SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number 0-25033

 

SUPERIOR BANCORP

(Exact Name of Registrant as Specified in Its Charter)

 

 

(205) 327-1400

(Registrant’s Telephone Number, Including Area Code)

 

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

 

Common Stock, par value $.001 per share

(Titles of Class)

 

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

NONE

 

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

 

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

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.

 

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

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

 

The aggregate market value of the voting common stock held by non-affiliates of the registrant as of March 12, 2007, based on a closing price of $11.21 per share of common stock, was $361,356,984.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date: the number of shares outstanding as of March 12, 2007, of the registrant’s only issued and outstanding class of common stock, its $.001 per share par value common stock, was 34,658,368.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The information set forth under Items 10, 11, 12, 13 and 14 of Part III of this Report is incorporated by reference from the registrant’s definitive proxy statement for its 2007 annual meeting of stockholders that will be filed no later than April 30, 2007.

 

 

PART I

 

 

General

 

We are a Delaware-chartered thrift holding company headquartered in Birmingham, Alabama. We offer a broad range of banking and related services in 54 locations in Alabama and Florida through Superior Bank, our principal subsidiary. Superior Bank’s consumer finance subsidiaries operate an additional 18 consumer finance offices in North Alabama. We had assets of approximately $2.441 billion, loans of approximately $1.640 billion, deposits of approximately $1.871 billion and stockholders’ equity of approximately $276 million at December 31, 2006. Our principal executive offices are located at 17 North 20th Street, Birmingham, Alabama 35203, and our telephone number is (205) 327-1400.

 

We were founded in 1997 and completed our initial public offering in December 1998. Beginning in the fall of 1998, we grew through the acquisition of various financial institutions in Alabama and Florida.

 

In January 2005, we began the transition from our founding management team to a new senior management team composed of veteran bankers with a strong operational track record and a history of enhancing stockholder value. During the remainder of 2005, we completed that management transition. In addition, in November 2005 we converted our principal subsidiary, now known as Superior Bank, from an Alabama state-chartered bank to a federally chartered thrift regulated by the Office of Thrift Supervision (“OTS”). We believe that this conversion allows us greater flexibility in our operations, as well as allowing Superior Bank to operate under a single regulatory system rather than the dual federal/state regulatory system that had been applicable to it.

 

During 2006, we expanded our franchise with two strategic acquisitions. On August 31, 2006, we entered the Tampa, Florida market when we acquired Kensington Bankshares, Inc. (“Kensington”) and its subsidiary, First Kensington Bank. On November 7, 2006, we increased our market presence in North Alabama by acquiring Community Bancshares, Inc (“Community”) and its subsidiary, Community Bank.

 

Recently Announced Merger Agreement

 

On January 18, 2007, we announced that we had signed a definitive agreement to merge with People’s Community Bancshares, Inc. (“People’s”). People’s is the holding company for People’s Community Bank of the West Coast, a Florida state bank with three branches in Sarasota and Manatee Counties in Florida. Under the terms of the merger agreement, we will issue 2.9036 shares of our common stock for each share of People’s stock. Based on recent closing prices per share for our common stock, the transaction would be valued at approximately $77.1 million. The actual value at consummation will be based on our share price at that time. Completion of the merger is subject to approval by the stockholders of People’s, to the receipt of required regulatory approvals, and to the satisfaction of usual and customary closing conditions.

 

Strategy

 

Operations.  We focus our services on small- to medium-sized businesses, as well as professionals and individuals, emphasizing our local decision-making, effective response time and personalized service. As a result, we conduct our business on a decentralized basis with respect to deposit gathering and most credit decisions, utilizing local knowledge and authority to make these decisions. We supplement this decentralized management approach with centralized loan administration, policy oversight, credit review, audit, legal, asset/liability management, data processing, human resources and risk management systems. We implement these standardized administrative and operational policies at each of our locations while retaining local management and advisory directors to capitalize on their knowledge of the local community.

 

Products and Services.  Superior Bank provides a wide range of retail and small business services, including noninterest-bearing and interest-bearing checking, savings and money market accounts, negotiable order of withdrawal (“NOW”) accounts, certificates of deposit and individual retirement accounts. In addition, Superior Bank offers an extensive array of consumer, small business, residential real estate and commercial real estate loan products. Other financial services include annuities, automated teller machines, debit cards, credit-related life and

disability insurance, safety deposit boxes, Internet banking, bill payment and telephone banking. Superior Bank attracts primary banking relationships through the customer-oriented service environment created by Superior Bank’s personnel combined with competitive financial products.

 

Superior Bank also owns two consumer finance companies, Superior Financial Services, LLC and 1^st Community Credit Corporation. The finance companies generally provide smaller loans to a market segment traditionally not pursued by Superior Bank. These loans typically involve greater risk and generate higher yields than standard bank loans. We believe that, by conducting this business, we reach a customer base not served by our banking operations.

 

Market Areas.  We are headquartered in Birmingham, Alabama. Our primary markets are located in northern and central Alabama, the panhandle of Florida and the Tampa, Florida area.

 

Superior Bank has branches in:

 

 

In addition to our branches, we operate loan production offices in Montgomery, Alabama, and Panama City and Tallahassee, Florida. Our finance company subsidiaries have offices in Albertville, Arab, Athens, Boaz, Cullman, Decatur, Fort Payne, Gadsden, Hartselle, Huntsville, Jasper, Oneonta, Oxford, Pell City and Talladega, Alabama.

 

Growth.  Our future growth depends primarily on the expansion of the business of our primary wholly owned subsidiary, Superior Bank. That expansion will depend on internal growth and the opening of new branch offices in new and existing markets. Superior Bank may also continue to engage in the strategic acquisition of other financial institutions and branches that have relatively high earnings and low-cost deposits or that we believe to have exceptional growth potential, such as the acquisitions completed in 2006 and the People’s acquisition described above. Our ability to increase profitability and to grow internally depends primarily on our ability to attract and retain low-cost core deposits while continuing to generate high-yielding, quality loans. Our ability to grow profitably through the opening or acquisition of new branches will depend primarily on, among other things, our ability to identify growing markets and branch locations within such markets that will enable us to attract the necessary deposits to operate such branches profitably, and identify lending and investment opportunities within such markets.

 

We periodically evaluate business combination opportunities and conduct discussions, due diligence activities and negotiations in connection with those opportunities. As a result, we may pursue business combination transactions involving cash, debt or equity securities from time to time. Any future business combination or series of business combinations that we might undertake may be material to our business, financial condition or results of operations in terms of assets acquired or liabilities assumed. Any future acquisition is subject to approval by the appropriate regulatory agencies. See “Supervision and Regulation.”

 

Lending Activities

 

General.  We offer various lending services, including real estate, consumer and commercial loans, primarily to individuals and businesses and other organizations that are located in or conduct a substantial portion of their business in our market areas. Our total loans at December 31, 2006 were $1.640 billion, or 78.9% of total earning assets. The interest rates we charge on loans vary with the risk, maturity and amount of the loan and are subject to competitive pressures, money market rates, availability of funds and government regulations. We do not have any foreign loans or loans for highly leveraged transactions.

 

The lending activities of Superior Bank are subject to the written underwriting standards and loan origination procedures established by Superior Bank’s Board of Directors and management. Loan originations are obtained from a variety of sources, including referrals, existing customers, walk-in customers and advertising. Loan applications are initially processed by loan officers who have approval authority up to designated limits.

 

We use generally recognized loan underwriting criteria, and attempt to minimize loan losses through various means. In particular, on larger credits, we generally rely on the cash flow of a debtor as the primary source of repayment and secondarily on the value of the underlying collateral. In addition, we attempt to utilize shorter loan terms in order to reduce the risk of a decline in the value of such collateral. As of December 31, 2006, approximately 77.9% of our loan portfolio consisted of loans that had variable interest rates or matured within one year.

 

We address repayment risks by adhering to internal credit policies and procedures that include officer and customer lending limits, a multi-layered loan approval process that includes senior management of Superior Bank and Superior Bancorp for larger loans, periodic documentation examination and follow-up procedures for any exceptions to credit policies. The level in our loan approval process at which a loan is approved depends on the size of the borrower’s overall credit relationship with Superior Bank.

 

Loan Portfolio

 

Real Estate Loans.  Loans secured by real estate are a significant component of our loan portfolio, constituting $1.413 billion, or 86.1% of total loans, at December 31, 2006. At that date, $456.3 million, or 27.8% of our total loan portfolio, consisted of single-family mortgage loans. Nonresidential mortgage loans include commercial and industrial loans. At December 31, 2006, $409.4 million, or 24.9% of our total loan portfolio, consisted of these loans. Our commercial real estate loans primarily provide financing for income-producing properties such as shopping centers, multi-family complexes and office buildings and for owner-occupied properties (primarily light industrial facilities and office buildings). These loans are underwritten with loan-to-value ratios ranging, on average, from 65% to 85% based upon the type of property being financed and the financial strength of the borrower. For owner-occupied commercial buildings, we underwrite the financial capability of the owner, with an 85% maximum loan-to-value ratio. For income-producing improved real estate, we underwrite the strength of the leases, especially those of any anchor tenants, with minimum debt service coverage of 1.2:1 and an 85% maximum loan-to-value ratio. While evaluation of collateral is an essential part of the underwriting process for these loans, repayment ability is determined from analysis of the borrower’s earnings and cash flow. Terms are typically three to five years and may have payments through the date of maturity based on a 15- to 30-year amortization schedule.

 

We make loans to finance the construction of and improvements to single-family and multi-family housing and commercial structures as well as loans for land development. At December 31, 2006, $547.8 million, or 33.4% of our total portfolio, consisted of such loans. Our construction lending is divided into three general categories: owner-occupied commercial buildings; income-producing improved real estate; and single-family residential construction. For construction loans related to income-producing properties, the underwriting criteria are the same as

outlined in the preceding paragraph. For single-family residential construction, we underwrite the financial strength and reputation of the builder, factoring in the general state of the economy and interest rates and the location of the home, with an 85% maximum loan-to-value ratio. The majority of land development loans consists of loans to convert raw land into residential subdivisions.

 

Commercial and Industrial Loans.  We make loans for commercial purposes in various lines of business. These loans are typically made on terms up to five years at fixed or variable rates and are secured by eligible accounts receivable, inventory or equipment. We attempt to reduce our credit risk on commercial loans by limiting the loan to value ratio to 80% on loans secured by eligible accounts receivable, 50% on loans secured by inventory and 75% on loans secured by equipment. Commercial and industrial loans constituted $172.9 million, or 10.5% of our loan portfolio, at December 31, 2006. We also, from time to time, make unsecured commercial loans.

 

Consumer Loans.  Our consumer portfolio includes installment loans to individuals in our market areas and consists primarily of loans to purchase automobiles, recreational vehicles, mobile homes and consumer goods. Consumer loans constituted $54.5 million, or 3.3% of our loan portfolio, at December 31, 2006. Consumer loans are underwritten based on the borrower’s income, current debt, credit history and collateral. Terms generally range from one to six years on automobile loans and one to three years on other consumer loans.

 

Credit Review and Procedures

 

There are credit risks associated with making any loan. These include repayment risks, risks resulting from uncertainties in the future value of collateral, risks resulting from changes in economic and industry conditions and risks inherent in dealing with individual borrowers. In particular, longer maturities increase the risk that economic conditions will change and adversely affect collectibility.

 

We have a loan review process designed to promote early identification of credit quality problems. We employ a risk rating system that assigns to each loan a rating that corresponds to the perceived credit risk. Risk ratings are subject to independent review by a centralized loan review department, which also performs ongoing, independent review of the risk management process, including underwriting, documentation and collateral control. Regular reports are made to senior management and the Board of Directors regarding credit quality as measured by assigned risk ratings and other measures, including, but not limited to, the level of past due percentages and nonperforming assets. The loan review function is centralized and independent of the lending function.

 

Deposits

 

Core deposits are our principal source of funds, constituting approximately 71.4% of our total deposits as of December 31, 2006. Core deposits consist of demand deposits, interest-bearing transaction accounts, savings deposits and certificates of deposit (excluding certificates of deposits over $100,000). Transaction accounts include checking, money market and NOW accounts that provide Superior Bank with a source of fee income and cross-marketing opportunities, as well as a low-cost source of funds. Time and savings accounts also provide a relatively stable and low-cost source of funding. The largest source of funds for Superior Bank is certificates of deposit. Certificates of deposit in excess of $100,000 are approximately $534 million, or 28.5% of our deposits. Approximately $149 million consist of wholesale, or “brokered”, certificates of deposits.

 

Our other primary source of funds is advances from the Federal Home Loan Bank (“FHLB”). These advances are secured by FHLB stock, agency securities and a blanket lien on certain residential and commercial real estate loans. We also have available unused federal funds lines of credit with regional banks, subject to certain restrictions and collateral requirements.

 

Deposit rates are set periodically by our internal Asset/Liability Management Committee, which includes certain members of senior management. We believe our rates are competitive with those offered by competing institutions in our market areas.

 

Competition

 

The banking industry is highly competitive, and our profitability depends principally upon our ability to compete in our market areas. In our market areas, we face competition from both super-regional banks and smaller

community banks, as well as non-bank financial services companies. We encounter strong competition both in making loans and attracting deposits. Competition among financial institutions is based upon interest rates offered on deposit accounts, interest rates charged on loans and other credit and service charges. Customers also consider the quality and scope of the services rendered, the convenience of banking facilities and, in the case of loans to commercial borrowers, relative lending limits. Customers may also take into account the fact that other banks offer different services. Many of the large super-regional banks against which we compete have significantly greater lending limits and may offer additional products; however, we believe we have been able to compete effectively with other financial institutions, regardless of their size, by emphasizing customer service and by providing a wide array of services. In addition, most of our non-bank competitors are not subject to the same extensive federal regulations that govern bank holding companies and federally insured banks. See “Supervision and Regulation.” Competition may further intensify if additional financial services companies enter markets in which we conduct business.

 

Employees

 

As of December 31, 2006, we employed approximately 711 full-time equivalent employees, primarily at Superior Bank. We believe that our employee relations have been and continue to be good.

 

Supervision and Regulation

 

General.  Superior Bancorp, as a unitary savings and loan holding company, and Superior Bank, as a federal savings bank, are required by federal law to report to, and otherwise comply with the rules and regulations of, OTS. We are subject to extensive regulation, examination and supervision by OTS, as our primary federal regulator, and the Federal Deposit Insurance Corporation (the “FDIC”), as the deposit insurer. We are a member of the Federal Home Loan Bank System and, with respect to deposit insurance, of the Deposit Insurance Fund managed by the FDIC. We must file reports with OTS and the FDIC concerning our activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other financial institutions. OTS conducts periodic examinations to test our safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which a thrift 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 regulatory requirements and policies, whether by OTS, the FDIC or Congress, could have a material adverse impact on us and our operations. Certain regulatory requirements applicable to us are referred to below or elsewhere herein. The description of statutory provisions and regulations applicable to thrifts and their holding companies set forth below does not purport to be a complete description of such statutes and regulations and their effects on us and is qualified in its entirety by reference to the actual laws and regulations.

 

Holding Company Regulation.  We are a nondiversified unitary savings and loan holding company within the meaning of such terms under federal law. The Gramm-Leach-Bliley Act of 1999 provides that no company may acquire control of a savings institution after May 4, 1999, unless it engages only in the financial activities permitted for financial holding companies under the law or for multiple savings and loan holding companies as described below. Further, the Gramm-Leach-Bliley Act specifies that certain savings and loan holding companies may only engage in such activities. Since we became a savings and loan holding company in 2005, we are limited to such activities. Upon any non-supervisory acquisition by us of another savings institution or savings bank that meets the qualified thrift lender test and is deemed to be a savings institution by OTS, we would become a multiple savings and loan holding company (if the acquired institution is held as a separate subsidiary) and would generally be limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the OTS, and certain activities authorized by OTS regulation. However, OTS has issued an interpretation concluding that the multiple savings and loan holding companies may also engage in activities permitted for financial holding companies.

 

A savings and loan holding company is prohibited from directly or indirectly acquiring more than 5% of the voting stock of another financial institution or savings and loan holding company without prior written approval of

OTS and from acquiring or retaining control of a depository institution that is not insured by the FDIC. In evaluating applications by holding companies to acquire other institutions, OTS considers, among other things, the financial and managerial resources and future prospects of the institutions involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community and competitive factors.

 

Subject to certain exceptions, OTS may not approve any acquisition that would result in a multiple savings and loan holding company’s controlling savings institutions in more than one state.

 

Although savings and loan holding companies are not currently subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, federal regulations prescribe such restrictions on subsidiary savings institutions, as described below. Superior Bank must notify OTS 30 days before declaring any dividend to Superior Bancorp. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by OTS, and OTS has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution.

 

Change in Bank Control Act.  Under the Federal Change in Bank Control Act, a notice must be submitted to OTS if any person, or group acting in concert, seeks to acquire “control” of a savings and loan holding company or a savings association. A change of control may occur, and prior notice may be required, upon the acquisition of more than 10% of our outstanding voting stock, unless OTS has found that the acquisition will not result in a change of control of Superior Bancorp. Under the Change in Bank Control Act, OTS generally has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition.

 

Regulation of Business Activities.  The activities of thrifts are governed by federal laws and regulations. These laws and regulations delineate the nature and extent of the activities in which thrifts may engage. In particular, certain lending authority for thrifts, e.g., commercial loans, non-residential real property loans and consumer loans, is limited to a specified percentage of the institution’s capital or assets.

 

Capital Requirements.  OTS capital regulations require savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the regulatory examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage ratio (3% for institutions receiving the highest examination rating), and, together with the risk-based capital standard itself, a 4% Tier 1 risk-based capital standard.

 

The risk-based capital standard for savings institutions requires the maintenance of ratios of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by OTS capital regulation based on the risks believed inherent in the type of asset. Core (Tier 1) capital includes, among other things, common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, and minority interests in equity accounts of consolidated subsidiaries. The components of supplementary capital currently include, among other things, cumulative perpetual preferred stock, mandatory convertible securities, and the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.

 

OTS also has authority to establish minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular circumstances. At December 31, 2006, Superior Bank met each of its capital requirements.

 

Prompt Corrective Regulatory Action.  OTS is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of undercapitalization. Generally, a savings institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (less than 3% for institutions with the highest examination rating) is considered to be “undercapitalized.” A savings institution that has a total risk-based capital ratio of less than 6%, a Tier 1 capital ratio of less than 3% or a leverage

ratio that is less than 3% is considered to be “significantly undercapitalized”, and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” Subject to a narrow exception, OTS is required to appoint a receiver or conservator within specified time frames for an institution that is “critically undercapitalized.” The regulation also provides that a capital restoration plan must be filed with OTS within 45 days of the date a savings institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by any parent holding company. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. OTS could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors.

 

Insurance of Deposit Accounts.  Superior Bank is a member of the Deposit Insurance Fund of the FDIC. The FDIC maintains a risk-based assessment system by which institutions are assigned to one of four categories based upon a combination of their capitalization and examination ratings. An institution’s assessment depends upon the category to which it is assigned. An institution assigned to the category with the lowest risk also has certain financial ratios taken into account in determining assessment rates, unless it is a large institution with at least one long-term debt issuer rating, in which case the rating will be taken into account in determining its assessment rate. Assessment rates for Deposit Insurance Fund members currently range from five basis points for the healthiest institutions to 43 basis points of assessable deposits for the riskiest. The FDIC has the authority to increase insurance assessments. A significant increase in Deposit Insurance Fund insurance premiums would likely have an adverse effect on the operating expenses and results of operations of Superior Bank. Management cannot predict what insurance assessment rates will be in the future.

 

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation to recapitalize the predecessor to the Savings Association Insurance Fund. During fiscal 2006, Financing Corporation payments for Savings Association Insurance Fund members approximated 1.385 basis points of assessable deposits.

 

Deposit insurance may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or OTS. We do not know of any practice, condition or violation that might lead to termination of deposit insurance.

 

Loans to One Borrower.  Federal law provides that savings institutions are generally subject to the limits on loans to one borrower applicable to national banks. Generally, subject to certain exceptions, a savings institution may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily-marketable collateral.

 

QTL Test.  Federal law requires savings institutions to meet a qualified thrift lender test. Under the test, a savings association is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less: (i) specified liquid assets up to 20% of total assets; (ii) intangibles, including goodwill; and (iii) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least nine months out of each 12-month period.

 

A savings institution that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. As of December 31, 2006, Superior Bank met the qualified thrift lender test. Recent legislation has expanded the extent to which education loans, credit card loans and small business loans may be considered “qualified thrift investments.”

 

Limitations on Capital Distributions.  OTS regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to shareholders of another institution in a cash-out merger. Under the regulations, an application to and prior approval of the OTS is required prior to any capital distribution if the institution does not meet the criteria for “expedited treatment” of

applications under OTS regulations, the total capital distributions (including the proposed capital distribution) for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with OTS. If an application is not required, the institution must still provide prior notice to OTS of the capital distribution if, like Superior Bank, it is a subsidiary of a holding company. In the event Superior Bank’s capital fell below its regulatory requirements or OTS notified it that it was in need of increased supervision, Superior Bank’s ability to make capital distributions could be restricted. In addition, OTS could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if OTS determines that such distribution would constitute an unsafe or unsound practice.

 

Transactions with Related Parties.  Superior Bank’s authority to engage in transactions with “affiliates” (i.e., any company that controls or is under common control with Superior Bank, including Superior Bancorp and its non-savings institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of a savings institution’s capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. The transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies, and no savings institution may purchase the securities of any affiliate other than a subsidiary.

 

The Sarbanes-Oxley Act of 2002 generally prohibits loans by Superior Bancorp and Superior Bank to their executive officers and directors. However, that act contains a specific exception for loans by a financial institution, such as Superior Bank, to its executive officers and directors that are made in compliance with federal banking laws. Under such laws, Superior Bank’s authority to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities such persons control, is limited. The law limits both the individual and aggregate amount of loans Superior Bank may make to insiders based, in part, on Superior Bank’s capital position and requires certain board approval procedures to be followed. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees.

 

Standards for Safety and Soundness.  The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. These guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If OTS determines that a savings institution fails to meet any standard prescribed by the guidelines, OTS may require the institution to submit an acceptable plan to achieve compliance with the standard.

 

Enforcement.  OTS has primary enforcement responsibility over savings institutions and has the authority to bring actions against the institution and all institution-affiliated parties, including stockholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to institution of receivership, conservatorship or termination of deposit insurance. Civil money penalties cover a wide range of violations and can amount to $5,000 per day, or even $1 million per day in especially egregious cases. In addition, the FDIC has the authority to recommend to the Director of OTS that enforcement action be taken with respect to a particular savings institution. If action is not taken by the Director, the FDIC has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.

 

Federal Home Loan Bank System.  Superior Bank is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions. Superior Bank, as a member of the Federal Home Loan Bank System, is required to acquire and hold shares of capital stock in the applicable FHLB (Atlanta) in an amount at least equal to 1.0% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at

the beginning of each year, or 1/20 of its advances (borrowings) from the applicable FHLB, whichever is greater. Superior Bank was in compliance with this requirement at December 31, 2006, with an investment in FHLB stock of $12.4 million.

 

Federal Reserve System.  The Federal Reserve Board regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: a 3% reserve ratio is assessed on net transaction accounts up to and including $48.3 million; a 10% reserve ratio is applied above $48.3 million. The first $7.8 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. These amounts are adjusted annually. Superior Bank complies with the foregoing requirements.

 

Community Reinvestment Act.  Superior Bank is subject to the CRA. The CRA and the regulations issued thereunder are intended to encourage financial institutions to help meet the credit needs of their service areas, including low and moderate income neighborhoods, consistent with the safe and sound operations of the financial institutions. These regulations also provide for regulatory assessment of an institution’s record in meeting the needs of its service area when considering applications to establish branches, merger applications, applications to engage in new activities and applications to acquire the assets and assume the liabilities of another institution. The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) requires federal banking agencies to make public a rating of an institution’s performance under the CRA. In the case of a holding company involved in a proposed transaction, the CRA performance records of the banks involved are reviewed by federal banking agencies in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or thrift or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction. Superior Bank has a satisfactory CRA rating.

 

Confidentiality of Customer Information.  Federal laws and regulations, including the Gramm-Leach-Bliley Act, require that financial institutions take certain steps to protect the security and confidentiality of customers’ non-public personal information. Among other things, these regulations restrict the ability of financial institutions to share non-public customer information with non-affiliated third parties and require financial institutions to provide customers with information about their privacy policies. Superior Bank has procedures in place that are intended to comply with these requirements.

 

Bank Secrecy Act.  Superior Bancorp and Superior Bank are subject to the federal Bank Secrecy Act of 1970, as amended, which establishes requirements for recordkeeping and reporting by banks and other financial institutions designed to help identify the source, volume and movement of currency and monetary instruments into and out of the United States in order to help detect and prevent money laundering and other illegal activities. The Bank Secrecy Act requires financial institutions to develop and maintain a program reasonably designed to ensure and monitor compliance with its requirements, to train employees in such program, and to test the effectiveness of such program. Any failure to meet the requirements of the Bank Secrecy Act can involve substantial penalties and adverse regulatory action. We have adopted policies and procedures intended to comply with the requirements of the Bank Secrecy Act.

 

USA Patriot Act.  On October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot Act”), which, among other things, amends the Bank Secrecy Act. The USA Patriot Act strengthened the ability of the U.S. government to detect and prosecute international money laundering and the financing of terrorism. Among its provisions, the USA Patriot Act requires that regulated financial institutions: (i) establish an anti-money laundering program that includes training and audit components; (ii) comply with regulations regarding the verification of the identity of any person seeking to open an account; (iii) take additional required precautions with non-U.S. owned accounts; and (iv) perform certain verification and certification of money laundering risk for any foreign correspondent banking relationships. We have adopted policies, procedures and controls to address compliance with the requirements of the USA Patriot Act under the existing regulations and will continue to revise and update our policies, procedures and controls to reflect changes required by the USA Patriot Act and implementing regulations.

 

Consumer Laws and Regulations.  In addition to the laws and regulations discussed herein, Superior Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. While the list set forth herein is not exhaustive, these laws and regulations include the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Fair Credit Reporting Act and the Real Estate Settlement Procedures Act, among others. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits from, making loans to, or engaging in other types of transactions with, such customers.

 

Instability of Regulatory Structure

 

Various bills are routinely introduced in the United States Congress and state legislatures with respect to the regulation of financial institutions. Some of these proposals, if adopted, could significantly change the regulation of banks and the financial services industry. We cannot predict whether any of these proposals will be adopted or, if adopted, how these proposals would affect us.

 

Effect on Economic Environment

 

The policies of regulatory authorities, especially the monetary policy of the Federal Reserve Board, have a significant effect on the operating results of savings and loan holding companies and their subsidiaries. Among the means available to the Federal Reserve Board to affect the money supply are open market operations in U.S. Government securities, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These means are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may affect interest rates charged on loans or paid for deposits.

 

Federal Reserve Board monetary policies have materially affected the operating results of commercial banks and thrifts in the past and are expected to continue to do so in the future. The nature of future monetary policies and the effect of such policies on our business and earnings cannot be predicted.

 

Available Information

 

We maintain an Internet website at www.superiorbank.com. We make available free of charge through our website various reports that we file with the Securities and Exchange Commission, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these reports. These reports are made available as soon as reasonably practicable after these reports are filed with, or furnished to, the Securities and Exchange Commission. From our home page at www.superiorbank.com, go to and click on “Investor Relations” and click on “SEC Filings” to access these reports.

 

Code of Ethics

 

We have adopted a code of ethics that applies to all of our employees, including our principal executive, financial and accounting officers. A copy of our code of ethics is available on our website. We intend to disclose information about any amendments to, or waivers from, our code of ethics that are required to be disclosed under applicable Securities and Exchange Commission regulations by providing appropriate information on our website. If at any time our code of ethics is not available on our website, we will provide a copy of it free of charge upon written request.

 

Item 1A.  Risk Factors.

 

Our business, and an investment in our securities, involves risks. The following summary describes factors we believe are material risks relating to our business and to the ownership of our securities. Our discussion of these risks contains forward-looking statements, and our actual results may differ materially from those anticipated by such forward-looking statements. In addition, financial condition and results of operations, and the market price of our common stock, may be substantially affected by other risks, including risks we have not identified or that we may

believe are immaterial or unlikely. This summary does not purport to describe all risks that might possibly affect our business, financial condition or results of operations or the market price of our common stock.

 

Risks Relating To Our Business

 

If the interest payments we make on our deposits increase relative to our interest income, we may be less profitable.  Our profitability depends to a large extent on Superior Bank’s net interest income, which is the difference between income from interest-earning assets, such as loans we make and investment securities we hold, and interest we pay on deposits and our own borrowings. Our net interest income is affected not only by actions we take, but by changes in general interest rate levels and by other economic factors beyond our control. Our net interest income may be reduced if (i) more interest-earning assets than interest-bearing liabilities reprice or mature at a time when interest rates are declining, or (ii) more interest-bearing liabilities than interest-earning assets reprice or mature at a time when interest rates are rising.

 

In addition, we may be affected by changes in the difference between short- and long-term interest rates. For example, short-term deposits may be used to support longer-term loans. If the difference between short-and long-term interest rates becomes smaller, the spread between the rates we pay on deposits and borrowings and the rates we receive on loans we make could narrow significantly, decreasing our net interest income.

 

Further, if market interest rates rise rapidly, interest rate adjustment caps may limit our ability to increase interest rates on adjustable-rate mortgage loans, but we may have to pay higher interest rates on deposits and borrowings. This could cause our net interest income to decrease.

 

An increase in loan prepayments may adversely affect our profitability.  The rate at which borrowers prepay loans is dependent on a number of factors outside our control, including changes in market interest rates, conditions in the housing and financial markets and general economic conditions. We cannot always accurately predict prepayment rates. If the prepayment rates with respect to our loans are greater than we anticipate, there may be a negative impact on our profitability because we may not be able to reinvest prepayment proceeds at rates comparable to those we received on the prepaid loans, particularly in a time of falling interest rates.

 

If our allowance for loan losses is inadequate, our profitability will be reduced.  We are exposed to the risk that our customers will be unable to repay their loans in accordance with their terms and that any collateral securing such loans will be insufficient to ensure full repayment. Such credit risk is inherent in the lending business, and our failure to adequately assess such credit risk could have material adverse effect on our financial condition and results of operations. We evaluate the collectibility of our loan portfolio and review our evaluation on a regular basis, and we provide an allowance for loan losses that we believe is adequate based on various factors that we believe may affect the credit quality of our loans. However, there can be no assurance that actual loan losses will not exceed the allowance that we have established, as such allowance is adjusted from time to time.

 

If our allowance for loan losses is inadequate for the actual losses we experience, there could be a material adverse effect on our results of operations. In addition, if as a result of our perception of adverse trends, we materially increase or allowance for loan losses in the future, such increase would also reduce our earnings.

 

Events in our geographic markets could adversely affect us.  Our business is concentrated in a limited number of markets in Alabama and Florida. Changes in general economic conditions and in the values of real estate in such geographic markets could have an adverse impact on our ability to achieve our loan and deposit growth targets and on our customers’ ability to repay existing loans. In addition, natural disasters, such as hurricanes and tornadoes, in our geographic markets could adversely affect our business.

 

We face substantial competition.  There are numerous competitors in our geographic markets, including national, regional and local banks and thrifts and other financial services businesses, some of which have substantially greater resources, higher brand visibility and a wider geographic presence than we have. Some of these competitors may offer a greater range of services, more favorable pricing and greater customer convenience than we are able to. In addition, in some of our markets, there are a significant number of new banks and other financial institutions that have opened in the recent past or are expected to open in the near future, and such new competitors may also seek to exploit our markets and customer base. If we are unable to maintain and grow our market share in the face of such competition, our results of operations will be adversely affected.

 

We are subject to extensive regulation.  Our operations are subject to regulation by the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. We are also subject to applicable regulations of the Federal Home Loan Bank. Regulation by these entities is intended primarily for the protection of our depositors and the deposit insurance fund and not for the benefit of our stockholders. We may incur substantial costs in complying with such regulations, and our failure to comply with them may expose us to substantial penalties.

 

In addition, we are subject to numerous consumer protection laws and other laws relating to the operation of financial institutions. Our failure to comply with such laws could expose us to liability, which could have a material adverse effect on our results of operations.

 

We may require additional capital to fund our growth plans.  Our business strategy includes the expansion of our business through the development of new locations and through the acquisition of other financial institutions and, to the extent permitted by applicable law, complementary businesses as appropriate opportunities arise. In order to finance such growth and to maintain required regulatory capital levels, we may require additional capital in the future. There can be no assurance that such capital will be available upon favorable terms, or at all.

 

We are dependent upon the services of our management team.  Our operations and strategy are directed by our senior management team, most of whom have joined Superior Bancorp since January 2005. Any loss of the services of members of our management team could have a material adverse effect on our results of operations and our ability to implement our business strategy.

 

Risks Related To an Investment in Our Common Stock

 

Our stock price may be volatile due to limited trading volume.  Our common stock is traded on the NASDAQ Global Market. However, the average daily trading volume in our common stock is relatively small, historically under 60,000 shares per day and sometimes less than that. With the increased number of outstanding shares, we expect trading activity to increase. For the fourth quarter of 2006, the average daily trading volume increased to 109,000 shares. Notwithstanding this increase, trades involving a relatively small number of shares may have a significant effect on the market price of our common stock, and it may be difficult for investors to acquire or dispose of large blocks of stock without significantly affecting the market price.

 

Our ability to pay dividends is limited.  Our ability to pay dividends is limited by regulatory requirements and the need to maintain sufficient consolidated capital to meet the capital needs of our business, including capital needs related to future growth. Our primary source of income is the payment of dividends from Superior Bank to us. Superior Bank, in turn, is likewise subject to regulatory requirements potentially limiting its ability to pay such dividends to us and by the need to maintain sufficient capital for its operations and obligations. Further, we are obligated, subject to regulatory limitations, to make periodic distributions on our trust preferred securities, which reduces the income that might otherwise be available to pay dividends on our common stock. Thus, there can be no assurance that we will pay dividends to our common stockholders, no assurance as to the amount or timing of any such dividends, and no assurance that such dividends, if and when paid, will be maintained, at the same level or at all, in future periods.

 

The market price of our common stock has risen significantly in a relatively short period of time.  The market price of our common stock, as reported on the NASDAQ Global Market, increased by approximately 38% between December 31, 2004 and December 31, 2006. We believe that this increase resulted in part from investors’ perception as to the ability of our new senior management team to execute our business strategy and enhance stockholder value. There can be no assurance that the market price of our common stock will remain at or near its current level, which is substantially above historic trading prices prior to 2005.

 

Use of our common stock for future acquisitions or to raise capital may be dilutive to existing stockholders.  When we determine that appropriate strategic opportunities exist, we may acquire other financial institutions and related businesses, subject to applicable regulatory requirements. We may use our common stock for such acquisitions. From time to time, we may also seek to raise capital through selling additional common stock. It is possible that the issuance of additional common stock in such acquisition or capital transactions may be dilutive to the interests of our existing stockholders (see “Recently Announced Merger Agreement” above).

 

Item 1B.  Unresolved Staff Comments.

 

Not applicable.

 

 

Our headquarters are located at 17 North 20th Street, Birmingham, Alabama. As of December 21, 1999, Superior Bancorp and Superior Bank, who jointly owned the building, converted the building into condominiums known as The Bank Condominiums. Superior Bancorp and Superior Bank collectively own 16 condominium units. This space includes a branch of Superior Bank, various administrative offices, operations facilities and our headquarters. Ten units are owned by third parties. We have leased or are pursuing the lease or sale of certain units (or parts thereof) not currently needed for our operations.

 

We operate through facilities at 86 locations. We own 44 of these facilities and lease 42 of these facilities. Rental expense on the leased properties totaled approximately $955,000 in 2006.

 

 

While we are a party to various legal proceedings arising in the ordinary course of our business, we believe that there are no proceedings threatened or pending against us at this time that will individually, or in the aggregate, materially and adversely affect our business, financial condition or results of operations. We believe that we have strong claims and defenses in each lawsuit in which we are involved. While we believe that we will prevail in each lawsuit, there can be no assurance that the outcome of the pending, or any future, litigation, either individually or in the aggregate, will not have a material adverse effect on our business, our financial condition or our results of operations.

 

 

On October 12, 2006, we held a special meeting of stockholders, at which our stockholders voted to approve the merger of Community Bancshares, Inc. with and into Superior Bancorp, as follows:

 

 

PART II

 

 

Market for Common Stock

 

Our common stock trades on NASDAQ Global Market under the ticker symbol “SUPR”. As of December 31, 2006, there were approximately 2,021 record holders of our common stock. The following table sets forth, for the calendar periods indicated, the range of high and low reported sales prices:

 

 

On March 12, 2007, the last reported sale price for the common stock was $11.21 per share.

 

Dividends

 

We paid dividends on our preferred stock aggregating $4.92 per preferred share in 2005. All of our preferred stock was converted into common stock effective June 30, 2005.

 

Holders of our common stock are entitled to receive dividends when, as and if declared by our board of directors. We derive cash available to pay dividends primarily, if not entirely, from dividends paid to us by our subsidiaries. There are certain restrictions that limit Superior Bank’s ability to pay dividends to us and, in turn, our ability to pay dividends. The restrictions that may limit our ability to pay dividends are discussed in this Report in Item 1 under the heading “Supervision and Regulation — Limitations on Capital Distributions.” Our ability to pay dividends to our stockholders will depend on our earnings and financial condition, liquidity and capital requirements, the general economic and regulatory climate, our ability to service any equity or debt obligations senior to our common stock and other factors deemed relevant by our board of directors. We do not currently pay dividends on our common stock, but expect to evaluate our common stock dividend policy from time to time as circumstances indicate, subject to applicable regulatory restrictions.

 

Equity Compensation Plan Information

 

The information required to be provided under Item 201(d) of Regulation S-K is incorporated by reference to the information provided under the caption “Executive Compensation and Other Information” included in our definitive proxy statement to be filed not later than April 30, 2007, in connection with our 2007 Annual Meeting of Stockholders.

 

Performance Graph

 

The performance graph below compares our cumulative shareholder return on our common stock over the last five fiscal years to the cumulative total return of the NASDAQ Composite Index and the NASDAQ Financial Index. Our cumulative shareholder return over a five-year period is based on an initial investment of $100 on December 31, 2001.

 

 

 

 

The following table sets forth selected financial data from our consolidated financial statements and should be read in conjunction with our consolidated financial statements including the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The selected historical financial data as of December 31, 2006 and 2005 and for each of the three years in the period ended December 31, 2006 is derived from our audited consolidated financial statements and related notes included in this Form 10-K. See “Item 8. Superior Bancorp and Subsidiaries Consolidated Financial Statements.”

 

 

 

 

 

General

 

The following is a narrative discussion and analysis of significant changes in our results of operations and financial condition. This discussion should be read in conjunction with the consolidated financial statements and selected financial data included elsewhere in this document.

 

Overview

 

Our principal subsidiary is Superior Bank (the “Bank”), which has since November 1, 2005, been chartered as a federal savings bank. Prior to that date, Superior Bank operated as an Alabama state bank. The Bank is headquartered in Birmingham, Alabama and operates 54 banking offices and three loan production offices in Alabama, and in the panhandle and Tampa Bay areas of Florida. Other subsidiaries include SFS, LLC, an Alabama limited liability company (“SFS”), Superior Financial Services, LLC, an Alabama limited liability company (“Superior Financial”), 1^st Community Credit Corporation, an Alabama corporation (“Community Credit”), Community (AL) Capital Trust I, a Delaware trust, TBC Capital Statutory Trust II (“TBC Capital II”), a Connecticut statutory trust, TBC Capital Statutory Trust III (“TBC Capital III”), a Delaware business trust, and Morris Avenue Management Group, Inc. (“MAMG”), an Alabama corporation, all of which are wholly owned. SFS was formed to acquire tax lien certificates. Superior Financial and Community Credit provide consumer finance services. Community (AL) Capital Trust I, TBC Capital II and TBC Capital III are unconsolidated special purpose entities formed solely to issue cumulative trust preferred securities. MAMG is a real estate management company that manages our headquarters, our branch facilities and certain other real estate owned by the Bank.

 

During the third quarter of 2006, we merged with Kensington Bancshares, Inc. of Tampa, Florida. In the fourth quarter of 2006, we merged with Community Bancshares of Blountsville, Alabama. These acquired entities had combined loans of approximately $470 million and deposits of $700 million.

 

Our primary source of revenue is net interest income, which is the difference between income earned on interest-earning assets, such as loans and investments, and interest paid on interest-bearing liabilities, such as deposits and borrowings. Our results of operations are also affected by the provision for loan losses and other noninterest expenses such as salaries and benefits, occupancy expenses and provision for income taxes. The effects of these noninterest expenses are partially offset by noninterest sources of revenue such as service charges and fees on deposit accounts and mortgage banking income. Our volume of business is influenced by competition in our markets and overall economic conditions including such factors as market interest rates, business spending and consumer confidence.

 

During 2006, our net interest income increased by 21.4%, primarily due to an increase in average interest-earning assets. The increase in our interest-earning assets resulted primarily from an overall increase in the average volume of our loan portfolio. During 2006 we continued our strategy of realigning our loan and deposit mix, primarily through our acquisitions.

 

Service charges and fees were up 4.9% in 2006 from 2005 due to an increase in deposit accounts. Mortgage banking income increased 17.2% in 2006 due to an increase in the volume of mortgage loan originations throughout the year.

 

Salaries and benefits increased from 2005 to 2006 due to our acquisitions and branch expansion. All other noninterest expenses remained relatively flat in 2006 compared to 2005. Several initiatives were implemented to control costs in 2005, such as a reduction in force, the termination or buyout of various deferred compensation agreements and tighter spending controls. These cost controls carried over into 2006.

 

Management reviews the adequacy of the allowance for loan losses on a quarterly basis. The provision for loan losses represents the amount determined by management necessary to maintain the allowance for loan losses at a level capable of absorbing inherent losses in the loan portfolio. (See “Critical Accounting Estimates” below.) For 2006 our provision for loan losses totaled $2.5 million and our net charge-offs totaled $2.3 million. As of December 31, 2006 our allowance for loan losses was $18.9 million, or 1.15% of loans, net of unearned income.

 

Critical Accounting Estimates

 

In preparing financial information, management is required to make significant estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses for the periods shown. The accounting principles we follow and the methods of applying these principles conform to accounting principles generally accepted in the United States and to general banking practices. Estimates and assumptions most significant to us are related primarily to our allowance for loan losses, income taxes and goodwill impairment are summarized in the following discussion and in the notes to the consolidated financial statements.

 

Allowance for Loan Losses

 

Management’s determination of the adequacy of the allowance for loan losses, which is based on the factors and risk identification procedures discussed in the following pages, requires the use of judgments and estimates that may change in the future. Changes in the factors used by management to determine the adequacy of the allowance or the availability of new information could cause the allowance for loan losses to be increased or decreased in future periods. In addition, our regulators, as part of their examination process, may require that additions or reductions be made to the allowance for loan losses based on their judgments and estimates.

 

Income Taxes

 

Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to reverse. These calculations are based on many complex factors, including estimates of the timing of reversals of temporary differences, the interpretation of federal and state income tax laws, and a determination of the differences between the tax and the financial reporting basis of assets and liabilities. Actual results could differ significantly from the estimates and interpretations used in determining the current and deferred income tax assets and liabilities.

 

Our determination of the realization of deferred tax assets (net of valuation allowances) is based upon management’s judgment of various future events and uncertainties, including future reversals of existing taxable temporary differences, the timing and amount of future income earned by our subsidiaries and the implementation of various tax planning strategies to maximize realization of the deferred tax assets. A portion of the amount of the deferred tax asset that can be realized in any year is subject to certain statutory federal income tax limitations. We believe that our subsidiaries will be able to generate sufficient operating earnings to realize the deferred tax benefits. We evaluate quarterly the realizability of the deferred tax assets and, if necessary, adjust any valuation allowance accordingly.

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. Specifically, the pronouncement prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The interpretation also provides guidance on the related derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition of uncertain tax positions. The interpretation is effective for fiscal years beginning after December 15, 2006. We are in the process of evaluating the impact, if any, the adoption of this interpretation will have on our financial statements.

 

Acquisitions

 

We recorded the assets and liabilities of Kensington and Community at their estimated fair values. Arriving at these fair values required numerous assumptions regarding the economic life of assets, decay rates for liabilities and other factors. We engaged a third party to assist us in valuing certain of the financial assets and liabilities of Kensington and Community. We also engaged a real estate appraisal firm to value the more significant properties that were acquired by us in the acquisition. As a result, we consider the values we have assigned to the acquired assets and liabilities of Kensington and Community to be reasonable and consistent with the application of generally accepted accounting principles. However, we are still in the process of obtaining and evaluating certain

additional information. Accordingly, we may reassess our purchase price allocations in the future based on such information. We believe that we will conclude the allocation of the purchase price to the acquired net assets during the second quarter of 2007.

 

Long-lived assets, including purchased intangible assets subject to amortization, such as our core deposit intangible asset, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated.

 

Goodwill and intangible assets that have indefinite useful lives are tested annually for impairment, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value. Our annual assessment date is December 31. Should we determine in a future period that the goodwill recorded in connection with our acquisitions has become impaired, then a charge to our earnings will be recorded in the period such determination is made.

 

Recent Developments

 

On January 18, 2007, we announced that we had signed a merger agreement with People’s Community Bancshares, Inc. (see “Recently Announced Merger Agreement” under Item 1 above).

 

Results of Operations

 

Year Ended December 31, 2006, Compared with Year Ended December 31, 2005

 

Our net income for the year ended December 31, 2006 was $4.9 million, compared to a net loss of $5.8 million for the year ended December 31, 2005. Net income available to common stockholders was $4.9 million for the year ended December 31, 2006, compared to a net loss of ($8.1 million) for the year ended December 31, 2005. Our basic and diluted net income (loss) per common share was $0.21 for the year ended December 31 2006, compared to $(0.42) per common share for the year ended December 31, 2005. Our return on average assets was 0.30% in 2006, compared to (0.41)% in 2005. Our return on average stockholders’ equity was 3.55% in 2006, compared to (5.68)% in 2005. Our book value per common share at December 31, 2006 and 2005 was $7.97 and $5.21, respectively, and our tangible book value per common share decreased to $4.31 at December 31, 2006 from $4.61 as of December 31, 2005. Average equity to average assets increased to 8.37% in 2006 from 7.26% in 2005.

 

The increase in earnings for the year ended December 31, 2006 compared to the year ended December 31, 2005 was primarily the result of an increase in net interest income and a decrease in management separation costs.

 

Net interest income is the difference between the income earned on interest-earning assets and interest paid on interest-bearing liabilities used to support such assets. Net interest income increased $8.4 million, or 21.4%, to $47.4 million for the year ended December 31, 2006 from $39.0 million for the year ended December 31, 2005. This was due to an increase in interest income of $31.5 million, or 40.8%, offset by a increase in total interest expense of $23.1 million, or 60.5%. The increase in total interest income was primarily attributable to a $28.8 million, or 45.1%, increase in interest income on average loans, which increased $230 million to $1.177 billion.

 

The increases in interest income were offset by a $18.6 million, or 66.6%, increase in interest expense on deposits and a $4.5 million, or 43.8%, increase in interest expense on other borrowings. Average interest- bearing deposits increased $179.1 million, or 18.4%, and average other borrowings increased $41.3 million, or 22.1%. The average rate paid on interest-bearing liabilities was 4.34% for the year ended December 31, 2006, compared to 3.21% for the year ended December 31, 2005. This increase is the result of higher average rates paid on all interest-bearing deposits due to higher market rates.

 

Our net interest spread and net interest margin were 2.93% and 3.17%, respectively, for the year ended December 31, 2006, compared to 3.00% and 3.14%, respectively, for the year ended December 31, 2005.

 

Our average interest-earning assets for the year ended December 31, 2006 increased $252.5 million, or 20.2%, to $1.499 billion from $1.247 billion for the year ended December 31, 2005. This increase in our average interest-earning assets was due primarily to mergers with Kensington and Community in late 2006 and increased loan production. Average interest-bearing liabilities increased $222.1 million, or 18.6%, to $1.414 billion from $1.192 billion for the year ended December 31, 2005. The increase in average interest-bearing liabilities is primarily due to mergers with Kensington and Community in late 2006. The ratio of our average interest-earning assets to average interest-bearing liabilities was 106.0% and 104.6% for the years ended December 31, 2006 and 2005, respectively. Our average interest-bearing assets produced a taxable equivalent yield of 7.27% for the year ended December 31, 2006, compared to 6.21% for the year ended December 31, 2005. The 106-basis point increase in the yield was offset by a 113-basis point increase in the average rate paid on interest-bearing liabilities.

 

The provision for loan losses represents the amount determined by management to be necessary to maintain the allowance for loan losses at a level capable of absorbing inherent losses in the loan portfolio. Management reviews the adequacy of the allowance for loan losses on a quarterly basis. The allowance for loan losses calculation is segregated into various segments that include classified loans, loans with specific allocations and pass rated loans. A pass rated loan is generally characterized by a very low to average risk of default and in which management perceives there is a minimal risk of loss. Loans are rated using an eight-point scale with loan officers having the primary responsibility for assigning risk ratings and for the timely reporting of changes in the risk ratings. These processes, and the assigned risk ratings, are subject to review by our internal loan review function and senior management. Based on the assigned risk ratings, the criticized and classified loans in the portfolio are segregated into the following regulatory classifications: Special Mention, Substandard, Doubtful or Loss. Generally, regulatory reserve percentages are applied to these categories to estimate the amount of loan loss allowance, adjusted for previously mentioned risk factors. Impaired loans are reviewed specifically and separately under Statement of Financial Accounting Standards (“SFAS”) Statement No. 114 to determine the appropriate reserve allocation. Management compares the investment in an impaired loan with the present value of expected future cash flow discounted at the loan’s effective interest rate, the loan’s observable market price or the fair value of the collateral, if the loan is collateral-dependent, to determine the specific reserve allowance. Reserve percentages assigned to non-rated loans are based on historical charge-off experience adjusted for other risk factors. To evaluate the overall adequacy of the allowance to absorb losses inherent in our loan portfolio, management considers historical loss experience based on volume and types of loans, trends in classifications, volume and trends in delinquencies and non-accruals, economic conditions and other pertinent information. Based on future evaluations, additional provisions for loan losses may be necessary to maintain the allowance for loan losses at an appropriate level. See “Financial Condition — Allowance for Loan Losses” for additional discussion.

 

The provision for loan losses was $2.5 million for the year ended December 31, 2006, a decrease of $1.0 million in comparison to $3.5 million in 2005. This decrease can be attributed primarily to the continued improvement in the overall quality of the Bank’s loan portfolios. While the provision is moderately lower in comparison to 2005, management continues to maintain a proactive approach to credit risk management as the economy experiences cycles and as the Bank continues to grow both internally and through mergers and acquisitions. Nonperforming loans increased, to 0.52% of loans at December 31, 2006 from 0.49% at December 31, 2005. During 2006, we had net charged-off loans totaling $2.3 million, compared to net charged-off loans of $4.0 million for 2005. The ratio of net charged-off loans to average loans was 0.20% for 2006 compared to 0.43% for 2005. The allowance for loan losses totaled $18.9 million, or 1.15% of loans, net of unearned income, at December 31, 2006, compared to $12.0 million, or 1.25% of loans, net of unearned income, at December 31, 2005. See “Financial Condition — Allowance for Loan Losses” for additional discussion.

 

Noninterest income decreased $2.9 million, or 19.6%, to $11.8 million in 2006 from $14.7 million in 2005. This decrease is primarily due to insurance proceeds received in 2005 of $5.1 million and was partially offset by $1.3 million in losses on the sale of available-for-sale securities in 2005 and changes in the fair values of derivatives. In 2006, changes in the fair value of derivatives totaled $374,000. The investment portfolio losses were realized primarily in the first quarter of 2005 as a result of a $50 million sale of bonds in the investment portfolio. We

reinvested the proceeds in bonds intended to enhance the yield and cash flows of our investment securities portfolio. The new investment securities were classified as available for sale.

 

Income from mortgage banking operations for the year ended December 31, 2006 increased $439,000, or 17.2%, to $3.0 million in 2006 from $2.6 million in 2005. This increase is due to increased origination activity during 2006. Income from customer service charges and fees increased $228,000, or 4.9%, to $4.9 million in 2006 from $4.6 million in 2005. This increase is primarily due to an increase of transaction accounts from 2005 to 2006. Management is currently pursuing new accounts and customers through direct marketing and other promotional efforts to increase this source of revenue. Other noninterest income was $3.5 million, a decrease of $86,000, or 2.3%, from $3.6 million in 2005.

 

Noninterest expense decreased $10.8 million, or 17.9%, to $49.8 million in 2006 from $60.6 million in 2005, primarily due to the management separation costs of $15.5 million incurred in the first six months of 2005. Salaries and employee benefits increased $3.7 million, or 16.0%, to $26.8 million in 2006 compared to $23.1 million in 2005. This increase is primarily the result of an increased employee base which resulted from the mergers with Kensington and Community in the third and fourth quarters of 2006. We incurred internal merger-related costs and subsidiary startup costs of $770,000.

 

All other noninterest expenses remained flat, at $22.0 million in 2006 and in 2005, as the new executive management team implemented certain cost control measures. See Note 21 to the Consolidated Financial Statements for more detail on the components of our noninterest expenses.

 

Income tax expense was $1.9 million in 2006, compared to a tax benefit of $4.6 million in 2005. The primary difference in the effective tax rate and the federal statutory rate of 34% for 2006 is due to the effect of certain tax-exempt interest and the increase in the cash surrender value of life insurance. See Note 13 to the Consolidated Financial Statements for more detail on the components of our income tax expense.

 

Our net deferred tax assets increased to $25.3 million as of December 31, 2006 from $14.8 million at December 31, 2005. This increase is primarily due to an increase in federal net operating loss carryforwards (“NOLs”). Approximately $26.0 million in NOLs were generated in prior periods by Community, which we acquired during the fourth quarter of 2006. These carryforwards are subject to certain statutory limitations, but we expect that future earnings will be sufficient to utilize these losses. These carryforwards do not begin to expire until the year 2023. Due to limitations on the use of net operating losses acquired in the merger with Community, a valuation allowance of $1.2 million has been established as of December 31, 2006 against such deferred income tax assets in purchase accounting. Any subsequently recognized income tax benefits relating to this valuation allowance will be reflected as a reduction of goodwill related to the acquisition.

 

Our determination of the realization of deferred tax assets (net of valuation allowance) is based upon management’s judgment of various future events and uncertainties, including future reversals of existing taxable temporary differences, the timing and amount of future income earned by our subsidiaries and the implementation of various tax planning strategies to maximize realization of the deferred tax assets. A portion of the amount of the deferred tax asset that can be realized in any year is subject to certain statutory federal income tax limitations. We believe that our subsidiaries will be able to generate sufficient operating earnings to realize the deferred tax benefits. We evaluate quarterly the realizability of the deferred tax assets and, if necessary, adjust any valuation allowance accordingly.

 

Our federal and state income tax returns for the years 2000 through 2005 are open for review and examination by governmental authorities. In the normal course of these examinations, we are subject to challenges from governmental authorities regarding amounts of taxes due. We have received notices of proposed adjustments relating to state taxes due for the years 2002 and 2003, which include proposed adjustments relating to income apportionment of one of the Bank’s subsidiaries. We believe adequate provision for income taxes has been recorded for all years open for review and intend to vigorously contest the proposed adjustments. To the extent that final resolution of the proposed adjustments results in significantly different conclusions from our current assessment of the proposed adjustments, our effective tax rate in any given financial reporting period may be materially different from our current effective tax rate.

 

Year Ended December 31, 2005, Compared with Year Ended December 31, 2004

 

Our net loss for the year ended December 31, 2005 was ($5.8 million), compared to net income of $1.2 million for the year ended December 31, 2004. Net loss available to common stockholders was ($8.1 million) for the year ended December 31, 2005, compared to net income of $741,000 for the year ended December 31, 2004. Our basic and diluted net (loss) income per common share was $(.42) for the year ended December 31 2005, compared to $.04 per common share for the year ended December 31, 2004. Our return on average assets was (.41)% in 2005, compared to .09% in 2004. Our return on average stockholders’ equity was (5.68)% in 2005, compared to 1.18% in 2004. Our book value per common share at December 31, 2005 and 2004 was $5.21 and $5.31, respectively, and our tangible book value per common share at December 31, 2005 increased to $4.61 at December 31, 2005 from $4.62 as of December 31, 2004. Average equity to average assets decreased to 7.26% in 2005 from 7.78% in 2004.

 

The decrease in earnings for the year ended December 31, 2005 compared to the year ended December 31, 2004 was primarily the result of an increase in the provision for loan losses, as more fully discussed below, and certain management separation costs.

 

Net interest income increased $1.0 million, or 2.6%, to $39.0 million for the year ended December 31, 2005 from $38.0 million for the year ended December 31, 2004. This was due to an increase in interest income of $11.1 million, or 16.8%, offset by a increase in total interest expense of $10.1 million, or 36.0%. This increase in total interest income was attributable to a $7.7 million, or 13.7%, increase in interest income on loans as a result of a $52.8 million increase in average loans, and a $2.8 million, or 31.7%, increase in interest income on investment securities as a result of a $54.7 million increase in average investment securities for the year.

 

The increases in interest income were offset by an $8.7 million, or 45.5%, increase in interest expense on deposits and a $1.4 million, or 15.7%, increase in interest expense on other borrowings. While average interest-bearing deposits increased $91.1 million, or 10.3%, and average other borrowings increased $4.2 million, or 2.0%, the increase in interest expense is primarily attributable to a 65-basis point increase in the average interest rates paid on interest-bearing liabilities. The average rate paid on interest-bearing liabilities was 3.21% for the year ended December 31, 2005, compared to 2.56% for the year ended December 31, 2004. This increase was due primarily to higher average rates paid on all deposits.

 

Our net interest spread and net interest margin were 3.00% and 3.14%, respectively, for the year ended December 31, 2005, compared to 3.20% and 3.31%, respectively, for the year ended December 31, 2004.

 

Our average interest-earning assets for the year ended December 31, 2005 increased $96.5 million, or 8.4%, to $1.247 billion from $1.150 billion for the year ended December 31, 2004. This increase in our average interest-earning assets was due primarily to increased loan production and increased investment securities. Average interest-bearing liabilities increased $95.3 million, or 8.7%, to $1.192 billion from $1.097 billion for the year ended December 31, 2004. The increase in average interest-bearing liabilities is primarily due to an increase in interest-bearing demand accounts, which is part of our strategy to improve our deposit mix. The ratio of our average interest-earning assets to average interest-bearing liabilities was 104.6% and 104.9% for the years ended December 31, 2005 and 2004, respectively. Our average interest-bearing assets produced a taxable equivalent yield of 6.21% for the year ended December 31, 2005, compared to 5.76% for the year ended December 31, 2004. The 45-basis point increase in the yield was offset by a 65-basis point increase in the average rate paid on interest-bearing liabilities.

 

The provision for loan losses was $3.5 million for the year ended December 31, 2005, an increase of $2.5 million in comparison to $975,000 in 2004. This increase can be attributed primarily to the reassessment of collateral values on certain nonperforming commercial credits and the settlement of a disputed collateral lien. These items accounted for approximately $2.3 million of the total increase in provision and represented 66.0% of the total net charge-off activity for the year. It should be noted that the provision expense for 2004 was unusually low due to the sale of approximately $32.0 million in certain classified loans and significant recoveries of charged-off loans of $3.7 million. Also, nonperforming loans decreased significantly, to .49% of loans at December 31, 2005 from .79% at December 31, 2004. During 2005, we had net charged-off loans totaling $4.0 million, compared to net charged-off loans of $13.6 million for 2004. The ratio of net charged-off loans to average loans was .43% for 2005 compared to 1.52% for 2004. The allowance for loan losses totaled $12.0 million, or 1.25% of loans, net of unearned income,

at December 31, 2005, compared to $12.5 million, or 1.34% of loans, net of unearned income, at December 31, 2004. See “Financial Condition — Allowance for Loan Losses” for additional discussion.

 

Noninterest income increased $3.4 million, or 30.5%, to $14.7 million in 2005 from $11.3 million in 2004. This increase is primarily due to insurance proceeds of $5.1 million and was partially offset by $1.3 million in losses on the sale of available-for-sale securities and changes in the fair values of derivatives (see Note 1 to the Consolidated Financial Statements). The investment portfolio losses were realized primarily in the first quarter of 2005 as a result of a $50 million sale of bonds in the investment portfolio. We reinvested the proceeds in bonds intended to enhance the yield and cash flows of our investment securities portfolio. The new investment securities were classified as available for sale.

 

Income from mortgage banking operations for the year ended December 31, 2005 increased $894,000, or 53.7%, to $2.6 million in 2005 from $1.7 million in 2004. This increase is due to increased origination activity during 2005. Income from customer service charges and fees decreased $517,000, or 9.9%, to $4.7 million in 2005 from $5.2 million in 2004. This decrease is primarily due to a loss of transaction accounts from 2004 to 2005. Management is currently pursuing new accounts and customers through direct marketing and other promotional efforts to increase this source of revenue. Service charges on deposit accounts increased $131,000, or 5.75%, in the last six-month period of 2005 over the first six-month period of 2005. Other noninterest income was $3.6 million, a decrease of $122,000, or 3.3%, from $3.7 million in 2004. This decrease is primarily the result of a decline in the amount earned on the cash surrender value of life insurance.

 

Noninterest expense increased $12.7 million, or 26.4%, to $60.6 million in 2005 from $47.9 million in 2004, primarily due to the management separation costs of $15.5 million incurred in the first six months of 2005. Salaries and employee benefits decreased $377,000, or 1.6%, to $23.1 million in 2005 compared to $23.5 million in 2004. This decrease is primarily the result of a reduction in force which occurred during the second and third quarters of 2005, partially offset by the recruitment of several new revenue-producing bankers.

 

All other noninterest expenses remained flat, at $22.0 million in 2005 compared to $22.2 million in 2004, as the new executive management team implemented certain cost control measures. See Note 21 to the Consolidated Financial Statements for more detail on the components of our noninterest expenses.

 

Our income tax benefit was $4.6 million in 2005, and $796,000 in 2004. The primary difference in the effective tax rate and the federal statutory rate of 34% for 2005 is due to the effect of certain tax-exempt interest and the increase in the cash surrender value of life insurance. (See Note 13 to the Consolidated Financial Statements)

 

Net Interest Income

 

The largest component of our net income is net interest income, which is the difference between the income earned on interest-earning assets and interest paid on deposits and borrowings. Net interest income is determined by the rates earned on our interest-earning assets, rates paid on our interest-bearing liabilities, the relative amounts of interest-earning assets and interest-bearing liabilities, the degree of mismatch and the maturity and repricing characteristics of our interest-earning assets and interest-bearing liabilities. Net interest income divided by average interest-earning assets represents our net interest margin.

 

Average Balances, Income, Expenses and Rates.  The following tables depict, on a taxable equivalent basis for the periods indicated, certain information related to our average balance sheet and our average yields on assets and average costs of liabilities. Such yields are derived by dividing income or expense by the average balance of the corresponding assets or liabilities. Average balances have been derived from daily averages.

 

 

 

 

Analysis of Changes in Net Interest Income.  The following table sets forth, on a taxable equivalent basis, the effect which the varying levels of interest-earning assets and interest-bearing liabilities and the applicable rates have had on changes in net interest income for the years ended December 31, 2006 and 2005.

 

 

 

 

Market Risk — Interest Rate Sensitivity

 

Market risk is the risk of loss arising from adverse changes in the fair value of financial instruments due to a change in interest rates, exchange rates and equity prices. Our primary market risk is interest rate risk.

 

We evaluate interest rate sensitivity risk and then formulate guidelines regarding asset generation and repricing, funding sources and pricing, and off-balance sheet commitments in order to moderate interest rate sensitivity risk. We use computer simulations that reflect various interest rate scenarios and the related impact on net interest income over specified periods of time.

 

The primary objective of asset/liability management is to manage interest rate risk and achieve reasonable stability in net interest income throughout interest rate cycles. This is achieved by maintaining the proper balance of interest rate sensitive earning assets and interest rate sensitive liabilities. In general, management’s strategy is to match asset and liability balances within maturity categories to limit our exposure to earnings variations and variations in the value of assets and liabilities as interest rates change over time. Our asset and liability management strategy is formulated and monitored by our Asset/Liability Management Committee (“ALCO”), which is composed of our head of asset/liability management and other senior officers, in accordance with policies approved by the board of directors. The ALCO meets monthly to review, among other things, the sensitivity of our assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, including those attributable to purchase and sale activity, and maturities of investments and borrowings. The ALCO also approves and establishes pricing and funding decisions with respect to overall asset and liability composition and reports regularly to our Board Loan and Investment Committee and the full board of directors.

 

One of the primary goals of the ALCO is to effectively manage the duration of our assets and liabilities so that the respective durations are matched as closely as possible. These duration adjustments can be accomplished either internally by restructuring our balance sheet, or externally by adjusting the duration of our assets or liabilities through the use of interest rate contracts, such as interest rate swaps, caps, and floors. In the fourth quarter of 2006, as it appeared short-term rates had reached a plateau, we purchased $50,000,000 in interest rate floors, reducing our level of asset sensitivity. (See “Interest Rate Floors” below)

 

We measure our interest rate risk by analyzing the correlation of interest-bearing assets to interest-bearing liabilities (“gap analysis”), net interest income simulation, and economic value of equity (“EVE”) modeling.

 

As of December 31, 2006, we had approximately $85 million more in interest-bearing assets than interest-earning liabilities that could reprice to current market rates during the next 12 months. However, shortcomings are inherent in any gap analysis, because the rates on certain assets and liabilities may not move proportionately as market interest rates change. For example, when national money market rates change, interest rates on our NOW, savings, and money market deposit accounts may not change as much as rates on commercial loans. We had approximately $596 million of such administratively priced deposits on December 31, 2006.

 

Our net interest income simulation model projects that net interest income will increase on an annual basis by 7.0%, or approximately $5.1 million, assuming an instantaneous and parallel increase in interest rates of 200 basis points. Assuming an instantaneous and parallel decrease of 200 basis points, net interest income is projected to decrease on an annual basis by 8.6%, or again approximately $6.2 million. The net interest income produced by these scenarios is within our asset and liability management policy.

 

EVE is a concept related to our longer-term interest rate risk. EVE is defined as the net present value of the balance sheet’s cash flows or the residual value of future cash flows. While EVE does not represent actual market liquidation or replacement value, it is a useful tool for estimating our balance sheet earnings capacity. The greater the EVE, the greater our earnings capacity. Our EVE model projects that EVE will increase 3.8% assuming an instantaneous and parallel increase in interest rates of 200 basis points. Assuming an instantaneous and parallel decrease of 200 basis points, EVE is projected to decrease 8.7%. The EVE produced by these scenarios is within our asset and liability management policy. The following table sets forth our EVE as of December 31, 2006:

 

 

Both the net interest income and EVE simulations include assumptions regarding balances, asset prepayment speeds, and interest rate relationships among balances that management believes to be reasonable for the various interest rate environments. Differences in actual occurrences from these assumptions, as well as non-parallel changes in the yield curve, may change our market risk exposure.

 

Our board has authorized the ALCO to utilize financial futures, forward sales, options and interest rate swaps, caps and floors, and other instruments to the extent necessary, in accordance with OTS regulations and our internal policy. We expect that interest rate swaps, caps and floors will be used as macro hedges against our securities, our loan portfolios and our liabilities.

 

We recognize that positions for hedging purposes are primarily a function of three main areas of risk exposure: (1) mismatches between assets and liabilities; (2) prepayment and other option-type risks embedded in our assets, liabilities and off-balance sheet instruments; and (3) the mismatched commitments for mortgages and funding sources. We will engage in only the following types of hedges: (1) those which synthetically alter the maturities or repricing characteristics of assets or liabilities to reduce imbalances; (2) those which enable us to transfer the interest rate risk exposure involved in our daily business activities; and (3) those which serve to alter the market risk inherent in our investment portfolio or liabilities and thus help us to match the effective maturities of the assets and liabilities.

 

The following is a discussion of our primary derivative positions.

 

Interest Rate Swaps

 

At December 31, 2006, we had interest rate swap positions with notional amounts of $46.5 million related to brokered CDs (See “Fair Value Hedges” below). Hedge accounting was discontinued on $36.5 million of these swap positions during the fourth quarter of 2006 because the instruments no longer qualified as an effective fair value hedge under SFAS 133. Therefore, all changes in fair value were recognized in earnings during the period of the change. The net cash settlement of these derivatives was included in noninterest income during the fourth quarter of 2006. As of December 31, 2006, these CD swaps had a recorded fair value of ($713,000) and a weighted average life of 8.99 years. The weighted average fixed rate (receiving rate) was 4.92% and the weighted average variable rate (paying rate) was 5.33% (LIBOR based). In the first quarter of 2007, we redesignated these swaps as fair value hedges.

 

Fair Value Hedges

 

As of December 31, 2006, we had entered into $46.5 million notional amount of swaps (“CD swaps”) to hedge the interest rate risk inherent in certain of its brokered certificates of deposits (“brokered CDs”). The CD swaps are used to convert the fixed rate paid on the brokered CDs to a variable rate based upon three-month LIBOR. Prior to the first quarter of 2006, these transactions did not qualify for fair value hedge accounting under SFAS 133 (see Note 1). During the first quarter of 2006, we designated these CD swaps as fair value hedges. As fair value hedges, the net cash settlements from the designated swaps are reported as part of net interest income. In addition, we will recognize in current earnings the change in fair value of both the interest rate swap and related hedged brokered CDs, with the ineffective portion of the hedge relationship reported in noninterest income. The fair value of the CD swaps is reported on the Consolidated Statements of Financial Condition in other liabilities and the change in fair value of the related hedged brokered CD is reported as an adjustment to the carrying value of the brokered CDs. Hedge accounting was discontinued on $36.5 million of these swap positions during the fourth quarter of 2006 because the instruments no longer qualified as an effective fair value hedge under SFAS 133 (see “Interest Rate Swaps” above). As of December 31, 2006, the amount of CD swaps designated as fair value hedges totaled $10.0 million and had a recorded fair value of ($84,000) and a weighted average life of 3.87 years. The weighted average fixed rate (receiving rate) was 4.13% and the weighted average variable rate (paying rate) was 5.38% (LIBOR based).

 

Interest Rate Floors

 

During the fourth quarter of 2006, we entered into certain interest rate floor contracts that have not been qualified for hedge accounting treatment and will be used as an economic hedge. An interest rate floor is a contract in which the counterparty agrees to pay to the difference between a current market rate of interest and an agreed rate multiplied by the amount of the notional amount. We entered into $50.0 million interest rate floor contracts for a three-year period with a 4.25% floor on the three-month LIBOR rate. We paid a $248,000 premium. These economic hedges will be carried at fair value in other assets or other liabilities and changes in the fair value of these derivatives and any payments received will be recognized in noninterest income. The floors had a positive fair value of $215,000 as of December 31, 2006.

 

Liquidity

 

The goal of liquidity management is to provide adequate funds to meet changes in loan demand or any potential unexpected deposit withdrawals. Additionally, management strives to maximize our earnings by investing our excess funds in securities and other securitized loan assets with maturities matching our offsetting liabilities. See the “Selected Loan Maturity and Interest Rate Sensitivity” and “Maturity Distribution of Investment Securities”.

 

Historically, we have maintained a high loan-to-deposit ratio. To meet our short-term liquidity needs, we maintain core deposits and have borrowing capacity through the FHLB, repurchase agreements and federal funds

lines. Long-term liquidity needs are met primarily through these sources, the repayment of loans, sales of loans and the maturity or sale of investment securities.

 

As shown in the Consolidated Statements of Cash Flows, operating activities did not provide any significant levels of funds in 2006, 2005 and 2004, primarily due to our having little or no operating income.

 

Investing activities in 2006 were a net user of funds, primarily due to loan fundings, capital expenditures and investments in tax lien certificates. A significant amount of securities that were acquired as part of our business combinations were sold and reinvested in loans and additional investment securities, continuing our strategy of realigning our balance sheet which we began in 2005. Investing activities were a net provider of funds in 2005 due to maturities and sale of securities available for sale. As noted above, we sold securities in 2005 as part of a strategy to deleverage and realign our balance sheet mentioned above. Investing activities, primarily in loans and securities, were a net user of funds in 2004, which required a significant amount of funds for investing activities. Funds needed for investing activities in 2004 were provided primarily by deposits and borrowings.

 

Financing activities were a net provider of funds in 2006, as we increased our level of deposits. The increase in deposits was offset by the restructuring of FHLB advances and maturity of repurchase agreements acquired in our business combinations. Financing activities were a net user of funds in 2005, as we decreased our levels of brokered certificates of deposit and repurchase agreements. This decrease was offset by an increase in interest-bearing demand deposit accounts, advances from the FHLB and proceeds from equity transactions. Increased brokered certificates of deposits, advances from the FHLB and repurchase agreements provided funds in 2004.

 

We have entered into certain contractual obligations and commercial commitments in the normal course of business that involve elements of credit risk, interest rate risk and liquidity risk.

 

The following tables summarize these relationships by contractual cash obligations and commercial commitments:

 

 

 

 

 

 

 

In addition, the FHLB has issued for the Bank’s benefit a $20,000,000 irrevocable letter of credit in favor of the Chief Financial Officer of the State of Florida to secure certain deposits of the State of Florida. The letter of credit expires January 6, 2008 upon 60 days’ prior notice of non-renewal; otherwise, it automatically extends for a successive one-year term.

 

We are constructing or have plans to construct various new branch locations. In that regard, we have entered into commitments as of, or subsequent to, December 31, 2006 for the construction of these branch locations totaling approximately $4,396,000.

 

Superior Bancorp also made use of a line of credit provided by a regional bank in the amount of $10,000,000, that was to maturing on June 6, 2007 with interest payable monthly at the 30-day LIBOR plus 2.50%. Collateral consisted of real estate owned by the Corporation and 100% of Superior Bank stock. On January 26, 2007, we replaced this line with a line of credit from another regional bank in the amount of $10,000,000, maturing on January 26, 2008; interest is based on the 30-day LIBOR plus 1.25% and the line is secured by 51% of the outstanding Superior Bank stock.

 

Financial Condition

 

Our total assets were $2.441 billion at December 31, 2006, a increase of $1.025 billion, or 72.4%, from $1.415 billion as of December 31, 2005. This growth in primarily attributable to the Community and Kensington acquisitions, as discussed below. Our average total assets for 2006 were $1.683 billion, which was supported by average total liabilities of $1.542 billion and average total stockholders’ equity of $140.8 million.

 

Kensington Acquisition

 

We completed the acquisition of 100% of the outstanding stock of Kensington on August 31, 2006 in exchange for 6,226,722 shares of our common stock valued at approximately $71.2 million. The shares were valued by using the average of the closing prices of our stock for several days prior to and after the terms of the acquisition were agreed to and announced. The total purchase price, which includes certain direct acquisition costs, was $71.3 million As a result of the acquisition we now operate 12 banking locations in the Tampa Bay area of Florida. This area is our largest market and has a higher projected population growth than any of our other current banking markets.

 

The Kensington transaction resulted in $44.9 million of goodwill allocated to the Florida reporting unit and $3.5 million of core deposit intangibles. The goodwill acquired is not tax deductible. The amount allocated to the core deposit intangible was determined by an independent valuation and is being amortized over an estimated useful life of ten years based on the undiscounted cash flow.

 

During the third quarter of 2006 management completed its plan to terminate Kensington’s data processing operations and convert Kensington’s accounts to our system. This conversion was completed in the first quarter of

2007. Certain costs associated with this conversion totaling approximately $1.4 million, which included primarily contract cancellations and employment-related costs, were estimated and accrued as of the acquisition date.

 

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

 

 

Community Acquisition

 

We completed the acquisition of 100% of the outstanding stock of Community on November 7, 2006 in exchange for 8,072,179 shares of our common stock valued at approximately $91.9 million. The shares were valued by using the average of the closing prices of our stock for several days prior to and after the terms of the acquisition were agreed to and announced. The total purchase price, which includes certain direct acquisition costs and cash payments due for the cancellation of stock options, was $97.2 million. As a result of the acquisition we added 18 banking locations and 15 consumer finance company locations in the State of Alabama.

 

The Community transaction resulted in $59.1 million of goodwill allocated to the Alabama reporting unit and $10.1 million of core deposit intangibles. The goodwill acquired is not tax deductible. The amount allocated to the core deposit intangible was determined by an independent valuation and is being amortized over an estimated useful life of ten years based on the undiscounted cash flow.

 

During the third quarter of 2006 management completed its plan to terminate Community’s data processing operations and convert Community’s accounts to our system. This conversion was completed in the fourth quarter of 2006. Certain costs associated with this conversion totaling approximately $1.2 million, which included primarily contract cancellations and employment-related costs, were estimated and accrued as of the acquisition date.

 

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition. We are in the process of obtaining appraisals on certain real property; thus, the allocation of the purchase price is subject to refinement:

 

 

Loans, net of unearned income.  Our loans, net of unearned income, totaled $1.640 billion at December 31, 2006, an increase of 70.2%, or $676.2 million, from $963.3 million at December 31, 2005. Of the increase, approximately $337 million can be attributed to the Community acquisition and approximately $136 million can be attributed to the Kensington acquisition. Mortgage loans held for sale totaled $24.4 million at December 31, 2006, an increase of $3.1 million from $21.3 million at December 31, 2005. Average loans, including mortgage loans held for sale, totaled $1.177 billion for 2006, compared to $947.2 million for 2005. Loans, net of unearned income, comprised 78.9% of interest-earning assets at December 31, 2006, compared to 77.2% at December 31, 2005. Mortgage loans held for sale comprised 1.2% of interest-earning assets at December 31, 2006, compared to 1.7% at December 31, 2005. The average yield of the loan portfolio was 7.87%, 6.75% and 6.28% for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in average yield is primarily the result of a general increase in market rates.

 

The following table details the distribution of our loan portfolio by category for the periods presented:

 

Distribution of Loans by Category

 

 

 

 

The repayment of loans as they mature is a source of liquidity for us. The following table sets forth our loans by category maturing within specified intervals at December 31, 2006. The information presented is based on the contractual maturities of the individual loans, including loans which may be subject to renewal at their contractual maturity. Renewal of such loans is subject to review and credit approval, as well as modification of terms upon their maturity. Consequently, management believes this treatment presents fairly the maturity and repricing of the loan portfolio.

 

Selected Loan Maturity and Interest Rate Sensitivity