UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20849
FORM 10-KSB
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 FOR THE YEAR ENDED DECEMBER 31, 2006
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF THE EXCHANGE ACT
FOR THE TRANSITION PERIOD
COMMISSION FILE NUMBER 0-50237
VSB Bancorp, Inc.
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(Name of Small Business Issuer in its charter)
New York
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(State or other jurisdiction of incorporation or organization)
11 - 3680128
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(I. R. S. Employer Identification No.)
4142 Hylan Boulevard, Staten Island, New York 10308
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(Address of principal executive offices)
(718) 979-1100
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Issuer's telephone number
Common Stock
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(Title of Class)
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. [X] 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-KSB/A or any amendment to
this Form 10-KSB/A. [ ].
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). [ ] Yes [X] No
Indicate by check mark if accelerated filer. [ ] Yes [X] No.
State Issuer's revenues for the most recent fiscal year: $15,015,110.
The aggregate market value of the voting stock held by non-affiliates of the
registrant at June 30, 2006 was $24,441,095.
The registrant had 1,891,759 common shares outstanding as of March 13, 2007.
Documents incorporated by reference:
Portions of the registrant's definitive proxy statement filed on or about March
23, 2007 into Part III of this Form 10-KSB.
Forward-Looking Statements
When used in this Form 10-KSB, or in any written or oral statement made
by us or our officers, directors or employees, the words and phrases "will
result," "expect," "will continue," "anticipate," "estimate," "project," or
similar terms are intended to identify "forward-looking statements." A variety
of factors could cause our actual results and experiences to differ materially
from the anticipated results or other expectations expressed in any
forward-looking statements. Some of the risks and uncertainties that may affect
our operations, performance, development and results, the interest rate
sensitivity of our assets and liabilities, and the adequacy of our loan loss
allowance, include, but are not limited to:
o deterioration in local, regional, national or global economic
conditions which could result in, among other things, an increase
in loan delinquencies, a decrease in property values, or a change
in the real estate turnover rate;
o changes in market interest rates or changes in the speed at which
market interest rates change;
o changes in laws and regulations affecting the financial service
industry;
o changes in competition; and
o changes in consumer preferences by our customers or the customers
of our business borrowers.
Please do not place undue reliance on any forward-looking statement,
which speaks only as of the date made. There are many factors, including those
described above, that could affect our future business activities or financial
performance and could cause our actual future results or circumstances to differ
materially from those we anticipate or project. We do not undertake any
obligation to update any forward-looking statement after it is made.
2
PART I
Item 1. Description of Business.
Business of VSB Bancorp, Inc.
VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company")
became the holding company for Victory State Bank (the "Bank"), a New York
chartered commercial bank, upon the completion of a reorganization of the Bank
into the holding company form of organization. The reorganization was effective
in May 2003. All the outstanding stock of Victory State Bank was exchanged for
stock of VSB Bancorp, Inc. on a three for two basis so that the stockholders of
Victory State Bank became the owners of VSB Bancorp, Inc. and VSB Bancorp, Inc.
owns all the stock of Victory State Bank. The common stock we issued in the
transaction qualifies as exempt securities under Section 3(a)(12) of the
Securities Act of 1933. Our primary business is owning all of the issued and
outstanding stock of the Bank. Our common stock was listed on the NASDAQ Capital
Market, formerly known as the NASDAQ SmallCap Market, effective on March 16,
2007. We continue to trade under our current symbol "VSBN".
The main office of the Company and the Bank is at 4142 Hylan Boulevard, Staten
Island, New York 10308, telephone (718) 979-1100. We maintain an Internet web
site at www.victorystatebank.com.
We also own all of the common stock of VSB Capital Trust I, a special purpose
trust established to issue $5 million of trust preferred securities in August
2003. Under Federal Reserve Regulations, provided that certain conditions are
met, up to 25% of our Tier I capital requirement may be satisfied through funds
raised by the sale of trust preferred securities. We used the proceeds from the
sale of the trust preferred securities to continue to satisfy our regulatory
capital requirements. We contributed $4.2 million of the proceeds from the sale
of those securities to Victory State Bank as capital, thus providing the Bank
with capital to support future growth. Trust preferred securities are long-term
debt securities in which interest paid to the owner of the security is tax
deductible to the holding company, in contrast to dividends paid by the holding
company, which do not provide a tax benefit to the company that pays the
dividends. The tax deductibility of the interest payments means that trust
preferred securities can be a low-cost source of capital.
Victory State Bank
Victory State Bank is a New York State chartered commercial bank, founded in
November 1997. The Bank is supervised by the New York State Banking Department
and the Federal Deposit Insurance Corporation ("FDIC"). The Bank's principal
business has been and continues to be attracting commercial deposits from
primarily the general public and investing those deposits, together with funds
generated from operations and repayments on existing investments, primarily in
loans for business purposes and investment securities. The Bank's revenues are
derived principally from interest on our commercial loan and investment
securities portfolios. The Bank's primary sources of funds are deposits and
principal and interest payments on loans and investment securities.
Victory State Bank serves its primary market of Staten Island, New York through
its five banking offices. The Bank opened its original main office in the
Oakwood section of Staten Island in November 1997 which was closed in February
2007 as the lease expired at that location; its first branch was opened in the
West Brighton section of Staten Island in June 1999; its second branch in the
St. George section of Staten Island in January 2000; its third branch in the
Dongan Hills section of Staten Island in December 2002 and its fourth branch in
the Rosebank section of Staten Island in April 2006. In February 2007, the Bank
opened its new main office in the Great Kills section of Staten Island. The
Bank's deposits are insured by the Federal Deposit Insurance Corporation up to
the maximum amounts permitted by law. Victory State Bank also serves its
customers through its website, www.victorystatebank.com.
3
Market Area and Competition
Victory State Bank has been, and continues to be, a community-oriented,
state-chartered commercial bank offering a variety of traditional financial
services to meet the needs of the communities in which it operates. Management
considers our reputation for customer service as its major competitive advantage
in attracting and retaining customers in its market area.
Our primary market area is concentrated in the neighborhoods surrounding our
branches in the New York City Borough of Staten Island. Management believes that
our branch offices are located in communities that can generally be
characterized as stable, residential neighborhoods of predominantly one- to
four-family residences and middle income families.
From 1990 to 2000, Staten Island's population grew to 443,728 from 378,977, or a
17% increase. There was a modest shift from the 20 to 44 year age group to the
45 to 64 year age group. As a percentage of population, the 45 to 64 year age
group increased from 19.8% to 23.4% during the decade. The largest age group
continued to be the 20 to 44 age group, at 37.0% of total population.
Median household income increased to $55,039 from $50,064 during the decade of
the 90's. Per capita income in 1999 was $23,905 in Staten Island, slightly
higher than $23,389, the per capita income of New York State. One third of the
households in Staten Island had household income of more than $75,000 in 1999.
These income levels compare favorably with the national household median of
$41,994 and the national per capita median of $21,587. The income levels in
Staten Island provide satisfactory support for personal home ownership, in turn
supporting the home building industry, which is a major industry focus for
Victory State Bank.
As the population grew, the total number of households increased to 156,341 from
130,519. Total housing units stood at 163,993 in 2000, as compared to 139,726 in
1990. Owner occupied housing units represented 63.8% of total housing units in
2000, which was consistent with the 63.7% level in 1990. This reflects an
increase of approximately 15,600 owner-occupied housing units during the decade
and demonstrates the importance of the housing market, especially people
purchasing homes for their personal use, to the local economy.
The New York City metropolitan area has a high density of financial
institutions, many of which are significantly larger and have greater financial
resources than we have, and all of which are our competitors to varying degrees.
Our competition for loans comes principally from commercial banks, savings banks
and insurance companies. Our most direct competition for deposits has come from
commercial banks and savings banks. In addition, we face increasing competition
for deposits from non-bank institutions such as brokerage firms and insurance
companies in such areas as short-term money market funds, corporate and
government securities funds, mutual funds and annuities.
RISK FACTORS
Bank lending is an inherently risky business. A substantial portion of our
assets are invested in loans, and loans necessarily present many risks. We must
first rely on our borrowers to repay their loans, and if they are unable to do
so, we must rely on the value of the collateral, if any, for the loan. Changing
business conditions, increases in unemployment, personal problems that a
borrower may experience, changes in the regulations that apply to a borrower's
business, changes in the political climate or in public policy, and many other
factors outside our control, could adversely affect the ability of our borrowers
to repay their loans or the value of the collateral we have received. Although
we seek to reduce these risks through underwriting procedures that we believe
are prudent, it is impossible for us to completely eliminate the risks which
arise from making loans except by eliminating our lending operations.
Fluctuations in interest rates could have an adverse affect on our
profitability. Our principal source of income is the difference between the
interest income we earn on interest-earning assets, such as loans and
securities, and our cost of funds, principally interest paid on deposits. These
rates of interest change from time to time, depending upon a number of factors,
including general market interest rates. However, the frequency of the changes
4
varies among different types of assets and liabilities. For example, for a
five-year loan with an interest rate based upon the prime rate, the interest
rate may change every time the prime rate changes. In contrast, the rate of
interest we pay on a five-year certificate of deposit adjusts only every five
years, based upon changes in market interest rates.
In general, the interest rates we pay on deposits adjust more slowly than the
interest rates we earn on loans because the largest part of our loan portfolio
consist of loans with interest rates that fluctuate based upon the prime rate.
In contrast, although many of our deposit categories have interest rates that
could adjust immediately, such as interest checking accounts and savings
accounts, changes in the interest rates on those accounts are at our discretion
and tend to occur more slowly. As a result, increases in market interest rates
could increase our net interest income because our cost of deposits would
probably increase more slowly than the yields on our loans. However, customer
preferences and competitive pressures may negate this positive effect because
customers may choose to move funds into higher-earning deposit types as higher
interest rates make them more attractive, or competitors offer premium rates to
attract deposits. We also have a substantial portfolio of investment securities
with fixed rates of interest, most of which are mortgage-backed securities with
an estimated average life of not more than 5 years.
There is only a very limited trading market for our common stock. We have
recently listed our common stock on the NASDAQ Capital Market, formerly known as
the NASDAQ SmallCap Market, which listing was effective on March 16, 2007. We
continue to trade under the symbol "VSBN." We applied for that listing in the
hope that it would increase the trading market in our stock and make it easier
for individuals to buy and sell our stock. However, our stock does not trade
every day and the average daily trading volume is limited. During the twelve
months ended March 1, 2007, there were trades were reported on only 97 out of
253 trading days, or slightly more than one out of every three trading days, and
our average daily trading volume during that period was 1,063 shares. We
currently have approximately 153 stockholders of record and we believe based
upon reports we have received from broker/dealers, that there are approximately
an additional 250 stockholders who own their shares in street name.
The geographic concentration of our loans increases the risk that adverse
economic conditions could affect our net income. Substantially all of our loans
are mortgage loans on property located in Staten Island, New York, or loans to
residents of Staten Island. Staten Island has experienced an economic down turn
in recent years. A continued economic slow-down or decline in the local economy
could have an adverse effect on us for a number of reasons. Adverse economic
conditions could hurt the ability of our borrowers to repay their loans. If real
estate values decline, reductions in the value of real estate collateral could
make it more difficult for us to recover the full amount due on loans which go
into default. Furthermore, economic difficulties can also increase deposit
outflows as customers must use savings to pay bills. This could increase our
cost of funds because of the need to replace the deposit outflow. All of these
factors might combine to reduce significantly our net income.
Our loans are concentrated in the residential building trades industry, and thus
a downturn in the local housing market could adversely affect our net income.
The largest segment of our loan portfolio is represented by loans to home
builders and others involved in the home building industry, such as equipment
and material suppliers. At December 31, 2006, 29.1% of our loans were
construction mortgage loans, primarily for the construction of residential
properties. Our non-mortgage commercial loans, totaling an additional 18.1% of
our loan portfolio were also concentrated in companies involved in the
construction industry and some of our other loans also involved companies in
related industries. As a result, a down turn in the housing market in our Staten
Island lending area could have a significant negative impact on both our loan
portfolio and our level of deposits. Not only could such a down turn adversely
affect the ability of our borrowers to repay their loans, but it could also
reduce our ability to generate new loans that satisfy our underwriting criteria.
Furthermore, businesses in the home building industry are a source of deposits
as well as loans, and if their businesses suffer, they are likely to reduce the
level of deposits they maintain at with us.
Changes in the federal or state regulation of financial institutions could have
an adverse effect on future operations. Federal and New York State banking laws
and regulations exert substantial control over our operations. Federal and state
regulatory authorities have extensive discretion in connection with their
supervision of Victory State Bank, such as the right to impose restrictions on
5
operations and the insistence that we increase our allowance for loan losses.
Furthermore, federal and state laws affecting banks are constantly being
revised, often imposing new restrictions or increasing competitive pressures
through de-regulation. Any change in the regulatory structure or statutes or
regulations applicable to banks, bank holding companies, or their competitors,
whether by the Congress, the FDIC, the Federal Reserve System, the New York
State legislature, the New York State Banking Department or any other regulator,
could have a material impact on our operations and profitability. For example,
in late 2006, the FDIC adopted new regulations regarding FDIC insurance premiums
that banks must pay and imposed premium assessments for the first time in a
number of years, effective beginning in 2007. Banks that were in existence prior
to December 31, 1996 have a credit against the assessments, but since we did not
open for business until 1997, we do not have the benefit of any credit. We
estimate that our FDIC insurance premium in 2007 will be approximately $100,000,
compared to no assessment in 2006.
We operate in an extremely competitive environment. We operate in one of the
most competitive environments for financial products in the world. Many of the
world's largest financial institutions have offices in our local communities,
and they have far greater financial resources than we have. We seek to
distinguish ourselves from those institutions by providing personalized service
and providing the same level of care to small community based businesses that
only Fortune 500 companies can obtain from the largest banks.
The Loss of Key Personnel Could Impair our Future Success. Mert Corn, our
President and CEO, has announced that he will be retiring on November 15, 2007.
Pursuant to a succession plan approved by the Board of Directors, Raffaele
Branca, our Executive Vice President and Chief Financial Officer, will be
assuming the position of President and CEO. Our future success depends in part
on the service of our executive officers, other key management, as well as our
staff, and our ability to continue to attract, motivate, and retain additional
highly qualified employees. The loss of one or more of our key personnel or our
inability to timely recruit replacements for such personnel, or otherwise
attract, motivate, or retain qualified personnel could have an adverse effect on
our business, operating results and financial condition.
Lending Activities
Loan Portfolio Composition. Our loan portfolio consists primarily of commercial
mortgage loans and unsecured commercial loans. At December 31, 2006, we had
total unsecured commercial loans outstanding of $10,882,002, or 16.3% of total
loans, and commercial real estate loans of $33,215,627, or 49.9% of total loans.
There was $19,377,797 of construction loans secured by real estate, $17,552,797
of which were construction loans to businesses for the construction of either
commercial property or residential property for sale, 26.4% representing of
total loans. Other loans in our portfolio principally included commercial loans
secured by assets other than real estate totaling $1,231,880 or 1.8% of total
loans at December 31, 2006 and consumer non-mortgage loans of $826,528 or 1.2%
of total loans. For the year ended December 31, 2006, approximately $56,918,242,
or 85.4%, of loans for business purposes had adjustable interest rates based on
the prime rate of interest.
The following table sets forth the composition of our loan portfolio in dollar
amounts and in percentages at the dates indicated
6
At December 31,
------------------------------------------------------------------------------------------------------------
2006 2005 2004 2003 2002
-------------------- -------------------- -------------------- -------------------- --------------------
% % % of % of % of
Amount of Total Amount of Total Amount Total Amount Total Amount Total
----------- -------- ----------- -------- ----------- -------- ----------- -------- ----------- --------
Commercial loans:
Commercial secured $ 1,231,880 1.8% $ 1,584,484 2.1% $ 1,572,824 2.3% $ 1,896,374 2.8% $ 4,014,494 6.3%
Commercial unsecured 10,882,002 16.3 11,078,101 14.9 9,620,243 14.1 8,905,587 13.1 11,322,164 17.7
----------- -------- ----------- -------- ----------- -------- ----------- -------- ----------- --------
Total commercial
loans 12,113,882 18.1 12,662,585 17.0 11,193,067 16.4 10,801,961 15.9 15,336,658 24.0
Real Estate loans:
Commercial 33,215,627 49.9 29,794,108 40.1 31,741,069 46.5 32,416,537 47.5 31,357,950 49.1
One-to-four family 165,801 0.2 298,779 0.4 1,112,032 1.6 1,382,490 2.0 493,504 0.8
----------- -------- ----------- -------- ----------- -------- ----------- -------- ----------- --------
Total real
estate loans 33,381,428 50.1 30,092,887 40.5 32,853,101 48.1 33,799,027 49.5 31,851,454 49.9
Construction loans:
Commercial 17,552,797 26.4 26,623,846 35.8 19,893,858 29.1 20,390,849 29.8 13,562,442 21.3
Owner occupied
one-to-four family 1,825,000 2.7 2,987,500 4.0 2,960,000 4.3 1,870,000 2.7 1,315,000 2.1
----------- -------- ----------- -------- ----------- -------- ----------- -------- ----------- --------
Total
construction
loans 19,377,797 29.1 29,611,346 39.8 22,853,858 33.4 22,260,849 32.5 14,877,442 23.4
Other loans:
Consumer loans 826,528 1.2 1,477,366 2.0 1,048,448 1.5 949,899 1.4 1,179,485 1.9
Other loans 974,278 1.5 486,009 0.7 435,837 0.6 510,617 0.7 509,073 0.8
----------- -------- ----------- -------- ----------- -------- ----------- -------- ----------- --------
Total other loans 1,800,806 2.7 1,963,375 2.7 1,484,285 2.1 1,460,516 2.1 1,688,558 2.7
Total loans 66,673,913 100.0% 74,330,193 100.0% 68,384,311 100.0% 68,322,353 100.0% 63,754,112 100.0%
----------- ======== ----------- ======== ----------- ======== ----------- ======== ----------- ========
Less:
Unearned discounts,
net and deferred
loan fees, net 263,236 386,088 337,426 340,892 339,601
Allowance for
loan losses 1,128,824 1,153,298 1,299,520 1,162,776 1,168,358
----------- ----------- ----------- ----------- -----------
Loans, net $65,281,853 $72,790,807 $66,747,365 $66,818,685 $62,246,153
=========== =========== =========== =========== ===========
The following table sets forth our loan originations and principal repayments
for the periods indicated. We did not purchase or sell any loans in 2006, 2005
or 2004.
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
------------ ------------ ------------
Commercial Loans (gross):
At beginning of period $ 12,662,585 $ 11,193,067 $ 10,801,961
Commercial loans originated:
Secured 997,696 1,318,810 537,400
Unsecured 65,961,375 39,289,021 23,088,067
------------ ------------ ------------
Total commercial loans 66,959,071 40,607,831 23,625,467
Principal repayments (67,507,774) (39,138,313) (23,234,361)
------------ ------------ ------------
At end of period $ 12,113,882 $ 12,662,585 $ 11,193,067
============ ============ ============
Real Estate loans:
At beginning of period $ 30,092,887 $ 32,853,101 $ 33,799,027
Real estate loans originated:
Commercial 17,983,000 11,228,592 10,373,324
One-to-four family 365,000 370,000 325,000
------------ ------------ ------------
Total real estate loans 18,348,000 11,598,592 10,698,324
Principal repayments (15,059,459) (14,358,806) (11,644,250)
------------ ------------ ------------
At end of period $ 33,381,428 $ 30,092,887 $ 32,853,101
============ ============ ============
Construction loans
At beginning of period $ 29,611,346 $ 22,853,858 $ 22,260,849
Construction loans originated 9,940,000 33,364,808 26,851,000
Principal repayments (20,173,549) (26,607,320) (26,257,991)
------------ ------------ ------------
At end of period $ 19,377,797 $ 29,611,346 $ 22,853,858
============ ============ ============
Other loans (gross):
At beginning of period $ 1,963,375 $ 1,484,285 $ 1,460,516
Other loans originated 1,251,666 1,801,270 1,242,684
Principal repayments (1,414,235) (1,322,180) (1,218,915)
------------ ------------ ------------
At end of period $ 1,800,806 $ 1,963,375 $ 1,484,285
============ ============ ============
Loan Maturity. The following table shows the contractual maturity of our loans
at December 31, 2006.
7
At December 31, 2006
---------------------------------------------------------------------------------------
Commercial Commercial Other
Unsecured Secured Construction Real Estate Loans Total
------------ ------------ ------------ ------------ ------------ ------------
Amounts due:
Within one year (1) $ 7,336,104 $ 478,330 $ 15,577,797 $ 5,563,886 $ 1,213,314 $ 30,169,431
After one year:
One to five years 3,545,898 753,550 3,800,000 15,366,159 587,492 24,053,099
Total due after five years -- -- -- 12,451,383 -- 12,451,383
------------ ------------ ------------ ------------ ------------ ------------
Total amount due 10,882,002 1,231,880 19,377,797 33,381,428 1,800,806 66,673,913
Less:
Unearned fees -- 280 93,867 169,089 -- 263,236
Allowance for loan
losses 337,054 10,859 198,901 531,121 50,889 1,128,824
------------ ------------ ------------ ------------ ------------ ------------
Loans, net $ 10,544,948 $ 1,220,741 $ 19,085,029 $ 32,681,218 $ 1,749,917 $ 65,281,853
============ ============ ============ ============ ============ ============
The following table sets forth at December 31, 2006, the dollar amount of all
loans, due after December 31, 2007, and whether such loans have fixed or
variable interest rates.
Due After December 31, 2006
---------------------------------------------
Fixed Variable Total
------------ ------------ ------------
Commercial Loans:
Unsecured $ 345,297 $ 3,200,601 $ 3,545,898
Secured 267,335 486,215 753,550
Real Estate
Commercial 790,291 26,934,374 27,724,665
One-to-four 92,877 -- 92,877
Construction 250,000 3,550,000 3,800,000
Other loans 587,492 -- 587,492
------------ ------------ ------------
Total loans $ 2,333,292 $ 34,171,190 $ 36,504,482
============ ============ ============
Commercial Business Lending. We originate commercial business loans directly to
the professional and business community in our market area. We target small to
medium sized business, and professionals such as lawyers, doctors and
accountants. Applications for commercial business loans are obtained primarily
from the efforts of our directors and senior management, who have extensive
contacts in the local business community, or from branch referrals. As of
December 31, 2006, commercial loans totaled $12,113,882 or 18.1% of total loans.
Commercial business loans we originate generally have terms of five years or
less and have adjustable interest rates tied to the Wall Street Journal Prime
Rate plus a margin. Such loans may be secured or unsecured. Secured commercial
business loans can be collateralized by receivables, inventory and other assets.
All these loans are either loans to individuals for which they have personal
liability or loans to entities backed by the personal guarantee of principals of
the borrower. The loans generally have shorter maturities and higher yields than
residential lending. Management has extensive experience in originating
commercial business loans within our marketplace.
Commercial business loans generally carry the greatest credit risks of the loans
in our portfolio because repayment is more dependent on the success of the
business operations of the borrower. Some of these loans are unsecured and those
that are secured frequently have collateral that rapidly depreciates or is
difficult to control in the event of a default.
Commercial Real Estate Lending. We originate commercial real estate loans that
are generally secured by properties used for business purposes such as retail
stores, other mixed-use (business and residential) properties, restaurants,
light industrial and small office buildings located in our primary market area.
Our commercial real estate loans are generally made in amounts up to 70% of the
8
appraised value of the property. These loans are most commonly made with terms
up to five years with interest rates that adjust to 100 or 150 basis points
above the floating prime rate. A significant portion of these loans are subject
to an interest rate floor ranging between 7.00% to 7.50%. Our underwriting
standards consider the collateral of the borrower, the net operating income of
the property and the borrower's expertise, credit history and profitability. We
require personal guarantees from the borrower or the principals of the borrowing
entity. At December 31, 2006, our commercial real estate loans totaled
$33,381,428 or 50.1% of total loans.
Loans secured by commercial real estate are generally larger and involve greater
risks than one-to-four family residential mortgage loans, but generally lesser
risks than commercial loans. Because payments on loans secured by commercial
real estate properties are often dependent on the successful operation and
management of the properties, repayment of such loans may be subject to adverse
conditions in the real estate market or the economy, to a greater extent than
other types of loans. We seek to minimize these risks through our lending
policies and underwriting standards, which restrict new originations of such
loans to our primary lending area and qualify such loans on the basis of the
property's income stream, collateral value and debt service ratio.
Construction Lending. Our construction loans primarily have been made to
builders and developers to finance the construction of one- to four-family
residential properties and, to a lesser extent, multi-family residential real
estate properties. Our policies provide that construction loans may be made in
amounts up to the lesser of 80% of the total hard and soft costs of the project
or Victory State bank's loans to-one borrower limitation. We generally require
personal guarantees. Construction loans generally are made with prime-based
interest rates with terms up to 18 months. Loan proceeds are disbursed in
increments as construction progresses and as inspections warrant. At December
31, 2006, our construction loans totaled $19,377,797 or 29.1% of total loans.
Construction loans generally carry greater credit risks than residential
mortgage loans on completed properties because their repayment is more dependent
on the borrower's ability to sell or rent units under construction and the
general as well as local economic conditions. Because payments on construction
loans are often dependent on the successful completion of construction project
and the management of the project, repayment of such loans may be subject to
adverse conditions in the real estate market or the economy, to a greater extent
than other types of loans.
Loan Approval Procedures and Authority. All unsecured loans in excess of
$200,000 and all secured loans over $400,000, are reviewed and approved by the
Loan Committee, which consists of seven directors of Victory State Bank, prior
to commitment. Smaller loans may be approved by underwriters designated by the
Bank's Chief Executive Officer. Consumer loans not secured by real estate and
unsecured consumer loans, depending on the amount of the loan and the loan to
value ratio, where applicable, require the approval of the Bank's Chief Lending
Officer and/or Chief Executive Officer.
Upon receipt of a completed loan application from a prospective borrower, we
order a credit report and we verify other information. If necessary, we request
additional financial information. An independent appraiser we designate performs
an appraisal of the real estate intended to secure the proposed loan. The Board
of Victory State Bank annually approves the independent appraisers and approves
the Bank's appraisal policy. It is our policy to obtain title insurance on all
real estate first mortgage loans. Borrowers must also obtain hazard insurance
prior to closing. Some borrowers are required to make monthly escrow deposits
which we then use to pay items such as real estate taxes.
Delinquencies and Classified Assets
Delinquent Loans. Our collection procedures for mortgage loans include sending a
past due notice at 15 days and a late notice after payment is 30 days past due.
In the event that payment is not received after the late notice, letters are
sent or phone calls are made to the borrower. We attempt to obtain full payment
or work out a repayment schedule with the borrower to avoid foreclosure.
Generally, we authorize foreclosure proceedings when a loan is over 90 days
delinquent. We record property acquired in foreclosure as real estate owned at
the lower of its appraised value less costs to dispose, or cost. We cease to
accrue interest on all loans 90 days past due and reverse all accrued but unpaid
interest when the loan becomes non-accrual. We continue to accrue interest on
construction loans that are 90 days past contractual maturity date if we expect
the loan to be paid in full in the next 60 days and all interest is paid up to
date.
9
The collection procedures for other loans generally include telephone calls to
the borrower after ten days of the delinquency and late notices at 15 and 25
days past due. Letters and telephone calls generally continue until the matter
is referred to a collection attorney or resolved. After the loan is 90 days past
due, the loan is referred to counsel and is written-off.
Classified Assets. Federal regulations and our Loan Review and Risk Rating
Policy provide for the classification of loans and other assets we consider to
be of lesser quality as "Substandard", "Doubtful" or "Loss" assets. An asset is
considered "Substandard" if it is inadequately protected by the current net
worth and paying capacity of the obligor or of the collateral pledged, if any.
"Substandard" assets include those characterized by the "distinct possibility"
that the insured institution will sustain "some loss" if the deficiencies are
not corrected. Assets classified as "Doubtful" have all of the weaknesses
inherent in those classified "Substandard" with the added characteristic that
the weaknesses present make "collection or liquidation in full," on the basis of
currently existing facts, conditions, and values, "highly questionable and
improbable." Assets classified as "Loss" are those considered "uncollectible"
and of such little value that their continuance as assets without the
establishment of a specific loss reserve is not warranted. Assets which do not
currently expose us to sufficient risk to warrant classification but which
possess weaknesses are designated "Special Mention" by management. We had twenty
four (24) loans, in the aggregate amount of $4,996,545, classified as special
mention, six (6) loans, in the aggregate amount of $887,319, classified as
substandard, one (1) loan, in the amount of $15,462, classified as doubtful, and
no loans classified as loss as of December 31, 2006.
When we classify an asset as Substandard or Doubtful, we provide, as part of our
general allowance for loan losses, an amount management deems prudent to
recognize the risks pertaining to the asset. A general allowance represents a
loss allowance which has been established to recognize the inherent risk
associated with lending activities, but which, unlike a specific allowance, has
not been allocated to particular problem assets. When we classify an asset as
"Loss," we either establish a specific allowance for losses equal to 100% of the
amount of the asset or charge off that amount.
Victory State Bank's Loan Review Officer and Board of Directors regularly review
problem loans and review all classified assets on a quarterly basis. We believe
our policies are consistent with the regulatory requirements regarding
classified assets. Our determination as to the classification of our assets and
the amount of our valuation allowances is subject to review by the New York
State Banking Department and the FDIC, which can order the establishment of
additional general or specific loss allowances.
The following table sets forth delinquencies in our loan portfolio as of the
dates indicated:
10
At December 31, 2006
------------------------------------------------------
60-89 Days 90 Days or more
Number Principal Number Principal
----------- ----------- ----------- -----------
Commercial real estate -- $ -- 3 $ 773,924
Commercial unsecured 2 29,648 1 20,709
Other 1 9,676 -- --
----------- ----------- ----------- -----------
Total 3 $ 39,324 4 $ 794,633
=========== =========== =========== ===========
Delinquent loans to total loans 0.06% 1.19%
At December 31, 2005
------------------------------------------------------
60-89 Days 90 Days or more
Number Principal Number Principal
----------- ----------- ----------- -----------
Commercial real estate -- $ -- 6 $ 1,123,081
Commercial construction -- -- 2 579,000
Commercial unsecured 1 8,420 -- --
----------- ----------- ----------- -----------
Total 1 $ 8,420 8 $ 1,702,081
=========== =========== =========== ===========
Delinquent loans to total loans 0.01% 2.29%
At December 31, 2004
------------------------------------------------------
60-89 Days 90 Days or more
Number Principal Number Principal
----------- ----------- ----------- -----------
Commercial real estate 2 $ 256,137 4 $ 160,310
Commercial unsecured -- -- 1 20,112
Other -- -- 1 2,476
----------- ----------- ----------- -----------
Total 2 $ 256,137 6 $ 182,898
=========== =========== =========== ===========
Delinquent loans to total loans 0.37% 0.27%
At December 31, 2003
------------------------------------------------------
60-89 Days 90 Days or more
Number Principal Number Principal
----------- ----------- ----------- -----------
Commercial real estate 2 $ 503,694 4 $ 259,026
Commercial construction -- -- 1 145,000
Commercial unsecured -- -- 1 30,619
Other -- -- 1 4,406
----------- ----------- ----------- -----------
Total 2 $ 503,694 7 $ 439,051
=========== =========== =========== ===========
Delinquent loans to total loans 0.74% 0.64%
At December 31, 2002
------------------------------------------------------
60-89 Days 90 Days or more
Number Principal Number Principal
----------- ----------- ----------- -----------
Commercial real estate -- $ -- 7 $ 925,952
Commercial unsecured -- -- 1 14,734
----------- ----------- ----------- -----------
Total -- $ -- 8 $ 940,686
=========== =========== =========== ===========
Delinquent loans to total loans 0.00% 1.48%
Loans 90 days or more past due represent non-accrual loans and loans that are
contractually past due maturity but are still accruing interest.
11
Non-performing Assets. The following table sets forth information about our
non-performing assets at December 31, 2006, 2005 and 2004.
At December 31, At December 31, At December 31,
2006 2005 2004
--------------- --------------- ---------------
Non-performing assets:
Commercial loans:
Unsecured $ 20,709 $ -- $ 20,112
Commercial real estate 188,872 1,022,097 121,810
Construction -- 579,000 --
Consumer loan -- -- 2,476
--------------- --------------- ---------------
Total non-performing
assets $ 209,581 $ 1,601,097 $ 144,398
=============== =============== ===============
Non-performing loans to total
loans 0.31% 2.15% 0.21%
Non-performing loans to total
assets 0.10% 0.74% 0.06%
Non-performing assets to total
assets 0.10% 0.74% 0.06%
The gross interest income that would have been recorded in 2006 if the
non-accrual loans had been current in accordance with their original terms was
$12,614. The amount of interest income on those loans that was included in net
income for 2006 was $454.
The following table sets forth the aggregate carrying value of our assets
classified as Substandard, Doubtful and Loss according to asset type:
At December 31, 2006 At December 31, 2006
Substandard Doubtful
----------------------- -----------------------
Number Amount Number Amount
---------- ---------- ---------- ----------
Classification of assets:
Commercial Loans:
Unsecured 4 $ 128,857 -- $ --
Commercial Real Estate 2 758,462 1 15,462
---------- ---------- ---------- ----------
Total loans 6 $ 887,319 1 $ 15,462
========== ========== ========== ==========
No assets were classified as Loss at year end 2006.
Allowance for Loan Losses
Our allowance for loan losses is established through a provision for loan losses
based on management's evaluation of the risks inherent in its loan portfolio and
the general economy. When analyzing the adequacy of the allowance for loan
losses, management first considers performing loans in our loan portfolio that
have no material identified weaknesses. Management considers historical
experience, the state of the economy, our credit process, the nature of
collateral, industry trends, geographic considerations and other factors, when
assessing these loans. Management then establishes an amount equal to a fixed
percentage of the performing loans in each of our five principal loan categories
as appropriate to be included in the allowance to cover inherent weaknesses in
the broad category of loans.
12
In addition, management analyzes each loan that has been identified as having
specific weaknesses to determine the appropriate level of the allowance for that
loan. This analysis considers both the general factors which are considered in
assessing performing loans as well as specific facts pertinent to each loan,
such as collateral value, borrower's income and ability to repay, payment
history, the reasons for and length of the delinquency, and the value of any
credit support. Although loans may be analyzed individually or in groups to
determine the allowance, the entire allowance is available for any losses that
occur.
In order to assist in determining the allowance, an independent loan review
firm, senior management and the Bank's Board of Directors review the allowance
for loan losses quarterly. If they determine that the allowance is inadequate,
then management increases the provision for loan losses to bring the allowance
up to the level required.
As of December 31, 2006, our allowance for loan losses was $1,128,824 or 1.69%
of total loans. Based upon all relevant and presently available information,
management believes that the allowance for loan losses is appropriate. We
continue to monitor and modify the level of the allowance for loan losses in
order to maintain the allowance at a level which management considers
appropriate. While management uses available information to recognize losses on
loans, future additions to the allowance may be necessary, based on changes in
economic and local market conditions beyond management's control. In addition,
federal and state bank regulatory agencies periodically review Victory State
Bank's loan loss allowance as part of their periodic safety and soundness
examinations of the Bank. They may recommend or seek to compel increases in the
allowance if they believe that weaknesses in the loan portfolio are more
significant than management's assessment.
The following table sets forth the activity in our allowance for loan losses:
For the Year
Ended
December 31,
--------------------------------------------------------------------------------
2006 2005 2004 2003 2002
------------ ------------ ------------ ------------ ------------
Allowance for Loan Losses:
Balance at beginning of period $ 1,153,298 $ 1,299,520 $ 1,162,776 $ 1,168,358 $ 894,692
Charge-offs:
Commercial loans:
Unsecured (62,181) (318,399) (180,125) (315,490) (130,191)
Consumer loan (17,511) -- -- -- --
Other loans (28,111) (25,302) (4,940) (17,138) (24,421)
------------ ------------ ------------ ------------ ------------
Total charge-offs (107,803) (343,701) (185,065) (332,628) (154,612)
Recoveries 148,329 257,479 171,809 122,046 73,278
------------ ------------ ------------ ------------ ------------
Net charge-offs 40,526 (86,222) (13,256) (210,582) (81,334)
Provision charged to income (65,000) (60,000) 150,000 205,000 355,000
------------ ------------ ------------ ------------ ------------
Balance at end of period $ 1,128,824 $ 1,153,298 $ 1,299,520 $ 1,162,776 $ 1,168,358
============ ============ ============ ============ ============
Ratio of net charge-offs during the period to
average loans outstanding during the period -0.06% 0.12% 0.02% 0.49% 0.27%
Ratio of allowance for loan losses to
total loans at the end of period 1.69% 1.55% 1.90% 1.70% 1.83%
Ratio of allowance for loan losses to
non-performing loans at the end of the period 538.61% 72.03% 899.96% 264.84% 356.45%
Ratio of allowance for loan losses to
non-performing assets at the end of the period 538.61% 72.03% 899.96% 264.84% 356.45%
The following table sets forth the allocation of our allowance for loan losses
among each of the categories listed.
13
At December 31, At December 31, At December 31, At December 31, At December 31,
2006 2005 2004 2003 2002
------------------- ------------------- ------------------- ------------------- -------------------
% of Loans % of Loans % of Loans % of Loans % of Loans
in Category in Category in Category in Category in Category
to to to to to
Total Total Total Total Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
---------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- ------
Allowance:
Commercial
loans:
Unsecured $ 337,054 16.3% $ 360,532 14.9% $ 351,215 14.1% $ 218,871 13.1% $ 290,496 17.7%
Secured 10,859 1.8 2,349 2.1 17,660 2.3 22,766 2.8 55,186 6.3
Commercial
real estate 518,620 49.9 363,072 40.1 490,488 46.5 523,209 47.5 567,390 49.1
Residential
real estate 12,501 0.2 7,835 0.4 11,296 1.6 12,957 2.0 8,896 0.8
Construction
loans 198,901 29.1 362,590 39.8 358,632 33.4 354,792 32.5 206,920 23.4
Other loans 50,889 2.7 56,920 2.7 70,229 2.1 30,181 2.1 39,470 2.7
---------- ------ ---------- ------ ---------- ------ ---------- ------ ---------- ------
Total allowances $1,128,824 100.0% $1,153,298 100.0% $1,299,520 100.0% $1,162,776 100.0% $1,168,358 100.0%
========== ====== ========== ====== ========== ====== ========== ====== ========== ======
Investment Activities
State-chartered banking institutions have the authority to invest in various
types of liquid assets, including United States Treasury Obligations, securities
of various federal agencies, certain certificates of deposits of insured banks
and savings institutions, certain bankers' acceptances, repurchase agreements
and federal funds. Additionally, it is appropriate for us to maintain
investments for ongoing liquidity needs and we have maintained liquid assets at
a level believed to be adequate to meet our normal daily activities.
Our investment policy, established by the Board of Directors of Victory State
Bank and implemented by its Asset/Liability Committee, attempts to provide and
maintain liquidity, generate a favorable return on investments without incurring
undue interest rate and credit risk, and complement our lending activities.
Although we classify most of our securities portfolio as available for sale, it
is our practice to retain most of our securities until they mature.
Our policies generally limit investments to government and federal agency
securities or AAA rated securities, including corporate debt obligations, that
are investment grade with weighted average lives of seven years or less. Our
policies provide that all investment purchases be ratified by the Bank's Board
and may only be initiated by the President or Chief Financial Officer of the
Bank. Investment securities consist of collateralized mortgage obligations
("CMO") with an estimated average lives of 4.5 years or less, mortgage-backed
securities ("MBS") with maturities of seven years or less and U.S. Agency notes
with a maturity of less than 15 years. These CMOs and MBS are backed by federal
agencies such as Federal National Mortgage Association ("FNMA") and the Federal
Home Loan Mortgage Corporation ("FHLMC") or are "AAA" rated whole loan
securities. At December 31, 2006, we had investment securities with a cost basis
of $116,354,168 and a fair value of $113,770,611. Of these, $105,326,705 were
either CMO's or MBS's. The entire investment portfolio at December 31, 2006 was
classified as available for sale and is accounted on a fair market value basis.
The following table sets forth certain information regarding the amortized cost
and fair values of the investment securities, available for sale portfolio at
the dates indicated:
At December 31,
---------------------------------------------------------------------------------------
2006 2005 2004
--------------------------- --------------------------- ---------------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
------------ ------------ ------------ ------------ ------------ ------------
Investments securities, available for sale
US Government Agency $ 8,500,000 $ 8,443,906 $ 8,500,000 $ 8,390,156 $ 8,500,000 $ 8,481,563
FNMA 7,607,408 7,397,799 9,348,861 9,067,796 11,245,666 11,118,275
FHLMC 228,986 229,625 321,113 320,258 517,411 523,766
GNMA 2,264,561 2,171,125 2,718,832 2,627,459 3,296,901 3,263,366
Whole Loan MBS 3,554,783 3,453,363 4,135,883 4,051,823 5,114,582 5,068,462
Collateralized mortgage obligations 94,198,430 92,074,793 83,665,009 81,565,801 100,728,914 100,077,335
------------ ------------ ------------ ------------ ------------ ------------
$116,354,168 $113,770,611 $108,689,698 $106,023,293 $129,403,474 $128,532,767
============ ============ ============ ============ ============ ============
14
The table below sets forth certain information regarding the amortized cost
value, weighted average yields and stated maturities of our investment
securities at December 31, 2006 and 2005.
At December 31, 2006
----------------------------------------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average
1 Year Yield Years Yield Years Yield Years Yield Total
------------ ---------- ------------ ---------- ------------ ---------- ------------ ---------- ------------
Investment
Securities:
US Government
Agency $ -- --% $ 8,500,000 3.26% $ -- --% $ -- --% $ 8,500,000
FNMA 7 Year
Balloon -- -- 2,028,436 4.34 504,405 5.16 5,074,567 3.84 7,607,408
FHLMC -- -- 228,985 4.73 -- -- -- -- 228,985
GNMA -- -- -- -- -- -- 2,264,561 4.40 2,264,561
Whole Loan MBS -- -- -- -- -- -- 3,554,784 4.71 3,554,784
Collateralized
Mortgage
Obligations -- -- -- -- 13,143,686 4.41 81,054,744 4.52 94,198,430
------------ ------------ ------------ ------------ ------------
Total $ -- --% $ 10,757,421 3.49% $ 13,648,091 4.34% $ 91,948,656 4.49% $116,354,168
============ ============ ============ ============ ============
At December 31, 2005
----------------------------------------------------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Less Than Average 1 To 5 Average 5 To 10 Average Over 10 Average
1 Year Yield Years Yield Years Yield Years Yield Total
------------ ---------- ------------ ---------- ------------ ---------- ------------ ---------- ------------
Investment
Securities:
US Government
Agency $ -- --% $ 5,500,000 3.00% $ 3,000,000 3.89% $ -- --% $ 8,500,000
FNMA 7 Year
Balloon 29,328 5.56 -- -- 2,889,149 4.15 6,430,384 3.90 9,348,861
FHLMC -- -- 321,113 4.95 -- -- -- -- 321,113
GNMA -- -- -- -- -- -- 2,718,832 4.40 2,718,832
Whole Loan MBS -- -- -- -- -- -- 4,135,883 4.74 4,135,883
Collateralized
Mortgage
Obligations -- -- -- -- 1,935,895 4.57 81,729,114 4.45 83,665,009
------------ ------------ ------------ ------------ ------------
Total $ 29,328 5.56% $ 5,821,113 3.11% $ 7,825,044 4.15% $ 95,014,213 4.42% $108,689,698
============ ============ ============ ============ ============
Source of Funds
General. Deposits are the primary source of our funds for use in lending,
investing and for other general purposes. In addition to deposits, we obtain
funds from principal repayments and prepayments on loans and securities. Loan
and securities repayments are a relatively stable source of funds, while deposit
inflows and outflows as well as unscheduled prepayments are influenced by
general interest rates and money market conditions.
Deposits. We offer a variety of deposit accounts having a range of interest
rates and terms. Our deposits consist of non-interest bearing checking accounts,
money market accounts, time deposit ("certificate") accounts, statement savings
and NOW accounts. The flow of deposits is influenced significantly by general
economic conditions, changes in money market rates, prevailing interest rates
and competition. Our deposits are obtained primarily from the areas in which our
offices are located. We do not actively solicit certificate accounts in excess
of $100,000, nor do we use brokers to obtain deposits. Management constantly
monitors our deposit accounts and, based on historical experience, management
believes it will retain a large portion of such accounts upon maturity. Deposit
account terms we offer vary according to the minimum balance required, the time
periods that the funds must remain on deposit and the interest rates, among
other factors. In determining the characteristics of the deposit account
programs we offer, we consider potential profitability, matching terms of the
deposits with loan products, the attractiveness to the customers and the rates
offered by our competitors.
Our focus on customer service, primarily for the business and professional
community in our marketplace, has facilitated our retention of non-interest
bearing checking accounts and low costing NOW, savings and money market
15
accounts, which generally have interest rates substantially less than
certificate of deposits. At December 31, 2006, these types of low cost deposit
accounts amounted to $118,192,843, or 63.3% of total deposits.
The following table presents deposit activity for the periods indicated.
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
-------------- -------------- --------------
Beginning balance $ 193,251,159 $ 215,423,473 $ 167,103,445
Net (decrease)/ increase before interest credited (9,416,115) (23,793,756) 47,520,990
Interest credited on deposits 2,848,106 1,621,442 799,038
-------------- -------------- --------------
Ending balance $ 186,683,150 $ 193,251,159 $ 215,423,473
============== ============== ==============
The following table provides information regarding the remaining term to
maturity of our time deposits over $100,000 at December 31, 2006:
Maturity Period Amount
-------------------- -------------
Three months or less $ 42,537,315
Over three through six months 12,353,658
Over six through 12 months 2,148,569
Over 12 months 137,893
-------------
Total $ 57,177,435
=============
The following table presents by various rate categories, the amount and the
periods to maturity of the certificate accounts outstanding at December 31,
2006.
Over Six Mos. Over One Year Over Two Years
Six Months Through One Through Two Through Three Over Three
And Less Year Years Years Years Total
------------- ------------- ------------- ------------- ------------- -------------
Certificate accounts:
2.00% to 2.99% $ 4,064,069 $ 27,010 $ -- $ -- $ -- $ 4,091,079
3.00% to 3.99% 41,583,041 519,111 704,834 564,000 496,000 43,866,986
4.00% to 4.99% 15,300,028 3,588,090 255,061 596,000 532,000 20,271,179
------------- ------------- ------------- ------------- ------------- -------------
$ 60,947,138 $ 4,134,211 $ 959,895 $ 1,160,000 $ 1,028,000 $ 68,229,244
============= ============= ============= ============= ============= =============
Borrowings
We do not routinely utilize borrowings, but in connection with the issuance of
$5 million in trust preferred securities in August 2003, we issued a $5.2
million subordinated note to VSB Capital Trust I. Therefore, at December 31,
2005 and 2006, we had $5.2 million in subordinated debt.
Personnel
As of December 31, 2006, we had 49 full-time employees and 17 part-time
employees. These employees are not represented by a collective bargaining unit
and we consider our relationship with our employees to be good.
16
REGULATION AND SUPERVISION
Regulation of VSB Bancorp, Inc.
VSB Bancorp, Inc., is a New York corporation and is subject to and governed by
the New York Business Corporation Law. It is a bank holding company and thus is
subject to regulation, supervision, and examination by the Federal Reserve.
Bank Holding Company Regulation. As a bank holding company, we are required to
file periodic reports and other information with the Federal Reserve and the
Federal Reserve may conduct examinations of us.
We are subject to capital adequacy guidelines of the Federal Reserve. The
guidelines apply on a consolidated basis and require bank holding companies to
maintain a minimum ratio of Tier1 capital to total assets of 4.0%. The minimum
ratio is 3.0% for the most highly rated bank holding companies. The Federal
Reserve's capital adequacy guidelines also require bank holding companies to
maintain a minimum ratio of qualifying total capital to risk-weighted assets of
8.0%, and a minimum ratio of Tier1 capital to risk-weighted assets of 4.0%. As
of December 31, 2006, the ratio of Tier 1 capital to total assets was 10.98%,
the ratio of Tier 1 capital to risk-weighted assets was 25.47%, and the ratio of
qualifying total capital to risk-weighted assets was 26.66%.
Our ability to pay dividends can be restricted if overall capital falls below
levels established by the Federal Reserve's guidelines.
Federal Reserve approval is required if we seek to acquire direct or indirect
ownership or control of 5% or more of the voting shares of a bank or bank
holding company. We must obtain Federal Reserve approval before we acquire all
or substantially all the assets of a bank or merge or consolidate with another
bank holding company. These provisions also would apply to a bank holding
company that sought to acquire 5% or more of the common stock of or to merge or
consolidate with us.
Bank holding companies like us may not engage in activities other than banking
and activities so closely related to banking or managing or controlling banks as
to be a proper incident thereto. Federal Reserve regulations contain a list of
permissible non-banking activities that are closely related to banking or
managing or controlling banks and the Federal Reserve has identified a limited
number of additional activities by order. These activities include lending
activities, certain data processing activities, and securities brokerage and
investment advisory services, trust activities and leasing activities. A bank
holding company must file an application or a notice with the Federal Reserve
prior to acquiring more than 5% of the voting shares of a company engaged in
such activities. A bank holding company that is well capitalized and well
managed and meets other conditions may provide notice after making the
acquisition.
We have the right to elect to be treated as a financial holding company if the
Bank is well capitalized and well managed and has at least a satisfactory record
of performance under the Community Reinvestment Act. Financial holding companies
that meet certain conditions may engage in activities that are financial in
nature or incidental to financial activities, or activities that are
complementary to a financial activity and do not pose a substantial risk to the
safety and soundness of depository institutions or the financial system
generally. Federal law identifies certain activities that are deemed to be
financial in nature, including non-banking activities currently permissible for
bank holding companies to engage in both within and outside the United States,
as well as insurance and securities underwriting and merchant banking
activities. The Federal Reserve may identify additional activities that are
permissible financial activities. No prior notice to the Federal Reserve is
required for a financial holding company to acquire a company engaged in these
activities or to commence these activities directly or indirectly through a
subsidiary.
We have not elected to be treated as a financial holding company since we have
no current plans to use the authority to engage in expanded activities. However,
we may elect to do so in the future.
17
Section 404 of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act of 2002
("Sarbanes-Oxley") implements a broad range of corporate governance and
accounting measures for public companies (including VSB Bancorp, Inc.) designed
to promote honesty and transparency in corporate America. Among many other
requirements, Sarbanes-Oxley includes a requirement, in Section 404, that annual
reports include Section 404 of the Act requires each annual report of a public
company to include a report by management on the company's internal control over
financial reporting. The Securities and Exchange Commission has extended the
deadline for non-accelerated filers (such as VSB Bancorp, Inc.) to comply with
the filing requirements under Section 404. Under the extension, we are not
required to comply with Section 404 until the fiscal year ending December 31,
2007. There have been proposals to amend, repeal or further delay the
implementation Section 404 requirements and we cannot determine the ultimate
outcome of those proposals. If we are required to implement Section 404 in its
current form, we would be required to allocate significant amounts of management
and other employee time to compliance and incur significant expense in fees to
our independent registered public accountants.
Statutory Restrictions on Acquisition of VSB Bancorp, Inc., and Victory State
Bank
Applicable provisions of the New York Banking Law, the federal Bank Holding
Company Act, and other federal statutes, restrict the ability of persons or
entities to acquire control of a bank holding company. Under the Change in Bank
Control Act, persons who intend to acquire control of a bank holding company,
either directly or indirectly or through or in concert with one or more persons
must give 60 days' prior written notice to the Federal Reserve. "Control" would
exist when an acquiring party directly or indirectly has voting control of at
least 25% of our voting securities or the power to direct our management or
policies. Under Federal Reserve regulations, a rebuttable presumption of control
would arise with respect to an acquisition where, after the transaction, the
acquiring party has ownership control, or the power to vote at least 10% (but
less than 25%) of our common stock.
The New York Banking Law requires prior approval of the New York Banking Board
before any action is taken that causes any company to acquire direct or indirect
control of a banking institution that is organized in the State of New York. The
term "control" is defined generally to mean the power to direct or cause the
direction of the management and policies of the banking institution and is
presumed to exist if the company owns, controls or holds with power to vote 10%
or more of the voting stock of the banking institution.
Section 912 of the New York Business Corporation Law, known as the New York
Anti-Takeover Law, restricts the ability of interested stockholders to engage in
business combinations with a New York corporation. In general terms, Section 912
prohibits any New York corporation covered by the statute from merging with an
interested shareholder (i.e., one who owns 20% or more of the outstanding voting
stock) for five years following the date on which the interested shareholder
first acquired 20% of the stock, unless before that date the Board of Directors
of the corporation had approved either the merger or the interested
shareholder's stock purchase.
Section 912 defines an interested stockholder as the beneficial owner, directly
or indirectly, of 20% or more of the outstanding voting stock of a corporation;
and certain other entities that have owned 20% or more of a corporation's stock
during the past five years. A business combination is defined as a merger,
consolidation, sale of 10% or more of the assets, or similar transaction.
Unless an interested stockholder waits five years after becoming an interested
stockholder to engage in a business combination, the business combination is
prohibited unless our Board of Directors has approved either (a) the business
combination or (b) the acquisition of stock by the interested stockholder,
before the interested stockholder acquired its 20% interest. Even though the
interested stockholder waits five years, the business combination is prohibited
unless either:
(i) the business combination or the acquisition of stock by the
interested stockholder was approved by the Board of Directors before the
interested stockholder acquired its 20% interest;
18
(ii) the business combination is approved by a majority vote of
all outstanding shares of stock not beneficially owned by the interested
stockholder or its affiliates or associates at a meeting held at least five
years after the interested stockholder becomes an interested stockholder; or
(iii) the price paid for common stock acquired in the business
combination is, in general terms, at least as much as the greater of (a) highest
price paid by the interested stockholder for any stock since the interested
stockholder first owned 5% of the stock of the corporation, or (b) the market
value of the stock as of the date of announcement of the business combination;
and the price paid for stock other than common stock is subject to comparable
minimum standards.
Regulation of Victory State Bank
The Bank is subject to extensive regulation and examination by the New York
State Banking Department ("Department"), as its chartering authority, and by the
FDIC, as the insurer of its deposits. The federal and state laws and regulations
which are applicable to banks regulate, among other things, the scope of their
business, their investments, their reserves against deposits, the timing of the
availability of deposited funds and the nature and amount of and collateral for
certain loans. The Bank must file reports with the Department and the FDIC
concerning its activities and financial condition, in addition to obtaining
regulatory approvals prior to entering into certain transactions such as
establishing branches and mergers with, or acquisitions of, other depository
institutions. There are periodic examinations by the Department and the FDIC to
test the Bank's compliance with various regulatory requirements. This regulation
and supervision establishes a comprehensive framework of activities in which an
institution can engage and is intended primarily for the protection of the
insurance fund and depositors. The regulatory structure also gives the
regulatory authorities extensive discretion in connection with their supervisory
and enforcement activities and examination policies, including policies with
respect to the classification of assets and the establishment of adequate loan
loss reserves for regulatory purposes. Any change in such regulation, whether by
the Department, the FDIC or as a result of the enactment of legislation, could
have a material adverse impact on the Bank and its operations.
Capital Requirements
The FDIC imposes capital adequacy standards on state-chartered banks, which,
like the Bank, are not members of the Federal Reserve System.
The FDIC's capital regulations establish a minimum 3.0% Tier I leverage capital
requirement for the most highly-rated state-chartered, non-member banks, with an
additional cushion of at least 100 basis points for all other state-chartered,
non-member banks, which effectively will increase the minimum Tier I leverage
ratio for such other banks to 4.0%. Under the FDIC's regulation, the
highest-rated banks are those that the FDIC determines are not anticipating or
experiencing significant growth and have well diversified risk, including no
undue interest rate risk exposure, excellent asset quality, high liquidity, good
earnings and, in general, which are considered a strong banking organization and
are rated composite 1 under the Uniform Financial Institutions Rating System.
Tier I or core capital is defined as the sum of common stockholders' equity
(including retained earnings), non-cumulative perpetual preferred stock and
related surplus, and minority interests in consolidated subsidiaries, minus all
intangible assets other than certain qualifying supervisory goodwill and certain
mortgage servicing rights.
The FDIC also requires that banks meet a risk-based capital standard. The
risk-based capital standard for banks requires the maintenance of a ratio of
total capital (which is defined as Tier I capital and supplementary capital) to
risk-weighted assets of 8.0% and Tier I capital to risk-weighted assets of 4%.
In determining the amount of risk-weighted assets, all assets, plus certain
off-balance sheet assets, are multiplied by a risk-weight of 0% to 100%, based
on the risks the FDIC believes are inherent in the type of asset or item. The
components of Tier I capital are the same as for the leverage capital standard.
The components of supplementary capital include certain perpetual preferred
stock, certain mandatory convertible securities, certain subordinated debt and
intermediate preferred stock and general allowances for loan and lease losses.
Allowance for loan and lease losses includable in supplementary capital is
limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of
capital counted toward supplementary capital cannot exceed 100% of core capital.
19
The FDIC has an additional, higher capital level, known as well-capitalized. In
order to be classified as well-capitalized, a bank must have a Tier1 leverage
ratio of at least 5%, a Tier1 risk-based capital ratio of at least 6% and a
total risk-based capital ratio of at least 10%.
At December 31, 2006, the Bank met each of its capital requirements.
The following table shows the Bank's actual capital amounts and ratios.
To be well-capitalized
For capital under prompt corrective
Actual adequacy purposes action provisions
--------------------------- --------------------------- ---------------------------
Amount Ratio Amount Ratio Amount Ratio
------------ ------------ ------------ ------------ ------------ ------------
As of December 31, 2006
Tier 1 Capital
(to Average Assets) $ 23,348,000 10.63% $ 8,783,920 4.00% $ 10,979,900 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 23,348,000 24.74% 3,775,560 4.00% 5,663,340 6.00%
Total Capital
(to Risk Weighted Assets) 24,477,000 25.93% 7,551,120 8.00% 9,438,900 10.00%
Activities and Investments of New York-Chartered Banks.
The Bank derives its lending, investment and other authority primarily from the
applicable provisions of New York State Banking Law and the regulations of the
Department, as limited by FDIC regulations and other federal laws and
regulations. See "Activities and Investments of FDIC Insured State-Chartered
Banks" below. These New York laws and regulations authorize the Bank to invest
in real estate mortgages, consumer and commercial loans, certain types of debt
securities, including certain corporate debt securities and obligations of
federal, State and local governments and agencies, and certain other assets. A
bank's aggregate lending powers are not subject to percentage of asset
limitations, although there are limits applicable to single borrowers. A New
York-chartered bank may also exercise trust powers upon approval of the
Department. The Bank does not have trust powers.
The New York Banking Board has the power to adopt regulations that enable state
chartered banks to exercise the rights, powers and privileges permitted for a
national bank. The Bank has not engaged in material activities authorized by
such regulations.
With certain limited exceptions, the Bank may not make loans or extend credit
for commercial, corporate or business purposes (including lease financing) to a
single borrower, the aggregate amount of which would be in excess of 15% of the
Bank's net worth, on an unsecured basis, and 25% of the net worth if the loan is
collateralized by readily marketable collateral or collateral otherwise having a
value equal to the amount by which the loan exceeds 15% of the Bank's net worth.
Theses limits do not apply to loans made by VSB Bancorp, Inc. directly at the
holding company level. The Bank currently complies with all applicable
loans-to-one-borrower limitations and VSB Bancorp, Inc. has not made any loans
in its own name.
Activities and Investments of FDIC-Insured State-Chartered Banks.
The activities and equity investments of FDIC-insured, state-chartered banks are
generally limited to those that are permissible for national banks. Under
regulations dealing with equity investments, an insured state bank generally may
not directly or indirectly acquire or retain any equity investment of a type, or
in an amount, that is not permissible for a national bank. An insured state bank
is not prohibited from, among other things, (i) acquiring or retaining a
majority interest in a subsidiary, (ii) investing as a limited partner in a
partnership the sole purpose of which is direct or indirect investment in the
acquisition, rehabilitation or new construction of a qualified housing project,
provided that such limited partnership investments may not exceed 2% of the
20
bank's total assets, (iii) acquiring up to 10% of the voting stock of a company
that solely provides or reinsures directors', trustees' and officers' liability
insurance coverage or bankers' blanket bond group insurance coverage for insured
depository institutions, and (iv) acquiring or retaining the voting shares of a
depository institution if certain requirements are met. In addition, an
FDIC-insured state-chartered bank may not directly, or indirectly through a
subsidiary, engage as "principal" in any activity that is not permissible for a
national bank unless the FDIC has determined that such activities would pose no
risk to the insurance fund of which it is a member and the bank is in compliance
with applicable regulatory capital requirements.
Regulatory Enforcement Authority
Applicable banking laws include substantial enforcement powers available to
federal banking regulators. This enforcement authority includes, among other
things, the ability to assess civil money penalties, to issue cease-and-desist
or removal orders and to initiate injunctive actions against banking
organizations and institution-affiliated parties, as defined. In general, these
enforcement actions may be initiated for violations of laws and regulations and
unsafe or unsound practices. Other actions or inactions may provide the basis
for enforcement action, including misleading or untimely reports filed with
regulatory authorities.
Under the New York State Banking Law, the Department may issue an order to a New
York-chartered banking institution to appear and explain an apparent violation
of law, to discontinue unauthorized or unsafe practices and to keep prescribed
books and accounts. Upon a finding by the Department that any director, trustee
or officer of any banking organization has violated any law, or has continued
unauthorized or unsafe practices in conducting the business of the banking
organization after having been notified by the Department to discontinue such
practices, such director, trustee or officer may be removed from office by the
Department after notice and an opportunity to be heard. The Bank does not know
of any past or current practice, condition or violation that might lead to any
proceeding by the Department against the Bank or any of its directors or
officers. The Department also may take possession of a banking organization
under specified statutory criteria.
Prompt Corrective Action.
Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the federal
banking regulators with broad power to take "prompt corrective action" to
resolve the problems of undercapitalized institutions. The extent of the
regulators' powers depends on whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." A bank is deemed to be (i)
"well capitalized" if it has total risk-based capital ratio of 10.0% or more,
has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage
capital ratio of 5.0% or more and is not subject to specified requirements to
meet and maintain a specific capital level for any capital measure, (ii)
"adequately capitalized" if it has a total risk-based capital ratio of 8.0% or
more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leverage
capital ratio of 4.0% or more (3.0% under certain circumstances) and does not
meet the definition of "well capitalized," (iii) "undercapitalized" if it has a
total risk-based capital ratio that is less than 8.0%, a Tier I risk-based
capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is
less than 4.0% (3.0% under certain circumstances), (iv) "significantly
undercapitalized" if it has a total risk-based capital ratio that is less than
6.0%, a Tier I risk-based capital ratio that is less than 3.0% or a Tier I
leverage capital ratio that is less than 3.0%, and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. The regulations also provide that a federal banking
regulator may, after notice and an opportunity for a hearing, reclassify a "well
capitalized" institution as "adequately capitalized" and may require an
"adequately capitalized" institution or an "undercapitalized" institution to
comply with supervisory actions as if it were in the next lower category if the
institution is in an unsafe or unsound condition or engaging in an unsafe or
unsound practice. The federal banking regulator may not, however, reclassify a
"significantly undercapitalized" institution as "critically undercapitalized."
An institution generally must file a written capital restoration plan which
meets specified requirements, as well as a performance guaranty by each company
that controls the institution, with an appropriate federal banking regulator
within 45 days of the date that the institution receives notice or is deemed to
have notice that it is "undercapitalized," "significantly undercapitalized" or
"critically undercapitalized." Immediately upon becoming undercapitalized, an
21
institution becomes subject to statutory provisions, which, among other things,
set forth various mandatory and discretionary restrictions on the operations of
such an institution.
At December 31, 2006, the Company and the Bank had capital levels which
qualified it as a "well-capitalized" institution.
FDIC Insurance
The Bank is a member of the FDIC. As insurer, the FDIC is authorized to conduct
examinations of, and to require reporting by, FDIC-insured institutions. It also
may prohibit any FDIC-insured institution from engaging in any activity the FDIC
determines by regulation or order to pose a serious threat to the FDIC.
On February 8, 2006, President Bush signed into law the Federal Deposit
Insurance Reform Act of 2005. The law increases the amount of deposit insurance
available for retirement accounts, indexes the amount of deposit insurance to
inflation, merges the two existing deposit insurance funds (one historically for
banks and one historically for savings and loan associations) into a single fund
and gives the FDIC greater flexibility in determining the amount of future
deposit insurance premiums that banks may be required to pay. The law also
grants banks that were in existence prior to December 31, 1996 and paid deposit
insurance premiums prior to that date a credit against future deposit insurance
assessments that the FDIC may make. Since the Bank did not open for business
until 1997, it is not entitled to any credit. In late 2006, the FDIC imposed
premium assessments for the first time in a number of years, effective beginning
in 2007. We estimate that our FDIC insurance premium in 2007 will be
approximately $100,000, compared to no assessment in 2006. Therefore, the Bank
may be at a competitive disadvantage when compared to institutions with longer
operating histories because those institutions might have lower expenses for
deposit insurance premiums.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines, after a hearing, that the
institution has engaged or is engaging in unsafe or unsound practices, is in an
unsafe or unsound condition to continue operations, or has violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances that would result in
termination of the Bank's deposit insurance.
Brokered Deposits
Under federal law and applicable regulations, (i) a well capitalized bank may
solicit and accept, renew or roll over any brokered deposit without restriction,
(ii) an adequately capitalized bank may not accept, renew or roll over any
brokered deposit unless it has applied for and been granted a waiver of this
prohibition by the FDIC and (iii) an undercapitalized bank may not (x) accept,
renew or roll over any brokered deposit or (y) solicit deposits by offering an
effective yield that exceeds by more than 75 basis points the prevailing
effective yields on insured deposits of comparable maturity in such
institution's normal market area or in the market area in which such deposits
are being solicited. The term "undercapitalized insured depository institution"
is defined to mean any insured depository institution that fails to meet the
minimum regulatory capital requirement prescribed by its appropriate federal
banking agency. The FDIC may, on a case-by-case basis and upon application by an
adequately capitalized insured depository institution, waive the restriction on
brokered deposits upon a finding that the acceptance of brokered deposits does
not constitute an unsafe or unsound practice with respect to such institution.
The Bank had no brokered deposits outstanding at December 31, 2006.
Community Reinvestment and Consumer Protection Laws
In connection with its lending activities, the Bank is subject to a variety of
federal laws designed to protect borrowers and promote lending to various
sectors of the economy and population. Included among these are the Home
22
Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending
Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community
Reinvestment Act ("CRA").
The CRA requires FDIC insured banks to define the assessment areas that they
serve, identify the credit needs of those assessment areas and take actions that
respond to the credit needs of the community. The FDIC must conduct regular CRA
examinations of the Bank and assign it a CRA rating of "outstanding,"
"satisfactory," "needs improvement" or "unsatisfactory." The Bank is also
subject to provisions of the New York State Banking Law which impose similar
obligations to serve the credit needs of its assessment areas. The New York
Banking Department makes a biennial written assessment of a bank's compliance,
and makes the assessment available to the public. Federal and New York State
laws both require consideration of these ratings when reviewing a bank's
application to engage in certain transactions, including mergers, asset
purchases and the establishment of branch offices. A negative assessment may
serve as a basis for the denial of any such application. The Bank has received
"Satisfactory" ratings from both the New York Banking Department and the FDIC.
Limitations on Dividends
The payment of dividends by the Bank is subject to various regulatory
requirements. Under New York State Banking Law, a New York-chartered stock bank
may declare and pay dividends out of its net profits, unless there is an
impairment of capital, but approval of the Superintendent of Banks is required
if the total of all dividends declared in a calendar year would exceed the total
of its net profits for that year combined with its retained net profits of the
preceding two years, subject to certain adjustments.
Miscellaneous
The Bank is subject to restrictions on loans to its non-bank subsidiaries, on
investments in the stock or securities thereof, on the taking of such stock or
securities as collateral for loans to any borrower, and on the issuance of a
guarantee or letter of credit on behalf of the Bank or its non-bank
subsidiaries. The Bank also is subject to restrictions on most types of
transactions with the Bank or its non-bank subsidiaries, requiring that the
terms of such transactions be substantially equivalent to terms of similar
transactions with non-affiliated firms.
Assessments
Banking institutions are required to pay assessments to both the FDIC and the
NYSBD to fund their operations. The assessments are based upon the amount of the
Bank's total assets. The Bank must also pay an examination fee to the NYSBD when
they conduct an examination. The Bank paid federal and state assessments and
examination fees of $60,832 in 2006.
Transactions with Related Parties
The Bank's authority to engage in transactions with related parties or
"affiliates" (i.e., any entity that controls or is under common control with an
institution, including the Bank) or to make loans to certain insiders, is
limited by Sections 23A and 23B of the Federal Reserve Act. Section 23A limits
the aggregate amount of transactions with any individual affiliate to 10% of the
capital and surplus of the institution and also limits the aggregate amount of
transactions with all affiliates to 20% of the institution's capital and
surplus.
Loans to affiliates must be secured by collateral with a value that depends on
the nature of the collateral. The purchase of low quality assets from affiliates
is generally prohibited. Loans and asset purchases with affiliates, must be on
terms and under circumstances, including credit standards, that are
substantially the same or at least as favorable to the institution as those
prevailing at the time for comparable transactions with nonaffiliated companies.
In the absence of comparable transactions, such transactions may only occur
under terms and circumstances, including credit standards that in good faith
would be offered to or would apply to nonaffiliated companies.
The Bank's authority to extend credit to executive officers, directors and 10%
shareholders, as well as entities controlled by such persons, is currently
governed by Regulation O of the Federal Reserve Board. Regulation O generally
23
requires such loans to be made on terms substantially similar to those offered
to unaffiliated individuals (except for preferential loans made in accordance
with broad based employee benefit plans), places limits on the amount of loans
the Bank may make to such persons based, in part, on the Bank's capital
position, and requires certain approval procedures to be followed.
Standards for Safety and Soundness
FDIC regulations require that Victory State Bank adopt procedures and systems
designed to foster safe and sound operations in the areas of internal controls,
information systems, internal and audit systems, loan documentation, credit
underwriting, interest rate risk exposure, asset growth, asset quality, earnings
and compensation, fees and benefits. Among other things, theses regulations
prohibit compensation and benefits and arrangements that are excessive or that
could lead to a material financial loss. If Victory State Bank fails to meet any
of these standards, it will be required to submit to the FDIC a plan specifying
the steps that will be taken to cure the deficiency. If it fails to submit an
acceptable plan or fails to implement the plan, FDIC the will require it or VSB
Bancorp, Inc. to correct the deficiency and until corrected, may impose
restrictions on them.
The FDIC has also adopted regulations that require Victory State Bank to adopt
written loan policies and procedures that are consistent with safe and sound
operation, are appropriate for the size of the Bank, and must be reviewed by the
Bank's Board of Directors annually. Victory State Bank has adopted such policies
and procedures, the material provisions of which are discussed above as part of
the discussion of our lending operations.
Federal Reserve System
The Federal Reserve Board regulations require banks to maintain non-interest
earning reserves against their transaction accounts (primarily regular checking
accounts and interest-bearing checking accounts). The Federal Reserve Board
regulations generally require that reserves be maintained against aggregate
transaction accounts as follows: for accounts aggregating $37.3 million or less
(subject to adjustment by the Federal Reserve Board) the reserve requirement is
3%; for accounts greater than $37.3 million, the reserve requirement is $1.1
million plus 10% (subject to adjustment by the Federal Reserve Board between 8%
and 14%) against that portion of total transaction accounts in excess of $45.8
million. The first $8.5 million of otherwise reservable balances (subject to
adjustments by the Federal Reserve Board) are exempted from the reserve
requirements. The Bank is in compliance these requirements. Because required
reserves must be maintained in the form of either vault cash or a
non-interest-bearing account at a Federal Reserve Bank or a pass-through account
as defined by the Federal Reserve Board, the effect of this reserve requirement
is to reduce our interest-earning assets.
TAXATION
Federal Taxation
General
We are subject to federal income taxation in the same general manner as other
corporations with some exceptions discussed below. The following discussion of
federal taxation is intended only to summarize certain pertinent federal income
tax matters and is not a comprehensive description of the tax rules applicable
to us. Our federal income tax returns have not been audited or closed without
audit by the Internal Revenue Service.
Method of Accounting
We report our income and expenses on the accrual method of accounting and use a
tax year ending December 31 for filing our consolidated federal income tax
returns. The Company files consolidated tax returns with the Bank and VSB
Capital Trust I.
24
Bad Debt Reserves
We use the experience method in computing bad debt deductions for federal tax
purposes.
Minimum Tax
The Internal Revenue Code imposes an alternative minimum tax ("AMT") at a rate
of 20% on a base of regular taxable income plus certain tax preferences
("alternative minimum taxable income" or "AMTI"). The AMT is payable to the
extent such AMT is in excess of the Company's regular tax liability. Net
operating losses can offset no more than 90% of AMT. Certain payments of
alternative minimum tax may be used as credits against regular tax liabilities
in future years. We have not been subject to the alternative minimum tax and
have no such amounts available as credits.
State and Local Taxation
New York State and New York City Taxation.
New York State Franchise Tax on corporations is imposed in an amount equal to
the greater of (a) 7.5% of "entire net income" allocable to New York State (b)
3% of "alternative entire net income" allocable to New York State (c) 0.01% of
the average value of assets allocable to New York State or (d) a nominal minimum
tax. Entire net income is based on federal taxable income, subject to certain
modifications. Alternative entire net income is equal to entire net income
without certain modifications. The New York City Corporation Tax is imposed
using similar alternative taxable income methods and rates.
A temporary Metropolitan Transportation Business Tax Surcharge on banking
corporations doing business in the Metropolitan District has been applied since
1982. We transact a significant portion of our business within this District and
thus we are subject to this surcharge. The current surcharge rate is 17% of the
State franchise tax liability. New York City does not impose comparable
surcharges.
For New York State and City tax purposes, the bad debt deduction may be computed
using a specific formula based on our actual loss history ("Experience Method").
Item 2. Description of Property.
At December 31, 2006, we conducted our business through five banking offices. In
February 2007, we closed our former main office and moved to a new main office
and banking facility at 4142 Hylan Boulevard, which was under construction at
year end 2006.
25
Original Net Book Value
Date Date of of Leasehold
Leased or Leased or Lease Improvements at
Location Description Owned Acquired Expiration (1) December 31, 2006
--------------- ------------- -------------- ---------------- -------------------
3155 Amboy Road
Staten Island, N.Y. 10306 Main Office Leased 1997 2/28/2007 $0
755 Forest Avenue
Staten Island, N.Y. 10310 Branch Leased 1999 11/30/2013 $96,232
One Hyatt Street
Staten Island, N.Y. 10301 Branch Leased 1999 10/30/2014 $51,961
1762 Hylan Boulevard (2)
Staten Island, N.Y. 10305 Branch Leased 2001 6/30/2016 $535,256
1766 Hylan Boulevard (3)
Staten Island, N.Y. 10305 Retail Stores Leased 2001 6/30/2016 $150,129
4142 Hylan Boulevard
Staten Island, N.Y. 10308 Branch Leased 2005 3/25/2020 (4)
1065 Bay Street
Staten Island, N.Y. 10305 Branch Leased 2006 04/26/2021 $192,562
-------------------
Total net book value $1,026,144
===================
(1) We have allowed our Amboy Road lease to expire. All other leases are
renewable at our option.
(2) Hylan Boulevard Branch commenced operations on December 4, 2002.
(3) We leased the retail stores at 1766 Hylan Boulevard as a component of the
lease for the Hylan branch and we sublease the property to retail tenants.
(4) Construction in progress. No recorded book value. Aggregate value of
construction in process was $2,142,866 at December 31, 2006.
Item 3. Legal Proceedings.
The Bank is a defendant in an action pending in Supreme Court, Richmond County,
commenced by IndyMac Bank, F.S.B. against the Bank, LaMattina & Associates, Inc.
("LAI") and various individuals and entities alleged to be officers, directors
or otherwise to have relationships with LAI. LAI was a deposit customer of the
Bank engaged in the business of providing real estate settlement services to
lenders making residential mortgage loans. The plaintiff alleges that it was
such a lender and that it had provided funds to LAI by wiring those funds to an
account of LAI at the Bank to use to fund mortgage loans to be made by the
plaintiff, only to have LAI not use those funds for their intended purpose. The
action was commenced in August 2005. In November 2005, the plaintiff amended its
complaint to add the Bank as a defendant. The plaintiff amended its complaint
again and the Bank moved to dismiss the claims. In February 2007, the court
dismissed two of the claims against the Bank but allowed the Plaintiff to
proceed and conduct discovery with respect to two claims, one for negligence and
the other for conversion.
The amended complaint requests monetary damages against the Bank of $1,817,041
plus recovery of attorneys' fees. The Bank intends to defend aggressively the
amended claims and has referred the litigation to its insurance carrier, which
has indicated that at least some of the claims asserted against the Bank are
covered by insurance. The Bank has also asserted cross-claims against various
former customers, principals of those customers, and other related persons on
the grounds that if the Bank is held liable to the plaintiff, then the liability
is the result of the misdeeds or negligence of those other parties.
VSB Bancorp, Inc., is not involved in any pending legal proceedings. The Bank,
from time to time, is involved in routine collection proceedings in the ordinary
course of business on loans in default. Management believes that such other
routine legal proceedings in the aggregate are immaterial to our financial
condition or results of operations.
26
Item 4, Submission of Matters to a Vote of Security Holders.
None
PART II
Item 5. Market for Common Equity and Related Stockholder Matters.
Our common stock is quoted on the NASDAQ Over the Counter Market ("OTC") under
the symbol "VSBN". We have filed an application with NASDAQ and we have been
approved to begin listing on the NASDAQ Capital Markets effective March 16,
2007. We will continue to trade under our current symbol "VSBN".
The following table reflects the high and low bid price for our common stock
during each calendar quarter of the last two fiscal years. Such information is
derived from quotations published by Bloomberg LP. These quotations reflect
inter-dealer prices, without retail mark-up, mark-down or commission and may not
represent actual transactions.
2006
----
First Quarter* Second Quarter Third Quarter Fourth Quarter
-------------- -------------- ------------- --------------
High Bid................. $16.40 $17.00 $18.15 $14.92
Low Bid.................. $15.40 $15.48 $14.50 $14.00
2005*
----
First Quarter Second Quarter Third Quarter Fourth Quarter
-------------- -------------- ------------- --------------
High Bid................. $20.40 $21.60 $18.40 $17.28
Low Bid.................. $17.24 $17.20 $16.80 $15.52
* All per share data has been adjusted retroactively for the 5-for 4 stock
split, in the form of a 25% stock dividend, paid on May 18, 2006.
We have approximately 153 stockholders of record. We have not paid any cash
dividends.
In a transaction consummated on May 30, 2003, we became the holding company for
Victory State Bank as the result of what is commonly known as a reverse
triangular merger. We issued our common stock to the then existing common
stockholders of Victory State Bank in exchange for the outstanding common stock
of Victory State Bank in the holding company reorganization. All shares issued
were common stock. There was no underwriter in connection with the transaction.
The shares issued on a three for two exchange basis. We issued 1,055,998 shares
of our common stock upon consummation of the transaction and settled for
fractional shares, aggregating two whole shares, in cash.
The transaction was exempt from registration under the Securities Act of 1933
pursuant to Section 3(a)(12) as a bank holding company reorganization. VSB
Bancorp, Inc. and Victory State Bank filed applications or notices with the New
York State Superintendent of Banks, the Federal Deposit Insurance Corporation
and the Board of Governors of the Federal Reserve System and received all
required approvals to complete the holding company reorganization from those
regulators.
27
Item 6. Management's Discussion and Analysis of Financial Condition and Results
of Operations
General
VSB Bancorp, Inc. (referred to using terms such as "we," "us," or the "Company")
became the holding company for Victory State Bank (the "Bank"), a New York State
chartered commercial bank, upon the completion of a reorganization of the Bank
into the holding company form of organization. The reorganization was effective
in May 2003. Our primary business is owning all of the issued and outstanding
stock of the Bank. Victory State Bank is a New York State chartered commercial
bank, founded in November 1997. The Bank is supervised by the New York State
Banking Department and the Federal Deposit Insurance Corporation ("FDIC"). The
Bank gathers deposits from individuals and businesses primarily in Staten Island
and makes loans throughout that community. The Bank invests funds that are not
used for lending primarily in government securities, mortgage backed securities
and collateralized mortgage obligations. Customer deposits are insured, up to
the applicable limit, by the FDIC. VSB Bancorp, Inc. common stock was quoted on
the NASDAQ Over the Counter Market ("OTC") under the symbol "VSBN". We have
filed an application with NASDAQ and we have been approved to begin listing on
the NASDAQ Capital Markets effective March 16, 2007. We will continue to trade
under our current symbol "VSBN".
Since the Bank opened for business in 1997, the Board of Directors and
management have pursued a strategy of growth and expansion in order to enhance
the long term value of our banking franchise. The Board of Directors and
management anticipate that an increase in customer deposits, and the resulting
increase in funds we would have available to fund asset growth, will generate an
increase in net interest income.
We experienced an overall decline in deposits in 2006 due to factors we discuss
below. We opened one new branch in 2006 and a new main office in 2007. We
anticipate that those new branches, as well as our existing branch network, will
generate an increase in funds for investment in the future.
In order to support branch expansion and asset growth, we have not paid cash
dividends since we opened for business. Instead, our Board of Directors has
elected to retain earnings to increase our capital base so that we can continue
to be classified as well-capitalized for regulatory capital purposes while we
grow.
We also recognize that, on a short term basis, the development of a branch
network generates significant expenses before it generates income from increased
business. Our Board of Directors views the adverse effect on net income which
occurs immediately after a branch opening as an investment in our future. As we
have seen with our existing banking offices, as they mature and their deposits
increase, we have increasing funds available for investment.
During 2006, we faced a number of challenges, including continued increases in
market interest rates that pushed up our cost of funds, due to the upward
pressure of deposit rates. The real estate market softened, which reduced loan
originations and deposit balances from our attorney base. Our customers moved
funds into higher rate deposit types such as certificate accounts as our rates
on those products were high enough to outweigh the decreased convenience
associated with them. However, the increase in the prime rate also allowed us to
increase the yields on our existing prime based loans and originate new loans at
higher initial interest rates.
Also important in 2006 was a shift in our deposit mix as we experienced a
decline in non-interest bearing demand deposits. This decline resulted from a
number of factors including a reduction in real estate activity, which reduced
demand deposits held in connection with pending real estate transactions; and a
shift in customer preferences towards interest bearing accounts as the yields on
those accounts increased to the point where they became desirable alternatives.
Management intends to exert efforts to continue growing our company in the
future. However, both internal and external factors could adversely affect our
future growth. The recent down turn in the economy has made it more difficult
for us to originate new loans that meet our underwriting standards. Not only
28
does that cause us to invest available funds in lower-yielding securities and
deposits with other banks, but it also slows the development of non-loan
relationships which sometimes flow from cross-selling to loan customers.
A continuation of adverse general economic conditions could make it difficult
for us to execute our growth plans. Furthermore, regulatory capital requirements
could have a negative effect on our ability to grow if growth outpaces our
ability to support that growth with increased capital.
Our results of operations are dependent primarily on net interest income, which
is the difference between the income we earn on our loan and investment
portfolios and our costs of funds, consisting primarily of interest paid on our
deposits. Our operating expenses principally consist of employee compensation
and benefits, occupancy expenses, professional fees, advertising and marketing
expenses and other general and administrative expenses. Our results of
operations are significantly affected by general economic and competitive
conditions, particularly changes in market interest rates, government policies
and actions of regulatory authorities.
Critical Accounting Policies
We are required to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and the amounts of revenues
and expenses during the reporting period. The allowance for loan losses,
prepayment estimates on the mortgage-backed securities and Collateralized
Mortgage Obligation portfolios, contingencies and fair values of financial
instruments are particularly subject to change and to management's estimates.
Actual results can differ from those estimates and may have an impact on our
financial statements.
Asset/Liability Management
We maintain the interest rate sensitivity of our assets by investing primarily
in CMO's and MBS's with short and intermediate average lives to generate cash
flows and by originating and retaining primarily loans with interest rates based
on the prime rate. As of December 31, 2006, prime based loans totaled
$62,840,808, or 84.5% of total loans. Many of these prime based loans are
subject to interest rate floors of 7.00% to 8.50%. We anticipate that we will
continue to concentrate on originating prime based loans in our principal market
areas. We also expect to continue to invest other available funds that we cannot
invest in loans in short-term investment grade securities.
Cash Flow Sensitivity Analysis. The matching of assets and liabilities may be
analyzed by examining our cash flow sensitivity "gap." An asset or liability is
said to be cash flow sensitive within a specific time period if it will mature
or reprice within that time period. The cash flow sensitivity gap is defined as
the difference between the amount of interest-earning assets maturing within a
specific time period and the amount of interest-bearing liabilities maturing
within that time period. A gap is considered positive when the amount of
interest earning assets exceeds the amount of interest bearing liabilities. A
gap is considered negative when the amount of interest bearing liabilities
exceeds the amount of interest earning assets.
During a period of falling interest rates, the net income of an institution with
a positive gap can be expected to be adversely affected because the yield on its
interest-earning assets should reprice downward faster than the decline in its
cost of funds. Conversely, during a period of rising interest rates, the net
income of an institution with a positive gap position can be expected to
increase as it is able to invest in higher yielding interest-earning assets at a
more rapid rate than its interest-earning liabilities reprice. A positive gap
may not protect an institution with a large portfolio of adjustable rate based
loans or mortgage-backed securities from increases in interest rates for
extended time periods if such loans or securities have annual and lifetime
interest rate caps. The increase in the cost of funds in a rapidly increasing
rate environment could exceed the cap on assets yields, negatively impacting net
interest income. However, our prime rate based loans and our securities
investments generally do not have any annual or lifetime caps.
In the current interest rate environment, we generally have been investing
available funds not needed for lending in CMOs and MBSs with estimated average
lives of four and one-half years or less. As a result of this strategy, and
based upon the assumptions used in the following table at December 31, 2006, our
total interest-bearing liabilities maturing within one year exceeded our total
interest-earning assets maturing in the same period by $16,989,547, representing
29
a one year cumulative gap ratio of negative 3.57%. We closely monitor our
interest rate risk as such risk relates to our operational strategies. The
Victory State Bank Board of Directors has established an Asset/Liability
Committee, responsible for reviewing our asset/liability policies and interest
rate risk position, which generally meets quarterly and reports back to the
Board on interest rate risk and trends on a quarterly basis. We are currently
attempting to achieve a positive gap position in light of the current interest
rate environment. There can be no assurance, however, that we will be able to
achieve a positive gap position or that our strategies will not result in
maintaining a negative gap position in the future. Although we have not
experienced a material runoff in our core deposits, there can be no assurances
that such a runoff will not occur in the future if depositors seek higher
yielding investments.
Our substantial level of non-interest-bearing demand deposits also furthers our
goal of maintaining a positive gap because the interest cost of those deposits
will not increase as market rates increase. However an increase in market
interest rates could cause our customers to shift funds from demand deposits
into interest earning deposits if interest rates are high enough to justify
maintaining multiple accounts. Furthermore, there have been frequent proposals
in Congress to permit the payment of interest on commercial demand deposits. The
adoption of such legislation could have a significant effect on our net income
by forcing us to pay interest on business demand deposits to maintain parity
with our competitors.
The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at December 31, 2006 which we estimate,
based upon certain assumptions, will mature in each of the future time periods
shown. Except as stated below, the amount of assets and liabilities shown which
mature during a particular period were determined in accordance with the earlier
of estimated repayment or runoff or the contractual terms of the asset or
liability. Our loan prepayment assumptions are based on peer banks' historical
performance and statistics, including a 26.7% prepayment assumption on other
loans and a 38.0% prepayment assumption on fixed-rate loans. There can be no
assurance that deposits would reprice to peer bank's historical levels if
interest rates were to increase. Certain shortcomings are inherent in the method
of analysis presented in the foregoing table. For example, although certain
assets and liabilities may have similar maturities, they may react in different
degrees to changes in market interest rates. Also, the interest rates on certain
types of assets and liabilities may fluctuate in advance of changes in market
interest rates, while interest rates on other types may lag behind changes in
market rates. Additionally, certain assets may have features which restrict
changes in interest rates on a short-term basis and over the life of the asset.
For example, if a prime rate loan has a minimum interest rate of 7.5%, an
increase in a very low prime rate might not be sufficient to increase the
interest rate on the loan to more than the minimum. Further, in the event of a
change in interest rates, prepayment and early withdrawal levels would likely
deviate significantly from those assumed in calculating the table. Finally, the
ability of many borrowers to service their prime rate loans may decrease in the
event of an interest rate increase.
30
At December 31, 2006
------------------------------------------------------------------------------------
Three Four More than
months to twelve One year to More than
or less months five years five years Total
------------- ------------- ------------- ------------- -------------
Interest-earning assets:
Commercial loans (1) $ 63,575,095 $ 91,478 $ 7,392 $ 178,759 $ 63,852,724
Consumer loans (1) 2,545,055 1,145 7,336 58,071 2,611,607
Money market investments 788,045 -- -- -- 788,045
Mortgage-backed securities 5,162,192 15,486,576 87,316,930 -- 107,965,698
Other interest-earning assets 16,493,040 -- -- -- 16,493,040
Investment securities -- -- 8,500,000 -- 8,500,000
------------- ------------- ------------- ------------- -------------
Total interest-earning assets 88,563,427 15,579,199 95,831,658 236,830 200,211,114
Less:
Unearned (discount) and deferred fees(2) (71,142) (213,425) (90,199) -- (374,766)
------------- ------------- ------------- ------------- -------------
Net interest-earning assets 88,492,285 15,365,774 95,741,459 236,830 199,836,348
Interest-bearing liabilities:
Savings accounts 12,526,485 -- -- -- 12,526,485
NOW accounts 19,935,769 -- -- -- 19,935,769
Money market accounts 19,147,052 -- -- -- 19,147,052
Certificate accounts 46,451,110 18,630,239 3,147,896 -- 68,229,245
Subordinated debt -- -- 5,155,000 -- 5,155,000
------------- ------------- ------------- ------------- -------------
Total interest-bearing liabilities 98,060,416 18,630,239 8,302,896 -- 124,993,551
Interest sensitivity gap $ (9,568,131) $ (3,264,465) $ 87,438,563 $ 236,830 $ 74,842,797
============= ============= ============= ============= =============
Cumulative gap $ (9,568,131) $ (12,832,596) $ 74,605,967 $ 74,842,797 $ 74,842,797
============= ============= ============= ============= =============
Cumulative gap as a percentage
of total interest-earning
assets -4.78% -6.41% 37.26% 37.38% 37.38%
Cumulative net interest-earning assets
as a percentage of total interest-
bearing liabilities 90.24% 89.00% 159.69% 159.88% 159.88%
(1) For purposes of the gap analysis, mortgage and other loans are reduced for
non-performing loans but are not reduced for the allowance for possible loan
losses.
(2) For purposes of the gap analysis, unearned discount and deferred fees are
pro-rated.
Analysis of Net Interest Income
Our profitability is primarily dependent upon net interest income. Net interest
income represents the difference between interest income on interest-earning
assets and the interest expense on interest-bearing liabilities. Net interest
income depends primarily upon the volume of interest-earning assets and
interest-bearing liabilities and the interest rates earned or paid on them.
31
Average Balance Sheet
The following table sets forth certain information relating to our consolidated
statements of financial condition and the consolidated statements of earnings
for the fiscal years ended December 31, 2006, 2005 and 2004 and reflects the
average yield on assets and average cost of liabilities for the period
indicated. Such yields and costs are derived by dividing income or expense by
the average balance of assets or liabilities, respectively, for the periods
shown. Average balances are derived from average daily balances. The average
balance of loans receivable does not include loans on which we have discontinued
accruing interest. The yields and costs include net fees, which are considered
adjustments to yields. No tax equivalent adjustments have been made.
Year Ended December 31, Year Ended December 31, Year Ended December 31,
2006 2005 2004
--------------------------------- ---------------------------------- -----------------------------------
Average Yield/ Average Yield/ Average Yield/
Balance Interest Cost Balance Interest Cost Balance Interest Cost
------------ ------------ ------ ------------ ------------ ------ ------------ ------------ ------
Assets:
Interest-earning
assets:
Loans receivable $ 69,711,760 $ 6,985,200 10.02% $ 71,521,353 $ 5,828,338 8.15% $ 68,513,503 $ 5,340,281 7.79%
Other interest
earning assets 18,737,570 887,663 4.74 18,196,007 585,512 3.22 22,406,937 293,464 1.31
Investment
securities 114,180,350 5,201,089 4.56 114,817,580 4,870,635 4.24 95,319,848 4,051,983 4.25
------------ ------------ ------------ ------------ ------------ ------------
Total interest-
earning assets 202,629,680 13,073,952 6.45 204,534,940 11,284,485 5.52 186,240,288 9,685,728 5.20
Non-interest
earning assets 14,291,015 13,044,634 13,260,423
------------ ------------ ------------
Total assets $216,920,695 $217,579,574 $199,500,711
============ ============ ============
Liabilities and
equity:
Interest-bearing
liabilities:
Savings accounts $ 13,421,670 85,413 0.64 $ 15,745,514 79,073 0.50 $ 12,596,720 63,130 0.50
Time accounts 70,221,095 2,301,764 3.28 60,071,303 1,200,566 2.00 41,259,632 433,374 1.05
Money market accounts 19,357,106 352,956 1.82 20,835,285 229,906 1.10 23,219,409 195,269 0.84
Now accounts 21,508,418 107,973 0.50 24,524,078 104,620 0.43 23,988,825 100,941 0.42
Short Term Borrowings 19,178 1,112 5.80 -- -- -- -- -- --
Subordinated debt 5,155,000 356,159 6.91 5,155,000 356,159 6.91 5,155,000 356,159 6.91
------------ ------------ ------------ ------------ ------------ ------------
Total interest-
bearing
liabilities 129,682,467 3,205,377 2.47 126,331,180 1,970,324 1.56 106,219,586 1,148,873 1.08
Checking accounts 68,870,282 74,654,567 79,654,202
------------ ------------ ------------
Total 198,552,749 200,985,747 185,873,788
Other liabilities 2,529,839 2,631,982 2,071,349
------------ ------------ ------------
Total liabilities 201,082,588 203,617,729 187,945,137
Equity 15,838,107 13,961,845 11,555,574
------------ ------------ ------------
Total liabilities
and equity $216,920,695 $217,579,574 $199,500,711
============ ============ ============
Net interest income/
net interest rate
spread $ 9,868,575 3.98% $ 9,314,161 3.96% $ 8,536,855 4.12%
============ ====== ============ ====== ============ ======
Net interest earning
assets/net interest
margin $ 72,947,213 4.87% $ 78,203,760 4.55% $ 80,020,702 4.58%
============ ====== ============ ====== ============ ======
Ratio of interest-
earning assets to
interest-bearing
liabilities 1.56x 1.62x 1.75x
============ ============ ============
Return On Average
Assets: 1.17% 1.18% 1.14%
====== ====== ======
Return On Average
Equity: 16.07% 18.39% 19.68%
====== ====== ======
Equity To Assets: 8.18% 6.73% 5.44%
====== ====== ======
32
Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and
changes in the volume of interest-earning assets and interest-bearing
liabilities have affected our interest income and interest expense during the
periods indicated. Information is provided in each category with respect to (i)
changes attributable to changes in volume (changes in volume multiplied by prior
rate), (ii) changes attributable to changes in rate (changes in rate multiplied
by prior volume), and (iii) the net change. The changes attributable to the
combined impact of volume and rate have been allocated proportionately to the
changes due to volume and the changes due to rate.
Year Ended December 31, 2006 Year Ended December 31, 2005 Year Ended December 31, 2004
Compared to Compared to Compared to
December 31, 2005 December 31, 2004 December 31, 2003
Increase/(Decrease) Increase/(Decrease) Increase/(Decrease)
In Net Interest Income In Net Interest Income In Net Interest Income
------------------------------------ ------------------------------------ -----------------------------------
Due to Due to Due to
------------------------ ----------------------- -----------------------
Volume Rate Net Volume Rate Net Volume Rate Net
----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- -----------
Interest-earning
assets:
Loans receivable ($ 147,482) $ 1,304,344 $ 1,156,862 $ 234,312 $ 253,745 $ 488,057 $ 21,048 $ 199,018 $ 220,066
Money market -- -- -- -- -- -- (3,234) 6 (3,228)
Other interest-
earning assets 17,438 284,713 302,151 (55,163) 347,211 292,048 (1,533) 84,815 83,282
Investment
securities, afs (27,019) 357,473 330,454 828,654 (10,002) 818,652 1,237,333 575,511 1,812,844
----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- -----------
Total (157,062) 1,946,529 1,789,467 1,007,802 590,955 1,598,757 1,253,614 859,350 2,112,964
Interest-bearing
liabilities:
Savings accounts (11,619) 17,959 6,340 15,744 199 15,943 21,714 (16,127) 5,587
Time accounts 202,996 898,202 1,101,198 197,523 569,669 767,192 156,306 (66,249) 90,057
Money market
accounts (16,260) 139,310 123,050 (20,027) 54,664 34,637 (22,464) (46,550) (69,014)
Now accounts (12,967) 16,320 3,353 2,248 1,431 3,679 (7,786) (14,730) (22,516)
Short term
borrowings 1,112 -- 1,112 -- -- -- -- -- --
Subordinated debt -- -- -- -- -- -- 238,130 -- 238,130
----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- -----------
Total 163,262 1,071,792 1,235,053 195,488 625,963 821,451 385,900 (143,656) 242,244
----------- ----------- ----------- ----------- ----------- ----------- ----------- ----------- -----------
Net change in net
interest income ($ 320,324) $ 874,737 $ 554,414 $ 812,314 ($ 35,008) $ 777,306 $ 867,715 $ 1,003,005 $ 1,870,720
=========== =========== =========== =========== =========== =========== =========== =========== ===========
Comparative Results for the Years Ended December 31, 2006 and December 31, 2005
General. We had net income of $2,545,593 for the year ended December 31, 2006,
as compared to net income of $2,567,429 for the year ended December 31, 2005.
The principal categories which make up the 2006 net income are:
o Interest income of $13,073,952
o Reduced by interest expense of $3,205,377
o Increased by a credit provision for loan losses of $65,000
o Increased by non-interest income of $1,941,158
o Reduced by non-interest expense of $7,108,866
o Reduced by $2,220,274 in income tax expense.
We discuss each of these categories individually and the reasons for
the differences between the years ended December 31, 2006 and 2005 in the
following paragraphs. The most significant factor that caused changes in net
interest income from 2005 to 2006 was the increase in short-term interest rates,
which increased our earnings on assets funded with non-interest bearing
liabilities and capital.
Our average yields earned are higher than our cost of funds, and thus
an increase in interest-earning assets provides more interest income than the
cost of the additional interest bearing liabilities needed to fund those assets.
Therefore, we are seeking to expand our deposit product line in 2007 and
implement other marketing efforts to seek to reverse the decline in assets we
experienced during 2006.
33
Interest Income. Interest income was $13,073,952 for the year ended
December 31, 2006, compared to $11,284,485 for the year ended December 31, 2005,
an increase of $1,789,467, or 15.9%. The reasons for this increase include a187
basis point increase in the yield on our loan portfolio and a152 basis point
increase in the yield on our other interest earning assets, which generated an
additional $1,459,013 of interest income despite a $1,809,593 decrease in the
average balance of loans. Toward the end of 2006, we increased the average
volume of investment securities and other interest earning assets because we
could not deploy available funds into loans. Our volume of loans was highest at
the beginning of 2006 and gradually declined during the year as principal on
existing loans was repaid and new originations did not keep pace with the
principal reductions. The yield on investment securities for the year ended 2006
increased 32 basis points from the prior year because new securities purchased
in 2006 had higher yields than the securities that were fully or partially
repaid during the year.
The increase in loan interest income was $1,156,862 or 19.8% due
primarily to the 187 basis point increase in the loan yield as noted above. The
slow real estate market in Staten Island, which reduced construction and
commercial loan originations, hampered our efforts to increase our loan
portfolio. The average yield on our loans increased because during 2006 the
prime rate increased and the majority of our loans have adjustable rates tied to
the prime rate.
Finally, we had a $302,151 increase in income from overnight funds and
other interest earning assets, as the yield increased 152 basis points during
2006 due to higher market rates on short term and overnight investments. The
volume of these assets was relatively flat as compared to 2005 as we purchased
investment securities with funds from overnight investments.
Interest Expense. Interest expense was $3,205,377 for the year ended
December 31, 2006, compared to $1,970,324 for the year ended December 31, 2005,
an increase of 62.7%. More than 89% of the $1,235,053 increase in interest
expense was represented by an increase in the cost of our time deposits. The
average balance of time accounts increased by $10,149,792 (or 16.9%), and the
average rate on those accounts increased by 128 basis points, which combined to
cause an increase of $1,101,198 in interest expense. The increase in rate was
due to the increase in market rates, while the volume increase, which
represented substantially all of our increase in average deposit balances
between the two years, was apparently the result of a shift in customer
preferences in favor of time deposit accounts and the addition of $20 million in
municipal jumbo CD deposits. We received those municipal jumbo CDs due to the
establishment of an enhanced banking development district at our newest branch
in Rosebank in 2006. The rates we paid on those municipal accounts increased as
market interest rates increased.
Our average cost of funds increased from 1.56% to 2.47% between the
periods because of the increase in the cost of time and money market deposits
and the shift in favor of time deposits, which are our highest cost deposit
category. In addition, average non-interest bearing checking accounts decreased
as a percentage of total deposits from 37.1% in 2005 to 35.6% in 2006.
Net Interest Income Before Provision for Loan Losses. Net interest
income before the provision for loan losses was $9,868,575 for the year ended
December 31, 2006, an increase of $554,414, or 6.0% over the $9,314,161 we had
for the year ended December 31, 2005. The increase was driven primarily by the
increase in the yield on average interest-earning assets, partially offset by
the increase in the cost of funds due to the higher market rates. Average
interest earning assets decreased $1,842,260, or 0.9% in 2006. Our interest rate
spread increased 2 basis points from 3.96% at December 31, 2005 to 3.98% at
December 31, 2006, principally for the following reasons:
o An increase in prevailing interest rates caused a substantial increase
of 93 basis points in the yield on average interest earning assets;
o This positive effect was substantially offset by the increase in the
cost of our money market and time deposits; and
o Our customers appear to continue their deposit preferences towards
higher cost time deposits as the increase in interest rates made those
deposits more attractive.
Our net interest margin, which takes into account the effect of non-interest
bearing funding sources such as checking accounts and capital, increased 32
basis points from 2005 to 2006. This increase occurred because zero cost funding
sources become more valuable as rising interest rates allow the funds to be
invested at higher yields. The increase in yields on assets funded by
34
non-interest bearing deposits and capital outweighed the negative effects of a
$5,784,285, or 7.7%, decline in the average balance of checking accounts from
$74,654,567 in 2005 to $68,870,282 in 2006.
The prime rate, which is the index used to adjust interest rates on
many of our loans, was 8.25% at the end of 2006, as compared to 7.25% at the end
of 2005. Although these loans primarily have interest rates with a margin of 100
to 150 basis points above the prime rate, many have interest rate floors so that
the rates on the loans cannot decline below 7.00% to 7.50%. As a result of the
prime rate increase, the index plus the margin exceeded the floors on these
loans in 2006, so our yields on these loans adjusted with increases in the prime
rate. As a result, we had higher loan yields in 2006 than we had in 2005. If the
prime rate falls, these loans will start to re-price downwards along with prime
until rates reach the interest rate floors. Conversely, if the prime rate rises,
these loans will re-price upward with prime.
Provision for Loan Losses. In 2006, we recorded a $65,000 credit to the
provision for loan losses, compared to a credit to the provision for loan losses
of $60,000 for the year ended December 31, 2005. The $5,000 increase in the
credit in the provision was primarily due to a decrease in the loan portfolio,
partially offset by a moderate increase in loan delinquencies. If we are able to
implement successfully our plan to increase our loan portfolio to increase
average asset yields, that may also require an increase in the provision for
loan losses.
The provision for loan losses in any period depends upon the amount
necessary to bring the allowance for loan losses to the level management
believes is appropriate, after taking into account charge offs and recoveries.
Our allowance for loan losses reflects probable incurred losses based on
management's evaluation of the loan portfolio, and the general economy, local
economic conditions and other factors affecting loan repayments. Management
periodically evaluates both broad categories of performing loans and problem
loans individually to assess the appropriate level of the allowance.
Although management uses available information to assess the
appropriateness of the allowance on a quarterly basis in consultation with
outside advisors and the board of directors, changes in national or local
economic conditions, the circumstances of individual borrowers, or other
factors, may change, increasing the level of problem loans and requiring an
increase in the level of the allowance. The allowance for loan losses
represented 1.70% of total loans at December 31, 2006, but there can be no
assurance that a higher level, or a higher provision for loan losses, will not
be necessary in the future.
Non-interest Income. Non-interest income was $1,941,158 for the year
ended December 31, 2006, compared to $2,117,640 during the same period last
year. The $176,482, or 8.3%, decrease was caused primarily by a $160,993
decrease in net rental income, as the Bank received a one-time payment of
$119,000 in 2005 from a tenant that opted to terminate its sub-lease for
premises leased by the Bank and the vacancy of that space continued until late
2006.
Service fees on deposit accounts declined from 2005 to 2006 as the
volume of deposit account transactions generating fee income declined. The
increase in time deposit accounts, which tend not to generate fee income, and
the overall decrease in average deposits lowered service fees on deposit
accounts by $100,071 when comparing 2006 against 2005. Most of the decline
during 2006 was in the non-interest bearing checking account category, which is
the account type that tends to generate the highest level of service fees.
Non-interest Expense. Non-interest expense was $7,108,866 for the year
ended December 31, 2006, compared to $6,684,898 for the year ended December 31,
2005, an increase of $423,968 or 6.3%. The principal causes of the increase
were:
o $124,875 increase in occupancy expenses as our fifth branch in Rosebank
opened in April 2006 and we also had pre-opening occupancy expenses
associated with our new main office in Great Kills;
o $40,081 in higher salary and benefits costs due to normal salary
increases and higher benefit costs, which were partially offset by a
$90,927 reduction in SAR expense due to the reduction in the Company's
stock price from year-end 2006 from 2005;
o $132,155 in higher legal expenses incurred in connection with a number
of pending lawsuits involving a former customer of the Bank;
35
o $54,900 in higher directors fees as per meeting fees and fixed board
fees increased; and
o $57,331 more of "supplies and service expenses," reflecting the effects
of branch expansion and the increased costs of service providers.
Income Tax Expense. Income tax expense was $2,220,274 for the year
ended December 31, 2006, compared to income tax expense of $2,239,474 for the
year ended December 31, 2005, due to the $41,031 decrease in income before
income taxes for the year ended December 31, 2006. Our effective tax rate
remained the same for 2006 and 2005 at 46.6%.
Changes in Financial Condition
Our total assets were $211,884,759 at December 31, 2006, a decrease
of $3,890,953, or 1.8%, since December 31, 2005. The decline resulted from a
need to fund a decline in deposits, principally interest bearing checking and
savings accounts. We funded the decline in deposits primarily with cash flows
from overnight funds. The total decrease in assets can be categorized as
follows.
o A $5,961,078 decrease in cash and equivalents; and
o A $7,508,954 decrease in net loans receivable
o Partially offset by a $7,747,318 increase in investment securities
available for sale as management reinvested principal paydowns on
loans.
In addition, we also experienced changes in other asset categories due
to normal fluctuations in operations.
Our deposits (including escrow deposits) were $186,683,150 at December
31, 2006, a decrease of $6,568,009, or 3.4%, from December 31, 2005. The
decrease in deposits included a $3,638,287 decrease in NOW accounts and a
$2,282,525 decrease in savings accounts and a $1,818,233 decrease in money
market accounts, partially offset by a $673,065 increase in demand deposit
accounts and a $497,971 increase in time deposits. The increase in time deposits
was primarily due to increases in municipal time deposits, including a $10
million deposit from the City of New York and a $10 million deposit from the
State of New York, into our Rosebank branch, under New York State and New York
City's new enhanced Bank Development District deposit program. This increase was
partially offset by the reduction of jumbo CDs due primarily to the maturity of
section 1031 exchange CDs as the aggregate dollar and volume of 1031 exchange
accounts decreased in 2006.
Total stockholders' equity was $17,740,297 at December 31, 2006, an
increase of $2,923,952 from December 31, 2005. The increase reflected net income
of $2,545,593 for the year ended December 31, 2006, increased by a reduction of
$169,078 in Unearned ESOP shares reflecting the effect of the gradual payment of
the loan we made to fund the ESOP's purchase of our stock The unrealized loss on
securities available for sale decreased by $44,249 in 2006. The unrealized loss
is excluded from the calculation of regulatory capital. Management does not
anticipate selling securities in this portfolio, but changes in market interest
rates or in the demand for funds may change management's plans with respect to
the securities portfolio. If there is a material increase in interest rates, the
market value of the available for sale portfolio may decline. Management
believes that the principal and interest payments on this portfolio, combined
with the existing liquidity, will be sufficient to fund loan growth and
potential deposit outflow.
The change in stockholders' equity also included a decrease of $75,535
in additional paid in capital due to reclassification of $114,615 representing
the Employee Stock Ownership Plan Repurchase Obligation, partially offset by the
$46,232 increase due to the exercise of options to purchase 3,750 shares of
common stock and a decrease in unearned ESOP shares of $169,078 reflecting the
effect of the gradual payment of the loan we made to fund the ESOP's purchase of
our stock.
VSB Bancorp, Inc. satisfied all capital ratio requirements of the
Federal Reserve at December 31, 2006, with a Tier I Leverage Capital ratio of
10.98%, a ratio of Tier I Capital to Risk-Weighted Assets ratio of 25.47%, and a
Total Capital to Risk-Weighted Assets ratio of 26.66%.
36
In May of 2004, we implemented the stockholder-approved ESOP. We lent
the ESOP the money to purchase shares of our stock with the expectation that the
ESOP will repay the loan principally from contributions from Victory State Bank
as part of its employee compensation program. The loan has a ten year term, with
periodic payments due annually sufficient to repay the loan, including interest,
in monthly installments over the term of the loan. The interest rate is fixed at
4.00%, the prime rate on the date of the loan.
Upon implementation, the ESOP purchased 92,900 shares of our common
stock out of our authorized but unissued shares, which initially had no net
effect on capital on the purchase date. The purchase price was $18.20 per share,
the fair market value at that time, for a total purchase price of $1.7 million.
As payments are made to reduce the ESOP loan, stock is released from the
security interest for the loan, resulting in an increase in capital equal to the
market value of the ESOP stock as it is released. However, under federal law
regarding employee stock ownership plans, since our stock is not considered to
be "readily tradable on an established market," employees who receive a
distribution of stock from the ESOP upon termination of employment have the
right to require that we repurchase the stock at fair value. We reflect this
contingent repurchase obligation on our balance sheet as a reclassification of
additional paid in capital of $399,026 to mezzanine capital, based upon our
quoted price on December 31, 2006, but the amount still qualifies as capital for
regulatory purposes. Employees are not permitted to make contributions to the
ESOP.
Liquidity and Capital Resources
Our primary sources of funds are increases in deposits and proceeds
from the repayment of investment securities. We use these funds principally to
purchase new investment securities and to fund increases in our loan portfolio.
For the year ended December 31, 2006, we had a net decrease in total
deposits of $6,568,009 as a result of a $3,638,287 decline in NOW accounts, a
$2,282,525 decline in savings accounts and a $1,818,233 decline in money market
accounts, partially offset by a $673,065 increase in demand deposits. We
received proceeds from repayment of investment securities of $21,538,473, which
we used to fund the deposit outflow, net loan reduction of $7,904,764 and the
purchase of $29,218,233 of investment securities. These deposits also tend to
decline in a rising rate environment, as customers have a greater incentive to
place their funds into higher interest-bearing accounts. The decrease in
deposits was partially offset by the increase in municipal time deposits due to
$10 million from the City of New York and $10 million from the State of New
York, into our Rosebank branch, under New York State and New York City's new
enhanced Bank Development District deposit program.
In contrast, for the year ended December 31, 2005, we had a net
decrease in total deposits of $22,172,314 as a result of a $35,430,119 decline
in demand deposit accounts, partially offset by a $13,260,766 increase in time
deposits. We received proceeds from repayment of investment securities of
$28,371,189, which we used to fund the deposit outflow, net loan growth of
$6,043,442 and the purchase of $7,776,706 of investment securities. The decrease
in deposits was primarily attributable to a decline in real estate activity in
our community, which resulted in a reduction in demand deposits created in
connection with pending real estate and mortgage loan transactions, as well as
our termination of our relationship with a customer in the real estate
settlement business. Demand deposits also tend to decline in a rising rate
environment, as customers have a greater incentive to place their funds in
interest-bearing accounts.
In 2006, we experienced a net decline of $5,961,078 in cash and
equivalents because of our strategy to invest available cash in investments as
opposed to lower yielding overnight deposits and to fund the deposit outflow.
Total cash and equivalents at December 31, 2006 were $25,363,069.
During 2005, we experienced a net decline of $4,334,926 in cash and
equivalents because we needed to fund the outflow of deposits. Total cash and
equivalents at December 31, 2005 were $31,324,147.
The following table sets forth our contractual obligations and commitments for
future lease payments, time deposit maturities and loan commitments.
37
Contractual Obligations and Commitments at December 31, 2006
Contractual Obligations Payment due by Period
------------------------------------------------------------------------
Less than One to three Four to five After Total Amounts
One Year years years five years committed
------------ ------------ ------------ ------------ ------------
Minimum annual rental payments under
non-cancelable operating leases $ 420,856 $ 793,156 $ 818,018 $ 2,637,308 $ 4,669,338
Remaining contractual maturities of time
deposits 65,081,349 1,224,226 1,923,669 -- 68,229,244
------------ ------------ ------------ ------------ ------------
Total contractual cash obligations $ 65,502,205 $ 2,017,382 $ 2,741,687 $ 2,637,308 $ 72,898,582
============ ============ ============ ============ ============
Other commitments Amount of commitment Expiration by Period
------------------------------------------------------------------------
Less than One to three Four to five After Total Amounts
One Year years years five years committed
------------ ------------ ------------ ------------ ------------
------------ ------------ ------------ ------------ ------------
Loan commitments $ 24,395,991 $ 4,296,448 $ 375,000 $ -- $ 29,067,439
============ ============ ============ ============ ============
Impact of Inflation and Changing Prices
The consolidated financial statements and related notes presented herein have
been prepared in accordance with accounting principles generally accepted in the
United States, which require the measurement of financial position and operating
results in terms of historical dollars without considering the changes in the
relative purchasing power of money over time and due to inflation. Unlike
industrial companies, nearly all of our assets and liabilities are monetary. As
a result, interest rates have a greater impact on our performance than do the
general levels of inflation. Interest rates do not necessarily move in the same
direction or to the same extent as the price of goods and services.
PART II
Item 7.
The company's financial statements appear on the following pages:
38
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm ..............................................F-1
Consolidated Statements of Financial Condition as of December 31, 2006 and 2005.......................F-2
Consolidated Statements of Earnings for the Years Ended December 31, 2006 and 2005....................F-3
Consolidated Statements of Stockholders' Equity for the Years Ended December 31, 2006 and 2005........F-4
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006 and 2005..................F-5
Notes to Consolidated Financial Statements............................................................F-6
39
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
VSB Bancorp, Inc.
Staten Island, New York
We have audited the accompanying consolidated statements of financial condition
of VSB Bancorp, Inc. as of December 31, 2006 and 2005 and the related
consolidated statement of earnings, stockholders' equity and comprehensive
income and cash flows for the years then ended. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based upon our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material results, the financial position of VSB Bancorp, Inc. as
of December 31, 2006 and 2005 and the results of its operations and its cash
flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America.
As discussed in Note 2 to the consolidated financial statements, the Company
adopted Staff Accounting Bulletin No. 108, "Considering the Effects of Prior
Year Misstatements When Quantifying Misstatements in Current Year Financial
Statements" and accordingly adjusted assets and liabilities at the beginning of
2006 with an offsetting adjustment to the opening balance of retained earnings.
/s/ Crowe Chizek and Company LLC
Livingston, New Jersey
March 16, 2007
F-1
VSB BANCORP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2006 AND 2005
--------------------------------------------------------------------------------
ASSETS 2006 2005
------------- -------------
Cash and cash equivalents $ 25,363,069 $ 31,324,147
Investment securities, available for sale 113,770,611 106,023,293
Loans receivable (net of allowance for loan losses
of $1,128,824 and $1,153,298, respectively) 65,281,853 72,790,807
Accrued interest receivable 805,681 728,627
Premises and equipment, net 1,554,363 1,441,087
Prepaid and other assets 3,078,535 1,169,556
Deferred income taxes, net 2,030,647 2,298,195
------------- -------------
Total assets $ 211,884,759 $ 215,775,712
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Deposits
Non-interest bearing $ 67,632,645 $ 66,959,580
Interest bearing 119,050,505 126,291,579
Subordinated Debt 5,155,000 5,155,000
Accounts payable, accrued expenses and other liabilities 2,306,312 2,553,208
------------- -------------
Total liabilities 194,144,462 200,959,367
------------- -------------
Employee Stock Ownership Plan Repurchase Obligation 399,026 284,411
STOCKHOLDERS' EQUITY
Common stock ($.0001 par value, 3,000,000 shares authorized,
1,891,759 issued and outstanding at December 31, 2006;
1,509,822 issued and outstanding at December 31, 2005) 189 151
Additional paid-in capital 8,667,665 8,743,200
Retained earnings 11,293,200 8,621,693
Unearned Employee Stock Ownership Plan shares (1,239,905) (1,408,983)
Accumulated other comprehensive loss, net of taxes
of $1,203,679 and $1,242,278, respectively (1,379,878) (1,424,127)
------------- -------------
Total stockholders' equity 17,341,271 14,531,934
------------- -------------
Total liabilities and stockholders' equity $ 211,884,759 $ 215,775,712
============= =============
See notes to consolidated financial statements.
F-2
VSB BANCORP, INC.
CONSOLIDATED STATEMENTS OF EARNINGS FOR THE YEARS ENDED DECEMBER 31,
2006 AND 2005
--------------------------------------------------------------------------------
2006 2005
------------ ------------
INTEREST INCOME:
Loans receivable $ 6,985,200 $ 5,828,338
Investment securities 5,201,089 4,870,635
Other interest income 887,663 585,512
------------ ------------
Total interest income 13,073,952 11,284,485
INTEREST EXPENSE:
Deposits 2,848,106 1,614,165
Federal Home Loan Bank advances 1,112 --
Subordinated Debt 356,159 356,159
------------ ------------
Total interest expense 3,205,377 1,970,324
Net interest income 9,868,575 9,314,161
PROVISION CREDIT FOR LOAN LOSSES (65,000) (60,000)
------------ ------------
Net interest income after
provision credit for loan losses 9,933,575 9,374,161
------------ ------------
NON-INTEREST INCOME:
Deposit service fees 1,585,127 1,685,198
Other income 356,031 432,442
------------ ------------
Total non-interest income 1,941,158 2,117,640
------------ ------------
NON-INTEREST EXPENSES:
Salaries and employee benefits 3,820,566 3,780,485
Occupancy and equipment 1,101,824 976,949
Data processing service fees 259,592 241,396
Legal fees 305,333 173,178
Professional fees 161,000 222,000
Director fees 221,950 167,050
Supplies and service 344,983 287,652
Checkbook charges 185,131 156,115
Other 708,487 680,073
------------ ------------
Total non-interest expenses 7,108,866 6,684,898
------------ ------------
INCOME BEFORE INCOME TAXES 4,765,867 4,806,903
------------ ------------
PROVISION FOR INCOME TAXES:
Current 2,101,161 2,238,114
Deferred 119,113 1,360
------------ ------------
Total income taxes 2,220,274 2,239,474
------------ ------------
NET INCOME $ 2,545,593 $ 2,567,429
============ ============
Earnings per share:
Basic $ 1.40 $ 1.42
============ ============
Diluted $ 1.36 $ 1.38
============ ============
Comprehensive income $ 2,589,842 $ 1,608,347
============ ============
See notes to consolidated financial statements.
F-3
VSB BANCORP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME FOR
THE YEARS ENDED DECEMBER 31, 2006 AND 2005
--------------------------------------------------------------------------------
Accumulated
Number of Additional Unearned Other Total
Common Common Paid-in Retained ESOP Comprehensive Stockholders'
Shares Stock Capital Earnings Shares Loss Equity
------------ ------------ ------------ ------------ ------------ ------------ ------------
Balance at January 1, 2005 1,505,022 $ 150 $ 8,818,313 $ 6,054,264 $ (1,578,061) $ (465,045) $ 12,829,621
Exercise of stock option
including tax benefit 4,800 1 63,731 63,732
Amortization of earned portion
of ESOP common stock 169,078 169,078
Amortization of excess fair
value of cost - ESOP 18,742 18,742
Transfer to ESOP repuchase
obligation (157,586) (157,586)
Comprehensive income:
Net income 2,567,429 2,567,429
Other comprehensive
income, net:
Change in unrealized
loss on securities
available for sale,
net of tax effects -- -- -- -- -- (959,082) (959,082)
------------ ------------ ------------ ------------ ------------ ------------ ------------
Total comprehensive income 1,608,347
Balance at December 31, 2005 1,509,822 151 8,743,200 8,621,693 (1,408,983) (1,424,127) 14,531,934
------------ ------------ ------------ ------------ ------------ ------------ ------------
Recast due to the adoption
of SEC SAB 108 -- -- -- 125,914 -- -- 125,914
------------ ------------ ------------ ------------ ------------ ------------ ------------
Balance at January 1, 2006 1,509,822 151 8,743,200 8,747,607 (1,408,983) (1,424,127) 14,657,848
------------ ------------ ------------ ------------ ------------ ------------ ------------
Exercise of stock option,
including tax benefit 3,750 46,232 46,232
Amortization of earned
portion of ESOP common
stock 169,078 169,078
5 for 4 stock split and
purchase of fractional
shares 378,187 38 (367) (329)
Amortization of deficit fair
value of cost - ESOP (6,785) (6,785)
Transfer to ESOP repuchase
obligation (114,615) (114,615)
Comprehensive income:
Net income 2,545,593 2,545,593
Other comprehensive
income, net:
Change in unrealized
gain on securities
available for sale,
net of tax effects -- -- -- -- -- 44,249 44,249
------------ ------------ ------------ ------------ ------------ ------------ ------------
Total comprehensive income 2,589,842
Balance at December 31, 2006 1,891,759 $ 189 $ 8,667,665 $ 11,293,200 $ (1,239,905) $ (1,379,878) $ 17,341,271
============ ============ ============ ============ ============ ============ ============
See notes to consolidated financial statements.
F-4
VSB BANCORP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31,
2006 and 2005
--------------------------------------------------------------------------------
2006 2005
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,545,593 $ 2,567,429
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 446,588 449,777
Accretion of discount, net amortization of premium (315,520) (177,651)
ESOP compensation expense 162,293 187,820
Credit provision for loan losses (65,000) (60,000)
Gain loss on the sale of other assets -- (4,500)
Changes in operating assets and liabilities:
Increase in prepaid and other assets (1,908,979) (449,886)
(Increase)/decrease in accrued interest receivable (77,054) 16,741
Decrease in deferred income taxes 228,949 1,360
(Decrease)/increase in accrued expenses, income tax payable
and other liabilities (120,982) 403,660
------------ ------------
Net cash provided by operating activities 895,888 2,934,750
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net decrease / (increase) in loans receivable 7,904,764 (5,686,497)
Proceeds from repayments and calls of investment securities,
available for sale 21,538,473 28,371,189
Purchase of investment securities, available for sale (29,218,233) (7,776,706)
Purchases of premises and equipment, net (559,864) (69,080)
------------ ------------
Net cash (used in)/provided by investing activities (334,860) 14,838,906
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net decrease in deposits (6,568,009) (22,172,314)
Exercise of stock options 46,232 63,732
Purchase of fractional shares, 5 for 4 split (329) --
------------ ------------
Net cash used in financing activities (6,522,106) (22,108,582)
------------ ------------
NET DECREASE IN CASH AND CASH EQUIVALENTS (5,961,078) (4,334,926)
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR 31,324,147 35,659,073
------------ ------------
CASH AND CASH EQUIVALENTS,
END OF YEAR $ 25,363,069 $ 31,324,147
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH
FLOW INFORMATION:
Cash paid during the period for:
Interest $ 2,900,877 $ 2,176,292
============ ============
Income taxes $ 2,173,620 $ 2,500,378
============ ============
See notes to consolidated financial statements.
F-5
VSB BANCORP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2006
and 2005
--------------------------------------------------------------------------------
1. GENERAL
VSB Bancorp, Inc. ("Bancorp" or "Company") became the holding company for
Victory State Bank ("Bank"), a New York State chartered commercial bank on May
30, 2003 as the result of a reorganization of the Bank into the holding company
form of organization. Through the Bank, the Company is primarily engaged in the
business of commercial banking, and to a lesser extent retail banking, in Staten
Island New York. The stockholders of the Bank became the stockholders of VSB
Bancorp, Inc. as a result of the reorganization, receiving three shares of VSB
Bancorp, Inc. stock for each two shares of Victory State Bank stock. Each
stockholder owned the same percentage interest in VSB Bancorp immediately after
the reorganization that the stockholder owned in the Bank immediately before the
reorganization, subject to immaterial differences due to adjustments for cash in
lieu of fractional shares. VSB Bancorp now owns 100% of the capital stock of the
Bank. No stockholders of the Bank exercised dissenter's rights to receive cash
instead of shares of the Company. The transaction between these entities under
common control was accounted for at historical cost on an "as if pooled basis".
Through the Bank, the Company is primarily engaged in the business of
commercial banking, and to a lesser extent retail banking. The Bank gathers
deposits from individuals and businesses primarily in Staten Island, New York
and makes loans throughout that community. The Bank invests funds that are not
used for lending primarily in government securities, mortgage backed securities
and collateralized mortgage obligations. Customer deposits are insured, up to
the applicable limit, by the Federal Deposit Insurance Corporation ("FDIC"). The
Bank is supervised by the New York State Banking Department and the FDIC.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following is a description of the significant accounting and reporting
policies followed in preparing and presenting the accompanying consolidated
financial statements. These policies conform with accounting principles
generally accepted in the United States of America ("GAAP").
Principles of Consolidation - The consolidated financial statements of the
Company include the accounts of the Company, including its subsidiary Victory
State Bank. All significant inter-company accounts and transactions between the
Company and Bank have been eliminated in consolidation.
Use of Estimates - The preparation of financial statements in conformity
with GAAP requires management to make estimates and assumptions that affect the
reported amounts of assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and the amounts
of revenues and expenses during the reporting period. Actual results can differ
from those estimates. The allowance for loan losses, prepayment estimates on the
mortgage-backed securities and Collateralized Mortgage Obligation portfolios,
contingencies and fair values of financial instruments are particularly subject
to change.
Reclassifications - Some items in the prior year financial statements were
reclassified to conform to the current presentation.
Cash and Cash Equivalents - Cash and cash equivalents consists of cash on
hand, due from banks and interest-bearing deposits. Net cash flows are reported
for customer loan and deposit transactions and interest-bearing deposits.
Regulation D of the Board of Governors of the Federal Reserve system requires
that Victory State Bank maintain non-interest-bearing deposits or cash on hand
as reserves against its demand deposits. The amount of reserves which Victory
State Bank is required to maintain depends upon its level of transaction
F-6
accounts. During the fourteen day period from December 21, 2006 through January
3, 2007, Victory State Bank was required to maintain reserves, after deducting
vault cash, of $3,583,000. Reserves are required to be maintained on a fourteen
day basis, so, from time to time, Victory State Bank may use available cash
reserves on a day to day basis, so long as the fourteen day average reserves
satisfy Regulation D requirements. Victory State Bank is required to report
transaction account levels to the Federal Reserve on a weekly basis.
Interest-bearing bank balances - Interest-bearing bank balances mature
overnight and are carried at cost.
Investment Securities, Available for Sale - Investment securities,
available for sale, are to be held for an unspecified period of time and include
securities that management intends to use as part of its asset/liability
strategy. These securities may be sold in response to changes in interest rates,
prepayments or other factors and are carried at estimated fair value. Gains or
losses on the sale of such securities are determined by the specific
identification method. Interest income includes amortization of purchase premium
and accretion of purchase discount. Premiums and discounts are recognized in
interest income using a method that approximates the level yield method without
anticipating prepayments, except for mortgage-backed securities where
prepayments are estimated. Unrealized holding gains or losses, net of deferred
income taxes, are excluded from earnings and reported as other comprehensive
income in a separate component of stockholders' equity until realized. Declines
in the fair value of securities below their cost that are other than temporary
are reflected as realized losses. In estimating other-than-temporary losses,
management considers: (1) the length of time and extent that fair value has been
less than cost, (2) the financial condition and near term prospects of the
issuer, and (3) the Company's ability and intent to hold the security for a
period sufficient to allow for any anticipated recovery in fair value.
The Company invests primarily in agency Collateralized Mortgage-Backed
Obligations ("CMOs") with estimated average lives primarily under 4.5 years and
Mortgage-Backed Securities. These securities are primarily issued by the Federal
National Mortgage Association ("FNMA"), the Government National Mortgage
Association ("GNMA") or the Federal Home Loan Mortgage Corporation ("FHLMC") and
are primarily comprised of mortgage pools guaranteed by FNMA, GNMA or FHLMC. The
Company also invests in whole loan CMOs, all of which are AAA rated. These
securities expose the Company to risks such as interest rate, prepayment and
credit risk and thus pay a higher rate of return than comparable treasury
issues.
Loans Receivable - Loans receivable, that management has the intent and
ability to hold for the foreseeable future or until maturity or payoff, are
stated at unpaid principal balances, adjusted for deferred net origination and
commitment fees and the allowance for loan losses. Interest income on loans is
credited as earned.
It is the policy of the Company to provide a valuation allowance for
probable incurred losses on loans based on the Company's past loan loss
experience, known and inherent risks in the portfolio, adverse situations which
may affect the borrower's ability to repay, estimated value of underlying
collateral and current economic conditions in the Company's lending area. The
allowance is increased by provisions for loan losses charged to earnings and is
reduced by charge-offs, net of recoveries. While management uses available
information to estimate losses on loans, future additions to the allowance may
be necessary based upon the expected growth of the loan portfolio and any
changes in economic conditions beyond management's control. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Bank's allowance for loan losses. Such agencies may
require the Bank to recognize additions to the allowance based on judgments
different from those of management. Management believes, based upon all relevant
and available information, that the allowance for loan losses is adequate.
The Company has a policy that all loans 90 days past due are placed on
non-accrual status. It is the Company's policy to cease the accrual of interest
on loans to borrowers past due less than 90 days where a probable loss is
estimated and to reverse out of income all interest that is due. The Company
applies payments received on non-accrual loans to the outstanding principal
balance due before applying any amount to interest, until the loan is restored
to an accruing status. On a limited basis, the Company may apply a payment to
F-7
interest on a non-accrual loan if there is no impairment or no estimatible loss
on this asset. The Company continues to accrue interest on construction loans
that are 90 days past contractual maturity date if the loan is expected to be
paid in full in the next 60 days and all interest is paid up to date.
Loan origination fees and certain direct loan origination costs are
deferred and the net amount recognized over the contractual loan terms using the
level-yield method, adjusted for periodic prepayments in certain circumstances.
The Company considers a loan to be impaired when, based on current
information, it is probable that the Company will be unable to collect all
principal and interest payments due according to the contractual terms of the
loan agreement. Loans that experience insignificant payment delays and payment
shortfalls generally are not classified as impaired. Impairment is measured on a
loan by loan basis for commercial and construction loans. Impaired loans are
measured based on the present value of expected future cash flows discounted at
the loan's effective interest rate or, as a practical expedient, at the loan's
observable market price or the fair value of the collateral. The fair value of
the collateral, as reduced by costs to sell, is utilized if a loan is collateral
dependent. Large groups of smaller balance homogeneous loans, such as consumer
loans and residential loans, are collectively evaluated for impairment.
Long-Lived Assets - The Company periodically evaluates the recoverability
of long-lived assets, such as premises and equipment, to ensure the carrying
value has not been impaired. In performing the review for recoverability, the
Company would estimate the future cash flows expected to result from the use of
the asset. If the sum of the expected future cash flows is less than the
carrying amount an impairment will be recognized. The Company reports these
assets at the lower of the carrying value or fair value.
Subordinated Debt - In August of 2003, the Company formed VSB Capital
Trust I (the "Trust"). The Trust is a statutory business trust organized under
Delaware law and the Company owns all of its common securities. The Trust issued
$5.0 million of Trust Preferred Capital Securities to an independent investor
and $155,000 of common securities to the Company. The Company issued a $5.16
million subordinated debenture to the Trust. The subordinated debenture is the
sole asset of the Trust. The subordinated debenture and the Trust Preferred
Capital Securities pay interest and dividends, respectively, on a quarterly
basis, at a rate of 6.909%, for the first five years. They mature thirty years
after the issuance of the securities and are non-callable for five years. After
the first five years, the Trust Preferred Securities may be called by the
Company at any quarterly interest payment date at par and the rate of interest
that fluctuates quarterly based upon 300 basis points over the 90 day LIBOR
rate. The Trust is not consolidated with the Company.
Premises and Equipment - Premises, leasehold improvements, and furniture
and equipment are stated at cost less accumulated depreciation and amortization.
Depreciation and amortization are accumulated by the straight-line method over
the estimated useful lives of the respective assets, which range from three to
ten years. Leasehold improvements are amortized at the lesser of their useful
life or the term of the lease.
Federal Home Loan Bank (FHLB) Stock - The Bank is a member of the FHLB
system. Members are required to own a certain amount of stock based on the level
of borrowings and other factors, and may invest in additional amounts. FHLB
stock is carried at cost, classified as a restricted security, and periodically
evaluated for impairment. Because this stock is viewed as a long term
investment, impairment is based on ultimate recovery of par value. Both cash and
stock dividends are reported as income.
Income Taxes - The Company utilizes the liability method to account for
income taxes. Under this method, deferred tax assets and liabilities are
determined on differences between financial reporting and the tax bases of
assets and liabilities and are measured using the enacted tax rates and laws
expected to be in effect when the differences are expected to reverse. As
changes in tax laws or rates are enacted, deferred tax assets and liabilities
are adjusted through the provision for income taxes.
F-8
Financial Instruments - In the ordinary course of business, the Company
has entered into off-balance sheet financial instruments, primarily consisting
of commitments to extend credit.
Basic and Diluted Net Income Per Common Share - Basic net income per share
of common stock is based on 1,818,646 shares and 1,802,486 shares, the weighted
average number of common shares outstanding for the years ended December 31,
2006 and 2005, respectively. Diluted net income per share of common stock is
based on 1,867,214 and 1,860,130, the weighted average number of common shares
and potentially dilutive common shares outstanding for the years ended December
31, 2006 and 2005, respectively. The weighted average number of potentially
dilutive common shares excluded in calculating diluted net income per common
share due to the anti-dilutive effect is 69,193 and 57,644 shares for the years
ended December 31, 2006 and 2005, respectively. Common stock equivalents were
calculated using the treasury stock method. All per share data throughout this
report has been adjusted to reflect, retroactively, a 5-for-4 stock split, in
the form of a 25% stock dividend that was declared by the Board of Directors to
stockholders of record on May 3, 2006.
The reconciliation of the numerators and the denominators of the basic and
diluted per share computations for the years ended December 31, are as follows:
2006 2005
------------------------------------------ ------------------------------------------
Weighted Weighted
Net Average Per Share Net Average Per Share
Income Shares Amount Income Shares Amount
------------ ------------ ------------ ------------ ------------ ------------
Basic earnings per
common share
--------------------------
Net income available to
common stockholders $ 2,545,593 1,818,646 $ 1.40 $ 2,567,429 1,802,486 $ 1.42
============ ============
Effect of dilutive shares
--------------------------
Weighted average
shares, if converted 48,568 57,644
------------ ------------
Diluted earnings per
common share
--------------------------
Net income available to
common stockholders $ 2,545,593 1,867,214 $ 1.36 $ 2,567,429 1,860,130 $ 1.38
============ ============ ============ ============ ============ ============
Stock Based Compensation - FAS 123, Revised, requires companies to record
compensation expense for stock options provided to employees in return for
employment service. The cost is measured at the fair value of the options when
granted, and this cost is expensed over the employment service period, which is
normally the vesting period of the options. This applies to awards granted or
modified in fiscal years beginning in 2006. Compensation cost will also be
recorded for prior option grants that vest after the date of adoption. The
effect on result of operations will depend on the level of future option grants
and the calculation of the fair value of the options granted at such future
date, as well as the vesting periods provided, and so cannot currently be
predicted. In December 2005, the Board authorized the acceleration of the
vesting of all outstanding stock options issued to both employees and directors.
The decision to accelerate the vesting of these options, which the Company
believes is in the best interest of its stockholders, was made primarily to
reduce non-cash compensation expense, approximately $169,000 of future
compensation expense, net of taxes, that would have been recorded in its income
statement in future periods upon the adoption of Financial Accounting Standards
Board Statement No. 123R (Share-Based Payment) in January 2006.
If compensation cost for awards had been measured based on the fair value of the
stock options awarded at the grant dates, net income and basic and diluted
earnings per common share would have been reduced to the pro-forma amounts on
the table below for the year ended December 31, 2005:
F-9
2005
--------------
Net Income
As reported $ 2,567,429
Less: Total stock-based compensation expense
determined under the fair value method for
all awards, net of related tax effects 218,887
--------------
Pro-forma $ 2,348,542
==============
2005
--------------
Basic earnings per common share
As reported $ 1.42
Less: Total stock-based compensation expense
determined under the fair value method for
all awards, net of related tax effects 0.12
--------------
Pro-forma $ 1.30
==============
2005
--------------
Diluted earnings per common share
As reported $ 1.38
Less: Total stock-based compensation expense
determined under the fair value method for
all awards, net of related tax effects 0.12
--------------
Pro-forma $ 1.26
==============
No stock options were awarded in 2006.
Employee Stock Ownership Plan ("ESOP") - The cost of shares issued to the
ESOP, but not yet allocated to participants, is shown as a reduction of
stockholders' equity. Compensation expense is based on the market price of
shares as they are committed to be released to participant accounts. Cash
dividends on allocated ESOP shares reduce retained earnings; cash dividends on
unearned ESOP shares reduce debt and accrued interest. As participants may put
their ESOP shares back to the Company upon termination, an amount of equity
equal to these shares times the current market price is reclassified out of
stockholders' equity.
Comprehensive Income - Comprehensive income consists of net income and
other comprehensive income. Other comprehensive income includes unrealized gains
and losses, net of taxes, on securities available for sale which are also
recognized as separate components of equity.
Recently-Issued Accounting Standards - In September 2006, the Securities
and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108,
Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements (SAB 108), which is effective
for fiscal years ending on or after November 15, 2006. SAB 108 provides guidance
on how the effects of prior-year uncorrected financial statement misstatements
should be considered in quantifying a current year misstatement. SAB 108
requires public companies to quantify misstatements using both an income
statement (rollover) and balance sheet (iron curtain) approach and evaluate
whether either approach results in a misstatement that, when all relevant
quantitative and qualitative factors are considered, is material. If prior year
errors that had been previously considered immaterial now are considered
material based on either approach, no restatement is required so long as
management properly applied its previous approach and all relevant facts and
circumstances were considered. Adjustments considered immaterial in prior years
under the method previously used, but now considered material under the dual
approach required by SAB 108, are to be recorded upon initial adoption of SAB
108. The amount so recorded is shown as a cumulative effect adjustment is
recorded in opening retained earnings as of January 1, 2006 for various accrued
F-10
expenses that accumulated through 2005. Included in this cumulative effect
adjustment are the following items and amounts: a decrease in accrued expenses
of $235,749 and a decrease in deferred taxes of $109,835 which resulted in a
$125,914 increase in retained earnings.
In June 2006, Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes. This
Interpretation clarifies the accounting for uncertainty in income taxes
recognized in an enterprise's financial statements in accordance with FASB
Statement No. 109, Accounting for Income Taxes. This Interpretation prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return. This Interpretation also provides guidance on de-recognition,
classification, interest and penalties, accounting in interim periods,
disclosure, and transition. This Interpretation is effective for fiscal years
beginning after December 15, 2006. The adoption of FIN 48 did not have a
material effect on the Company's financial statements.
In February 2006, FASB issued Statement of Financial Accounting Standards
No. 155, Accounting for Certain Hybrid Instruments. This standard amended the
guidance in FASB Statements No. 133, Accounting for Derivative Instruments and
Hedging Activities, and No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities. Statement 155 permits fair
value re-measurement for any hybrid financial instrument that contains an
embedded derivative that otherwise would require bifurcation and clarifies which
interest-only and principal-only strips are not subject to the requirements of
Statement 133. Statement 155 is effective for all financial instruments acquired
or issued after the beginning of an entity's first fiscal year that begins after
September 15, 2006. The adoption of this standard did not have a material impact
on the Company's financial statements.
In March 2006, FASB issued Statement No. 156, Accounting for Servicing of
Financial Assets - An Amendment of FASB Statement No. 140. This standard amends
the guidance in Statement No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities with respect to the
accounting for separately recognized servicing assets and servicing liabilities.
Among other requirements, Statement 156 requires an entity to recognize a
servicing asset or servicing liability each time it undertakes an obligation to
service a financial asset by entering into a servicing contract in certain
situations, including a transfer of the servicing loans that meets the
requirements for sale accounting. Statement 156 is effective as of the beginning
of an entity's first fiscal year that begins after September 15, 2006. The
adoption of this standard did not have a material impact on the Company's
financial statements.
In September 2006, FASB issued Statement No. 157, Fair Value Measurements.
This Statement defines fair value, establishes a framework for measuring fair
value in GAAP, and expands disclosures about fair value measurements. This
Statement applies under other accounting pronouncements that require or permit
fair value measurements, the Board having previously concluded in those
accounting pronouncements that fair value is the relevant measurement attribute.
Accordingly, this Statement does not require any new fair value measurements.
However, for some entities, the application of this Statement will change
current practice. This Statement is effective for financial statements issued
for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. The adoption of this standard is not expected to have a
material impact on the Company's financial statements.
3. INVESTMENT SECURITIES, AVAILABLE FOR SALE
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 at December 31, 2006 and 2005:
F-11
December 31, 2006
-------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Value Gains Losses
-------------- -------------- --------------
US Government Agency $ 8,443,906 $ -- $ (56,094)
FNMA MBS 7,397,799 -- (209,609)
FHLMC MBS 229,625 639 --
GNMA MBS 2,171,125 -- (93,436)
Whole Loan MBS 3,453,363 -- (101,420)
Collateralized mortgage obligations 92,074,793 11,247 (2,134,884)
-------------- -------------- --------------
$ 113,770,611 $ 11,886 $ (2,595,443)
============== ============== ==============
December 31, 2005
-------------------------------------------------
Estimated Gross Gross
Fair Unrealized Unrealized
Value Gains Losses
-------------- -------------- --------------
US Government Agency $ 8,390,156 $ -- $ (109,844)
FNMA MBS 9,067,796 169 (281,234)
FHLMC MBS 320,258 325 (1,180)
GNMA MBS 2,627,459 -- (91,373)
Whole Loan MBS 4,051,823 -- (84,060)
Collateralized mortgage obligations 81,565,801 29,588 (2,128,796)
-------------- -------------- --------------
$ 106,023,293 $ 30,082 $ (2,696,487)
============== ============== ==============
The tax benefits related to these net unrealized gains and losses were
$1,203,679 and $1,242,278 at December 31, 2006 and 2005, respectively.
The following table shows the gross unrealized losses and estimated fair
value of the Company's investments, aggregated by investment category and length
of time that an individual security has been in the continuous unrealized loss
position at December 31, 2006 and 2005:
F-12
December 31, 2006 Less than 12 months More than 12 months Total
--------------------------------------------------------------------------------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
-------------- -------------- -------------- -------------- -------------- --------------
US Government Agency $ -- $ -- $ 8,443,906 $ (56,094) $ 8,443,906 $ (56,094)
FHLMC MBS -- -- -- -- -- --
FNMA MBS -- -- 7,397,799 (209,609) 7,397,799 (209,609)
GNMA MBS -- -- 2,171,125 (93,436) 2,171,125 (93,436)
Whole Loan MBS -- -- 3,453,363 (101,420) 3,453,363 (101,420)
Collateralized mortgage
obligations 17,478,801 (72,510) 68,742,470 (2,062,374) 86,221,271 (2,134,884)
-------------- -------------- -------------- -------------- -------------- --------------
$ 17,478,801 $ (72,510) $ 90,208,663 $ (2,522,933) $ 107,687,464 $ (2,595,443)
============== ============== ============== ============== ============== ==============
December 31, 2005 Less than 12 months More than 12 months Total
--------------------------------------------------------------------------------------------------------
Fair Unrealized Fair Unrealized Fair Unrealized
Value Loss Value Loss Value Loss
-------------- -------------- -------------- -------------- -------------- --------------
US Government Agency $ -- $ -- $ 8,390,156 $ (109,844) $ 8,390,156 $ (109,844)
FHLMC MBS 258,602 (1,180) -- -- 258,602 (1,180)
FNMA MBS 501,974 (8,126) 8,536,325 (273,108) 9,038,299 (281,234)
GNMA MBS -- -- 2,627,459 (91,373) 2,627,459 (91,373)
Whole Loan MBS 3,093,344 (58,415) 958,479 (25,645) 4,051,823 (84,060)
Collateralized mortgage
obligations 37,031,800 (575,439) 40,740,451 (1,553,357) 77,772,251 (2,128,796)
-------------- -------------- -------------- -------------- -------------- --------------
$ 40,885,720 $ (643,160) $ 61,252,870 $ (2,053,327) $ 102,138,590 $ (2,696,487)
============== ============== ============== ============== ============== ==============
The Company evaluates securities for other-than-temporary impairment at
least on a quarterly basis, and more frequently when economic or market concerns
warrant such evaluation. Consideration is given to the length of time and the
extent to which the fair value has been less than cost, the financial condition
and near-term prospects of the issuer, and the intent and ability of the Company
to retain its investment in the issuer for a period of time sufficient to allow
for any anticipated recovery in fair value. In analyzing an issuer's financial
condition, the Company may consider whether the securities are issued by the
federal government or its agencies, whether downgrades by bond rating agencies
have occurred, and the results of reviews of the issuer's financial condition.
At December 31, 2006, the unrealized loss on investment securities was
caused by interest rate increases. We expect that these securities, at maturity,
will not be settled for less than the amortized cost of the investment. Because
the decline in fair value is attributable to changes in interest rates and not
credit quality, and because the Company has the ability and intent to hold these
securities until a market price recovery or maturity, these investments are not
considered other-than-temporarily impaired. At December 31, 2006, there were
eleven debt securities with unrealized losses with aggregate depreciation of 5%
or more from the Company's amortized cost basis. As the market value decline of
these securities is caused by interest rate increases and management has the
ability to hold these securities until maturity, or for the foreseeable future,
if classified as available for sale, these securities are not deemed to be
other-than-temporarily impaired.
The maturity schedule of all investment securities available for sale at
amortized cost and estimated fair values for December 31, 2006 was as follows:
F-13
Estimated
Securities, Available for Sale Amortized Fair
Expected Maturity Cost Value
------------ ------------
Less than one year $ -- $ --
Due after one year through 10,757,421 10,633,321
five years
Due after five years through 13,648,091 13,407,574
ten years
Due after ten years 91,948,656 89,729,716
------------ ------------
$116,354,168 $113,770,611
============ ============
Expected maturities may differ from contractual maturities because
borrowers may have the right to call or prepay obligations with or without
penalties.
Securities pledged at year end 2006 and 2005 had a carrying amount of
$40,741,668 and $27,725,000, respectively and were pledged to secure public
deposits and balances in excess of the deposit insurance limit on certain
customer accounts.
4. LOANS RECEIVABLE, NET
Loans receivable, net at December 31, 2006 and 2005 are summarized as
follows:
2006 2005
------------ ------------
Commercial loans (principally variable rate):
Secured $ 1,231,880 $ 1,584,484
Unsecured 10,882,002 11,078,101
------------ ------------
Total commercial loans 12,113,882 12,662,585
Real estate loans:
Commercial 33,215,627 29,794,108
One-to-four family 165,801 298,779
------------ ------------
Total real estate loans 33,381,428 30,092,887
Construction loans (net of undisbursed funds of
$5,723,134 and $10,160,576, respectively) 19,377,797 29,611,346
Consumer loans 826,528 1,477,366
Other loans 974,278 486,009
------------ ------------
1,800,806 1,963,375
------------ ------------
Total loans receivable 66,673,913 74,330,193
Less:
Unearned loans fees, net (263,236) (386,088)
Allowance for loan losses (1,128,824) (1,153,298)
------------ ------------
Total $ 65,281,853 $ 72,790,807
============ ============
The activity in the allowance for loan losses, for the years ended December
31, 2006 and 2005 are summarized as follows:
F-14
2006 2005
------------ ------------
Beginning balance $ 1,153,298 $ 1,299,520
Charge-offs (107,803) (343,701)
Recoveries 148,329 257,479
(Credit) Provision (65,000) (60,000)
------------ ------------
Ending balance $ 1,128,824 $ 1,153,298
============ ============
Nonaccrual loans outstanding at December 31, 2006 and 2005 are summarized
as follows:
2006 2005
------------ ------------
Nonaccrual loans:
Unsecured commercial loans $ 20,709 $ --
Commercial real estate 188,872 1,022,097
Construction -- 579,000
------------ ------------
Total nonaccrual loans $ 209,581 $ 1,601,097
============ ============
2006 2005
------------ ------------
Interest income that would have been recorded during
the year on nonaccrual loans outstanding at year-end
in accordance with original terms $ 12,614 $ 64,880
============ ============
The Company's recorded investment in impaired loans at December 31 is as
follows:
2006 2005
----------------------------- -----------------------------
Investment in Related Investment in Related
Impaired Allowance for Impaired Allowance for
Loans loan losses Loans loan losses
------------- ------------- ------------- -------------
Impaired loans
With a related allowance for loan losses
Commercial and financial $ 20,709 $ 4,142 $ -- $ --
Commercial real estate 188,872 33,743 1,022,097 160,171
Construction -- -- 579,000 86,850
------------- ------------- ------------- -------------
$ 209,581 $ 37,885 $ 1,601,097 $ 247,021
============= ============= ============= =============
The following table sets forth certain information about impaired loans at
December 31:
Investment in
Impaired Loans
-----------------------
2006 2005
---------- ----------
Average recorded investment $ 618,904 $ 803,971
========== ==========
Interest income recognized during time period that loans were impaired,
using cash-basis method of accounting $ 454 $ 18,667
========== ==========
The Company's loan portfolios are primarily comprised of commercial loans
made to small businesses and individuals located in the Borough of Staten
Island. As of December 31, 2006 and 2005, the Company had no restructured loans.
F-15
5. ACCRUED INTEREST RECEIVABLE
Accrued interest receivable at December 31, 2006 and 2005 are summarized
as follows:
2006 2005
---------- ----------
Loans receivable $ 326,338 $ 300,178
Investment securities, available for sale 479,343 428,449
---------- ----------
Total $ 805,681 $ 728,627
========== ==========
6. PREMISES AND EQUIPMENT
Premises and equipment at December 31, 2006 and 2005 are summarized as
follows:
2006 2005
------------ ------------
Leasehold improvements $ 1,904,831 $ 1,822,390
Computer equipment and software 422,016 383,156
Furniture, fixtures and equipment 767,090 787,949
Other 26,323 26,323
------------ ------------
3,120,260 3,019,818
Less accumulated depreciation and amortization (1,565,897) (1,578,731)
------------ ------------
Total $ 1,554,363 $ 1,441,087
============ ============
Depreciation and amortization expense amounted to $446,588 and $449,777 for
the years ended December 31, 2006 and 2005, respectively.
At December 31, 2006, the Company was obligated under six non-cancelable
operating leases on property used for banking purposes. Rental expense under
these leases was $513,011 and $363,477 for the years ended December 31, 2006 and
2005, respectively.
The projected minimum rental payments under the terms of the leases at
December 31, 2006 are summarized as follows:
Year Ending
December 31, Amount
------------------- ---------------
2007 $ 420,856
2008 394,093
2009 399,063
2010 404,951
2011 413,067
Thereafter 2,637,308
---------------
Total $ 4,669,338
===============
F-16
7. PREPAID AND OTHER ASSETS
Prepaid and other assets at December 31, 2006 and 2005 are summarized as
follows:
2006 2005
------------ ------------
Accounts receivable and other assets $ 73,402 $ 267,158
Construction in progress 2,142,866 --
Security deposit receivable 56,825 57,360
Prepaid assets 216,896 218,706
Equity securities, primarily FHLB stock 290,600 337,600
Investment in unconsolidated subsidiary 155,000 155,000
Subordinated debt related placement cost 47,263 75,763
Income tax receivable 39,217 --
Late charges receivable 56,466 57,969
------------ ------------
$ 3,078,535 $ 1,169,556
============ ============
8. DEPOSITS
Deposits are summarized, according to their original terms, at December
31, 2006 and 2005 as follows:
2006 2005
------------------------------------------- -------------------------------------------
Weighted Weighted
Average Average
Amount Percent Stated Rate Amount Percent Stated Rate
------------ ------------ ------------ ------------ ------------ ------------
Checking $ 67,371,582 36.09% --% $ 66,692,436 34.52% --%
Variable-rate money market 18,359,007 9.83 1.48 20,177,240 10.44 0.81
Statement savings 12,526,485 6.71 0.63 14,809,010 7.66 0.50
Interest-bearing checking 19,935,769 10.68 0.33 23,574,056 12.20 0.33
------------ ------------ ------------ ------------
118,192,843 63.31 0.35 125,252,742 64.82 0.25
Time deposits:
Less than six months 35,590,306 19.06 3.70 39,444,207 20.41 2.51
Six months to one year 28,351,165 15.19 4.27 23,583,453 12.20 3.28
More than one year 4,287,773 2.30 3.96 4,703,613 2.43 3.56
------------ ------------ ------------ ------------
68,229,244 36.55 3.95 67,731,273 35.04 2.85
Other deposits 261,063 0.14 -- 267,144 0.14 --
------------ ------------ ------------ ------------
Total $186,683,150 100.00% 0.82% $193,251,159 100.00% 0.54%
============ ============ ============ ============ ============ ============
The aggregate amount of jumbo certificates of deposit with a minimum
denomination of $100,000 was approximately $57,177,435 and $56,977,338 at
December 31, 2006 and 2005 respectively.
Scheduled maturities of time deposits at December 31, 2006 are as follows:
F-17
Amount Percent
------------ ------------
Within six months $ 60,947,138 89.33%
Six months to one year 4,134,211 6.06
One to five years 3,147,895 4.61
------------ ------------
Total $ 68,229,244 100.00%
============ ============
9. INCOME TAXES
The Company files consolidated federal, state and local income tax returns
on a calendar-year basis. For federal, state and local income tax purposes, the
Company uses the specific charge-off method in computing its federal, state and
local tax bad debt deduction.
The basis for the determination of state and local tax is the greater of
a tax on entire net income or a tax computed on taxable assets. Federal, state
and city income tax provisions were determined based on the tax computed on net
income for the years ended December 31, 2006 and 2005.
The components of the income tax expense/(benefit) for the years ended
December 31, 2006 and 2005 are summarized as follows:
2006 2005
------------ ------------
Current:
Federal $ 1,291,714 $ 1,380,322
State and local 809,447 857,792
------------ ------------
2,101,161 2,238,114
Deferred:
Federal 74,152 847
State and local 44,961 513
------------ ------------
119,113 1,360
------------ ------------
$ 2,220,274 $ 2,239,474
============ ============
The components of the deferred income tax asset, net as of December 31,
2006 and 2005 are summarized as follows:
2006 2005
------------ ------------
Deferred loan fees $ 170,064 $ 215,337
Excess book allowance for loan losses 428,310 482,898
Unrealized loss on investment securities 1,203,679 1,242,278
Other compensation expense 75,016 145,009
Other 153,578 212,673
------------ ------------
Deferred tax asset, net $ 2,030,647 $ 2,298,195
============ ============
Management evaluated the weight of available evidence and concluded that
it is more likely than not that the Company will realize the net deferred tax
asset in future years. Factors influencing management's judgment include, among
F-18
other things, changes in the levels of actual and expected future taxable income
and anticipated reversals of net deductible temporary differences.
The Company's effective tax rates differ from the statutory Federal tax
rate for the years ended December 31, 2006 and 2005 and are as follows:
2006 2005
---------------------- ----------------------
Federal income tax provision
at statutory rates $ 1,620,395 34.0% $ 1,634,347 34.0%
State and local taxes, net of
Federal income tax benefit 586,202 12.3 591,249 12.3
Other 13,677 0.3 13,878 0.3
------------ ------ ------------ ------
$ 2,220,274 46.6% $ 2,239,474 46.6%
============ ====== ============ ======
10. REGULATORY MATTERS
The Bank is a New York State chartered stock form commercial bank. The
Bank's deposits are insured by the Federal Deposit Insurance Corporation
("FDIC"). The Bank is subject to certain FDIC capital requirements. Failure to
meet minimum capital requirements can initiate certain mandatory and possibly
discretionary actions by the regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet certain specific capital guidelines that involve quantitative measures
of the Bank's assets, liabilities and certain off-balance sheet items calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings and other factors.
As of the latest notification from the FDIC, the Bank was classified as
"well capitalized" under the regulatory framework for prompt corrective action.
To be categorized as "well capitalized," the Bank must maintain Tier 1 Leverage,
Tier 1 Risk-Based and minimum Total Risk-based ratios as set forth in the table
below. There are no conditions or events since that notification that management
believes have changed the Bank's category. Management believes, as of December
31, 2006, that the Bank meets all capital adequacy requirements to which it is
subject.
The Bank is subject to certain restrictions on the availability of its
undistributed earnings for payment of dividends to stockholders, including prior
regulatory approval.
In accordance with the New York State Banking Law and the New York State
Banking Board Regulations, the Bank credits 10% of quarterly net income to
regulatory surplus and is required to do so until such time as shareholders'
equity is equal to 10% of amounts due to depositors. As of December 31, 2006,
regulatory surplus equals 10% of deposits.
The following table is the Bank's actual capital amounts and ratios, as
well as the minimum required levels for both "capital adequacy purposes" and to
be considered "well capitalized". No deductions were made for qualitative
judgments by regulators:
F-19
To be well-capitalized
For capital under prompt corrective
Actual adequacy purposes action provisions
-------------------------------- ------------------------------ ---------------------------------
Amount Ratio Amount Ratio Amount Ratio
------------------- ------------ ------------------ ----------- ------------------ --------------
As of December 31, 2006:
Tier 1 Capital
(to Average Assets) $ 23,348,000 10.63% $8,783,920 4.00% $ 10,979,900 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 23,348,000 24.74 3,775,560 4.00 5,663,340 6.00
Total Capital
(to Risk Weighted Assets) 24,477,000 25.93 7,551,120 8.00 9,438,900 10.00
As of December 31, 2005:
Tier 1 Capital
(to Average Assets) $ 20,453,000 9.19% $8,897,920 4.00% $ 11,122,400 5.00%
Tier 1 Capital
(to Risk Weighted Assets) 20,453,000 19.66 4,162,120 4.00 6,243,180 6.00
Total Capital
(to Risk Weighted Assets) 21,606,000 20.76 8,324,240 8.00 10,405,300 10.00
The Company's consolidated capital ratios as of December 31, 2006 were as
follows: Tier 1 Capital to Average Assets of 10.98%; Tier 1 Capital to Risk
Weighted Assets of 25.47%; and Total Capital to Risk Weighted Assets of 26.66%,
which are not substantially different than the Bank's capital ratios at December
31, 2006 and therefore are not presented separately.
11. EMPLOYEE BENEFITS
The Company does not currently maintain a defined contribution benefit
plan but sponsors an incentive savings plan (401(k) plan) which started March 1,
1999. All eligible employees, who have reached the age of 21, have at least one
year of service and work a minimum of 1,000 hours per year will be permitted to
make tax deferred contributions up to certain limits. The Bank may reduce or
cease matching contributions if it is determined that the current or accumulated
net earnings or undivided profits of the Bank are insufficient to pay the full
contributions in a plan year. The Bank contributed $131,442 to the 401(k) plan
in 2006 and $120,530 in 2005.
Stock Options
The Company has granted options pursuant to five different stock option
plans. Options to buy stock are granted to directors, officers and employees
under the VSB Bancorp, Inc. 2000 Incentive Plan, the 1998 Incentive Plan, the
2004 Directors' Plan, the 2000 Directors' Plan and the 1998 Directors' Plan
which, in the aggregate, provide for issue up to 243,750 options. Exercise price
is the market price at the date of grant, and compensation expense will be
recognized in the income statement in accordance with FAS 123, Revised. The
maximum option term is ten years, and the options vesting period is up to five
years.
As of December 31, 2005 the Board accelerated the vesting on all
outstanding options so that they became immediately exercisable. By accelerating
the vesting of these options, we estimated that approximately $169,000 of future
compensation expense, net of taxes, was eliminated. There were no stock option
grants in 2006 and 2005.
F-20
The stock option components of the 2000 Incentive Plan, the 1998 Incentive
Plan and the 2004 Directors' Plan, the 2000 Directors' Plan and the 1998
Directors' Plan, as of December 31, 2006, and 2005, and changes during the years
ended, consist of the following:
2006 2005
--------------------------------------------- --------------------------------------------
Weighted Weighted
Average Aggregate Average Aggregate
Exercise Intrinsc Exercise Intrinsc
Shares Price Value Shares Price Value
------------- ------------ --------------- ------------- ------------ ------------
Options outstanding 182,498 $10.31 189,915 $10.28
at the beginning of the year
Granted -- -- -- --
Canceled -- -- (1,417) 15.60
Exercised (4,500) 6.24 (6,000) 8.14
------------- -------------
Options outstanding
at the end of the year 177,998 $10.36 $ 736,911 182,498 $10.31 $1,074,547
============= ============ =============== ============= ============ ============
Options exercisable
at the end of the year 177,998 $10.36 $ 736,911 182,498 $10.31 $1,074,547
============= ============ =============== ============= ============ ============
Weighted average remaining contractual life of
options outstanding at the end of the year 4.7 Years 5.6 Years
All share and per share data throughout this report has been adjusted to
reflect, retroactively, a 5 for 4 stock split, in the form of a 25% stock
dividend, that was declared by the Board of Directors to stockholders of
record on May 3, 2006.
Information related to the stock option plan during each year follows:
2006 2005
-------- --------
Intrinsic value of options exercised $ 48,550 $ 63,744
Cash received from option exercise $ 28,062 $ 64,067
Tax benefit realized from option exercise $ 18,170 $ 14,955
Weighted average fair value of options exercised $ 1.48 $ 3.34
Described below is the range of exercise prices for options granted under the
following option plans:
Number of Weighted Average Weighted Average
Plan Description Exercisable Shares Exercise Price Contractual Life
-------------------------------------- ------------------ ---------------- ----------------
1998 Director Stock Option Plan 23,750 $ 6.13 2.11
1998 Incentive Stock Option Plan 32,500 5.76 2.04
2000 Director Stock Option Plan 25,000 4.39 3.40
2000 Incentive Stock Option Plan 41,748 10.40 5.33
2004 Director Stock Option Plan 55,000 17.60 7.50
------------------ ---------------- ----------------
All Plans 177,998 $ 10.36 4.70
================== ================ ================
All share and per share data throughout this report has been adjusted to
reflect, retroactively, a 5 for 4 stock split, in the form of a 25% stock
dividend, that was declared by the Board of Directors to stockholders of
record on May 3, 2006.
F-21
Stock Appreciation Rights
The Company issued stock appreciation rights ("SARs") to an officer of the
Company to advance the interests of the Company and its shareholders by
providing this key officer of the Company and its affiliates, upon whose
judgment, initiative and efforts were instrumental upon the formation and
development of the Company and its affiliates, with an additional incentive to
perform in a superior manner. Pursuant to the terms, 31,250 SARs with an
exercise price of $4.00 per SAR (as adjusted for prior stock dividends), as
determined by the Board of Directors, have been issued. There are no SARs
available to be granted and those SARs, which terminate, or are forfeited
without being exercised, can not be recycled into new grants. The term of each
SAR is determined by the Committee of the Board of Directors and may not exceed
ten years after the date of the grant. The SARs vest and are exercisable for the
cash value between the Company's stock price less the exercise price. The SARs
vest over five years, 40% two years after the grant date and 20% per year after.
In 2006, 3,750 SARs were exercised. As of December 31, 2006, of the remaining
17,500 SARs, all 17,500 were granted and all 17,500 were vested or exercisable.
The accounting for these instruments is according to FIN 28: "Accounting for
Stock Appreciation Rights and Other Variable Stock Option or Award Plans," for
which compensation expense was $31,000 for the year ended December 31, 2005.
The Company did not issue any SAR grants in 2006 and 2005.
12. COMMITMENTS, CONTINGENCIES AND FINANCIAL INSTRUMENTS WITH OFF-BALANCE
SHEET RISK
The Company is a party to financial instruments with off-balance sheet
risk in the normal course of business in order to meet the financing needs of
its customers. Such financial instruments primarily include commitments to
extend credit.
A summary of these commitments and contingent liabilities, all of which
are variable rate commitments, at December 31:
2006 2005
------------ ------------
Amount Amount
------------ ------------
Commitments to fund secured construction loans $ 18,028,134 $ 10,160,576
Commitments to fund all other commercial loans 10,719,693 18,638,006
------------ ------------
$ 28,747,827 $ 28,798,582
============ ============
Commitments to extend credit are legally binding agreements to lend to a
customer. Commitments are issued following the Company's evaluation of each
applicant's creditworthiness on a case-by-case basis. The Company's exposure to
credit loss in the event of nonperformance by the other party to the financial
instrument is represented by the contractual notional amount of those
instruments.
The Bank is a defendant in a lawsuit against a former customer brought by
a third party. The Bank intends to defend aggressively the claims made against
it.
VSB Bancorp, Inc. is not involved in any pending legal proceedings. The
Bank, from time to time, is involved in routine collection proceedings in the
ordinary course of business on loans in default. Management believes that such
other routine legal proceedings in the aggregate are immaterial to our financial
condition or results of operations.
F-22
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial
instruments is made in accordance with the requirements of SFAS No. 107,
"Disclosures about Fair Value of Financial Instruments." The estimated fair
value amounts have been determined by the Company using available market
information and appropriate valuation methodologies. However, considerable
judgment is necessarily required to interpret market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
The following methods and assumptions were used by the Company in
estimating fair values of financial instruments:
Interest-bearing bank balances - Interest-bearing bank balances mature
within one year and are carried at cost.
Money Market Investments - The fair value of these securities
approximates their carrying value due to the relatively short time to
maturity
Investment Securities, Available For Sale - The estimated fair value of
these securities is determined by using available market information
and appropriate valuation methodologies. The estimates presented herein
are not necessarily indicative of the amounts that the Company could
realize in a current market exchange.
Loans Receivable - The fair value of commercial and construction loans
are approximated by the carrying value as the loans are tied directly
to the Prime Rate and are subject to change on a daily basis. The fair
value of the remainder of the portfolio is determined by discounting
the future cash flows of the loans using the appropriate discount rate
and prepayment assumptions.
Other Financial Assets - The fair value of these assets, principally
accrued interest receivable, approximates their carrying value due to
their short maturity.
Non-Interest Bearing and Interest Bearing Deposits - The fair value
disclosed for non-interest bearing deposits is equal to the amount
payable on demand at the reporting date. The fair value of interest
bearing deposits is based upon the current rates for instruments of the
same remaining maturity. Interest bearing deposits with a maturity of
greater than one year are estimated using a discounted cash flow
approach that applies interest rates currently being offered.
Subordinated Debt- The fair value of subordinated debt is based upon
the current rates for such instruments of the same remaining maturity.
Other Liabilities - The estimated fair value of other liabilities,
which primarily include accrued interest payable, approximates their
carrying amount.
Off-Balance Sheet Items - The estimated fair value of off-balance sheet
items, including loan commitments, unused lines of credit and letters
of credit are not material and are not included in the fair value
table.
The estimated fair values of the Company's financial instruments at
December 31, 2006 and 2005 were as follows:
F-23
2006 2005
--------------------------- ---------------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
------------ ------------ ------------ ------------
Financial Assets:
Cash and cash equivalents $ 25,363,069 $ 25,363,069 $ 31,324,147 $ 31,324,147
Investment securities 113,770,611 113,770,611 106,023,293 106,023,293
Loans receivable 65,281,853 68,842,721 72,790,807 72,739,105
Other financial assets 805,681 805,681 728,627 728,627
------------ ------------ ------------ ------------
Total Financial Assets $205,221,214 $208,782,082 $210,866,874 $210,815,172
============ ============ ============ ============
Financial Liabilities:
Non-interest bearing deposits $ 67,632,645 $ 67,632,645 $ 66,959,580 $ 66,959,580
Interest bearing deposits 119,050,505 114,973,833 126,291,579 126,313,306
Trust preferred securities 5,155,000 5,309,537 5,155,000 5,107,565
Other liabilities 482,774 482,774 176,063 176,063
------------ ------------ ------------ ------------
Total Financial Liabilities $192,320,924 $188,398,789 $198,582,222 $198,556,514
============ ============ ============ ============
14. INTEREST RATE RISK (UNAUDITED)
The Company's principal business of originating loans, issuing term
certificates of deposit and other interest-bearing deposit accounts and
investing in short-term investment securities inherently includes elements of
interest rate risk and requires careful application of interest rate management
techniques to manage such risks.
Because the Company has a varied array of investment, loan and deposit
products, which differ as to maturity, repricing terms and interest rate spreads
relative to various rate indices, different interest rate risk management
strategies are utilized.
The Company funds its assets primarily with deposits. A substantial
portion of these, mature or reprice within one year of their origination or last
repricing date.
In view of the short maturity profile of the Company's funding sources,
the Company invests in loans and investments which have a maturity or repricing
date designed to match the Company's funding maturities and serve as a natural
hedge of the related interest rate risk.
Net interest income will fluctuate based on changes in the general level
of interest rates, changes in the levels of interest sensitive assets and
liabilities, and changes in the relationships between different interest rate
indices. In addition, net interest income can also be affected by timing of
repricing dates and repayments and changes in estimated prepayments.
15. RELATED PARTIES
In the ordinary course of business, the Bank at times has had loans, and
other financial transactions, with its executive officers and directors. At
December 31, 2006, the aggregate amount of loans outstanding to directors was
$174,754. There were no loans granted to executive officers.
The change in aggregate amount of loans outstanding to directors as of
December 31, 2006 and 2005 are as follows:
F-24
2006 2005
------------ ------------
Beginning balance $ 239,838 $ 1,468,153
Originations 301,806 314,377
Payments (366,890) (1,542,692)
------------ ------------
Ending balance $ 174,754 $ 239,838
============ ============
The interest income that was paid on these loans was $18,766 and $75,530
for 2006 and 2005, respectively. Certain officers and directors own, in the
aggregate, 32.8% and 33.2% of the common shares outstanding at December 31, 2006
and 2005, respectively.
16. CONDENSED FINANCIAL STATEMENTS OF THE PARENT COMPANY ONLY
VSB BANCORP, INC.
STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2006 and 2005
-----------------------------------------------------------------------------------------------
2006 2005
------------ ------------
ASSETS
Cash and cash equivalents $ -- $ 321
Money markets 788,045 730,758
Investment in subsidiaries 22,123,004 19,075,629
Deferred taxes 15,178 --
Other assets 48,839 242,942
------------ ------------
Total assets $ 22,975,066 $ 20,049,650
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Subordinated debt $ 5,155,000 $ 5,155,000
Accounts payable, accrued expenses and other liabilities 79,769 78,305
------------ ------------
Total liabilities 5,234,769 5,233,305
------------ ------------
COMMITMENTS AND CONTINGENT LIABILITIES
STOCKHOLDERS' EQUITY
Common stock ($.0001 par value, 3,000,000 shares authorized,
1,891,759 issued and outstanding at December 31, 2006;
1,509,822 issued and outstanding at December 31, 2005) 189 151
Additional paid-in capital 9,066,691 9,027,611
Retained earnings 11,293,200 8,621,693
Unearned Employee Stock Ownership Plan shares (1,239,905) (1,408,983)
Accumulated other comprehensive loss, net of taxes of $1,203,679
and $1,242,278, respectively (1,379,878) (1,424,127)
------------ ------------
Total stockholders' equity 17,740,297 14,816,345
------------ ------------
Total liabilities and stockholders' equity $ 22,975,066 $ 20,049,650
============ ============
F-25
VSB BANCORP, INC.
STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
--------------------------------------------------------------------------------
2006 2005
------------ ------------
INTEREST INCOME:
Loans recievable $ 56,341 $ 63,104
Other interest income 12,919 7,277
------------ ------------
Total interest income 69,260 70,381
INTEREST EXPENSE:
Subordinated debt 356,159 356,159
------------ ------------
Total interest expense 356,159 356,159
------------ ------------
Net interest loss (286,899) (285,778)
------------ ------------
NON-INTEREST INCOME:
Other 10,709 10,709
------------ ------------
10,709 10,709
NON-INTEREST EXPENSES:
Legal fees 28,000 48,000
Other 57,239 61,067
------------ ------------
Total non-interest expenses 85,239 109,067
------------ ------------
LOSS BEFORE INCOME TAXES (361,429) (384,136)
------------ ------------
PROVISION/(BENEFIT) FROM INCOME TAXES:
Current (178,477) (209,669)
Deferred (16,163) 1,187
------------ ------------
Total income taxes (194,640) (208,482)
------------ ------------
EQUITY IN UNDISTRIBUTED EARNINGS, NET OF TAXES 2,712,382 2,743,083
------------ ------------
NET INCOME $ 2,545,593 $ 2,567,429
============ ============
F-26
VSB BANCORP, INC.
STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 2006 AND 2005
-------------------------------------------------------------------------------------------------
2006 2005
------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,545,593 $ 2,567,429
Adjustments to reconcile net income to net cash
used in operating activities:
Changes in operating assets and liabilities:
ESOP compensation expense (6,785) 18,742
Undistributed income of subsidiaries (2,712,382) (2,743,083)
Increase in other assets 194,103 108,038
Increase in deferred income taxes (15,178) 203
(Decrease)/increase in accrued expenses, income taxes payable
and other liabilities (163,366) 13,993
------------ ------------
Net cash used by operating activities (158,015) (34,678)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loan receivable 169,078 169,078
Net decrease/(increase) in money market deposit (57,287) (199,768)
------------ ------------
Net cash used in investing activities 111,791 (30,690)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Exercise stock option 46,232 63,732
5 for 4 stock split and the purchase of fractional shares (329) --
------------ ------------
Net cash provided by financing activities 45,903 63,732
------------ ------------
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS (321) (1,636)
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR 321 1,957
------------ ------------
CASH AND CASH EQUIVALENTS,
END OF YEAR $ -- $ 321
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH
FLOW INFORMATION:
Cash paid during the period for:
Interest $ 345,450 $ 345,450
============ ============
Income taxes $ -- $ --
============ ============
17. EMPLOYEE STOCK OWNERSHIP PLAN
Employees participate in an Employee Stock Ownership Plan ("ESOP"). VSB
Bancorp, Inc. ESOP Trust was formed on May 1, 2004. The ESOP borrowed from the
Company to purchase 92,900 shares of stock at $18.20 per share. The Company
makes discretionary contributions to the ESOP, as well as paying dividends on
unallocated shares to the ESOP, and the ESOP uses funds it receives to repay the
loan. When loan payments are made, ESOP shares are allocated to participants
based on relative compensation and expense is recorded. Dividends on allocated
shares increase participant accounts.
Shares allocated to each participant, to the extent vested, are
distributed to the participant upon termination of employment. As required by
federal law, a participant may require the Company to repurchase shares so
distributed unless the stock is traded on an established market.
The contribution to the ESOP was $169,078 and $169,078 for the years ended
December 31, 2006 and 2005, respectively. ESOP expense was $162,293 and
$187,820, for the years ended December 31, 2006 and 2005, respectively.
F-27
Shares held by the ESOP at December 31, 2006 and 2005 were as follows:
2006 2005
------------ ------------
Shares allocated to participants 27,748 17,589
Shares released to participants (229) (33)
Unearned shares 65,152 75,311
------------ ------------
Total ESOP Shares 92,671 92,867
============ ============
Fair value of unearned shares $ 944,704 $ 1,220,038
============ ============
Fair value of allocated shares subject
to repurchase obligation $ 399,026 $ 284,411
============ ============
All per share data throughout this report has been adjusted to reflect,
retroactively, a 5 for 4 stock split, in the form of a 25% stock dividend, that
was declared by the Board of Directors to stockholders of record on May 3, 2006.
18. SUBORDINATED DEBENTURES
In August of 2003, the Company formed VSB Capital Trust I (the "Trust").
The Trust is a statutory business trust organized under Delaware law and the
Company owns all of its common securities. The Trust issued $5.0 million of
Trust Preferred Capital Securities to an independent investor and $155,000 of
common securities to the Company. The Company issued a $5.16 million
subordinated debenture to the Trust. The subordinated debenture is the sole
asset of the Trust. The subordinated debenture and the Trust Preferred Capital
Securities pay interest and dividends, respectively, on a quarterly basis, at a
rate of 6.909%, for the first five years. They mature thirty years after the
issuance of the securities and are non-callable for five years. After the first
five years, the Trust Preferred Securities may be called by the Company at any
quarterly interest payment date at par and the rate of interest that fluctuates
quarterly based upon 300 basis points over the 90 day LIBOR rate.
The Company reports as liabilities the subordinated debentures issued by
the Company and held by the Trust.
*****************
F-28
Item 8. Changes In and Disagreements With Accountants on Accounting and
Financial Disclosure
Not applicable.
Item 8A. Disclosure
As of the end of the period covered by this report, we carried out an
evaluation, under the supervision of, and with the participation of, our
management, including our Chief Executive Officer and Chief Financial Officer,
of the effectiveness of the design and operation of our disclosure controls and
procedures as contemplated by Rule 13a-15 under the Securities Exchange Act of
1934 (the "Exchange Act"). Based upon, and as of the date of, that evaluation,
our Chief Executive Officer and our Chief Financial Officer concluded that the
Company's disclosure controls and procedures are effective, in all material
respects, in timely alerting them to material information relating to the
Company (and its consolidated subsidiaries) required to be included in the
periodic reports the Company is required to file and submit to the Securities
and Exchange Commission under the Exchange Act.
Item 8B. Other Information.
Not applicable.
PART III
Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance
with Section 16(a) of the Exchange Act
Incorporated by reference to pages 4 and 5 of the Proxy Statement under the
caption "General Information Regarding Nominees and Our Other Directors"; page
13 of the Proxy Statement under the caption "Section 16a Beneficial Ownership
Reporting Compliance"; and pages 5 and 6 of the Proxy Statement under the
caption "Audit Committee."
The Company has a Code of Ethics that applies to all officers and employees. The
Code of Ethics is posted on our web site - www.victorystatebank.com - and can be
found under the "Investor Relations" tab.
Item 10. Executive Compensation
The information required by this Item is incorporated by reference to
pages 8 through 11 of the Proxy Statement under the caption Compensation through
and including the sub-caption "Directors Compensation."
Item 11. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
The information required by this Item is incorporated by reference to
pages 11 through 12 of the Proxy Statement under the caption "Security Ownership
of Management and Certain Beneficial Owners."
Item 12. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to
pages 12 through 13 of the Proxy Statement under the caption "Transactions with
Directors and Officers and Their Related Interests."
Item 13. Exhibits
Exhibit No. Title of Exhibit
----------- ----------------
2.1 Restated Certificate of Incorporation of VSB Bancorp, Inc.*
2.2 Bylaws of VSB Bancorp, Inc.*
6.1 Employment Agreement between Merton Corn and Victory State Bank*
6.2 Victory State Bank 2000 Incentive Stock Option Plan*
6.3 Victory State Bank 2000 Directors Stock Option Plan*
6.4 Victory State Bank 1998 Incentive Stock Option Plan*
6.5 Victory State Bank 1998 Directors Stock Option Plan*
6.6 VSB Bancorp, Inc. Restated 2000 Incentive Stock Option Plan*
6.7 VSB Bancorp, Inc. Restated 2000 Directors Stock Option Plan*
6.8 VSB Bancorp, Inc. Restated 1998 Incentive Stock Option Plan*
6.9 VSB Bancorp, Inc. Restated 1998 Directors Stock Option Plan*
6.10 VSB Bancorp, Inc. 2004 Directors Stock Option Plan**
12.1 Agreement, Plan of Reorganization and Plan of Acquisition among
Victory State Bank, VSB Bancorp, Inc. and Victory Interim Bank
(in formation)*
21. Subsidiaries of the Registrant
23. Consent of Independent Registered Public Accounting Firm
31.1 Rule 13A-14(a)/15D-14(a) Certification of Chief Executive Officer
31.2 Rule 13A-14(a)/15D-14(a) Certification of Chief Financial Officer
32.1 Certification by CEO pursuant to 18 U.S.C. 1350.
32.2 Certification by CFO pursuant to 18 U.S.C. 1350.
* - previously filed as exhibit to the Issuer's Registration Statement on Form
10-SB (File No. 0-50237) as filed with the Securities and Exchange Commission on
April 4, 2003.
** - previously filed as an exhibit included in the Issuer's proxy statement for
its 2004 Annual Meeting of Stockholders on Form 14A.
Item 14. Principal Accountant Fees and Services.
The information required by this Item is incorporated by reference to pages 13
through 14 of the Proxy Statement under the caption "Audit and Other Fees."
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of
1934, the registrant has duly caused this registration statement to be signed on
its behalf by the undersigned, thereunto duly authorized.
VSB Bancorp, Inc.
(Registrant)
Date: March 27, 2007
By: /s/ MERTON CORN
----------------------------
Merton Corn, President and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant in
the capacities indicated below.
/s/ MERTON CORN March 27, 2007
--------------------------------------------------- --------------
Merton Corn, President, Chief Executive Officer Date
and Director
/s/ RAFFAELE M. BRANCA March 27, 2007
--------------------------------------------------- --------------
Raffaele M. Branca, Executive Vice President, Date
Chief Financial and Accounting Officer and Director
/s/ JOSEPH J. LIBASSI March 27, 2007
--------------------------------------------------- --------------
Joseph J, LiBassi, Chairman of the Board Date
/s/ JOAN NERLINO CADDELL March 27, 2007
--------------------------------------------------- --------------
Joan Nerlino Caddell, Director Date
/s/ ROBERT S. CUTRONA, SR. March 27, 2007
--------------------------------------------------- --------------
Robert S. Cutrona, Sr., Director Date
/s/ CHAIM FARKAS March 27, 2007
--------------------------------------------------- --------------
Chaim Farkas, Director Date
/s/ ALFRED C. JOHNSEN March 27, 2007
--------------------------------------------------- --------------
Alfred C. Johnsen, Director Date
/s/ CARLOS PEREZ March 27, 2007
--------------------------------------------------- --------------
Carlos Perez, Director Date
/s/ BRUNO SAVO March 27, 2007
--------------------------------------------------- --------------
Bruno Savo, Director Date