15% generally within 5 years. If the reserve ratio exceeds 1.35%, the FDIC must generally dividend to DIF members half of the amount above the amount necessary to maintain the DIF at 1.35%. The FDIC declares a 50% dividend when the reserve ratio reaches 1.35% and a 100% dividend when the reserve ratio reaches above 1.50%. The designated reserve ratio is currently set at 1.25%. The FDIC has the discretion to price deposit insurance according to the risk for all insured institutions regardless of the level of the reserve ratio.

The DIF reserve ratio is maintained by assessing depository institutions an insurance premium based upon statutory factors that include the balance of insured deposits as well as the degree of risk the institution poses to the insurance fund. Under a risk-based assessment system required by the FDICIA, FDIC-insured depository institutions pay quarterly insurance premiums at rates based on their risk classification. Institutions assigned to higher-risk classifications (that is, institutions that pose a greater risk of loss to their respective deposit insurance funds) pay assessments at higher rates than institutions that pose a lower risk. An institution’s risk classification is assigned based on its capital levels and the level of supervisory concern the institution poses to regulators. An institution’s risk assignment includes assignment to Risk Category I, II, III, or IV.

 

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On January 1, 2009, the FDIC increased the DIF assessment rates as part of the FDIC’s DIF restoration plan. As a result, initial base assessment rates currently range from 12 to 14 basis points for Risk Category I institutions, 17 basis points for Risk Category II institutions, 35 basis points for Risk Category III institutions, and 50 basis points for Risk Category IV institutions. On February 27, 2009, the board of directors of the FDIC issued final rules to amend the restoration plan for the DIF, change the risk-based assessment system and set assessment rates to begin in the second quarter of 2009. Effective April 1, 2009, total base assessment rates range from 7 to 24 basis points for Risk Category I institutions, 17 to 43 basis points for Risk Category II institutions, 27 to 58 basis points for Risk Category III institutions, and 40 to 77.5 basis points for Risk Category IV institutions. Risk assessments remain in effect for future assessment periods until changed by the FDIC. On May 22, 2009, the FDIC announced that it would levy a special assessment on insured institutions as part of its effort to rebuild the DIF. The special assessment equaled five basis points on each FDIC-insured depository institution’s assets, minus its Tier 1 capital, as of June 30, 2009.

Additionally, on November 17, 2009, the FDIC adopted a final rule that required insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012, at the same time that institutions paid their regular quarterly deposit insurance assessments for the third quarter of 2009. The FDIC is to maintain assessment rates at their current levels through the end of 2010 and assessment rates will be increased by an annualized 3 basis points effective January 1, 2011.

Under generally accepted accounting principles, prepaid assessments would not immediately affect a bank’s earnings. Each institution recorded the entire amount of its prepaid assessment as a prepaid expense (an asset) as of December 30, 2009, the date the payment was made. As of December 31, 2009, and each quarter thereafter, each institution records an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. Once the asset is exhausted, the institution would resume paying and accounting for quarterly deposit insurance assessments as currently done. The institutions would record an accrued expense payable each quarter for the assessment payment, which would be made to the FDIC at the end of the following quarter. The FDIC would also have the authority to exercise its discretion as supervisor and insurer to exempt an institution from the prepayment requirement if the FDIC determines that the prepayment would significantly impair the institution’s liquidity or would otherwise create significant hardship.

Safety and Soundness. There are a number of obligations and restrictions imposed on bank holding companies and their depository institution subsidiaries by federal law and regulatory policy that are designed to reduce potential loss exposure to the depositors of such depository institutions and to the FDIC insurance funds in the event that the depository institution is insolvent or is in danger of becoming insolvent. These obligations and restrictions are not for the benefit of investors. Regulators may pursue an administrative action against any bank holding company or national bank which violates the law, engages in an unsafe or unsound banking practice or which is about to engage in an unsafe and unsound banking practice. The administrative action could take the form of a cease and desist proceeding, a removal action against the responsible individuals or, in the case of a violation of law or unsafe and unsound banking practice, a civil penalty action. A cease and desist order, in addition to prohibiting certain action, could also require that certain action be undertaken. Under the policies of the FRB, SNBV is required to serve as a source of financial strength to the Bank and to commit resources to support the Bank in circumstances where SNBV might not do so otherwise.

Capital Requirements. Each of the FRB and the FDIC has issued risk-based and leverage capital guidelines applicable to banking organizations that it supervises. Under the risk-based capital requirements, SNBV and the Bank are each generally required to maintain a minimum ratio of total capital to risk-weighted assets (including specific off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of “Tier 1 Capital,” which is defined as common equity, retained earnings and qualifying perpetual preferred stock, less certain intangibles. The remainder may consist of “Tier 2 Capital,” which is defined as specific subordinated debt, some hybrid capital instruments and other qualifying preferred stock and a limited amount of the loan loss allowance. In addition, each of the federal banking regulatory agencies has established minimum leverage capital requirements for banking organizations. Under these

 

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requirements, banking organizations must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets equal to 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness. In sum, the capital measures used by the federal banking regulators are:

 

   

the Total Risk-Based Capital ratio, which is the total of Tier 1 Risk-Based Capital and Tier 2 Capital;

 

   

the Tier 1 Risk-Based Capital ratio; and

 

   

the leverage ratio.

Under these regulations, a state bank will be:

 

   

“well capitalized” if it has a Total Risk-Based Capital ratio of 10% or greater, a Tier 1 Risk-Based Capital ratio of 6% or greater, a leverage ratio of 5% or greater, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure;

 

   

“adequately capitalized” if it has a Total Risk-Based Capital ratio of 8% or greater, a Tier 1 Risk-Based Capital ratio of 4% or greater, and a leverage ratio of 4% or greater—or 3% in certain circumstances—and is not well capitalized;

 

   

“undercapitalized” if it has a Total Risk-Based Capital ratio of less than 8% or greater, a Tier 1 Risk-Based Capital ratio of less than 4% (or 3% in certain circumstances), or a leverage ratio of less than 4% (or 3% in certain circumstances);

 

   

“significantly undercapitalized” if it has a Total Risk-Based Capital ratio of less than 6%, a Tier 1 Risk-Based Capital ratio of less than 3%, or a leverage ratio of less than 3%; or

 

   

“critically undercapitalized” if its tangible equity is equal to or less than 2% of tangible assets.

The risk-based capital standards of each of the FRB and the FDIC explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by the agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy.

The federal banking agencies’ risk-based and leverage ratios are minimum supervisory ratios generally applicable to banking organizations that meet certain specified criteria. Banking organizations not meeting these criteria are expected to operate with capital positions well above the minimum ratios. The federal bank regulatory agencies may set capital requirements for a particular banking organization that are higher than the minimum ratios when circumstances warrant. FRB guidelines also provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

Prompt Corrective Action. Under Section 38 of the Federal Deposit Insurance Act (“FDIA”), each federal banking agency is required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies (including the FRB and the FDIC) have adopted substantially similar regulations to implement Section 38 of the FDIA. Section 38 of the FDIA and the regulations promulgated thereunder also specify circumstances under which the FDIC may reclassify a well capitalized bank as adequately capitalized and may require an adequately capitalized bank or an undercapitalized bank to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized bank as critically undercapitalized).

The FRB and the FDIC may take various corrective actions against any undercapitalized bank and any bank that fails to submit an acceptable capital restoration plan or fails to implement a plan accepted by the FRB or the FDIC. These powers include, but are not limited to, requiring the institution to be recapitalized, prohibiting asset

 

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growth, restricting interest rates paid, requiring prior approval of capital distributions by any bank holding company that controls the institution, requiring divestiture by the institution of its subsidiaries or by the holding company of the institution itself, requiring a new election of directors, and requiring the dismissal of directors and officers.

The aggregate liability of the holding company of an undercapitalized bank is limited to the lesser of 5% of the institution’s assets at the time it became undercapitalized or the amount necessary to cause the institution to be “adequately capitalized.” The bank regulators have greater power in situations where an institution becomes “significantly” or “critically” undercapitalized or fails to submit a capital restoration plan. For example, a bank holding company controlling such an institution can be required to obtain prior FRB approval of proposed dividends, or might be required to consent to a consolidation or to divest the troubled institution or other affiliates.

Brokered Deposit Restrictions. Adequately capitalized institutions (as defined for purposes of the prompt corrective action rules described above) cannot accept, renew or roll over brokered deposits except with a waiver from the FDIC, and are subject to restrictions on the interest rates that can be paid on such deposits. Undercapitalized institutions may not accept, renew, or roll over brokered deposits.

Payment of Dividends. SNBV is a legal entity separate and distinct from Sonabank. The principal sources of SNBV’s cash flow, including cash flow to pay dividends to its stockholders, are dividends that Sonabank pays to its sole shareholder, SNBV. Statutory and regulatory limitations apply to Sonabank’s payment of dividends to us as well as to SNBV’s payment of dividends to its stockholders.

The policy of the FRB that a bank holding company should serve as a source of strength to its subsidiary banks also results in the position of the FRB that a bank holding company should not maintain a level of cash dividends to its stockholders that places undue pressure on the capital of its bank subsidiary or that can be funded only through additional borrowings or other arrangements that may undermine the bank holding company’s ability to serve as a source of strength. Sonabank has no present plans to pay dividends to SNBV.

Under federal law, the Bank cannot pay a dividend if, after paying the dividend, the bank will be “undercapitalized.” The bank regulatory agencies may declare a dividend payment to be unsafe and unsound even though the Bank would continue to meet its capital requirements after the dividend.

The ability of SNBV to pay dividends is also subject to the provisions of Virginia law. The payment of dividends by SNBV and Sonabank may also be affected by other factors, such as the requirement to maintain adequate capital above regulatory guidelines. The federal banking agencies have indicated that paying dividends that deplete a depository institution’s capital base to an inadequate level would be an unsafe and unsound banking practice. Under the Federal Deposit Insurance Corporation Improvement Act of 1991, a depository institution may not pay any dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the federal agencies have issued policy statements that provide that bank holding companies and insured banks should generally only pay dividends out of current operating earnings.

In the event of a bank holding company’s bankruptcy under Chapter 11 of the U.S. Bankruptcy Code, the trustee will be deemed to have assumed and to cure immediately any deficit under any commitment by the debtor holding company to any of the federal banking agencies to maintain the capital of an insured depository institution. Any claim for breach of such obligation will generally have priority over most other unsecured claims.

Because we are a legal entity separate and distinct from our subsidiary Sonabank, our right to participate in the distribution of assets of any subsidiary upon the subsidiary’s liquidation or reorganization will be subject to the prior claims of the subsidiary’s creditors. In the event of a liquidation or other resolution of an insured depository institution, the claims of depositors and other general or subordinated creditors are entitled to a

 

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priority of payment over the claims of holders of any obligation of the institution to its shareholders, arising as a result of their status as shareholders, including any depository institution holding company (such as us) or any shareholder or creditor thereof.

Privacy. Under the GLBA, financial institutions are required to disclose their policies for collecting and protecting confidential information. Customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under narrow circumstances, such as the processing of transactions requested by the consumer or when the financial institution is jointly sponsoring a product or service with a nonaffiliated third party. Additionally, financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers. Sonabank has established policies and procedures to assure our compliance with all privacy provisions of the GLBA.

Consumer Credit Reporting. On December 4, 2003, President Bush signed the Fair and Accurate Credit Transactions Act amending the federal Fair Credit Reporting Act. These amendments to the Fair Credit Reporting Act (the “FCRA Amendments”) became effective in 2004.

The FCRA Amendments include, among other things:

 

   

requirements for financial institutions to develop policies and procedures to identify potential identity theft and, upon the request of a consumer, place a fraud alert in the consumer’s credit file stating that the consumer may be the victim of identity theft or other fraud;

 

   

consumer notice requirements for lenders that use consumer report information in connection with risk-based credit pricing programs;

 

   

for entities that furnish information to consumer reporting agencies (which would include Sonabank), requirements to implement procedures and policies regarding the accuracy and integrity of the furnished information and regarding the correction of previously furnished information that is later determined to be inaccurate; and

 

   

a requirement for mortgage lenders to disclose credit scores to consumers.

The FCRA Amendments also prohibit a business that receives consumer information from an affiliate from using that information for marketing purposes unless the consumer is first provided a notice and an opportunity to direct the business not to use the information for such marketing purposes (the opt-out), subject to certain exceptions. We do not share consumer information among our affiliated companies for marketing purposes, except as allowed under exceptions to the notice and opt-out requirements. Because no affiliate of SNBV is currently sharing consumer information with any other affiliate for marketing purposes, the limitations on sharing of information for marketing purposes do not have a significant impact on us.

Audit Reports. Insured institutions with total assets of $500 million or more must submit annual audit reports prepared by independent auditors to federal and state regulators. In some instances, the audit report of the institution’s holding company can be used to satisfy this requirement. Auditors must receive examination reports, supervisory agreements and reports of enforcement actions. For institutions with total assets of $1 billion or more, financial statements prepared in accordance with generally accepted accounting principles, management’s certifications concerning responsibility for the financial statements, internal controls and compliance with legal requirements designated by the FDIC, and an attestation by the auditor regarding the statements of management relating to the internal controls must be submitted. For institutions with total assets of more than $3 billion, independent auditors may be required to review quarterly financial statements. FDICIA requires that independent audit committees be formed, consisting of outside directors only. The committees of such institutions must include members with experience in banking or financial management, must have access to outside counsel, and must not include representatives of large customers.

 

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Anti-Terrorism and Money Laundering Legislation. Sonabank is subject to the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism of 2001 (the “USA PATRIOT Act”), the Bank Secrecy Act and rules and regulations of the Office of Foreign Assets Control (the “OFAC”). These statutes and related rules and regulations impose requirements and limitations on specific financial transactions and account relationships intended to guard against money laundering and terrorism financing. Sonabank has established a customer identification program under Section 326 of the USA PATRIOT Act and the Bank Secrecy Act, and otherwise has implemented policies and procedures intended to comply with the foregoing rules.

Virginia Law. Certain state corporation laws may have an anti-takeover affect. Virginia law restricts transactions between a Virginia corporation and its affiliates and potential acquirers. The following discussion summarizes the two Virginia statutes that may discourage an attempt to acquire control of SNBV.

Virginia Code Sections 13.1-725 – 727.1 govern “Affiliated Transactions.” These provisions, with several exceptions discussed below, require approval by the holders of at least two-thirds of the remaining voting shares of material acquisition transactions between a Virginia corporation and any holder of more than 10% of any class of its outstanding voting shares. Affiliated Transactions include mergers, share exchanges, material dispositions of corporate assets not in the ordinary course of business, any dissolution of the corporation proposed by or on behalf of an interested shareholder, or any reclassification, including a reverse stock split, recapitalization, or merger of the corporation with its subsidiaries which increases the percentage of voting shares owned beneficially by any 10% shareholder by more than 5%.

For three years following the time that a shareholder becomes an owner of 10% of the outstanding voting shares, a Virginia corporation cannot engage in an Affiliated Transaction with that shareholder without approval of two-thirds of the voting shares other than those shares beneficially owned by that shareholder, and majority approval of the disinterested directors. A disinterested director is a member of the company’s board of directors who was (i) a member on the date the shareholder acquired more than 10%, and (ii) recommended for election by, or was elected to fill a vacancy and received the affirmative vote of, a majority of the disinterested directors then on the board. At the expiration of the three-year period, the statute requires approval of Affiliated Transactions by two-thirds of the voting shares other than those beneficially owned by the 10% shareholder.

The principal exceptions to the special voting requirement apply to transactions proposed after the three-year period has expired and require either that the transaction be approved by a majority of the corporation’s disinterested directors or that the transaction satisfies the fair-price requirement of the statute. In general, the fair-price requirement provides that in a two-step acquisition transaction, the 10% shareholder must pay the shareholders in the second step either the same amount of cash or the same amount and type of consideration paid to acquire the Virginia corporation’s shares in the first step.

None of the foregoing limitations and special voting requirements applies to a transaction with any 10% shareholder whose acquisition of shares taking him or her over 10% was approved by a majority of the corporation’s disinterested directors.

These provisions were designed to deter certain takeovers of Virginia corporations. In addition, the statute provides that, by affirmative vote of a majority of the voting shares other than shares owned by any 10% shareholder, a corporation can adopt an amendment to its articles of incorporation or bylaws providing that the Affiliated Transactions provisions shall not apply to the corporation. SNBV “opted out” of the Affiliated Transactions provisions when it incorporated.

Virginia law also provides that shares acquired in a transaction that would cause the acquiring person’s voting strength to meet or exceed any of the three thresholds (20%, 33   1 /3% or 50%) have no voting rights for those shares exceeding that threshold, unless granted by a majority vote of shares not owned by the acquiring person. This provision empowers an acquiring person to require the Virginia corporation to hold a special meeting of shareholders to consider the matter within 50 days of the request. SNBV also “opted out” of this provision at the time of its incorporation.

 

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Federal Reserve Monetary Policy. The Bank will be directly affected by government monetary and fiscal policy and by regulatory measures affecting the banking industry and the economy in general. The actions of the FRB as the nation’s central bank can directly affect the money supply and, in general, affect the lending activities of banks by increasing or decreasing the cost and availability of funds. An important function of the FRB is to regulate the national supply of bank credit. Among the instruments of monetary policy used by the FRB to implement this objective are open market operations in United States government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against bank deposits. These means are used in varying combinations to influence overall growth of bank loans, investments and deposits, and interest rates charged on loans or paid on deposits. The monetary policies of the FRB have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future.

Reserve Requirements. In 1980, Congress enacted legislation that imposed reserve requirements on all depository institutions that maintain transaction accounts or nonpersonal time deposits. NOW accounts, money market deposit accounts and other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to these reserve requirements, as are any nonpersonal time deposits at an institution. For net transaction accounts in 2010, the first $10.7 million will be exempt from reserve requirements. A 3.0% reserve ratio will be assessed on net transaction accounts over $10.7 million to and including $55.2 million. A 10.0% reserve ratio will be applied to net transaction accounts in excess of $55.2 million. These percentages are subject to adjustment by the FRB.

Transactions with Affiliates. Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any bank or entity that controls, is controlled by or is under common control with such bank. Generally, Sections 23A and 23B (i) limit the extent to which the bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such institution’s capital stock and surplus, and maintain an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital stock and surplus, and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the bank as those provided to a nonaffiliate. The term “covered transaction” includes the making of loans, purchase of assets, issuance of a guarantee and similar other types of transactions. Section 23B applies to “covered transactions” as well as sales of assets and payments of money to an affiliate. These transactions must also be conducted on terms substantially the same, or at least favorable, to the bank as those provided to nonaffiliates.

Loans to Insiders. The Federal Reserve Act and related regulations impose specific restrictions on loans to directors, executive officers and principal shareholders of banks. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a principal shareholder of a bank, and to entities controlled by any of the foregoing, may not exceed, together with all other outstanding loans to such person and entities controlled by such person, the bank’s loan-to-one borrower limit. Loans in the aggregate to insiders and their related interests as a class may not exceed two times the bank’s unimpaired capital and unimpaired surplus until the bank’s total assets equal or exceed $100 million, at which time the aggregate is limited to the bank’s unimpaired capital and unimpaired surplus. Section 22(h) also prohibits loans, above amounts prescribed by the appropriate federal banking agency, to directors, executive officers and principal shareholders of a bank or bank holding company, and to entities controlled by such persons, unless such loan is approved in advance by a majority of the board of directors of the bank with any “interested” director not participating in the voting. The FDIC has prescribed the loan amount, which includes all other outstanding loans to such person, as to which such prior board of director approval is required, as being the greater of $25,000.00 or 5.0% of capital and surplus (up to $500,000.00). Section 22(h) requires that loans to directors, executive officers and principal shareholders be made on terms and underwriting standards substantially the same as offered in comparable transactions to other persons. Further, Section 402 of the Sarbanes-Oxley Act of 2002, with certain exceptions, prohibits loans to directors and executive officers.

Community Reinvestment Act. Under the Community Reinvestment Act and related regulations, depository institutions have an affirmative obligation to assist in meeting the credit needs of their market areas, including low and moderate-income areas, consistent with safe and sound banking practice. The Community

 

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Reinvestment Act requires the adoption by each institution of a Community Reinvestment Act statement for each of its market areas describing the depository institution’s efforts to assist in its community’s credit needs. Depository institutions are periodically examined for compliance with the Community Reinvestment Act and are periodically assigned ratings in this regard. Banking regulators consider a depository institution’s Community Reinvestment Act rating when reviewing applications to establish new branches, undertake new lines of business, and/or acquire part or all of another depository institution. An unsatisfactory rating can significantly delay or even prohibit regulatory approval of a proposed transaction by a bank holding company or its depository institution subsidiaries.

The GLBA and federal bank regulators have made various changes to the Community Reinvestment Act. Among other changes, Community Reinvestment Act agreements with private parties must be disclosed and annual reports must be made to a bank’s primary federal regulatory. A bank holding company will not be permitted to become a financial holding company and no new activities authorized under the GLBA may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a “satisfactory” rating in its latest Community Reinvestment Act examination. The Bank received a “satisfactory” rating in the most recent examination for Community Reinvestment Act compliances in October 2007.

Fair Lending; Consumer Laws. In addition to the Community Reinvestment Act, other federal and state laws regulate various lending and consumer aspects of the banking business. Governmental agencies, including the Department of Housing and Urban Development, the Federal Trade Commission and the Department of Justice, have become concerned that prospective borrowers experience discrimination in their efforts to obtain loans from depository and other lending institutions. These agencies have brought litigation against depository institutions alleging discrimination against borrowers. Many of these suits have been settled, in some cases for material sums, short of a full trial.

Recently, these governmental agencies have clarified what they consider to be lending discrimination and have specified various factors that they will use to determine the existence of lending discrimination under the Equal Credit Opportunity Act and the Fair Housing Act, including evidence that a lender discriminated on a prohibited basis, evidence that a lender treated applicants differently based on prohibited factors in the absence of evidence that the treatment was the result of prejudice or a conscious intention to discriminate, and evidence that a lender applied an otherwise neutral non-discriminatory policy uniformly to all applicants, but the practice had a discriminatory effect, unless the practice could be justified as a business necessity.

Banks and other depository institutions also are subject to numerous consumer-oriented laws and regulations. These laws, which include the Truth in Lending Act, the Truth in Savings Act, the Real Estate Settlement Procedures Act, the Electronic Funds Transfer Act, the Equal Credit Opportunity Act, and the Fair Housing Act, require compliance by depository institutions with various disclosure requirements and requirements regulating the availability of funds after deposit or the making of some loans to customers.

The foregoing is only a brief summary of certain statutes, rules, and regulations that may affect SNBV and the Bank. Numerous other statutes and regulations also will have an impact on the operations of SNBV and the Bank. Supervision, regulation and examination of banks by the regulatory agencies are intended primarily for the protection of depositors, not shareholders.

Future Regulatory Uncertainty. Because federal regulation of financial institutions changes regularly and is the subject of constant legislative debate, we cannot forecast how federal regulation of financial institutions may change in the future and impact our operations. SNBV fully expects that the financial institution industry will remain heavily regulated in the near future and that additional laws or regulations may be adopted further regulating specific banking practices.

 

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Legislative Initiatives. In light of current conditions and the market outlook for continuing weak economic conditions, regulators have increased their focus on the regulation of financial institutions. A number of government initiatives designed to respond to the current conditions have been introduced recently and proposals for legislation that could substantially intensify the regulation of financial institutions are expected to be introduced in Congress and State Legislatures. Such initiatives may change banking statutes and the operating environment for us and Sonabank in substantial and unpredictable ways. We cannot determine the ultimate effect that any potential legislation, if enacted, or implementing regulations with respect thereto, would have, upon the financial condition or results of our operations or the operations of Sonabank. A change in statutes, regulations or regulatory policies applicable to us or Sonabank could have a material effect on the financial condition, results of operations or business of our company and Sonabank.

In June 2009, the U.S. President’s administration proposed a wide range of regulatory reforms that, if enacted, may have significant effects on the financial services industry in the United States. Significant aspects of the administration’s proposals that may affect us included, among other things, proposals: (i) to reassess and increase capital requirements for banks and bank holding companies and examine the types of instruments that qualify as regulatory capital; (ii) to expand the current eligibility requirements for financial holding companies such as us so that the financial holding company must be “well capitalized” and “well managed” on a consolidated basis; (iii) to create a federal consumer financial protection agency to be the primary federal consumer protection supervisor with broad examination, supervision and enforcement authority with respect to consumer financial products and services; and (iv) to further limit the ability of banks to engage transactions with affiliates.

Separate comprehensive financial reform bills intended to address the proposals set forth by the administration were introduced in both houses of Congress in the second half of 2009 and remain under review by both the U.S. House of Representatives and the U.S. Senate. We cannot predict whether or in what form further legislation or regulations may be adopted or the extent to which we may be affected thereby.

On October 22, 2009, the FRB issued a comprehensive proposal on incentive compensation policies (the “Incentive Compensation Proposal”) intended to ensure that the incentive compensation policies of banking organizations do not undermine the safety and soundness of such organizations by encouraging excessive risk-taking. The Incentive Compensation Proposal, which covers all employees that have the ability to materially affect the risk profile of an organization, either individually or as part of a group, is based upon the key principles that a banking organization’s incentive compensation arrangements should (i) provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks, (ii) be compatible with effective internal controls and risk management, and (iii) be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors. Banking organizations are instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-taking and implement corrective programs as needed. Where there are deficiencies in the incentive compensation arrangements, they must be immediately addressed.

The FRB will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations, such as us, that are not “large, complex banking organizations.” These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements. The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, which can affect the organization’s ability to make acquisitions and take other actions. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

The scope and content of the U.S. banking regulators’ policies on executive compensation are continuing to develop and are likely to continue evolving in the near future. It cannot be determined at this time whether compliance with such policies will adversely affect our ability to hire, retain and motivate our key employees.

 

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Item 1A. Risk Factors

We have a limited operating history, which makes it difficult to predict future prospects and financial performance.

We have only been operating as a bank holding company since April of 2005. Due to this limited operating history, it may be difficult to evaluate our business prospects and future financial performance. There can be no assurance that we can maintain our profitability. Further, our future operating results depend upon a number of factors, including our ability to manage our growth, retain our customer base and to successfully identify and respond to emerging trends in our market areas.

Difficult market conditions and economic trends have adversely affected the banking industry and could adversely affect our business, financial condition and results of operations.

We are operating in a challenging and uncertain economic environment, including generally uncertain conditions nationally and locally in our markets. Financial institutions continue to be affected by declines in the real estate market that have negatively impacted the credit performance of mortgage, construction and commercial real estate loans and resulted in significant write-downs of assets by many financial institutions. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. We retain direct exposure to the residential and commercial real estate markets, and we are affected by these events. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse affect on our borrowers and/or their customers, which could adversely affect our business, financial condition and results of operations.

Our ability to assess the creditworthiness of customers and to estimate the losses inherent in our credit portfolio is made more complex by these difficult market and economic conditions. We also expect to face increased regulation and government oversight as a result of these downward trends. This increased government action may increase our costs and limit our ability to pursue certain business opportunities. In addition, we may be required to pay even higher FDIC deposit insurance premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions and other factors have significantly depleted and may continue to deplete the Deposit Insurance Fund and reduce its ratio of reserves to insured deposits.

A prolonged national economic recession or further deterioration of these conditions in our markets could drive losses beyond that which is provided for in our allowance for loan losses and result in the following consequences:

 

   

increases in loan delinquencies;

 

   

increases in nonperforming assets and foreclosures;

 

   

decreases in demand for our products and services, which could adversely affect our liquidity position; and

 

   

decreases in the value of the collateral securing our loans, especially real estate, which could reduce customers’ borrowing power.

We do not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult economic conditions on us, our customers and the other financial institutions in our market. As a result, we may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.

The U.S Treasury and the FDIC have initiated programs to address economic stabilization, yet the efficacy of these programs in stabilizing the economy and the banking system at large are uncertain.

 

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Liquidity risk could impair our ability to fund operations and jeopardize our financial condition, results of operations and cash flows.

Liquidity is essential to our business. Our ability to implement our business strategy will depend on our ability to obtain funding for loan originations, working capital, possible acquisitions and other general corporate purposes. An inability to raise funds through deposits, borrowings, securities sold under repurchase agreements, the sale of loans and other sources could have a substantial negative effect on our liquidity. We do not anticipate that our retail and commercial deposits will be sufficient to meet our funding needs in the foreseeable future. We therefore rely on deposits obtained through intermediaries, FHLB advances, securities sold under agreements to repurchase and other wholesale funding sources to obtain the funds necessary to implement our growth strategy.

Our access to funding sources in amounts adequate to finance our activities or on terms which are acceptable to us could be impaired by factors that affect us specifically or the financial services industry or economy in general, including a decrease in the level of our business activity as a result of a downturn in the markets in which our loans are concentrated or adverse regulatory action against us. Our ability to borrow could also be impaired by factors that are not specific to us, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets. To the extent we are not successful in obtaining such funding, we will be unable to implement our strategy as planned which could have a material adverse effect on our financial condition, results of operations and cash flows.

Sonabank’s reliance on brokered deposits could adversely affect its liquidity and results of operations.

Among other sources of funds, Sonabank relies on brokered deposits to provide funds with which to make loans and provide for its other liquidity needs. Like many community banks, Sonabank’s loan demand has exceeded the rate at which it has been able to increase its deposits, and, as a result, Sonabank has relied on brokered deposits as a source of funds. As of December 31, 2009, brokered deposits, which include brokered certificates of deposit and brokered money market deposits, amounted to $97.0 million, or approximately 21.3% of total deposits, a decrease of $48.3 million, or 33.2%, compared with brokered certificates of deposit and brokered money market deposits of $145.3 million at December 31, 2008. Generally, brokered deposits may not be as stable as other types of deposits, and, in the future, those depositors may not renew their deposits when they mature, or Sonabank may have to pay a higher rate of interest to keep those deposits or to replace them with other deposits or with funds from other sources. Additionally, if Sonabank ceases to be “well capitalized” for bank regulatory purposes, it will not be able to accept, renew or rollover brokered deposits without a waiver from the FDIC. As of December 31, 2009, Sonabank is categorized as well-capitalized with total risk-based capital, Tier 1 risk-based capital and leverage ratios of 17.66%, 16.63% and 16.68%, respectively. An inability to maintain or replace these brokered deposits as they mature could adversely affect Sonabank’s liquidity. Further, paying higher interest rates to maintain or replace these deposits could adversely affect Sonabank’s net interest margin and its results of operations.

Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance and capital.

We maintain an investment portfolio that includes, but is not limited to, collateralized mortgage obligations, agency mortgage-backed securities and pooled trust preferred securities. The market value of investments in our portfolio has become increasingly volatile over the past two years. The market value of investments may be affected by factors other than the underlying performance of the issuer or composition of the bonds themselves, such as ratings downgrades, adverse changes in the business climate and a lack of liquidity for resales of certain investment securities. We periodically, but not less than quarterly, evaluate investments and other assets for impairment indicators. We may be required to record additional impairment charges if our investments suffer a decline in value that is considered other-than-temporary. For the year ended December 31, 2008, we incurred other-than-temporary impairment charges of $1.5 million pre-tax on our holding of Freddie Mac perpetual preferred stock. During the year ended December 31, 2009, we incurred other-than-temporary impairment charge

 

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of $7.7 million pre-tax on seven of our trust preferred securities holdings and one collateralized mortgage obligation. If in future periods we determine that a significant impairment has occurred, we would be required to charge against earnings the credit-related portion of the other-than-temporary impairment, which could have a material adverse effect on our results of operations in the periods in which the write-offs occur.

Our pooled trust preferred securities are particularly vulnerable to the performance of the issuer of the subordinated debentures that are collateral for the trust preferred securities. Deterioration of these trust preferred securities can occur because of defaults by the issuer of the collateral or because of deferrals of dividend payments on the securities. Numerous financial institutions have failed and their parent bank holding companies have filed for bankruptcy, which has led to defaults in the subordinated debentures that collateralize the trust preferred securities. Further, increased regulatory pressure has been placed on financial institutions to maintain capital ratios above the required minimum to be well-capitalized, which often results in restrictions on dividends, and leads to deferrals of dividend payments on the trust preferred securities. More specifically, the Federal Reserve has stated that a bank holding company should eliminate, defer or significantly reduce dividends if (i) its net income available to shareholders for the past four quarters, net of dividends paid, is not sufficient to fully fund the dividends, (ii) its prospective rate of earnings retention is not consistent with its capital needs or (iii) it is in danger of not meeting its minimum regulatory capital adequacy ratios. Additional defaults in the underlying collateral or deferrals of dividend payments for these securities could lead to additional charges on these securities and/or other-than-temporary impairment charges on other trust preferred securities we own.

The failure of other financial institutions could adversely affect us.

In addition to the risk to our pooled trust preferred securities discussed above, our ability to engage in routine funding transactions could be adversely affected by the actions and potential failures of other financial institutions. Financial institutions are interrelated as a result of trading, clearing, counterparty and other relationships. We have exposure to many different industries and counterparties, and we routinely execute transactions with a variety of counterparties in the financial services industry. As a result, defaults by, or even rumors or concerns about, one or more financial institutions with whom we do business, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral we hold cannot be sold at prices that are sufficient for us to recover the full amount of our exposure. Any such losses could materially and adversely affect our financial condition and results of operations.

If the goodwill that we recorded in connection with business acquisitions becomes impaired, it could have a negative impact on our profitability.

Goodwill represents the amount of acquisition cost over the fair value of net assets we acquired in the purchase of another entity. We review goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate the carrying value of the asset might be impaired. Examples of those events or circumstances include the following:

 

   

significant adverse changes in business climate;

 

   

significant changes in credit quality;

 

   

significant unanticipated loss of customers;

 

   

significant loss of deposits or loans; or

 

   

significant reductions in profitability.

We determine impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments

 

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are reflected in our results of operations in the periods in which they become known. As of December 31, 2009, our goodwill totaled $8.7 million. While we have recorded no such impairment charges since we initially recorded the goodwill, there can be no assurance that our future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on our financial condition and results of operations.

A significant amount of our loans are secured by real estate and the continued economic slowdown and depressed residential real estate market in our primary markets could be detrimental to our financial condition and results of operations.

Real estate lending (including commercial, construction, land development, and residential loans) is a large portion of our loan portfolio, constituting $384.4 million, or approximately 83.1% of our total loan portfolio, as of December 31, 2009. Total real estate loans covered under the FDIC loss sharing agreement amount to $107.8 million. The residential and commercial real estate sectors of the U.S. economy experienced an economic slowdown that has continued in 2009. Specifically, the values of residential and commercial real estate located in our market areas have declined, and these declines may continue in the future. If the loans that are collateralized by real estate become troubled during a time when market conditions are declining or have declined, then we may not be able to realize the full value of the collateral that we anticipated at the time of originating the loan, which could require us to increase our provision for loan losses and adversely affect our financial condition and results of operations.

Current market conditions include an over-supply of land, lots, and finished homes in many markets, including those where we do business. As of December 31, 2009, $158.5 million, or approximately 34.3% of our total loans, were secured by residential real estate. This includes $94.8 million in residential 1-4 family loans, $54.8 million in home equity lines of credit and $8.9 million in construction loans to residential builders. Total residential real estate loans covered under the FDIC loss sharing agreement amount to $81.5 million. If housing markets in our market areas continue to deteriorate, we may experience a further increase in nonperforming loans, provisions for loan losses and charge-offs. While it is difficult to predict how long these conditions will exist and which markets, products or other segments of our loan and securities portfolio might ultimately be affected, these factors could adversely affect our ability to grow our earning assets or affect our results of operations.

If the value of real estate in our market areas were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on our asset quality, capital structure and profitability.

As of December 31, 2009, a significant portion of our loan portfolio was comprised of loans secured by either commercial real estate or single family homes which are under construction. In the majority of these loans, real estate was the primary collateral component. In some cases, and out of an abundance of caution, we take real estate as security for a loan even when it is not the primary component of collateral. The real estate collateral that provides the primary or an alternate source of repayment in the event of default may deteriorate in value during the term of the loan as a result of changes in economic conditions, fluctuations in interest rates and the availability of loans to potential purchasers, changes in tax and other laws and acts of nature. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, which we have seen and continue to experience, our earnings and capital could be adversely affected. We are subject to increased lending risks in the form of loan defaults as a result of the high concentration of real estate lending in our loan portfolio should the real estate market in Virginia and our market area maintain its downward turn. A continued weakening of the real estate market in our primary market areas could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing the loans and the value of real estate owned by us. If real estate values decline further, it is also more likely that we would be required to increase our allowance for loan losses, which could adversely affect our financial condition and results of operations.

 

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We are subject to risks related to our concentration of construction and land development and commercial real estate loans.

As of December 31, 2009, we had $53.8 million of construction loans, of which $5.8 million are covered loans under the FDIC loss sharing agreement. Construction loans are subject to risks during the construction phase that are not present in standard residential real estate and commercial real estate loans. These risks include:

 

   

the viability of the contractor;

 

   

the value of the project being subject to successful completion;

 

   

the contractor’s ability to complete the project, to meet deadlines and time schedules and to stay within cost estimates; and

 

   

concentrations of such loans with a single contractor and its affiliates.

Real estate construction loans may involve the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan and also present risks of default in the event of declines in property values or volatility in the real estate market during the construction phase. Our practice, in the majority of instances, is to secure the personal guaranty of individuals in support of our real estate construction loans which provides us with an additional source of repayment. As of December 31, 2009, we had no non-covered nonperforming construction and development loans and $2.8 million of non-covered assets that have been foreclosed. If one or more of our larger borrowers were to default on their construction and development loans, and we did not have alternative sources of repayment through personal guarantees or other sources, or if any of the aforementioned risks were to occur, we could incur significant losses.

As of December 31, 2009, we had $167.8 million of commercial real estate loans, of which $21.4 million is covered by the FDIC loss sharing agreement. Commercial real estate lending typically involves higher loan principal amounts and the repayment is dependent, in large part, on sufficient income from the properties securing the loan to cover operating expenses and debt service. Federal bank regulatory authorities issued the Interagency Guidance on Concentrations in Commercial Real Estate Lending in December of 2006 to provide guidance regarding significant concentrations of commercial real estate loans within bank loan portfolios. The FDIC reiterated this guidance in a letter to financial institutions dated March 17, 2008 (FIL-22-2008) titled “Managing Commercial Real Estate Concentrations in a Challenging Environment” to remind banks that their risk management practices and capital levels should be commensurate with the level and nature of their commercial real estate concentration risk. Banks with higher levels of commercial real estate loans are expected to implement improved underwriting, internal controls, risk management policies and portfolio stress testing, as well as higher levels of allowances for loan losses and capital levels as a result of commercial real estate lending growth and exposures. Sonabank’s commercial real estate loans are below the thresholds identified as significant by the regulatory guidance. If there is deterioration in our commercial real estate portfolio or if regulatory authorities conclude that we have not implemented appropriate risk management policies and practices, it could adversely affect our business and result in a requirement of increased capital levels, and such capital may not be available at that time.

Changes to government guaranteed loan programs could affect our SBA business.

Sonabank relies on originating, purchasing, pooling and selling government guaranteed loans, in particular those guaranteed by the SBA. As of December 31, 2009, Sonabank had $39.7 million of SBA loans. Sonabank originated $17.7 million, $11.0 million and $19.8 million in SBA loans in the years ended December 31, 2009, 2008 and 2007, respectively. Sonabank sold the guaranteed portions of some of its SBA loans in the secondary market in 2008 and 2009 and intends to continue such sales, which are a source of non-interest income for Sonabank, when market conditions are favorable. We can provide no assurance that Sonabank will be able to continue originating these loans, that it will be able to sell the loans in the secondary market or that it will continue to realize premiums upon any sale of SBA loans.

 

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SBA lending is a federal government created and administered program. As such, legislative and regulatory developments can affect the availability and funding of the program. This dependence on legislative funding and regulatory restrictions from time to time causes limitations and uncertainties with regard to the continued funding of such loans, with a resulting potential adverse financial impact on our business. Currently, the maximum limit on individual 7(a) loans which the SBA will permit is $2.0 million. Any reduction in this level could adversely affect the volume of our business. In addition, the fees associated with SBA loans are currently waived by the government and a decision to reinstate these fees would increase the cost of these loans to our customers. As of December 31, 2009, our SBA business constitutes 8.6% of our total loans. The periodic uncertainty of the SBA program relative to availability, amounts of funding and the waiver of associated fees creates greater risk for our business than do more stable aspects of our business.

The federal government presently guarantees 75% to 90% of the principal amount of each qualifying SBA loan under the 7(a) program. We can provide no assurance that the federal government will maintain the SBA program, or if it does, that such guaranteed portion will remain at its current funding level. Furthermore, it is possible that Sonabank could lose its preferred lender status which, subject to certain limitations, allows it to approve and fund SBA loans without the necessity of having the loan approved in advance by the SBA. It is also possible the federal government could reduce the amount of loans which it guarantees. In addition, we are dependent on the expertise of our personnel who make SBA loans in order to continue to originate and service SBA loans. If we are unable to retain qualified employees in the future, or if there are climbs in interest rates in the future, our income from the origination, sale and servicing of SBA loans could be substantially reduced.

Because we began operations in 2005, there is limited repayment history against which we can fully assess the adequacy of our allowance for loan losses. If our allowance for loan losses is not adequate to cover actual loan losses, our earnings will decrease.

There is limited repayment history against which we can fully assess the adequacy of our allowance for loan losses. As a lender, we are exposed to the risk that our loan clients may not repay their loans according to the terms of these loans, and the collateral securing the payment of these loans may be insufficient to assure repayment. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of the borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We maintain an allowance for loan losses to cover any probable incurred loan losses in the loan portfolio. In determining the size of the allowance, we rely on a periodic analysis of our loan portfolio, our historical loss experience and our evaluation of general economic conditions. If our assumptions prove to be incorrect or if we experience significant loan losses, our current allowance may not be sufficient to cover actual loan losses and adjustments may be necessary to allow for different economic conditions or adverse developments in our loan portfolio. A material addition to the allowance for loan losses could cause our earnings to decrease. Due to the relatively unseasoned nature of our loan portfolio, we cannot assure you that we will not experience an increase in delinquencies and losses as these loans continue to mature.

In addition, federal regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further charge-offs, based on judgments different than those of our management. Any significant increase in our allowance for loan losses or charge-offs required by these regulatory agencies could have a material adverse effect on our results of operations and financial condition.

Our business strategy includes strategic growth, and our financial condition and results of operations could be negatively affected if we fail to grow or fail to manage our growth effectively.

We completed the acquisition and assumption of certain assets and liabilities of Greater Atlantic Bank from the FDIC on December 4, 2009, the acquisition of a branch of Millennium Bank in Warrenton, Virginia on September 28, 2009, the acquisition of the Leesburg branch location from Founders Corporation which opened on February 11, 2008, the acquisition of 1st Service Bank in December of 2006 and the acquisition of the Clifton Forge branch of First Community Bancorp, Inc. in December of 2005. We intend to continue pursuing a growth

 

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strategy for our business. Our prospects must be considered in light of the risks, expenses and difficulties frequently encountered by growing companies such as the continuing need for infrastructure and personnel, the time and costs inherent in integrating a series of different operations and the ongoing expense of acquiring and staffing new banks or branches. We may not be able to expand our presence in our existing markets or successfully enter new markets and any expansion could adversely affect our results of operations. Failure to manage our growth effectively could have a material adverse effect on our business, future prospects, financial condition or results of operations, and could adversely affect our ability to successfully implement our business strategy. Our ability to grow successfully will depend on a variety of factors, including the continued availability of desirable business opportunities, the competitive responses from other financial institutions in our market areas and our ability to manage our growth. There can be no assurance of success or the availability of branch or bank acquisitions in the future.

Future growth or operating results may require us to raise additional capital, but that capital may not be available or it may be dilutive.

We and Sonabank are each required by the Federal Reserve to maintain adequate levels of capital to support our operations. In the event that our future operating results erode capital, if Sonabank is required to maintain capital in excess of well-capitalized standards, or if we elect to expand through loan growth or acquisitions, we may be required to raise additional capital. Our ability to raise capital will depend on conditions in the capital markets, which are outside our control, and on our financial performance. Accordingly, we cannot be assured of our ability to raise capital on favorable terms when needed, or at all. If we cannot raise additional capital when needed, we will be subject to increased regulatory supervision and the imposition of restrictions on our growth and business. These outcomes could negatively impact our ability to operate or further expand our operations through acquisitions or the establishment of additional branches and may result in increases in operating expenses and reductions in revenues that could have a material adverse effect on our financial condition and results of operations. In addition, in order to raise additional capital, we may need to issue shares of our common stock that would dilute the book value of our common stock and reduce our current shareholders’ percentage ownership interest to the extent they do not participate in future offerings.

Our business is subject to interest rate risk and variations in interest rates may negatively affect our financial performance.

The majority of our assets and liabilities are monetary in nature and subject us to significant risk from changes in interest rates. Fluctuations in interest rates are not predictable or controllable. Like most financial institutions, changes in interest rates can impact our net interest income as well as the valuation of our assets and liabilities, which is the difference between interest earned from interest-earning assets, such as loans and investment securities, and interest paid on interest-bearing liabilities, such as deposits and borrowings. We expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities, meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets, or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” will negatively impact our earnings. Many factors impact interest rates, including governmental monetary policies, inflation, recession, changes in unemployment, the money supply, and international disorder and instability in domestic and foreign financial markets.

Based on our analysis of the interest rate sensitivity of our assets, an increase in the general level of interest rates may negatively affect the market value of the portfolio equity, but will positively affect our net interest income since most of our assets have floating rates of interest that adjust fairly quickly to changes in market rates of interest. Additionally, an increase in interest rates may, among other things, reduce the demand for loans and our ability to originate loans. A decrease in the general level of interest rates may affect us through, among other things, increased prepayments on our loan and mortgage-backed securities portfolios and increased competition for deposits. Accordingly, changes in the level of market interest rates affect our net yield on interest-earning assets, loan origination volume, loan and mortgage-backed securities portfolios, and our overall results. Although

 

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our asset liability management strategy is designed to control our risk from changes in market interest rates, it may not be able to prevent changes in interest rates from having a material adverse effect on our results of operations and financial condition.

We may be required to pay significantly higher FDIC deposit insurance premiums and assessments in the future.

Recent insured depository institution failures, as well as deterioration in banking and economic conditions, have significantly depleted the FDIC’s Deposit Insurance Fund, resulting in a decline in the ratio of reserves to insured deposits to historical lows. The FDIC anticipates that additional insured depository institutions are likely to fail in the foreseeable future so the reserve ratio may continue to decline. In addition, the deposit insurance limit on FDIC deposit insurance coverage generally has increased to $250,000 through December 31, 2013. These developments will cause the premiums assessed on us by the FDIC to increase and materially increase our noninterest expense.

On December 16, 2008, the FDIC Board of Directors determined deposit insurance assessment rates for the first quarter of 2009 at 12 to 14 basis points per $100 of deposits. Beginning April 1, 2009, the rates increased to 12 to 16 basis points per $100 of deposits. Additionally, on May 22, 2009, the FDIC announced a final rule imposing a special emergency assessment as of June 30, 2009, payable September 30, 2009, based on $0.05 for each $100 of assets, less Tier 1 capital, as of June 30, 2009, but the amount of the assessment is capped at 10 basis points of domestic deposits. We paid a special assessment of $190,000.

On November 17, 2009, the FDIC adopted a final rule that required insured institutions to prepay their estimated quarterly risk-based assessments for the fourth quarter of 2009 and for all of 2010, 2011 and 2012, at the same time that institutions paid their regular quarterly deposit insurance assessments for the third quarter of 2009. Under the final rule, the FDIC is to maintain assessment rates at their current levels through the end of 2010 and assessment rates will be increased by an annualized 3 basis points effective January 1, 2011. Each institution recorded the entire amount of its prepaid assessment as a prepaid expense (a non-earning asset) as of December 30, 2009, the date the payment was made. As of December 31, 2009, and each quarter thereafter, each institution records an expense (charge to earnings) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. Once the asset is exhausted, the institution would resume paying and accounting for quarterly deposit insurance assessments as currently done. The institutions would record an accrued expense payable each quarter for the assessment payment, which would be made to the FDIC at the end of the following quarter. These higher FDIC assessment rates and special assessments will have an adverse impact on our results of operations. Our FDIC insurance related costs were $755 thousand for the year ended December 31, 2009 compared with $211 thousand and $140 thousand for the years ended December 31, 2008 and 2007, respectively. We are unable to predict the impact in future periods; including whether and when additional special assessments will occur, in the event the economic crisis continues.

A loss of our executive officers could impair our relationship with our customers and adversely affect our business.

Many community banks attract customers based on the personal relationships that the banks’ officers and customers establish with each other and the confidence that the customers have in the officers. As a relatively new enterprise, we depend on the performance of Ms. Georgia S. Derrico, chairman and chief executive officer, and R. Roderick Porter, president, of our company and Sonabank. Ms. Derrico is a well-known banker in our market areas, having operated a successful financial institution there for more than 18 years prior to founding our company and Sonabank. We do not have an employment agreement with either individual. The loss of the services of either of these officers or their failure to perform management functions in the manner anticipated by our board of directors could have a material adverse effect on our business. Our success will be dependent upon the board’s ability to attract and retain quality personnel, including these officers. We have attempted to reduce our risk by entering into a change in control agreement that includes a non-competition covenant with Ms. Derrico and Mr. Porter.

 

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Our profitability depends significantly on local economic conditions in the areas where our operations and loans are concentrated.

Our profitability depends on the general economic conditions in our market areas of Northern Virginia, Maryland, Washington D.C., Charlottesville and Clifton Forge (Alleghany County), Front Royal, New Market and the surrounding areas. Unlike larger banks that are more geographically diversified, we provide banking and financial services to clients primarily in our market areas. As of December 31, 2009, substantially all of our commercial real estate, real estate construction and residential real estate loans were made to borrowers in our market area. The local economic conditions in this area have a significant impact on our commercial, real estate and construction and consumer loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. In addition, if the population or income growth in this region slows, stops or declines, income levels, deposits and housing starts could be adversely affected and could result in the curtailment of our expansion, growth and profitability. Recently, economic conditions in our market area have declined and if this continues for a prolonged period of time, we would likely experience significant increases in nonperforming loans, which could lead to operating losses, impaired liquidity and eroding capital.

Additionally, political conditions could impact our earnings. Acts or threats of war, terrorism, an outbreak of hostilities or other international or domestic calamities, or other factors beyond our control could impact these local economic conditions and could negatively affect the financial results of our banking operations.

The properties that we own and our foreclosed real estate assets could subject us to environmental risks and associated costs.

There is a risk that hazardous substances or wastes, contaminants, pollutants or other environmentally restricted substances could be discovered on our properties or our foreclosed assets (particularly in the case of real estate loans). In this event, we might be required to remove the substances from the affected properties or to engage in abatement procedures at our sole cost and expense. Besides being liable under applicable federal and state statutes for our own conduct, we may also be held liable under certain circumstances for actions of borrowers or other third parties on property that collateralizes one or more of our loans or on property that we own. Potential environmental liability could include the cost of remediation and also damages for any injuries caused to third-parties. We cannot assure you that the cost of removal or abatement will not substantially exceed the value of the affected properties or the loans secured by those properties, that we would have adequate remedies against prior owners or other responsible parties or that we would be able to resell the affected properties either prior to or following completion of any such removal or abatement procedures. If material environmental problems are discovered prior to foreclosure, we generally will not foreclose on the related collateral or will transfer ownership of the loan to a subsidiary. It should be noted, however, that the transfer of the property or loans to a subsidiary may not protect us from environmental liability. Furthermore, despite these actions on our part, the value of the property as collateral will generally be substantially reduced and, as a result, we may suffer a loss upon collection of the loan.

The small to medium-sized businesses we lend to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to us that could materially harm our operating results.

We make loans to professional firms and privately owned businesses that are considered to be small to medium-sized businesses. Small to medium-sized businesses frequently have smaller market shares than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial volatility in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. A continued economic downturn and other events that negatively impact our target markets could cause us to incur substantial loan losses that could materially harm our operating results.

 

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We are heavily regulated by federal and state agencies; changes in laws and regulations or failures to comply with such laws and regulations may adversely affect our operations and our financial results.

We and Sonabank are subject to extensive regulation, supervision and examination by federal and state banking authorities. Any change in applicable regulations or federal or state legislation could have a substantial impact on us and Sonabank, and our respective operations. Additional legislation and regulations may be enacted or adopted in the future that could significantly affect our powers, authority and operations or the powers, authority and operations of Sonabank, which could have a material adverse effect on our financial condition and results of operations.

Further, bank regulatory authorities have the authority to bring enforcement actions against banks and their holding companies for unsafe or unsound practices in the conduct of their businesses or for violations of any law, rule or regulation, any condition imposed in writing by the appropriate bank regulatory agency or any written agreement with the agency. Possible enforcement actions against us could include the issuance of a cease-and-desist order that could be judicially enforced, the imposition of civil monetary penalties, the issuance of directives to increase capital or enter into a strategic transaction, whether by merger or otherwise, with a third party, the appointment of a conservator or receiver, the termination of insurance of deposits, the issuance of removal and prohibition orders against institution-affiliated parties, and the enforcement of such actions through injunctions or restraining orders. The exercise of this regulatory discretion and power may have a negative impact on us.

As a regulated entity, Sonabank must maintain certain required levels of regulatory capital that may limit our operations and potential growth.

We and Sonabank are subject to various regulatory capital requirements administered by the Federal Reserve. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Sonabank’s and our company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Sonabank must meet specific capital guidelines that involve quantitative measures of Sonabank’s assets, liabilities and certain off-balance sheet commitments as calculated under these regulations.

Quantitative measures established by regulation to ensure capital adequacy require Sonabank to maintain minimum amounts and defined ratios of total and Tier 1 capital to risk-weighted assets and of Tier 1 capital to adjusted total assets, also known as the leverage ratio. For Sonabank, Tier 1 capital consists of shareholders’ equity excluding unrealized gains and losses on certain securities, less a portion of its mortgage servicing asset that is disallowed for capital. For Sonabank, total capital consists of Tier 1 capital plus the allowance for loan and lease loss less a deduction for low level recourse obligations.

As of December 31, 2009, Sonabank exceeded the amounts required to be well capitalized with respect to all three required capital ratios. To be well capitalized, a bank must generally maintain a leverage ratio of at least 5%, a Tier 1 risk-based capital ratio of at least 6% and a total risk-based capital ratio of at least 10%. However, the Federal Reserve could require Sonabank to increase its capital levels. For example, regulators have recently required certain banking companies to maintain a leverage ratio of at least 8% and a total risk-based capital ratio of at least 12%. As of December 31, 2009, Sonabank’s leverage, Tier 1 risk-based capital and total risk-based capital ratios were 16.68%, 16.63% and 17.66%, respectively.

Many factors affect the calculation of Sonabank’s risk-based assets and its ability to maintain the level of capital required to achieve acceptable capital ratios. For example, changes in risk weightings of assets relative to capital and other factors may combine to increase the amount of risk-weighted assets in the Tier 1 risk-based capital ratio and the total risk-based capital ratio. Any increases in its risk-weighted assets will require a corresponding increase in its capital to maintain the applicable ratios. In addition, recognized loan losses in excess of amounts reserved for such losses, loan impairments, impairment losses on securities and other factors will decrease Sonabank’s capital, thereby reducing the level of the applicable ratios.

 

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Sonabank’s failure to remain well capitalized for bank regulatory purposes could affect customer confidence, our ability to grow, our costs of funds and FDIC insurance costs, our ability to pay dividends on our capital stock, our ability to make acquisitions, and on our business, results of operations and financial condition. Under FDIC rules, if Sonabank ceases to be a well capitalized institution for bank regulatory purposes, the interest rates that it pays on deposits and its ability to accept, renew or rollover brokered deposits may be restricted. As of December 31, 2009, we had $97.0 million of brokered deposits, which represented 21.3% of our total deposits.

We may not be able to successfully compete with others for business.

The metropolitan statistical area in which we operate is considered highly attractive from an economic and demographic viewpoint, and is a highly competitive banking market. We compete for loans, deposits and investment dollars with numerous regional and national banks, online divisions of out-of-market banks and other community banking institutions, as well as other kinds of financial institutions and enterprises, such as securities firms, insurance companies, savings associations, credit unions, mortgage brokers and private lenders. Many competitors have substantially greater resources than us, and operate under less stringent regulatory environments. The differences in resources and regulations may make it harder for us to compete profitably, reduce the rates that we can earn on loans and investments, increase the rates we must offer on deposits and other funds and adversely affect our overall financial condition and earnings.

We are subject to transaction risk, which could adversely affect our business, financial condition and results of operation.

We, like all businesses, are subject to transaction risk, which is the risk of loss resulting from human error, fraud or unauthorized transactions due to inadequate or failed internal processes and systems, and external events that are wholly or partially beyond our control (including, for example, computer viruses or electrical or telecommunications outages). Transaction risk also encompasses compliance risk, which is the risk of loss from violations of, or noncompliance with, laws, rules, regulations, prescribed practices or ethical standards. Although we seek to mitigate transaction risk through a system of internal controls, there can be no assurance that we will not suffer losses from transaction risks in the future that may be material in amount. Any losses resulting from transaction risk could take the form of explicit charges, increased operational costs, litigation costs, harm to reputation or forgone opportunities, any and all of which could have a material adverse effect on business, financial condition and results of operations.

We must respond to rapid technological changes and these changes may be more difficult or expensive than anticipated.

If competitors introduce new products and services embodying new technologies, or if new industry standards and practices emerge, our existing product and service offerings, technology and systems may become obsolete. Further, if we fail to adopt or develop new technologies or to adapt our products and services to emerging industry standards, we may lose current and future customers, which could have a material adverse effect on our business, financial condition and results of operations. The financial services industry is changing rapidly and in order to remain competitive, we must continue to enhance and improve the functionality and features of our products, services and technologies. These changes may be more difficult or expensive than we anticipate.

Item 1B.—Unresolved Staff Comments

SNBV does not have any unresolved staff comments to report for the year ended December 31, 2009.

 

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Item 2.—Properties

The following table sets forth the date opened or acquired, ownership status and the total deposits, not including brokered deposits, for each of our banking locations, as of December 31, 2009:

 

Location

   Date Opened
or Acquired
   Owned or
Leased
   Deposits
(in thousands)

Home Office and Branch:

        

6830 Old Dominion Drive

   December 2006    Leased    $ 41,953

McLean, Virginia 22101

        

Branch Offices:

        

511 Main Street

   December 2005    Owned    $ 44,073

Clifton Forge, Virginia 24442

        

1770 Timberwood Boulevard

   April 2005    Leased    $ 30,195

Charlottesville, Virginia 22911

        

11527 Sunrise Valley Drive

   December 2006    Leased    $ 39,507

Reston, Virginia 20191

        

10855 Fairfax Boulevard

   December 2006    Leased    $ 14,002

Fairfax, Virginia 22030

        

550 Broadview Avenue

   April 2007    Leased    $ 17,740

Warrenton, Virginia 20186

        

1 East Market Street

   April 2008    Leased    $ 14,714

Leesburg, Virginia 20176

        

11 Main Street

   September 2009    Leased    $ 26,982

Warrenton, Virginia 20186

        

*11834 Rockville Pike

   December 2009       $ 55,352

Rockville, Maryland 20852

        

*1 South Front Royal Avenue

   December 2009       $ 34,864

Front Royal, Virginia 22630

        

*9484 Congress Street

   December 2009       $ 34,095

New Market, Virginia 22844

        

*43086 Peacock Market Plaza

   December 2009       $ 8,679

South Riding, Virginia 20152

        

Loan Production Offices:

        

230 Court Square

   March 2005    Leased      NA

Charlottesville, Virginia 22902

        

2217 Princess Anne Street

   April 2005    Leased      NA

Fredericksburg, Virginia 22401

        

550 Broadview Avenue

   September 2005    Leased      NA

Warrenton, Virginia 20186

        

2805 McRae Road, Suite 5A

   July 2007    Leased      NA

Richmond, Virginia 23235

        

Executive Offices:

        

1002 Wisconsin Avenue

   April 2005    Leased      NA

Washington, D.C. 20007

        

 

* These properties are Greater Atlantic Bank branch locations. As the acquisition was a FDIC-assisted transaction, final settlement for lease/purchase is pending.

 

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Item 3.—Legal Proceedings

While SNBV and Sonabank may, from time to time, be a party to various legal proceedings arising in the ordinary course of business, there are no proceedings pending, or to management’s knowledge, threatened, against SNBV or Sonabank as of December  31, 2009.

Item 4.—Reserved

 

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PART II

Item 5.—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Common Stock Market Prices

On November 6, 2006, SNBV closed on the initial public offering of its common stock, $0.01 par value. The shares of common stock sold in the offering were registered under the Securities Act of 1933, as amended on a Registration Statement (Registration No. 333-136285) that was declared effective by the Securities and Exchange Commission on October 31, 2006. The shares of common stock were sold at a price to the public of $14.00 per share (equivalent to $12.73 after the stock dividend declared in May 2007).

SNBV completed a public offering of its common stock in an underwritten public offering. FIG Partners, LLC acted as the sole manager for the offering. SNBV closed on the offering on November 4, 2009, selling 4,791,665 shares of common stock, including 624,999 shares sold pursuant to an over-allotment option granted to the underwriter, at a price of $6.00 per share. The gross proceeds from the shares sold were $28.7 million. The net proceeds to SNBV from the offering were approximately $26.9 million after deducting $1.3 million in underwriting commission and an estimated $486 thousand in other expenses incurred in connection with the offering.

SNBV’s common stock is traded on the Nasdaq Global Market under the symbol “SONA”. Our common stock began trading on the Nasdaq Capital Market in November 2006, and the exchange listing was upgraded to the Nasdaq Global Market at the open of trading on December 18, 2007.

There were 11,590,212 shares of our common stock outstanding at the close of business on March 2, 2010, which were held by 182 shareholders of record.

The following table presents the high and low intra-day sales prices for quarterly periods during 2009 and 2008:

 

     Market Values
   2009    2008
   High    Low    High    Low

First Quarter

   $ 7.50    $ 3.25    $ 10.97    $ 8.12

Second Quarter

     8.90      5.50      9.30      6.35

Third Quarter

     8.45      7.00      8.50      5.30

Fourth Quarter

     7.97      6.00      8.25      5.30

Dividend Policy

Dividends are paid at the discretion of our board of directors. While we paid a nonrecurring 10% stock dividend to our holders of common stock in 2007, we have never paid a cash dividend on our common stock, and our board of directors does not intend to pay a cash or stock dividend for the foreseeable future. The amount and frequency of dividends, if any, will be determined by our board of directors after consideration of our earnings, capital requirements, our financial condition and our ability to service any equity or debt obligations senior to our common stock, and will depend on cash dividends paid to us by our subsidiary bank. As a result, our ability to pay future dividends will depend on the earnings of Sonabank, its financial condition and its need for funds.

There are a number of restrictions on our ability to pay cash dividends. It is the policy of the FRB that bank holding companies should pay cash dividends on common stock only out of net income available over the past year and only if prospective earnings retention is consistent with the organization’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash

 

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dividends that undermines the bank holding company’s ability to serve as a source of financial strength to its banking subsidiary. For a foreseeable period of time, our principal source of cash will be dividends paid by our subsidiary bank with respect to its capital stock. There are certain restrictions on the payment of these dividends imposed by federal and state banking laws, regulations and authorities.

Regulatory authorities could administratively impose limitations on the ability of our subsidiary bank to pay dividends to us if such limits were deemed appropriate to preserve certain capital adequacy requirements or in the interests of “safety and soundness.”

Recent Sales of Unregistered Securities

None

Securities Authorized for Issuance under Equity Compensation Plans

As of December 31, 2009, the Company had outstanding stock options granted under its Stock Option Plan, which is approved by the Company’s shareholders. The following table provides information as of December 31, 2009 regarding the Company’s equity compensation plans under which the Company’s equity securities are authorized for issuance:

 

Plan category

   Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
(a)
   Weighted-average
exercise price of
outstanding options
(b)
   Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
column (a))
(c)

Equity compensation plans approved by security holders

   281,675    $ 8.56    20,825

Equity compensation plans not approved by security holders

   —        —      —  
                

Total

   281,675    $ 8.56    20,825
                

Issuer Purchases of Equity Securities

None

 

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Performance Graph

The following chart compares the cumulative total shareholder return on SNBV common stock for the period from November 1, 2006, when the common stock was registered under Section 12 of the Securities Exchange Act of 1934 and first listed on the Nasdaq Capital Market, to December 31, 2009, with the cumulative total return of the Russell 2000 Index and the SNL Bank and Thrift Index for the same period. Dividend reinvestment has been assumed. This comparison assumes $100 invested on November 1, 2006 in SNBV common stock, the Russell 2000 Index and the SNL Bank and Thrift Index. The historical stock price performance for SNBV common stock shown on the graph below is not necessarily indicative of future stock performance.

LOGO

 

Index

   Period Ending
   11/01/06    12/31/06    12/31/07    12/31/08    12/31/09

Southern National Bancorp of Virginia, Inc.

   100.00    108.14    64.50    42.57    51.60

Russell 2000

   100.00    104.98    103.34    68.42    87.01

SNL Bank and Thrift Index

   100.00    104.72    79.86    45.93    45.31

 

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Item 6.—Selected Financial Data

The following table sets forth selected financial data for SNBV as of December 31, 2009, 2008, 2007, 2006 and 2005, and for the years ended December 31, 2009, 2008, 2007 and 2006, and the period from inception at April 14, 2005 through December 31, 2005:

 

    2009     2008     2007     2006     2005  
  (in thousands, except per share amounts)  

Results of Operations:

         

Interest income

  $ 23,406      $ 24,401      $ 21,795      $ 10,814      $ 2,396   

Interest expense

    8,077        11,983        11,086        4,860        605   
                                       

Net interest income

    15,329        12,418        10,709        5,954        1,791   

Provision for loan losses

    6,538        1,657        1,290        546        1,020   
                                       

Net interest income after provision for loan losses

    8,791        10,761        9,419        5,408        771   

Noninterest income (loss)

    5,574        (129     311        219        50   

Noninterest expenses

    11,062        9,109        7,886        4,618        3,077   
                                       

Income (loss) before income taxes

    3,303        1,523        1,844        1,009        (2,256

Income tax expense

    947        315        108        —          —     
                                       

Net income (loss)

  $ 2,356      $ 1,208      $ 1,736      $ 1,009      $ (2,256
                                       

Per Share Data (1):

         

Earnings (loss) per share—Basic

  $ 0.31      $ 0.18      $ 0.26      $ 0.24      $ (0.59

Earnings (loss) per share—Diluted

  $ 0.31      $ 0.18      $ 0.25      $ 0.23      $ (0.59

Book value per share

  $ 8.38      $ 10.12      $ 10.19      $ 10.04      $ 8.39   

Tangible book value per share

  $ 7.30      $ 8.37      $ 8.34      $ 7.83      $ 7.61   

Weighted average shares outstanding—Basic

    7,559,962        6,798,547        6,798,547        4,244,957        3,850,000   

Weighted average shares outstanding—Diluted

    7,559,962        6,798,547        6,875,559        4,323,620        3,850,000   

Shares outstanding at end of period

    11,590,212        6,798,547        6,798,547        6,798,547        3,850,000   

Selected Performance Ratios and Other Data:

         

Return on average assets

    0.52     0.29     0.54     0.65     (5.35 %) 

Return on average equity

    3.24     1.75     2.51     2.74     (9.89 %) 

Yield on earning assets

    5.60     6.45     7.47     7.31     5.88

Cost of funds

    2.27     3.70     4.75     4.44     3.58

Cost of funds including non-interest bearing deposits

    2.12     3.49     4.42     4.15     3.17

Net interest margin

    3.66     3.28     3.67     4.03     4.40

Efficiency ratio (2)

    66.36     67.05     68.94     74.81     167.14

Net charge-offs to average loans

    1.65     0.32     0.24     0.21     0.00

Allowance for loan losses to total non-covered loans

    1.48     1.40     1.33     1.33     1.36

Stockholders’ equity to total assets

    15.88     15.92     18.36     23.48     26.29

Financial Condition:

         

Total assets

  $ 610,674      $ 431,924      $ 377,283      $ 290,574      $ 122,908   

Total loans, net of unearned income

    462,287        302,266        261,407        204,544        75,031   

Total deposits

    455,791        309,460        265,469        215,804        77,263   

Stockholders’ equity

    97,124        68,776        69,275        68,227        32,313   

 

(1) Reflects 10% stock dividend declared April 19, 2007.
(2) Efficiency ratio is calculated by dividing noninterest expense by the sum of net interest income plus noninterest income, excluding any gains/losses on sales of securities, gains/write-downs on OREO, gains on acquisitions and gains on sale of loans.

 

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Item 7.—Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s discussion and analysis is presented to aid the reader in understanding and evaluating the financial condition and results of operations of SNBV. This discussion and analysis should be read with the consolidated financial statements, the footnotes thereto, and the other financial data included in this report.

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains statements about future expectations, activities and events that constitute forward-looking statements within the meaning of, and subject to the protection of, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Forward-looking statements are based on our beliefs, assumptions and expectations of our future financial and operating performance and growth plans, taking into account the information currently available to us. These statements are not statements of historical fact. The words “believe,” “may,” “should,” “anticipate,” “estimate,” “expect,” “intend,” “continue,” “would,” “could,” “hope,” “might,” “assume,” “objective,” “seek,” “plan,” “strive” or similar words, or the negatives of these words, identify forward-looking statements.

Forward-looking statements involve risks and uncertainties that may cause our actual results to differ materially from the expectations of future results we express or imply in any forward-looking statements. In addition to the other factors discussed in the “Risk Factors” section of this prospectus, factors that could contribute to those differences include, but are not limited to:

 

   

our limited operating history;

 

   

changes in the strength of the United States economy in general and the local economies in our market areas adversely affect our customers and their ability to transact profitable business with us, including the ability of our borrowers to repay their loans according to their terms or a change in the value of the related collateral;

 

   

changes in the availability of funds resulting in increased costs or reduced liquidity;

 

   

our reliance on brokered deposits;

 

   

a deterioration or downgrade in the credit quality and credit agency ratings of the securities in our securities portfolio;

 

   

impairment concerns and risks related to our investment portfolio of collateralized mortgage obligations, agency mortgage-backed securities and pooled trust preferred securities;

 

   

the incurrence and possible impairment of goodwill associated with an acquisition and possible adverse short-term effects on our results of operations;

 

   

increased credit risk in our assets and increased operating risk caused by a material change in commercial, consumer and/or real estate loans as a percentage of our total loan portfolio;

 

   

the concentration of our loan portfolio in loans collateralized by real estate;

 

   

our level of construction and land development and commercial real estate loans;

 

   

changes in the levels of loan prepayments and the resulting effects on the value of our loan portfolio;

 

   

the failure of assumptions underlying the establishment of and provisions made to the allowance for loan losses;

 

   

our ability to expand and grow our business and operations, including the establishment of additional branches and acquisition of additional branches and banks, and our ability to realize the cost savings and revenue enhancements we expect from such activities;

 

   

changes in interest rates and market prices, which could reduce our net interest margins, asset valuations and expense expectations;

 

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increased competition for deposits and loans adversely affecting rates and terms;

 

   

increases in FDIC deposit insurance premiums and assessments;

 

   

the continued service of key management personnel;

 

   

increased asset levels and changes in the composition of assets and the resulting impact on our capital levels and regulatory capital ratios;

 

   

our ability to acquire, operate and maintain cost effective and efficient systems without incurring unexpectedly difficult or expensive but necessary technological changes; and

 

   

fiscal and governmental policies of the United States federal government.

Forward-looking statements are not guarantees of performance or results. A forward-looking statement may include a statement of the assumptions or bases underlying the forward-looking statement. We believe we have chosen these assumptions or bases in good faith and that they are reasonable. We caution you, however, that assumptions or bases almost always vary from actual results, and the differences between assumptions or bases and actual results can be material. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements in this prospectus. These statements speak only as of the date of this prospectus (or an earlier date to the extent applicable). Except as required by applicable law, we undertake no obligation to update publicly these statements in light of new information or future events.

CRITICAL ACCOUNTING POLICIES

Our accounting policies are in accordance with U. S. generally accepted accounting principles and with general practices within the banking industry. Management makes a number of estimates and assumptions relating to reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during periods presented. Different assumptions in the application of these methods or policies could result in material changes in our financial statements. As such, the following policies are considered “critical accounting policies” for us.

Allowance for Loan Losses

The allowance for loan losses is established and maintained at levels management and the board of directors deem adequate to absorb probable incurred credit losses from identified and otherwise inherent risks in the portfolio as of the balance sheet date. In assessing the adequacy of the allowance, we review the quality of, and risks in, loans in the portfolio. We also consider such factors as:

 

   

composition of the loan portfolio;

 

   

value and adequacy of the collateral;

 

   

current economic conditions;

 

   

historical loan loss experience; and

 

   

other known internal and external factors that affect collectability as of the report date.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan losses is prepared by our executive credit officer and presented to our board of directors for review and approval on at least a quarterly basis. We may determine, based on our analysis, which includes risk factors such as charge-off rates, past dues, economic concerns, portfolio composition and loan growth, that our future loan loss provision needs to increase or decrease in order for us to maintain the allowance at a level sufficient to absorb probable incurred credit losses. If we become aware that any of these factors has materially changed, our estimate of credit losses in the loan portfolio and the related allowance could also change. The allowance consists of general and unallocated components. The value of the general reserve is based on historical loss experience adjusted for qualitative factors.

 

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While it is our policy to charge off loans in the current period when a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, management’s judgment as to the adequacy of the allowance is necessarily approximate and imprecise.

Based on management’s current judgments about credit quality of the loan portfolio considering all known relevant internal and external factors that affect loan collectability as of December 31, 2009, an allowance of $5.2 million, or 1.48% of total non-covered loans was an adequate estimate of losses within the loan portfolio as of December 31, 2009. This estimate resulted in provision for loan losses on the income statement of $6.5 million during 2009. If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, an adjustment to the allowance for loan losses and the resulting effect on the income statement could be material. The risk of credit loss on the loans acquired in the Greater Atlantic transaction that are covered under the FDIC loss sharing agreement was considered at acquisition.

Goodwill and Intangible Assets

Management is required to assess goodwill and other intangible assets annually for impairment or more often if certain factors are identified which could imply potential impairment. This assessment involves preparing analyses of market multiples for similar operations, and estimating the fair value of the reporting unit to which the goodwill is allocated. If the analysis results in an estimate of fair value materially less than the carrying value SNBV would be required to take a charge against earnings to write down the asset to the lower fair value. Based on its assessment completed with the help of an outside investment banking firm, SNBV believes its goodwill of $8.7 million and other identifiable intangibles of $3.9 million are not impaired and are properly recorded in the consolidated financial statements as of December 31, 2009.

Other Than Temporary Impairment (“OTTI”) of Investment Securities

Securities are monitored to determine whether a decline in their value is other than temporary. Management utilizes criteria outlined in ASC 320-10-65, ASC 820-10 and ASC 325-40, such as the probability of collecting amounts due per the contractual terms of the investment security agreement, to determine whether the loss in value is other than temporary. The term “other than temporary” is not intended to indicate that the decline in value is permanent. It indicates that the prospects for a near-term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to , or greater than, the carrying value of the investment. Once a decline in value is determined to be other than temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

Management has evaluated each of the trust preferred securities for potential impairment under ASC 325 and the most recently issued guidance described in Note 1, and has reviewed each of the issues’ collateral participants using various techniques including the ratings provided in the Bank Financial Quarterly published by IDC Financial Publishing, Inc. Management has also reviewed the interest and principal coverage of each of the tranches it owns. In performing a detailed cash flow analysis of each security, management works with independent third parties to identify its best estimate of the cash flow estimated to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following assumptions:

 

   

We assume that 2% of the remaining performing collateral will default or defer in the first quarter of 2010 and 2% in the second quarter of 2010. We assume 50 basis points per annum thereafter (the previous assumption was 37.5 basis points).

 

   

We assume recoveries ranging from 15% to 25% with a two year lag on new defaults and deferrals, and we assume 15% recoveries on existing defaults and deferrals.

 

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We assume no prepayments for 10 years and then 1% per annum for the remaining life of the security.

 

   

Our securities have been modeled using the above assumptions by Sandler O’Neill and Sterne Agee using the forward LIBOR curve plus original spread to discount projected cash flows to present values.

These assumptions, combined with increased actual defaults and deferrals, resulted in OTTI of $7.6 million on the trust preferred securities during 2009.

We also own $2.0 million of SARM 2005-22 1A2. This residential collateralized mortgage obligation was downgraded from B to CCC by Standard and Poors in September 2009, and it was downgraded from BBB to CC by Fitch in August 2009. This security was originated in 2005. The average FICO score of the underlying loans at origination was 748. As of December 31, 2009, delinquencies of more than 60 days, foreclosures and REO totaled 32.1% compared to 30.3% at September 30, 2009. Credit support is 10.24 compared to 14 when originally issued, which provides coverage of 0.97 times projected losses in the collateral. The fair market value is $1.6 million. We have evaluated this security for potential impairment and, based on our review of the trustee report, shock analysis and current information regarding delinquencies, nonperforming loans and credit support. The assumptions used in the analysis included a 5% prepayment speed, 10% default rate, a 50% loss severity and an accounting yield of 4.75%. Based on this analysis, an OTTI existed as of December 31, 2009 in the amount of $139 thousand.

Valuation of Deferred Tax Asset

Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus changes in deferred taxes related primarily to differences between the basis of the net operating losses carryforward and allowance for loan losses. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

Until the second quarter of 2007, SNBV maintained a valuation allowance against its deferred tax assets. During the second quarter of 2007, the valuation allowance on the net deferred tax assets was no longer necessary given the sustained income and growth over the past six calendar quarters. The tax valuation allowance reversal was $2.5 million, of which $1.9 million was related to the net deferred tax assets obtained in the 1 st Service Bank acquisition and reduced goodwill.

SNBV adopted the guidance issued by the FASB with respect to accounting for uncertainty in income taxes as of January 1, 2007. A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. The effect of adopting this new guidance had no effect on our consolidated financial statements. .We have no unrecognized tax benefits and do not anticipate any increase in unrecognized benefits during the next twelve months. Should the accrual of any interest or penalties relative to unrecognized tax benefits be necessary, it is our policy to record such accruals in our income tax accounts; no such accruals exist as of December 31, 2009. SNBV and its subsidiary file a consolidated U. S. federal tax return and a Virginia state income tax return. These returns are subject to examination by taxing authorities for all years after 2005.

 

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OVERVIEW

Southern National Bancorp of Virginia, Inc. (“SNBV”) is a corporation formed on July 28, 2004 under the laws of the Commonwealth of Virginia and is the holding company for Sonabank (“Sonabank”) a Virginia state bank. Sonabank was originally chartered as a national bank under the laws of the United States of America on April 14, 2005. On January 1, 2009, Sonabank converted from a nationally chartered bank to a state chartered bank and moved its headquarters from Charlottesville to McLean, Virginia. Sonabank is now regulated by the State Corporation Commission of Virginia and the Federal Reserve Bank of Richmond. Sonabank conducts full-service banking operations in Charlottesville, Clifton Forge, Leesburg, Warrenton, New Market, Front Royal, South Riding and Fairfax County in Virginia and in Rockville, Maryland. We also have loan production offices in Charlottesville, Fredericksburg, Warrenton and Richmond in Virginia. We have administrative offices in Warrenton and an executive office in Georgetown, Washington, D.C where senior management is located.

On September 28, 2009, Southern National Bancorp of Virginia, Inc. completed the purchase of the Warrenton branch office, acquired at fair value selected loans in the amount of $23.8 million and assumed at fair value approximately $26.8 million of deposits from Millennium Bank, N.A. No premium was paid in this transaction.

SNBV completed a public offering of its common stock in an underwritten public offering. FIG Partners, LLC acted as the sole manager for the offering. SNBV closed on the offering on November 4, 2009, selling 4,791,665 shares of common stock, including 624,999 shares sold pursuant to an over-allotment option granted to the underwriter, at a price of $6.00 per share. The gross proceeds from the shares sold were $28.7 million. The net proceeds to SNBV from the offering were approximately $26.9 million after deducting $1.3 million in underwriting commission and an estimated $486 thousand in other expenses incurred in connection with the offering.

SNBV expects to use the net proceeds from the offering to provide capital to Sonabank to support its anticipated organic growth, to support potential future acquisitions of branches or whole banks, including the possible acquisitions of failed financial institutions in FDIC assisted transactions, and for other general corporate purposes.

Effective December 4, 2009, Sonabank assumed certain deposits and liabilities and acquired certain assets of Greater Atlantic from the FDIC as receiver for Greater Atlantic Bank, pursuant to the terms of a purchase and assumption agreement entered into by the Bank and the FDIC on December 4, 2009 (the “Agreement”). On December 5, 2009, the former Greater Atlantic offices, located in Reston, New Market, Front Royal and South Riding, Virginia and Rockville, Maryland opened as Sonabank branches.

Under the terms of the Agreement, the Bank acquired substantially all of the assets of Greater Atlantic Bank, including all loans, and assumed substantially all of its liabilities, including the insured and uninsured deposits. Based on the closing with the FDIC as of December 4, 2009, the Bank (a) acquired at fair value $113.6 million in loans, $1.0 million in foreclosed assets, $28.1 million in securities available-for-sale and $73.0 million in cash and other assets, and (b) assumed at fair value $178.7 million in deposits, $25.4 million in borrowings and $407 thousand in other liabilities and recorded a deferred tax liability of $3.8 million. The Bank also recorded a core deposit intangible asset in the amount of $1.2 million and recorded a pre-tax gain on the transaction of $11.2 million. In connection with the Greater Atlantic acquisition, the FDIC made a cash payment to the Bank of approximately $27.0 million. The foregoing amounts are estimates and subject to adjustment based upon final settlement with the FDIC. The terms of the Agreement provide for the FDIC to indemnify the Bank against claims with respect to liabilities of Greater Atlantic not assumed by the Bank and certain other types of claims listed in the Agreement.

The Bank paid no cash or other consideration to acquire Greater Atlantic Bank. As part of the Greater Atlantic acquisition, the Bank and the FDIC entered into a loss sharing agreement (the “loss sharing agreement”)

 

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on approximately $143.4 million (cost basis) of Greater Atlantic Bank’s assets. The Bank will share in the losses on the loans and foreclosed loan collateral with the FDIC as specified in the loss sharing agreement; we refer to these assets collectively as “covered assets.” Pursuant to the terms of the loss sharing agreement, the FDIC is obligated to reimburse the Bank for 80% of losses of up to $19 million with respect to the covered assets. The FDIC will reimburse the Bank for 95% of losses in excess of $19 million with respect to the covered assets. The Bank will reimburse the FDIC for 80% of recoveries with respect to losses for which the FDIC paid the Bank 80% reimbursement under the loss sharing agreement, and for 95% of recoveries with respect to losses for which the FDIC paid the Bank 95% reimbursement under the loss sharing agreement.

RESULTS OF OPERATIONS

Net Income

Net income for the year ended December 31, 2009 was $2.4 million, up from $1.2 million for the year ended December 31, 2008. During 2009 we recognized the gain of $11.2 million on the Greater Atlantic acquisition as well as a gain on the Millennium Warrenton branch acquisition in the amount of $423 thousand. OTTI charges were $7.7 million in 2009 compared to $1.5 million in 2008.

Net income for the year ended December 31, 2008, was $1.2 million compared to $1.7 million in the year ended December 31, 2007. We recognized OTTI charges on FHLMC preferred stock in the amount of $1.5 million and $440 thousand in 2008 and 2007, respectively.

Net Interest Income

Our operating results depend primarily on our net interest income, which is the difference between interest and dividend income on interest-earning assets such as loans and investments, and interest expense on interest-bearing liabilities such as deposits and borrowings.

Net interest income for the year ended December 31, 2009 was $15.3 million compared to $12.4 million for the same period last year. Average interest-earning assets for the year ended December 31, 2009 increased $40.1 million over the same period in 2008. Approximately $51.9 million of this growth was an increase in average loans outstanding. Average investment securities decreased by $15.7 million in the year ended December 31, 2009, compared to the same period last year. The average yield on interest-earning assets decreased from 6.45% in 2008 to 5.60% in 2009. Average interest-bearing liabilities for the year ended December 31, 2009 increased $32.3 million compared to the same period in 2008. Average interest-bearing deposits increased by $27.6 million, while average borrowings increased by $4.7 million compared to 2008. The average cost of interest-bearing liabilities decreased from 3.70% in 2008 to 2.27% in 2009. The interest rate spread for the year ended December 31, 2009 increased from 2.75% to 3.33% compared to the same period last year. The net interest margin for the year ended December 31, 2009 increased to 3.66% from 3.28% compared to the same period last year. The net interest margin improved in each quarter of the year ended December 31, 2009 as a result of reduced funding costs.

Net interest income for the year ended December 31, 2008 was $12.4 million compared to $10.7 million for the same period last year. Average interest-earning assets for the year ended December 31, 2008 increased $86.4 million over the same period in 2007. Approximately $63.4 million of this growth was an increase in average loans outstanding. Average investment securities increased by $15.8 million in the year ended December 31, 2008, compared to the same period last year. The average yield on interest-earning assets decreased from 7.47% in 2007 to 6.45% in 2008 primarily because of the prime rate decreases of 400 basis points during the 2008 which accompanied the Federal Reserve Board’s reductions in its federal funds target rate. Average interest-bearing liabilities for the year ended December 31, 2008 increased $90.6 million compared to the same period in 2007. Average interest-bearing deposits increased by $62.4 million, while average borrowings increased by $28.3 million compared to 2007. The average cost of interest-bearing liabilities decreased from 4.75% in 2007 to

 

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3.70% in 2008. The interest rate spread for the year ended December 31, 2008 increased from 2.72% to 2.75% compared to the same period last year. The net interest margin for the year ended December 31, 2008 decreased to 3.28% from 3.67% compared to the same period last year. The decline in the interest margin was a result of several factors. In addition to the prime rate decreases previously discussed, we have maintained much more cash in interest-earning accounts at the Federal Home Loan Bank of Atlanta and the Federal Reserve Bank of Richmond during the second half of 2008 than we usually do. As of September 30, 2008, we had pre-funded our total brokered certificate of deposit (“CD”) maturities through November 2008. As of December 31, 2008, we had pre-funded our brokered CD maturities for January 2009. As a result, our cash and cash equivalents at December 31, 2008 were $14.8 million compared to $1.3 million at the end of last year. The negative carry on our interest-earning deposit accounts cost us 4 basis points. Also, the failure of our Freddie Mac preferred stock to pay dividends during the second half of 2008 cost us 2 basis points.

Our commercial loans (non-real estate), acquisition and development loans, construction loans and SBA loans are predominately priced to a spread over the prime rate, and these loans reprice virtually immediately. Commercial real estate loans are generally priced at a spread over the one, three or five year constant maturity treasury yield (CMT) or our marginal cost of funds and fixed for one, three or five years. On the liability side of the balance sheet we have a large segment of our funding which floats; but certificates of deposit (CDs) reprice only at maturity resulting in a lag which can adversely affect net interest income and the net interest margin when interest rates decline. We have seen substantial improvements during 2009. We had CDs mature during 2009 in an amount of $197.5 million with a weighted average rate of 3.41%. During the same period we issued $210.6 million in new CDs at an average rate of 1.35%.

 

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The following tables detail average balances of interest-earning assets and interest-bearing liabilities, the amount of interest earned/paid on such assets and liabilities, and the yield/rate for the periods indicated:

Average Balance Sheets and Net Interest

Analysis For the Years

Ended December 31, 2009, 2008 and 2007

 

    2009     2008     2007  
    Average
Balance
    Interest
Income/
Expense
  Yield/
Rate
    Average
Balance
    Interest
Income/
Expense
  Yield/
Rate
    Average
Balance
    Interest
Income/
Expense
  Yield/
Rate
 
    (Dollar amounts in thousands)  

Assets

                 

Interest-earning assets:

                 

Loans, net of unearned income (1) (2)

  $ 339,113      $ 20,540   6.06   $ 287,249      $ 19,875   6.92   $ 223,881      $ 17,938   8.01

Investment securities

    62,509        2,701   4.32     78,227        4,194   5.36     62,459        3,552   5.69

Other earning assets

    16,687        165   0.99     12,698        332   2.61     5,472        305   5.57
                                               

Total earning assets

    418,309        23,406   5.60     378,174        24,401   6.45     291,812        21,795   7.47
                             

Allowance for loan losses

    (4,608         (3,943         (2,966    

Intangible assets

    11,581            12,244            13,791       

Other non-earning assets

    31,314            29,143            19,257       
                                   

Total assets

  $ 456,596          $ 415,618          $ 321,894       
                                   

Liabilities and stockholders’ equity

                 

Interest-bearing liabilities:

                 

NOW accounts

  $ 8,048        16   0.19   $ 6,356        14   0.22   $ 6,569        17   0.26

Money market accounts

    58,462        970   1.66     52,803        1,226   2.32     40,855        1,712   4.19

Savings accounts

    2,505        14   0.55     2,186        5   0.23     2,658        12   0.45

Time deposits

    234,540        5,728   2.44     214,624        9,271   4.32     163,531        8,489   5.19
                                               

Total interest-bearing deposits

    303,555        6,728   2.22     275,969        10,516   3.81     213,613        10,230   4.79

Borrowings

    52,565        1,349   2.57     47,865        1,467   3.06     19,592        856   4.37
                                               

Total interest-bearing liabilities

    356,120        8,077   2.27     323,834        11,983   3.70     233,205        11,086   4.75
                             

Noninterest-bearing liabilities:

                 

Demand deposits

    24,001            19,992            17,698       

Other liabilities

    3,678            2,723            1,798       
                                   

Total liabilities

    383,799            346,549            252,701       

Stockholders’ equity

    72,797            69,069            69,193       
                                   

Total liabilities and stockholders’ equity

  $ 456,596          $ 415,618          $ 321,894       
                                   

Net interest income

    $ 15,329       $ 12,418       $ 10,709  
                             

Interest rate spread

      3.33       2.75       2.72

Net interest margin

      3.66       3.28       3.67

 

(1) Includes loan fees in both interest income and the calculation of the yield on loans.
(2) Calculations include non-accruing loans in average loan amounts outstanding.

 

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The following table summarizes changes in net interest income attributable to changes in the volume of interest-bearing assets and liabilities compared to changes in interest rates. The change in interest, due to both rate and volume, has been proportionately allocated between rate and volume.

 

    Year Ended December 31, 2009 vs. 2008     Year Ended December 31, 2008 vs. 2007  
  Increase (Decrease) Due to Change in:     Increase (Decrease) Due to Change in:  
      Volume             Rate             Net Change             Volume             Rate             Net Change      
  (in thousands)  

Interest-earning assets:

           

Loans, net of unearned income

  $ 2,146      $ (1,481   $ 665      $ 3,740      $ (1,803   $ 1,937   

Investment securities

    (760     (733     (1,493     830        (188     642   

Other earning assets

    171        (338     (167     45        (18     27   
                                               

Total interest-earning assets

    1,557        (2,552     (995     4,615        (2,009     2,606   
                                               

Interest-bearing liabilities:

           

NOW accounts

    4        (2     2        (1     (2     (3

Money market accounts

    154        (410     (256     926        (1,412     (486

Savings accounts

    1        8        9        (2     (5     (7

Time deposits

    961        (4,504     (3,543     1,690        (908     782   
                                               

Total interest-bearing deposits

    1,120        (4,908     (3,788     2,613        (2,327     286   

Borrowings

    180        (298     (118     770        (159     611   
                                               

Total interest-bearing liabilities

    1,300        (5,206     (3,906     3,383        (2,486     897   
                                               

Change in net interest income

  $ 257      $ 2,654      $ 2,911      $ 1,232      $ 477      $ 1,709   
                                               

Provision for Loan Losses

The provision for loan losses is a current charge to earnings made in order to increase the allowance for loan losses to a level deemed appropriate by management based on an evaluation of the loan portfolio, current economic conditions, changes in the nature and volume of lending, historical loan experience and other known internal and external factors affecting loan collectability. Our loan loss allowance is calculated by segmenting the loan portfolio by loan type and applying risk factors to each segment. The risk factors are determined by considering peer data, as well as applying management’s judgment.

The provision for loan losses charged to operations for the years ended December 31, 2009, 2008 and 2007 was $6.5 million, $1.7 million, and $1.3 million, respectively. We had charge-offs totaling $5.7 million during 2009, $923 thousand during 2008, and charge-offs during 2007 were $540 thousand. There were recoveries totaling $157 thousand during 2009, $8 thousand during 2008 and there were no recoveries during 2007. The increase in the provision for loan losses during 2009 was due to overall growth in the loan portfolio, charge offs and adverse economic factors.

During the fourth quarter of 2009 we charged off one $1.8 million commercial and industrial loan which had paid principal and interest on time from inception in April 2007 through August 2009 (at the end of September 2009 it was 40 days past due) when it abruptly stopped making payments in the fourth quarter. The company is still operating but their attorney alleges that one of the members of the LLC exceeded his authority and submitted fraudulent documents to us at the time the loan was made. We continued to work with the Company’s management and their legal counsel to work out the loan issue throughout the fourth quarter. We are aggressively pursuing all of the legal remedies available to us, but given the uncertainties associated with the loan we have charged it off in its entirety.

 

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We also charged off $1.3 million on two other loans during the fourth quarter of 2009. One of those loans is a commercial real estate loan placed on non-accrual last quarter and on which we have now begun foreclosure proceedings. The other is a commercial and industrial (C&I) loan which is current (but is now on non-accrual) due to an impairment in the value of our collateral.

Noninterest Income

The following table presents the major categories of noninterest income for the years ended December 31, 2009, 2008 and 2007 (in thousands):

 

     2009     2008     Change  

Account maintenance and deposit service fees

   $ 676      $ 499      $ 177   

Income from bank-owned life insurance

     579        588        (9

Net gain on acquisitions

     11,584        —          11,584   

Gain on sale of loans

     206        107        99   

Net gain (loss) on other assets

     (214     (136     (78

Net impairment losses recognized in earnings

     (7,714     (1,536     (6,178

Gain on sale of securities

     371        269        102   

Other

     86        80        6   
                        

Total noninterest income (loss)

   $ 5,574      $ (129   $ 5,703   
                        
     2008     2007     Change  

Account maintenance and deposit service fees

   $ 499      $ 338      $ 161   

Income from bank-owned life insurance

     588        347        241   

Gain on sale of loans

     107        —          107   

Net gain (loss) on other assets

     (136     21        (157

Net impairment losses recognized in earnings

     (1,536     (440     (1,096

Gain on sale of securities

     269        —          269   

Other

     80        45        35   
                        

Total noninterest income (loss)

   $ (129   $ 311      $ (440
                        

Noninterest income was $5.6 million during 2009, compared to a loss of $129 thousand during 2008. During 2009 we recognized the gain of $11.2 million on the Greater Atlantic acquisition as well as a gain on the Millennium Warrenton branch acquisition in the amount of $423 thousand. OTTI charges were $7.7 million in 2009 compared to $1.5 million in 2008. We recognized pre-tax impairment charges of $7.6 million related to our holdings of trust preferred securities and a pre-tax impairment charge of $139 thousand related to a private label CMO. Income from account maintenance fees increased due to an increase in the number of accounts.

Noninterest loss was $129 thousand during 2008, compared to income of $311 thousand during 2007. The decline in noninterest income was largely attributable to the OTTI charge of $1.5 million on the Freddie Mac preferred stock in 2008. Noninterest income for 2008 included gains of $107 thousand from the sale of the guaranteed portion of SBA loans and gains of $269 thousand from the sale of $15.5 million of available-for-sale mortgage-backed securities. Also during 2008, we had a write-down on other real estate owned (OREO) in the amount of $200 thousand which was offset by gains of $64 thousand on the sales of OREO. Income from account maintenance fees increased due to an increase in the number of accounts. Bank-owned life insurance also increased compared to 2007, as we had a full year of earnings.

 

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Noninterest Expense

The following table presents the major categories of noninterest expense for the years ended December 31, 2009, 2008 and 2007 (in thousands):

 

     2009    2008    Change  

Salaries and benefits

   $ 4,461    $ 4,016    $ 445   

Occupancy expenses

     1,615      1,494      121   

Furniture and equipment expenses

     516      484      32   

Amortization of core deposit intangible

     731      727      4   

Virginia franchise tax expense

     562      549      13   

FDIC assessment

     755      211      544   

Data processing expense

     339      260      79   

Telephone and communication expense

     283      256      27   

Acquisition expenses

     499      —        499   

Other operating expenses

     1,301      1,112      189   
                      

Total noninterest expense

   $ 11,062    $ 9,109    $ 1,953   
                      
     2008    2007    Change  

Salaries and benefits

   $ 4,016    $ 3,346    $ 670   

Occupancy expenses

     1,494      1,086      408   

Furniture and equipment expenses

     484      439      45   

Amortization of core deposit intangible

     727      727      —     

Virginia franchise tax expense

     549      550      (1

FDIC assessment

     211      140      71   

Data processing expense

     260      224      36   

Telephone and communication expense

     256      222      34   

Other operating expenses

     1,112      1,152      (40
                      

Total noninterest expense

   $ 9,109    $ 7,886    $ 1,223   
                      

Despite the costs associated with the Greater Atlantic and Millennium acquisitions, the new branch and drive-through facility we opened in Leesburg last year, the increased FDIC assessments and costs to support other organic growth of Sonabank, noninterest expenses were well controlled and rose 21.4% from $9.1 million for the year ended December 31, 2008 to $11.1 million for 2009. Despite these additional costs, Southern National’s efficiency ratio improved from 67.1% for the year ended December 31, 2008 to 66.4% for the year ended December 31, 2009, excluding the impairment charges, gains on sales of securities, gains on acquisitions, gains on sales of loans and gains/write-downs on OREO. As of December 31, 2009 we had 103 full-time equivalent employees compared to 65 at the end of 2008. We had thirteen branches and the Leesburg drive-through facility at year end 2009 compared to seven branches and the Leesburg drive-through facility at the end of 2008. The increase in occupancy expense was due primarily to the new branches acquired, inflationary increases in rent expense and one additional month of rent expense for the Leesburg branch compared to 2008. The acquisition expenses of $499 thousand are related to the Greater Atlantic transaction. The increase in the FDIC assessment was due to the special assessment in the third quarter of 2009 in the amount of $190 thousand, increases in the assessment rates and an increase in the deposits that make up the assessment base.

In February 2008 Sonabank opened a branch and a drive-through facility in Leesburg, Virginia. The incremental costs of these facilities were approximately $638 thousand per annum. Despite these additional costs, Southern National’s efficiency ratio improved from 68.9% for the year ended December 31, 2007 to 67.1% for the year ended December 31, 2008, excluding the impairment charges, gains on sales of securities, gains on sales of loans and gains/write-downs on OREO. As of December 31, 2008 we had 65 full-time equivalent employees compared to 59 at the end of 2007. We had seven branches and the Leesburg drive-through facility at year end 2008 compared to six branches at

 

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the end of 2007. The increase of $670 thousand in salaries and benefits expense in 2008 compared to 2007 is attributable to staffing the Leesburg branch and drive-through facility, the deferred compensation plan, and general increases in salaries and benefits. The increase in occupancy expense is attributable to the Leesburg branch and drive-through facility.

FINANCIAL CONDITION

Total assets were $610.7 million as of December 31, 2009, up from $431.9 million as of December 31, 2008. Net loans, non-covered and covered, grew from $298.0 million at the end of 2008 to $457.1 million at the end of 2009. The increase was due to acquiring loans in the amount of $113.6 million and $23.6 million in the Greater Atlantic and the Millennium transaction, respectively, as well as organic growth. Total cash and cash equivalents decreased from $14.8 million as of December 31, 2008 to $8.1 million at the end of 2009. At the end of 2008, we had built up liquidity to fund maturities of brokered certificates of deposit.

Total deposits rose from $309.5 million at December 31, 2008, to $455.8 million as of December 31, 2009. The growth was attributable to the assumption of $178.7 million in deposits in the Greater Atlantic transaction and $26.8 million in the Millennium acquisition. Brokered certificates of deposit were $118.3 million at December 31, 2008, compared to $70.0 million at December 31, 2009.

Loan Portfolio

As part of the Greater Atlantic acquisition, the Bank and the FDIC entered into a loss sharing agreement on approximately $143.4 million (cost basis) of Greater Atlantic Bank’s assets. The Bank will share in the losses on the loans and foreclosed loan collateral with the FDIC as specified in the loss sharing agreement; we refer to these assets collectively as “covered assets.” Loans that are not covered in the loss sharing agreement are referred to as “non-covered loans.”

Non-covered Loans

Non-covered loans, net of unearned income, grew from $302.3 million at the end of 2008 to $350.3 million at the end of 2009. Commercial real estate loans grew 40% from $104.9 million at year end 2008 to $146.3 million at the end of 2009. Non-real estate commercial loans increased 16% from $60.8 million at the end of 2008 to $70.8 million at the end of 2009. Construction and land loans decreased 15% from $56.6 million at the end of 2008 to $48.0 million at year end 2009.

Our residential mortgage loan portfolio increased from $60.4 million at December 31, 2008, to $61.0 million at December 31, 2009. The residential mortgage portfolio includes $34.5 million remaining from the 1 st Service acquisition. Sonabank is not in the retail residential mortgage origination business, but in the ordinary course of business does provide residential mortgage financing to its business clients.

Our commercial real estate lending program includes both loans closed under the Small Business Administration (“SBA”) 7(a) and 504 loan programs and loans closed outside of the SBA programs that serve both the investor and owner-occupied facility market. The 504 loan program is used to finance long-term fixed assets, primarily real estate and heavy equipment and gives borrowers access to up to 90% financing for a project. SBA 7(a) loans may be used for the purchase of real estate, construction, renovation or leasehold improvements, as well as machinery, equipment, furniture, fixtures, inventory and in some instances, working capital and debt refinancing. The SBA guarantees up to 85% of the loan balance in the 7(a) program, and start-up businesses are eligible to participate in the program. During 2009 we closed loans totaling $14.2 million through the SBA’s 7(a) program and $3.4 million under the SBA’s 504 program. During 2008 we closed loans totaling $6.6 million through the SBA’s 7(a) program and $4.4 million under the SBA’s 504 program.

 

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Covered Loans

A summary of covered loans acquired in the Greater Atlantic Bank acquisition as of December 31, 2009 and the related discounts is as follows (in thousands):

 

     Credit Impaired
Loans
    Other
Loans
    Total
Loans
 

Commercial loans

   $ 1,876      $ 3,579      $ 5,455   

Commercial real estate loans

     3,050        31,715        34,765   

Construction and land loans

     5,649        318        5,967   

Consumer loans

     —          193        193   

Home equity lines of credit

     —          56,705        56,705   

Residential real estate loans

     —          36,926        36,926   
                        

Total loans (at contract)

   $ 10,575      $ 129,436      $ 140,011   

Total discount (resulting from acquisition date fair value adjustments)

     (4,329     (23,693     (28,022
                        

Net loans (at fair value)

   $ 6,246      $ 105,743      $ 111,989   
                        

We refer to the loans acquired in the Greater Atlantic acquisition as “covered loans” as we will be reimbursed by the FDIC for a substantial portion of any future losses on them under the terms of the loss sharing agreement. At the December 4, 2009 acquisition date, we estimated the fair value of the Greater Atlantic loan portfolio at $113.6 million, which represents the expected cash flows from the portfolio discounted at a market-based rate. In estimating such fair value, we (a) calculated the contractual amount and timing of undiscounted principal and interest payments (the “undiscounted contractual cash flows”) and (b) estimated the amount and timing of undiscounted expected principal and interest payments (the “undiscounted expected cash flows”). The amount by which the undiscounted expected cash flows exceed the estimated fair value (the “accretable yield”) totals $12.1 million and is accreted into interest income over the life of the loans. The difference between the undiscounted contractual cash flows and the undiscounted expected cash flows is the nonaccretable difference. The nonaccretable difference totals $15.9 million and represents an estimate of the credit risk in the Greater Atlantic loan portfolio at the acquisition date.

Credit-impaired covered loans are those loans showing evidence of credit deterioration since origination and it is probable, at the date of acquisition, that SNBV will not collect all contractually required principal and interest payments. Generally, acquired loans that meet SNBV’s definition for nonaccrual status fall within the definition of credit-impaired covered loans.

 

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The following table summarizes the composition of our loans, net of unearned income at the dates indicated:

 

              Total
2009
    Non-covered  
    2009       2008     2007     2006     2005  
    Covered   Non-covered     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent     Amount     Percent  
    (in thousands)  

Mortgage loans on real estate:

                       

Commercial

  $ 21,414   $ 146,295      $ 167,709      36.2   $ 104,866      34.7   $ 87,150      33.3   $ 70,553      34.4   $ 41,668      55.3

Construction and land loans

    5,810     48,000        53,810      11.6     56,588      18.7     50,510      19.3     34,607      16.9     15,954      21.2

Residential 1-4 family

    33,815     61,024        94,839      20.5     60,376      19.9     51,862      19.8     63,141      30.8     7,814      10.4

Multi- family residential

    2,570     10,726        13,296      2.9     5,581      1.8     8,273      3.2     3,720      1.8     —        0.0

Equity lines of credit

    44,235     10,532        54,767      11.9     11,509      3.8     8,428      3.2     10,509      5.1     1,125      1.5
                                                                                   

Total real estate loans

    107,844     276,577        384,421      83.1     238,920      78.9     206,223      78.8     182,530      89.0     66,561      88.4

Commercial loans

    3,952     70,757        74,709      16.1     60,820      20.1     53,208      20.3     19,581      9.6     6,720      8.9

Consumer loans

    193     3,528        3,721      0.8     3,074      1.0     2,476      0.9     2,861      1.4     2,011      2.7
                                                                                   

Gross loans

    111,989     350,862        462,851      100.0     302,814      100.0     261,907      100.0     204,972      100.0     75,292      100.0

Less unearned income on loans

    —       (564     (564       (548       (500       (428       (261  
                                                               

Loans, net of unearned income

  $ 111,989   $ 350,298      $ 462,287        $ 302,266        $ 261,407        $ 204,544        $ 75,031     
                                                               

As of December 31, 2009, substantially all of our loans were to customers located in Virginia and Maryland. We are not dependent on any single customer or group of customers whose insolvency would have a material adverse effect on operations.

At December 31, 2009 we had $167.7 million in commercial real estate loans, of which approximately 55% were loans secured by owner occupied/operated real estate and 45% were non-owner occupied commercial real estate loans.

The following table sets forth the contractual maturity ranges of the commercial business and construction loan portfolio and the amount of those loans with fixed and floating interest rates in each maturity range as of December 31, 2009 (in thousands):

 

          After 1 Year
Through 5 Years
   After 5 Years     
   One Year
or Less
   Fixed
Rate
   Floating
Rate
   Fixed
Rate
   Floating
Rate
   Total

Real estate construction

   $ 37,834    $ 4,185    $ 10,181    $ —      $ 1,610    $ 53,810

Commercial and industrial

     26,693      15,931      8,985      2,321      20,779      74,709
                                         

Total

   $ 64,527    $ 20,116    $ 19,166    $ 2,321    $ 22,389    $ 128,519
                                         

Past Due Loans and Nonperforming Assets

We will generally place a loan on nonaccrual status when it becomes 90 days past due. Loans will also be placed on nonaccrual status in cases where we are uncertain whether the borrower can satisfy the contractual terms of the loan agreement. Cash payments received while a loan is categorized as nonaccrual will be recorded as a reduction of principal as long as doubt exists as to future collections.

We maintain appraisals on loans secured by real estate, particularly those categorized as nonperforming loans and potential problem loans. In instances where appraisals reflect reduced collateral values, we make an evaluation of the borrower’s overall financial condition to determine the need, if any, for possible specific allocations or write-down to their net realizable values. If foreclosure occurs, we record other real estate owned at the lower of our recorded investment in the loan or fair value less our estimated costs to sell.

 

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Our loss and delinquency experience on our loan portfolio has been limited by a number of factors, including our underwriting standards and the relatively short period of time since the loans were originated. Whether our loss and delinquency experience in the area of our portfolio will increase significantly depends upon the value of the real estate securing loans and economic factors such as the overall economy of the region.

The following table presents a comparison of non-covered nonperforming assets as of December 31, (in thousands):

 

     2009     2008     2007     2006     2005  

Nonaccrual loans

   $ 4,190      $ 1,078      $ 371      $ —        $ —     

Loans past due 90 days and accruing interest

     —          135        —          —          —     
                                        

Total nonperforming loans

     4,190        1,213        371        —          —     

Other real estate owned

     2,797        3,434        3,648        —          —     
                                        

Total nonperforming assets

   $ 6,987      $ 4,647      $ 4,019      $ —        $ —     
                                        

Allowance for loan losses to nonaccrual loans

     123.44     347.73     936.93     na        na   

Allowance for loan losses to total non-covered loans

     1.48     1.40     1.33     1.33     1.36

Nonperforming assets to total non-covered assets

     1.40     1.08     1.07     na        na   

Nonperforming assets to total non-covered loans

     1.99     1.54     1.54     na        na   

Covered nonperforming assets are not included in the table above because the carrying value includes a component for credit losses (the nonaccretable yield).

The following table presents covered nonperforming assets as of December 31, 2009 (in thousands):

 

     2009

Nonaccrual loans

   $ 5,080

Loans past due 90 days and accruing interest

     —  
      

Total nonperforming loans

     5,080

Other real estate owned

     740
      

Total nonperforming assets

   $ 5,820
      

Allowance for Loan Losses

We are very focused on the asset quality of our loan portfolio, both before and after the loan is made. We have established underwriting standards that have proven to be effective in maintaining high credit quality in our loan portfolio. We have experienced loan officers who take personal responsibility for the loans they underwrite, a standing credit committee that reviews each loan application carefully, and a requirement that loans that are 60% or more of our legal lending limit must be approved by three executive members of our standing credit committee and an outside director. We have implemented standardized underwriting and credit analysis.

Our allowance for loan losses is established through charges to earnings in the form of a provision for loan losses. Management evaluates the allowance at least quarterly. In addition, on a quarterly basis our board of directors reviews our loan portfolio, evaluates credit quality, reviews the loan loss provision and the allowance for loan and lease losses and makes changes as may be required. In evaluating the allowance, management and the Board of directors consider the growth, composition and industry diversification of the portfolio, historical loan loss experience, current delinquency levels and all other known factors affecting loan collectability.

The allowance for loan losses represents management’s estimate of an amount appropriate to provide for probable incurred losses in the loan portfolio in the normal course of business. We make specific allowances for each loan based on its type and classification as discussed below. However, there are additional factors

 

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contributing to losses that cannot be quantified precisely or attributed to particular loans or categories of loans, including general economic and business conditions and credit quality trends. We have established an unallocated portion of the allowance based on our evaluation of these factors, which management believes is prudent and consistent with regulatory requirements. Due the uncertainty of risks in the loan portfolio, management’s judgment of the amount necessary to absorb loan losses is approximate. The allowance is also subject to regulatory examinations and determination by the regulatory agencies as to the appropriate level of the allowance.

Our loan review program is conducted by a third party consultant who reports directly to the Audit Committee of the Board of Directors. In 2009, loan review reviewed more than 60% of the non-consumer and non-residential loan portfolio outstanding as of December 31, 2008. In 2010 loan review will review at least 60% of the non-consumer and non-residential loan portfolio outstanding as of December 31, 2009. The purpose of loan review is to validate management’s assessment of risk of the individual loans in the portfolio and to determine whether the loan was approved, underwritten and is being monitored in accordance with the bank’s credit policy and regulatory guidance. Management’s risk assessment of individual loans takes into consideration among other factors, the estimated value of the underlying collateral, the borrower’s ability to repay, the borrower’s payment history and current payment status.

The following table presents an analysis of the allowance for loan losses for the periods indicated (in thousands):

 

    For the Year
Ended
December 31,
2009
    For the Year
Ended
December 31,
2008
    For the Year
Ended
December 31,
2007
    For the Year
Ended
December 31,
2006
    For the Period
From Inception
at April 14, 2005
Through
December 31,
2005

Balance, beginning of period

  $ 4,218      $ 3,476      $ 2,726      $ 1,020      $ —  

Allowance from acquired bank

    —          —          —          1,374        —  

Provision charged to operations

    6,538        1,657        1,290        546        1,020

Recoveries credited to allowance

    157        8        —          —          —  
                                     

Total

    10,913        5,141        4,016        2,940        1,020

Loans charged off:

         

Real estate—commercial

    790        65        50        —          —  

Real estate—construction, land and other

    —          —          400        200        —  

Real estate—residential 1-4 family

    1,086        738        75        —          —  

Commercial

    3,852        120        —          —          —  

Consumer

    13        —          15        14        —  
                                     

Total loans charged off

    5,741        923        540        214        —  
                                     

Balance, end of period

  $ 5,172      $ 4,218      $ 3,476      $ 2,726      $ 1,020
                                     

Net charge-offs to average loans, net of unearned income

    1.65     0.32     0.24     0.21     —  

The provision for loan losses charged to operations for the year ended December 31, 2009 increased significantly to $6.5 million from $1.7 million in 2008. We had charge-offs totaling $5.7 million during 2009 compared to $923 thousand in 2008. The increase in the provision for loan losses during 2009 was due to overall growth in the loan portfolio, charge offs and adverse economic factors.

During the fourth quarter of 2009 we charged off one $1.8 million commercial and industrial loan which had paid principal and interest on time from inception in April 2007 through August 2009 (at the end of

 

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September 2009 it was 40 days past due) when it abruptly stopped making payments in the fourth quarter. The company is still operating but their attorney alleges that one of the members of the LLC exceeded his authority and submitted fraudulent documents to us at the time the loan was made. We continued to work with the Company’s management and their legal counsel to work out the loan issue throughout the fourth quarter. We are aggressively pursuing all of the legal remedies available to us, but given the uncertainties associated with the loan we have charged it off in its entirety.

We also charged off $1.3 million on two other loans during the fourth quarter of 2009. One of those loans is a commercial real estate loan placed on non-accrual last quarter and on which we have now begun foreclosure proceedings. The other is a commercial and industrial (C&I) loan which is current (but is now on non-accrual) due to an impairment in the value of our collateral.

The following table describes the allocation of the allowance for loan losses among various categories of loans and certain other information for the dates indicated. The allocation is made for analytical purposes only and is not necessarily indicative of the categories in which future losses may occur.

 

    As of
December 31, 2009
    As of
December 31, 2008
    As of
December 31, 2007
    As of
December 31, 2006
    As of
December 31, 2005
 
  Amount   Percent
of Loans
in Each
Category
to Total
Loans
    Amount   Percent
of Loans
in Each
Category
to Total
Loans
    Amount   Percent
of Loans
in Each
Category
to Total
Loans
    Amount   Percent
of Loans
in Each
Category
to Total
Loans
    Amount   Percent
of Loans
in Each
Category
to Total
Loans
 
                        (in thousands)  

Commercial

  $ 992   16.1   $ 787   20.1   $ 700   20.3   $ 270   9.6   $ 75   8.9

Consumer

    103   0.8     90   1.0     82   0.9     98   1.4     21   2.7

Real estate—commercial

    1,894   36.2     1,337   34.7     1,080   33.3     907   33.8     120   55.3

Real estate—multifamily residential

    122   2.9     198   1.8     104   3.2     48   1.8     —     —     

Real estate—construction and land loans

    1,177   11.6     1,334   18.7     1,080   19.3     927   17.5     234   21.2

Real estate—residential 1-4 family

    274   32.4     347   23.7     301   23.0     394   35.9     7   11.9

Unallocated

    610   —          125   —          129   —          82   —          563   —     
                                                           

Total

  $ 5,172   100.0   $ 4,218   100.0   $ 3,476   100.0   $ 2,726   100.0   $ 1,020   100.0
                                                           

Because there are additional risks of losses that cannot be quantified precisely or attributed to particular loans or types of loans, including general economic and business conditions and credit quality trends, we have established an unallocated portion of the allowance for loan losses based on our evaluation of these risks. The unallocated portion was 3% of the total allowance for loan losses at December 31, 2008 and 11.8% at December 31, 2009.

At year end 2008 we estimated the impact of emerging external environmental factors on credit losses, and as a result, increased the allowance for loan losses by $863 thousand, and allocated these estimated credit losses to loan portfolio components. At year end 2009 these same factors were applied. Loan portfolio growth and changes in composition increased estimated allocated losses arising from these environmental factors to $947 thousand.

Changes in total non-farm employment in our market areas including mass layoffs is an important external environmental factor driving the financial strength of many of our small business customers. According to the U.S. Bureau of Labor Statistics total non-farm employment in the state of Virginia declined by 54,700 or approximately 1.5% in 2009. The decline in Virginia total non-farm employment in 2008 was similar. These were the largest declines in Virginia employment since the year 2001. At the end of 2008 the direction of employment trends in Virginia was clear, and management estimated the affect this and other environmental factors would have on credit losses within

 

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portfolio components. At the end of 2009 the directional trend in total Virginia non-farm employment was unclear and moderating. Total employment was flat in October and November and up slightly in December. During this same time frame, initial unemployment claims in Virginia increased from 12,738 in 2008 to 33,637 in 2009 and mass layoff events increased from 116 in 2008 to 330 in 2009. The impact that these external factors, which may be contra-indicative, will have on individual portfolio components is difficult to estimate. Management plans to allocate these estimated credit losses when the impact of changing environmental factors on the performance of loan portfolio components can be more reliably estimated.

We believe that the allowance for loan losses at December 31, 2009 is sufficient to absorb probable incurred credit losses in our loan portfolio based on our assessment of all known factors affecting the collectability of our loan portfolio. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance for loan losses cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examination, may require additional charges to the provision for loan losses in future periods if the results of their reviews warrant additions to the allowance for loan losses.

Investment Securities

Our securities portfolio composition is meant to provide a rate-sensitive, stable source of income until we can deploy a large portion of these assets into underwritten loans. Our securities portfolio also provides us with required liquidity and securities to pledge as required collateral for certain governmental deposits and borrowed funds.

Our securities portfolio is managed by our president and our treasurer, both of whom have significant experience in this area, with the concurrence of our Asset/Liability Committee. In addition to our president (who is chairman of the Asset/Liability Committee) and our treasurer, this committee is comprised of two outside directors. Investment management is performed in accordance with our investment policy, which is approved annually by the Asset/Liability Committee and the board of directors. Our investment policy addresses our investment strategies, approval process, approved securities dealers and authorized investments. Our investment policy authorizes us to invest in:

 

   

Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC) mortgage-backed securities (MBS)

 

   

Collateralized mortgage obligations

 

   

Treasury securities

 

   

SBA guaranteed loan pools

 

   

Agency securities

 

   

Pooled trust preferred securities comprised of a minimum of 80% bank collateral with an investment grade rating or a minimum of 60% bank collateral with a AAA rating at purchase

 

   

Other corporate debt securities rated Aa3/AA- or better at purchase

Mortgage-backed securities are securities that have been developed by pooling a number of real estate mortgages and which are principally issued by government sponsored entities (GSE’s) such as the GNMA, FNMA and FHLMC. These securities are deemed to have high credit ratings, and minimum regular monthly cash flows of principal and interest are guaranteed by the issuing agencies.

Unlike U.S. Treasury and U.S. government agency securities, which have a lump sum payment at maturity, mortgage-backed securities provide cash flows from regular principal and interest payments and principal prepayments throughout the lives of the securities. Mortgage-backed securities which are purchased at a

 

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premium will generally suffer decreasing net yields as interest rates drop because homeowners tend to refinance their mortgages. Thus, the premium paid must be amortized over a shorter period. Conversely, mortgage-backed securities purchased at a discount will obtain higher net yields in a decreasing interest rate environment. As interest rates rise, the opposite will generally be true. During a period of increasing interest rates, fixed rate mortgage-backed securities do not tend to experience heavy prepayments of principal, and consequently the average life of these securities will be lengthened. If interest rates begin to fall, prepayments will increase.

Collateralized mortgage obligations (CMOs) are bonds that are backed by pools of mortgages. The pools can be GNMA, FNMA or FHLMC pools or they can be private-label pools. The CMOs are designed so that the mortgage collateral will generate a cash flow sufficient to provide for the timely repayment of the bonds. The mortgage collateral pool can be structured to accommodate various desired bond repayment schedules, provided that the collateral cash flow is adequate to meet scheduled bond payments. This is accomplished by dividing the bonds into classes to which payments on the underlying mortgage pools are allocated. The bond’s cash flow, for example, can be dedicated to one class of bondholders at a time, thereby increasing call protection to bondholders. In private-label CMOs, losses on underlying mortgages are directed to the most junior of all classes and then to the classes above in order of increasing seniority, which means that the senior classes have enough credit protection to be given the highest credit rating by the rating agencies.

SNBV’s corporate bonds consist of pooled trust preferred securities issued by banks, thrifts and insurance companies. The collateral pools of these trust preferred securities are generally at least 80% banks or thrifts. If the rating is Aaa/AAA, the collateral pool must be at least 60% banks or thrifts. These securities generally have a long term (25 years or more), allow early redemption by the issuers, make periodic variable interest payments and mature at face value. Trust preferred securities allow the deferral of interest payments for up to five years.

We classify our securities as either: “held-to-maturity” or “available-for-sale.” Securities totaling $57.7 million were in the held-to-maturity portfolio at December 31, 2009, compared to $59.3 million at December 31, 2008. Securities totaling $18.5 million were in the available-for-sale portfolio at December 31, 2009, compared to $15.6 million at December 31, 2008.

We acquired $28.1 million of securities available-for-sale at estimated fair market value in the Greater Atlantic acquisition. Shortly after acquisition, we sold the residential government-sponsored mortgage-backed securities, residential government-sponsored collateralized mortgage obligations and other securities. The acquired fair value at December 4, 2009 is equal to the net proceeds from the subsequent sales.

The following table presents the composition of the securities available-for-sale portfolio acquired at December 4, 2009 (in thousands):

 

     Fair Value

Residential government-sponsored mortgage-backed securities

   $ 8,734

Residential government-sponsored collateralized mortgage obligations

     2,357

SBA guaranteed loan pools

     13,597

Other securities

     3,363
      

Total securities available-for-sale

   $ 28,051
      

 

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As of December 31, 2009, we owned pooled trust preferred securities as follows (in thousands):

 

Security

  Tranche
Level
  Ratings When
Purchased
  Current
Ratings
  Par
Value
  Book
Value
  Estimated
Fair
Value
  Current
Defaults
and

Deferrals
  % of
Current

Defaults
and

Deferrals
to
Current

Collateral
    Sandler
O’Neill (a)
Sterne
Agee (b)
Estimated
Incremental
Defaults
Required to
Break
Yield (1)
  Previously
Recognized
Cumulative
Other
Comprehensive
Loss (2)
   
    Moody’s   Fitch   Moody’s   Fitch                

Investment Grade:

              (in thousands)          

ALESCO VII A1B

  Senior   Aaa   AAA   A3   AA   $ 8,734   $ 7,760   $ 7,177   $ 143,056   23   $ 177,572 b   $ 328  

MMCF II B

  Senior Sub   A3   AA-   Baa2   BBB     577     529     503     34,000   26     16,900 a     48  

MMCF III B

  Senior Sub   A3   A-   Baa3   B     702     685     414     24,000   20     25,100 a     17  
                                         
              10,013     8,974     8,094         $ 393  
                                         
                                                  Cumulative
Other
Comprehensive
Loss (3)
  OTTI
Related to
Credit
Loss (3)

Other Than Temporarily Impaired:

                         

TPREF FUNDING II

  Mezzanine   A1   A-   Caa3   CC     1,500     478     478     104,100   30     —         780   $ 242

TRAP 2007-XII C1

  Mezzanine   A3   A   Ca   CC     2,021     124     124     133,250   27     —         1,318     579

TRAP 2007-XIII D

  Mezzanine   NR   A-   NR   C     2,032     —       —       207,750   28     —         —       2,032

MMC FUNDING XVIII

  Mezzanine   A3   A-   Ca   C     1,028     83     83     90,500   27     —         475     470

ALESCO V C1

  Mezzanine   A2   A   Ca   CC     2,021     552     552     84,442   25     —         956     513

ALESCO XV C1

  Mezzanine   A3   A-   Ca   CC     3,043     28     28     206,800   31     —         456     2,559

ALESCO XVI C

  Mezzanine   A3   A-   Ca   CC     2,028     113     113     132,250   26     —         735     1,180
                                             
              13,673     1,378     1,378         $ 4,720   $ 7,575
                                             

Total

            $ 23,686   $ 10,352   $ 9,472          
                                     

 

(1) A break in yield for a given tranche means that defaults/deferrals have reached such a level that the tranche would not receive all of its contractual cash flows (principal and interest) by maturity (so not just a temporary interest shortfall, but an actual loss in yield on the investment). In other words, the magnitude of the defaults/deferrals has depleted all of the credit enhancement (excess interest and over-collateralization) beneath the given tranche. This represents additional defaults beyond those currently existing.
(2) Pre-tax, and represents unrealized losses at date of transfer from available-for-sale to held-to-maturity
(3) Pre-tax

Since late 2007, the markets for trust preferred securities have become increasingly inactive. According to information received from FTN Financial, there have been no issuances of pooled trust preferred securities since 2007. Beginning in the second quarter of 2008, the purchase and sale activity of trust preferred securities decreased significantly as investors elected to hold the securities instead of selling them at depressed prices. Brokers have indicated that little if any activity is occurring in this sector, and the trust preferred securities trades that are taking place are primarily distressed sales. As a result, the bid-ask spreads have widened significantly and the volume of trades decreased compared to historical volumes.

The decline in the level of observable inputs and market activity in this class of investments by the measurement date has been significant and resulted in unreliable external pricing. Broker pricing and bid/ask spreads, when available, vary widely. The once active market has become comparatively inactive. As such, management utilized guidance in ASC 820-10 to value these securities. The base input in calculating fair value is a Bloomberg Fair Value Index yield curve for single issuer trust preferred securities which correspond to the ratings of the securities we own. We also use composite rating indices to fill in the gaps where the bank rating indices did not correspond to the ratings in our portfolio. When a bank index that matches the rating of our security is not available, we used the bank index that most closely matches the rating, adjusted by the spread between the composite index that most closely matches the security’s rating and the composite index with a rating that matches the bank index used. We then use the adjusted index yield, which is further adjusted by a liquidity premium, as the discount rate to be used in the calculation of the present value of the same cash flows used to evaluate the securities for OTTI. The liquidity premiums were derived in consultation with FTN Financial. The liquidity premiums we

 

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used ranged from .25% to 5%, and the adjusted discount rates ranged from 6.73% to 17.05%. Due to current market conditions as well as the limited trading activity of these securities, the market value of the securities is highly sensitive to assumption changes and market volatility. We have determined that our trust preferred securities are classified within Level 3 of the fair value hierarchy.

Six of the trust preferred securities owned by Sonabank have not continued to pay principal and interest in accordance with the contractual terms of the securities. When this happens the cash flows to the lower classes are temporarily suspended and used to pay down the principal of the senior classes in order to restore the over-collateralization levels of the senior classes. The bonds will continue to accrue interest, but it will be capitalized rather than paid in cash, also known as payment in kind. Interest will be earned on the capitalized interest at the current coupon rate. Once the senior class coverage test is satisfied, the lower classes will begin to receive current interest as well as capitalized interest.

Management has evaluated each of these securities for potential impairment under ASC 325 and the most recently issued guidance described in Note 1 to our financial statements, and has reviewed each of the issues’ collateral participants using various techniques including the ratings provided in the Bank Financial Quarterly published by IDC Financial Publishing, Inc. Management has also reviewed the interest and principal coverage of each of the tranches it owns. In performing a detailed cash flow analysis of each security, management works with independent third parties to identify its best estimate of the cash flow estimated to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an OTTI is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following assumptions:

 

   

We assume that 2% of the remaining performing collateral will default or defer in the first quarter of 2010 and 2% in the second quarter of 2010. We assume 50 basis points per annum thereafter (the previous assumption was 37.5 basis points).

 

   

We assume recoveries ranging from 15% to 25% with a two year lag on new defaults and deferrals, and we assume 15% recoveries on existing defaults and deferrals.

 

   

We assume no prepayments for 10 years and then 1% per annum for the remaining life of the security.

 

   

Our securities have been modeled using the above assumptions by Sandler O’Neill and Sterne Agee using the forward LIBOR curve plus original spread to discount projected cash flows to present values.

Based on our analysis, seven of the ten trust preferred securities we own were considered to be other than temporarily impaired. The total par value of these seven securities was $13.7 million and the fair value was $1.4 million at December 31, 2009. We recognized an OTTI charge of $7.6 million in net income and the remainder through other comprehensive income during 2009.

We also own $2.0 million of SARM 2005-22 1A2. This residential collateralized mortgage obligation was downgraded from B to CCC by Standard and Poors in September 2009, and it was downgraded from BBB to CC by Fitch in August 2009. This security was originated in 2005. The average FICO score of the underlying loans at origination was 748. As of December 31, 2009, delinquencies of more than 60 days, foreclosures and REO totaled 32.1% compared to 30.3% at September 30, 2009. Credit support is 10.24 compared to 14 when originally issued, which provides coverage of 0.97 times projected losses in the collateral. The fair market value is $1.6 million. We have evaluated this security for potential impairment and, based on our review of the trustee report, shock analysis and current information regarding delinquencies, nonperforming loans and credit support, determined that an OTTI does exist as of December 31, 2009 in the amount of $139 thousand.

 

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The fair value of available for sale securities and the related gross unrealized gains and losses recognized in accumulated other comprehensive income (loss) were as follows (in thousands):

 

    Amortized
Cost
  Gross Unrealized     Fair
Value
    Gains   Losses    

December 31, 2009

       

Residential government-sponsored mortgage-backed securities

  $ 4,967   $ —     $ (53   $ 4,914

SBA guaranteed loan pools

    13,412     151     (13     13,550

FHLMC preferred stock

    16     25     —          41
                         

Total

  $ 18,395   $ 176   $ (66   $ 18,505
                         
      Amortized
Cost
  Gross Unrealized     Fair
Value
    Gains   Losses    

December 31, 2008

       

Residential government-sponsored mortgage-backed securities

  $ 15,431   $ 243   $ (65   $ 15,609

FHLMC preferred stock

    24     —       —          24
                         

Total

  $ 15,455   $ 243   $ (65   $ 15,633
                         

The carrying amount, unrecognized gains and losses, and fair value of securities held to maturity were as follows (in thousands):

 

      Carrying
Amount
  Gross Unrecognized     Fair
Value
    Gains   Losses    

December 31, 2009

       

Residential government-sponsored mortgage-backed securities

  $ 45,369   $ 1,173   $ (169   $ 46,373

Residential government-sponsored collateralized mortgage obligations

    398     21     —          419

Other residential collateralized mortgage obligations

    1,577     —       —          1,577

Trust preferred securities

    10,352     —       (880     9,472
                         
  $ 57,696   $ 1,194   $ (1,049   $ 57,841
                         
      Carrying
Amount
  Gross Unrecognized     Fair
Value
    Gains   Losses    

December 31, 2008

       

Residential government-sponsored mortgage-backed securities

  $ 34,924   $ 783   $ (71   $ 35,636

Residential government-sponsored collateralized mortgage obligations

    2,772     15     —          2,787

Other residential collateralized mortgage obligations

    2,510     —       (834     1,676

Trust preferred securities

    19,120     —       (10,435     8,685
                         
  $ 59,326   $ 798   $ (11,340   $ 48,784
                         

 

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The following table sets forth the amortized cost and estimated fair value of our investment securities by contractual maturity at December 31, 2009. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties (in thousands).

 

     Securities Available for Sale  
   Amortized
Cost
   Estimated
Fair Value
   Weighted
Average
Yield
 

Residential government-sponsored mortgage-backed securities
    Due after ten years

   $ 4,967    $ 4,914    4.40
                

SBA guaranteed loan pools

        

Due in one to five years

     261      262    2.33

Due in five to ten years

     1,653      1,663    2.32

Due after ten years

     11,498      11,625    2.96
                

Total SBA guaranteed loan pools

     13,412      13,550    2.87

FHLMC preferred stock

     16      41    0.00
                
   $ 18,395    $ 18,505    3.28
                
     Securities Held to Maturity  
   Amortized
Cost
   Estimated
Fair Value
   Weighted
Average
Yield
 

Residential government-sponsored mortgage-backed securities
    Due after ten years

   $ 45,369    $ 46,373    4.51
                

Residential government-sponsored collateralized mortgage obligations
    Due after five years through ten years

     398      419    5.88
                

Other residential collateralized mortgage obligations
    Due after ten years

     1,577      1,577    3.62
                

Total collateralized mortgage obligations

     1,975      1,996    4.08
                

Trust preferred securities
    Due after ten years

     10,352      9,472    3.41
                
   $ 57,696    $ 57,841    4.30
                

Deposits and Other Borrowings

The market for deposits is competitive. We offer a line of traditional deposit products that currently includes non-interest-bearing and interest-bearing checking (or NOW accounts), commercial checking, money market accounts, savings accounts and certificates of deposit. We compete for deposits through our banking branches with competitive pricing, advertising and online banking. We use deposits as a principal source of funding for our lending, purchasing of investment securities and for other business purposes.

Non-interest bearing deposits increased from $23.2 million at December 31, 2008, to $33.3 million at December 31, 2009.

Interest bearing deposits rose from $286.2 million at December 31, 2008, to $422.5 million as of December 31, 2009. The growth was attributable to the assumption of $178.7 million in deposits in the Greater Atlantic transaction and $26.8 million in the Millennium acquisition. Brokered certificates of deposit were $118.3 million at December 31, 2008, compared to $70.0 million at December 31, 2009.

 

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We utilize brokered certificates of deposit and brokered money market deposits and will continue to utilize these sources for deposits when they can be cost-effective. At December 31, 2009 and 2008, these brokered deposits constituted approximately 21% and 47% of our total deposits, respectively. The brokered certificates of deposit we typically obtain have terms to maturity of three months to two years. These deposits generally have the effect of slightly increasing our cost of funds and slightly decreasing our net interest margin when compared to our local deposit base.

The following table sets forth the average balance and average rate paid on each of the deposit categories for the years ended December 31, 2009, 2008 and 2007:

 

     2009     2008     2007  
   Average
Balance
   Average
Rate
    Average
Balance
   Average
Rate
    Average
Balance
   Average
Rate
 
   (in thousands)  

Noninterest-bearing deposits

   $ 24,001      $ 19,992      $ 17,698   

Interest-bearing deposits:

               

Savings accounts

     2,505    0.55     2,186    0.23     2,658    0.45

Money market accounts

     58,462    1.66     52,803    2.32     40,855    4.19

NOW accounts

     8,048    0.19     6,356    0.22     6,569    0.26

Time deposits

     234,540    2.44     214,624    4.32     163,531    5.19
                           

Total interest-bearing deposits

     303,555    2.22     275,969    3.81     213,613    4.79
                           

Total deposits

   $ 327,556      $ 295,961      $ 231,311   
                           

The following table sets forth the maturities of certificates of deposit of $100 thousand and over as of December 31, 2009 (in thousands):

 

Within 3 Months

   3 to 6 Months    6 to 12 Months    Over 12 Months    Total
$26,614    $ 22,828    $