10-K 1 c15488e10vk.htm FORM 10-K Form 10-K
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
(Mark One)
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
     
þ   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2010
or
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission file number: 000-49912
MOUNTAIN NATIONAL BANCSHARES, INC.
(Exact name of registrant as specified in its charter)
     
Tennessee   75-3036312
     
(State or other jurisdiction
of incorporation or organization)
  (I.R.S. Employer Identification No.)
     
300 East Main Street, Sevierville, Tennessee   37862
(Address of principal executive offices)   (Zip code)
(865) 428-7990
(Registrant’s telephone number, including area code)
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $1.00 par value
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 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 whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (of for such shorter period that the registrant was required to submit and post such files). Yes o 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 the 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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
             
Large accelerated filer o   Accelerated filer o   Non-accelerated filer o   Smaller reporting company þ
        (Do not check if a smaller reporting company)    
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $15,131,763.
There were 2,631,611 shares of Common Stock outstanding as of February 28, 2011.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement for the 2011 Annual Meeting of Shareholders (the “2011 Proxy Statement”) are incorporated by reference into Part III of this Report. Other than those portions of the 2011 Proxy Statement specifically incorporated by reference herein pursuant to Part III, no other portions of the 2011 Proxy Statement shall be deemed so incorporated.
 
 


 

MOUNTAIN NATIONAL BANCSHARES, INC.
Annual Report on Form 10-K
For the Fiscal Year Ended December 31, 2010
Table of Contents
         
Item   Page  
Number   Number  
 
Part I        
         
1. Business     1  
         
1A. Risk Factors     24  
         
2. Properties     35  
         
3. Legal Proceedings     36  
         
4. Removed and Reserved     36  
         
Part II        
         
5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities     37  
         
7. Management’s Discussion and Analysis of Financial Condition and Results of Operations     38  
         
8. Financial Statements and Supplementary Data     70  
         
9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     71  
         
9A. Controls and Procedures     71  
         
9B. Other Information     73  
         
Part III        
         
10. Directors, Executive Officers and Corporate Governance     73  
         
11. Executive Compensation     73  
         
12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters     74  
         
13. Certain Relationships and Related Transactions, and Director Independence     74  
         
14. Principal Accountant Fees and Services     74  
         
Part IV        
 
15. Exhibits, Financial Statement Schedules     74  
         
    78  
         
 Exhibit 10.3
 Exhibit 21
 Exhibit 23
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32.1
 Exhibit 32.2

 


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PART I
ITEM 1.  
BUSINESS
Forward-Looking Statements
Certain of the statements made herein under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere, are “forward-looking statements” within the meaning and subject to the protections of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
Forward-looking statements include statements with respect to our beliefs, plans, objectives, goals, expectations, anticipations, assumptions, estimates, intentions, and future performance, and involve known and unknown risks, uncertainties and other factors, which may be beyond our control, and which may cause the actual results, performance or achievements of Mountain National Bancshares, Inc. (“Mountain National” or the “Company”) to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.
All statements other than statements of historical fact are statements that could be forward-looking statements. You can identify these forward-looking statements through our use of words such as “may,” “will,” “anticipate,” “assume,” “should,” “indicate,” “seek,” “attempt,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “plan,” “point to,” “project,” “could,” “intend,” “target,” “potential” and other similar words and expressions of the future. These forward-looking statements may not be realized due to a variety of factors, including, without limitation, those set forth in Item 1A. Risk Factors below and the following factors:
   
the effects of greater than anticipated deterioration in economic and business conditions (including in the residential and commercial real estate construction and development segment of the economy) nationally and in our local market;
 
   
deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses;
 
   
increased levels of non-performing and repossessed assets;
 
   
lack of sustained growth in the economy in the Sevier County and Blount County, Tennessee area;
 
   
government monetary and fiscal policies as well as legislative and regulatory changes, including changes in banking, securities and tax laws and regulations;
 
   
the risks of changes in interest rates on the levels, composition and costs of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities;
 
   
the effects of competition from a wide variety of local, regional, national and other providers of financial, and investment services;
 
   
the failure of assumptions underlying the establishment of reserves for possible loan losses and other estimates;

 

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the risks of mergers, acquisitions and divestitures, including, without limitation, the related time and costs of implementing such transactions, integrating operations as part of these transactions and the possible failure to achieve expected gains, revenue growth and/or expense savings from such transactions;
 
   
the effects of failing to comply with our regulatory commitments;
 
   
changes in accounting policies, rules and practices;
 
   
changes in technology or products that may be more difficult, or costly, or less effective, than anticipated;
 
   
the effects of war or other conflicts, acts of terrorism or other catastrophic events that may affect general economic conditions;
 
   
results of regulatory examinations;
 
   
the remediation efforts related to the Company’s material weakness in internal control over financial reporting;
 
   
the ability to raise additional capital;
 
   
the prepayment of FDIC insurance premiums and higher FDIC assessment rates;
 
   
the effects of negative publicity;
 
   
the Company’s recording of a further allowance related to its deferred tax asset; and
 
   
other factors and information described in this report and in any of our other reports that we make with the Securities and Exchange Commission (the “Commission”) under the Exchange Act.
All written or oral forward-looking statements that are made by or are attributable to us are expressly qualified in their entirety by this cautionary notice. Except as required by the federal securities laws we do not undertake to update, revise or correct any of the forward-looking statements after the date of this report, or after the respective dates on which such statements otherwise are made.
The Company
Mountain National is a bank holding company registered with the Board of Governors of the Federal Reserve System (“Federal Reserve”) under the Bank Holding Company Act of 1956, as amended (the “BHC Act”). The Company provides a full range of banking services through its banking subsidiary, Mountain National Bank (the “Bank”).
For the purposes of the discussions in this report, the words “we,” “us,” and “our” refer to the combined entities of the Company and the Bank unless otherwise indicated or evident. The Company’s main office is located at 300 East Main Street, Sevierville, Tennessee 37862. The Company was incorporated as a business corporation in March 2002 under the laws of the State of Tennessee for the purpose of acquiring 100% of the issued and outstanding shares of common stock of the Bank. Effective July 1, 2002, the Company and the Bank entered into a reorganization pursuant to which the Company acquired 100% of the outstanding shares of the Bank and the shareholders of the Bank became the shareholders of the Company. In June 2003, the Company received approval from the Federal Reserve Bank of Atlanta to become a bank holding company.
At December 31, 2010, the assets of the Company consisted primarily of its ownership of the capital stock of the Bank.

 

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The Company is authorized to engage in any activity permitted by law to a corporation, subject to applicable federal and state regulatory restrictions on the activities of bank holding companies. The Company’s holding company structure provides it with greater flexibility than the Bank would otherwise have relative to expanding and diversifying its business activities through newly formed subsidiaries or through acquisitions. While management of the Company has no present plans to engage in any other business activities, management may from time to time study the feasibility of establishing or acquiring subsidiaries to engage in other business activities to the extent permitted by law.
The Bank
The Bank is organized as a national banking association. The Bank applied to the Office of the Comptroller of the Currency (the “OCC”), and the Federal Deposit Insurance Corporation, (the “FDIC”), on February 16, 1998, to become an insured national banking association. The Bank received approval from the OCC to organize as a national banking association on June 16, 1998 and commenced business on November 23, 1998. The Bank’s principal business is to accept demand and savings deposits from the general public and to make residential mortgage, commercial and consumer loans.
Our Banking Business
General. Our banking business consists primarily of traditional commercial banking operations, including taking deposits and originating loans. We conduct our banking activities from our main office located in Sevierville, Tennessee and through eight additional branch offices in Sevier County, Tennessee, as well as a regional headquarters and two branch offices in Blount County, Tennessee. Sevier County is adjacent to Knox County, Tennessee and the Knoxville SMSA, and Blount County is also adjacent to Knox County and part of the Knoxville SMSA. Both Sevier County and Blount County are adjacent to the Great Smokey Mountains National Park and have a significant portion of their respective communities dependent upon the tourism and resort industries. Blount County also benefits from economic growth of the Knoxville SMSA.
We offer a variety of retail banking services. We seek savings and other time and demand deposits from consumers and businesses in our primary market area by offering a full range of deposit accounts, including savings, demand deposit, retirement, including individual retirement accounts, or “IRA’s,” and professional and checking accounts, as well as certificates of deposit. We use the deposit funds we receive to originate mortgage, commercial and consumer loans, and to make other authorized investments. In addition, we currently maintain 20 full-service ATMs throughout our market area. Because the Bank is a member of a number of payment systems networks, Bank customers may also access banking services through ATMs and point of sale terminals throughout the world. In addition to traditional deposit-taking and lending services, we also provide a variety of checking accounts, savings programs, night depository services, safe deposit facilities and credit card plans.

 

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The banking industry is significantly affected by prevailing economic conditions, as well as government policies and regulations concerning, among other things, monetary and fiscal affairs, the housing industry and financial institutions. Deposits at commercial banks are influenced by economic conditions, including interest rates and competing investment instruments, levels of personal income and savings, among others. Lending activities are also influenced by a number of economic factors, including demand for and supply of housing, conditions in the construction industry, local economic and seasonal factors and availability of funds. Our primary sources of funding for lending activities include savings and demand deposits, income from investments, loan principal payments and borrowings. For additional information relating to our deposits and loans, refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Market Areas. Our primary market areas are Sevier and Blount Counties, contiguous counties located in eastern Tennessee. We intend to continue our focus on these primary market areas in the future. Additionally, even with our current market area focus, some of our business may come from other areas contiguous to our primary market area.
Lending Activities
General. We concentrate on developing a diversified loan portfolio consisting of first mortgage loans secured by residential properties, loans secured by commercial properties and other commercial and consumer loans.
Real Estate Lending. We originate permanent and construction loans having terms in the case of the permanent loans of up to 30 years that are typically secured by residential real estate comprised of single-family dwellings and multi-family dwellings of up to four units. All of our residential real estate loans consist of conventional loans that are not insured or guaranteed by government agencies. We also originate and hold in our portfolio traditional fixed-rate mortgage loans in appropriate circumstances.
Consumer Lending. We originate consumer loans that typically fall into the following categories:
   
loans secured by junior liens on real estate, including home improvement and home equity loans, which have an average maturity of about three years and generally are limited to 80% of appraised value, and home equity lines of credit;
   
loans secured by personal property, such as automobiles, recreational vehicles or boats, which typically have 36 to 60 month maturities;
   
loans to our depositors secured by their time deposit accounts or certificates of deposit;
   
unsecured personal loans and personal lines of credit; and
   
credit card loans.
Consumer loans generally entail greater risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or that are secured by rapidly depreciating assets such as automobiles. Where consumer loans are unsecured or secured by depreciating assets, the absence of collateral or the insufficiency of any repossessed collateral to serve as an adequate source of repayment of the outstanding loan balance poses greater risk of loss to us. When a deficiency exists between the outstanding balance of a defaulted loan and the value of collateral repossessed, the borrower’s financial instability and life situations that led to the default (which may include job loss, divorce, illness or personal bankruptcy, among other things) often do not warrant substantial further collection efforts. Furthermore, the application of various federal and state laws, including federal bankruptcy and state insolvency laws, may limit the amount that we can recover in the event a consumer defaults on an unsecured or undersecured loan.

 

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Construction Lending. We offer single-family residential construction loans to borrowers for construction of one-to-four family residences in our primary market area, although volume has reduced substantially. Generally, we limit our construction lending to construction-permanent loans and make these loans to individuals building their primary residences. We also originate construction loans to selected local builders for construction of single-family dwellings.
Our construction loans may have fixed or adjustable interest rates and are underwritten in accordance with the same standards that we apply to permanent mortgage loans, with the exception that our construction loans generally provide for disbursement of the loan amount in stages during a construction period of up to 12 months, during which period the borrower is required to make monthly payments of accrued interest on the outstanding loan balance. We typically require a maximum loan-to-value ratio of 80% on construction loans we originate. While our construction loans generally convert to permanent loans following construction, the construction loans we extend to builders generally require repayment in full upon the completion of construction, or, alternatively, may be assumed by the borrower.
Construction lending affords us the opportunity to earn higher interest rates and fees with shorter terms to maturity than does single-family permanent mortgage lending. Construction lending, however, is generally considered to involve a higher degree of risk than single-family permanent mortgage lending because of the inherent difficulty in estimating both a property’s value at completion of the project and the projected cost of the project. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to complete the project. If the estimate of value upon completion proves inaccurate, we may be confronted at, or prior to, the maturity of the loan with collateral of insufficient value to assure full repayment. Construction projects may also be jeopardized by downturns in the economy or demand in the area where the project is being undertaken, disagreements between borrowers and builders and by the failure of builders to pay subcontractors.
Commercial Lending. We originate secured and unsecured loans for commercial, corporate, business and agricultural purposes, and we engage in commercial real estate activities consisting of loans for hotels, motels, restaurants, retail store outlets and service providers such as insurance agencies. Currently, we concentrate our commercial lending efforts on originating loans to small businesses for purposes of providing working capital, capital improvements, and construction and leasehold improvements. These loans typically have one-year maturities, if they are unsecured loans, or, in the case of small business loans secured by real estate, have an average maturity of five years. We also participate in the Small Business Administration’s guaranteed commercial loan program.

 

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Commercial lending, while generally considered to involve a higher degree of credit risk than long-term financing of residential properties, generally provides higher yields and greater interest rate sensitivity than do residential mortgage loans. Commercial loans are generally adjustable rate loans or loans that have short-term maturities of one to three years. The higher risks inherent in commercial lending include risks specific to the business venture, delays in leasing the collateral and excessive collateral dependency, vacancy, delays in obtaining or inability to obtain permanent financing and difficulties we may experience in exerting influence over or acquiring the collateral following a borrower’s default. Moreover, commercial loans often carry larger loan balances to single borrowers or groups of related borrowers than do residential real estate loans. With respect to commercial real estate lending, the borrower’s ability to make principal and interest payments on loans secured by income-producing properties is typically dependent on the successful operation of the related real estate project and thus may be subject to a greater extent to adverse conditions in the real estate market or in the economy generally. We attempt to mitigate the risks inherent in commercial lending by, among other things, securing our loans with adequate collateral and extending commercial loans only to persons located in our primary market area.
Creditworthiness and Collateral. We require each prospective borrower to complete a detailed loan application which we use to evaluate the applicant’s creditworthiness. All loan applications are reviewed and approved or disapproved in accordance with guidelines established by the Bank’s Board of Directors. We also require that loan collateral be appraised by an in house evaluation or by independent appraisers approved by the Bank’s Board of Directors and require borrowers to maintain fire and casualty insurance on collateral in accordance with guidelines established by the Bank’s Board of Directors. Title insurance is required for most real property collateral.
Loan Originations. We originate loans primarily for our own portfolio but, subject to market conditions, we may sell certain loans we originate in the secondary market. Initially, most of our loans are originated based on referrals and to walk-in customers. We also use various methods of local advertising to stimulate originations.
Secondary Market Activities. We engage in secondary mortgage market activities, principally the sale of certain residential mortgage loans on a servicing-released basis, subject to market conditions. Secondary mortgage market activities permit us to generate fee income and sale income to supplement our principal source of income — net interest income resulting from the interest margin between the yield on interest-earning assets like loans and investment securities and the interest paid on interest-bearing liabilities such as savings deposits, time deposit certificates and funds borrowed by the Bank.
From time to time we originate a limited number of permanent, conventional residential mortgage loans that we sell on a servicing-released basis to private institutional investors such as savings institutions, banks, life insurance companies and pension funds. We originate these loans on terms and conditions similar to those required for sale to the Federal Home Loan Mortgage Corporation (“FHLMC”), and the Federal National Mortgage Association (“FNMA”), except that we occasionally offer these loans with higher dollar limits than are permissible for FHLMC or FNMA-eligible loans.
The loan-to-value ratios we require for the residential mortgage loans we originate are determined based on guidelines established by the Bank’s Board of Directors pursuant to applicable law.

 

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Income from Lending Activities. Our lending activities generate interest and loan origination fee income. Loan origination fees are calculated as a percentage of the principal amount of the mortgage loans we originate and are charged to the borrower by the Bank for originating the loan. We also receive loan fees and charges related to existing loans, which include late charges and assumption fees.
Loan Delinquencies and Defaults. When a borrower fails to make a required loan payment for 30 days, we classify the loan as delinquent. If the delinquency exceeds 90 days and is not cured through the Bank’s normal collection procedures, we institute more formal recovery efforts. If a foreclosure action is initiated and the loan is not reinstated, paid in full or refinanced, the property is sold at a judicial or trustee sale at which, in some instances, the Bank acquires the property. Thereafter, such acquired property is recorded in the Bank’s records as “other real estate owned” (“OREO”) until the property is sold. In some cases, we may finance sales of OREO, which may involve our origination of “loans to facilitate” that typically involve a lower down payment or a longer term.
Investment Activities
Our investment securities portfolio is an integral part of our total assets and liabilities management strategy. We use our investments, in part, to further our interest rate risk management objective of reducing our sensitivity to interest-rate fluctuations. Our primary objective in making investment determinations with respect to our securities portfolio is to achieve a high degree of maturity and rate matching between these assets and our interest-bearing liabilities. In order to achieve this goal, we concentrate our investments, which constituted approximately 16% of our total assets at December 31, 2010, in U.S. government securities or other securities of similar low risk. The U.S. government and other investment-grade securities in which we invest typically have maturities ranging from 30 days to 30 years.
Sources of Funds
General. Deposits are the primary source of funds we use to support our lending activities and other general business activities. Other sources of funds include loan repayments, loan sales and borrowings. Although deposit activity is significantly influenced by fluctuations in interest rates and general market conditions, loan repayments are a relatively stable source of funds. We also use short-term borrowings to compensate in periods where our normal funding sources are insufficient to satisfy our funding needs. We use long-term borrowings to support extended activities and to extend the term of our liabilities.
Deposits. We offer a variety of programs designed to attract both short-term and long-term deposits from the general public in our market areas. These programs include savings accounts, NOW accounts, demand deposit accounts, money market deposit accounts, fixed-rate and variable-rate certificate of deposit accounts of varying maturities, retirement accounts and certain other accounts. We particularly focus on promoting long-term deposits, such as IRA accounts and certificates of deposit. Additionally, we historically have used brokered deposits that are comparable to our traditional certificates of deposit; however, management has recently sought to reduce its reliance on this source of wholesale funding because of its volatility.

 

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Borrowings. The Bank became a member of the Federal Home Loan Bank of Cincinnati (the “FHLB of Cincinnati”) in December 2001. The FHLB of Cincinnati functions as a central reserve bank that provides credit for member institutions. As a member, the Bank is required to own capital stock in the FHLB of Cincinnati. Membership in the FHLB of Cincinnati entitles the Bank, provided certain standards related to creditworthiness have been met, to apply for advances on the security of the FHLB of Cincinnati stock it holds as well as on the security of certain of its residential mortgage loans, commercial loans and other assets (principally, its investment securities that are obligations of, or guaranteed by, the United States). The FHLB of Cincinnati makes advances to the Bank pursuant to several different credit programs. Each credit program has its own interest rate and range of maturities. Interest rates on FHLB of Cincinnati advances are generally variable and adjust to reflect actual conditions existing in the credit markets. The uses for which we may employ funds received pursuant to FHLB of Cincinnati advances are prescribed by the various lending programs, which also prescribe borrowing limitations. Acceptable uses prescribed by the FHLB of Cincinnati have included expansion of residential mortgage lending and funding short-term liquidity needs. Depending on the particular credit program under which we borrow, borrowing limitations are generally based on the FHLB of Cincinnati’s assessment of our creditworthiness. The FHLB of Cincinnati is required to review the credit limitations and standards to which we are subject at least once every six months.
Financing. In August of 1998, the Bank completed an offering of common stock which yielded proceeds of $12,000,000. On November 7, 2003, the Company completed the sale, through its wholly owned statutory trust subsidiary, MNB Capital Trust I, of $5,500,000 of trust preferred securities, which we refer to as “Capital Securities I,” which mature on December 31, 2033, and have a liquidation amount of $50,000 per Capital Security. Interest on the Capital Securities I is to be paid quarterly on the last day of each March, June, September and December and is reset quarterly based on the three-month LIBOR plus 305 basis points. The Company used the net proceeds from the offering of Capital Securities I to pay off an outstanding line of credit.
On June 20, 2006, the Company completed the sale, through its wholly owned statutory trust subsidiary, MNB Capital Trust II, of $7,500,000 of trust preferred securities, which we refer to as “Capital Securities II,” which mature on July 7, 2036, and have a liquidation amount of $1,000 per Capital Security. Interest on the Capital Securities II is to be paid quarterly on the seventh day of each January, April, July and October and is reset quarterly based on the three-month LIBOR plus 160 basis points. The Company used the net proceeds from the offering of Capital Securities II to increase regulatory capital for the Company and for operating funds for the Bank.
On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.

 

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Competition
We face significant competition in our primary market areas from a number of sources, including eight commercial banks and one savings institution in Sevier County and twelve commercial banks and one savings institution in Blount County. As of June 30, 2010, there were 57 commercial bank branches and three savings institutions branches located in Sevier County and 48 commercial bank branches and one savings institution branch located in Blount County.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 and other federal and state laws have resulted in increased competition from both conventional banking institutions and other businesses offering financial services and products. Mortgage banking firms, finance companies, real estate investment trusts, insurance companies, leasing companies and certain government agencies provide additional competition for loans and for certain financial services. We also compete for deposit accounts with a number of other financial intermediaries, including securities brokerage firms, money market mutual funds, government and corporate securities and credit unions. The primary criteria on which institutions compete for deposits and loans are interest rates, loan origination fees and range of services offered.
During our operating history, we have been successful in hiring a staff with significant local bank experience that shares our commitment to providing our customers with the highest levels of customer service. While focusing on customer service, we are also able to offer our customers most of the banking services offered by our local competitors, including Internet banking, investment services and sweep accounts.
Employees
We currently employ a total of 151 employees, including 150 full time employees. We are not a party to any collective bargaining agreements with our employees, and we consider relations with our employees to be good.
Seasonality
Due to the predominance of the tourism industry in Sevier County, a significant portion of our commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks and financial institutions in other market areas. Deposit growth generally slows during the first quarter each year and then increases during each of the last three quarters. The tourism industry in Sevier County has remained relatively stable during the past couple of years, particularly with respect to overnight rentals and hospitality services, and management does not anticipate any significant changes in that trend in the future.

 

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Supervision and Regulation
Supervision and Regulation
Bank holding companies and banks are extensively regulated under federal and state law. These laws and regulations are generally intended to protect depositors and borrowers, not shareholders. In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law, incorporating numerous financial institution regulatory reforms. Many of these reforms will be implemented over the course of 2011 through regulations to be adopted by various federal banking and securities regulations. This new law will significantly change the current bank regulatory structure and affect the lending, deposit, investment, trading and operating activities of financial institutions and their holding companies, including the Company and the Bank. A broad range of new rules and regulations by various federal agencies must be adopted and, consequently, many details and much of the impact of this act may not be known for many months or years.
This discussion is qualified in its entirety by reference to the particular statutory and regulatory provisions referred to below and is not intended to be a complete description of the statutes or regulations applicable to the Company’s and the Bank’s business. Supervision, regulation, and examination of the Company and the Bank and their respective subsidiaries by the bank regulatory agencies are intended primarily for the protection of bank depositors rather than holders of Company capital stock. Any change in applicable law or regulation may have a material effect on the Company’s business.
Bank Holding Company Regulation
The Company, as a bank holding company, is subject to supervision and regulation by the Board of Governors of the Federal Reserve under the BHC Act. Bank holding companies are generally limited to the business of banking, managing or controlling banks, and other activities that the Federal Reserve determines to be so closely related to banking, or managing or controlling banks, as to be a proper incident thereto. The Company is required to file with the Federal Reserve periodic reports and such other information as the Federal Reserve may request. The Federal Reserve examines the Company and may examine non-bank subsidiaries the Company may acquire.
The BHC Act requires prior Federal Reserve approval for, among other things, the acquisition by a bank holding company of direct or indirect ownership or control of more than 5% of the voting shares or substantially all the assets of any bank, or for a merger or consolidation of a bank holding company with another bank holding company. With certain exceptions, the BHC Act prohibits a bank holding company from acquiring direct or indirect ownership or control of voting shares of any company which is not a bank or bank holding company, and from engaging directly or indirectly in any activity other than banking or managing or controlling banks or performing services for its authorized subsidiaries. A bank holding company, may, however, engage in or acquire an interest in a company that engages in activities which the Federal Reserve has determined by regulation or order to be so closely related to banking or managing or controlling banks as to be a proper incident thereto.

 

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The Gramm-Leach-Bliley Act of 1999 (the “GLB Act”) substantially revised the statutory restrictions separating banking activities from certain other financial activities. Under the GLB Act, bank holding companies that are “well-capitalized” and “well-managed”, as defined in Federal Reserve Regulation Y, which have and maintain “satisfactory” Community Reinvestment Act (“CRA”) ratings, and meet certain other conditions, can elect to become “financial holding companies.” Financial holding companies and their subsidiaries are permitted to acquire or engage in previously impermissible activities such as insurance underwriting, securities underwriting, travel agency activities, broad insurance agency activities, merchant banking, and other activities that the Federal Reserve determines to be financial in nature or complementary thereto. In addition, under the merchant banking authority added by the GLB Act and Federal Reserve regulation, financial holding companies are authorized to invest in companies that engage in activities that are not financial in nature, as long as the financial holding company makes its investment with the intention of limiting the term of its investment and does not manage the company on a day-to-day basis, and the invested company does not cross-market with any of the financial holding company’s controlled depository institutions. Financial holding companies continue to be subject to the overall oversight and supervision of the Federal Reserve, but the GLB Act applies the concept of functional regulation to the activities conducted by subsidiaries. For example, insurance activities would be subject to supervision and regulation by state insurance authorities. While the Company has no present plans to become a financial holding company, it may elect to do so in the future in order to exercise the broader activity powers provided by the GLB Act. The GLB Act also includes consumer privacy provisions, and the federal bank regulatory agencies have adopted extensive privacy rules implementing the GLB Act.
The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company. The Company and the Bank are subject to Section 23A of the Federal Reserve Act and Federal Reserve Regulation W thereunder. Section 23A defines “covered transactions,” which include extensions of credit, and limits a bank’s covered transactions with any affiliate to 10% of such bank’s capital and surplus. All covered and exempt transactions between a bank and its affiliates must be on terms and conditions consistent with safe and sound banking practices, and banks and their subsidiaries are prohibited from purchasing low-quality assets from the bank’s affiliates. Finally, Section 23A requires that all of a bank’s extensions of credit to its affiliates be appropriately secured by acceptable collateral, generally United States government or agency securities. The Company and the Bank also are subject to Section 23B of the Federal Reserve Act, which generally limits covered and other transactions among affiliates to be on terms, including credit standards, that are substantially the same or at least as favorable to the bank or its subsidiary as those prevailing at the time for similar transactions with unaffiliated companies.
The Dodd-Frank Act expands the affiliate transaction rules of the federal law to broaden the definition of affiliate and to apply such rules to securities lending, repurchase agreements, and derivative activities that the Bank may have with an affiliate, as well as to strengthen collateral requirements and limit FRB exemptive authority. The definition of “extension of credit” for transactions with executive officers, directors, and principal shareholders is also being expanded to include credit exposure arising from a derivative transaction, a repurchase or reverse repurchase agreement, and securities lending or borrowing transactions.

 

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The BHC Act, as amended by the Dodd-Frank Act, permits acquisitions of banks by bank holding companies, such that, if well-capitalized and well managed, Mountain National and any other bank holding company located in Tennessee may acquire a bank located in any other state, and, if well-capitalized and well managed, any bank holding company located outside Tennessee may lawfully acquire any bank based in another state, subject to certain deposit-percentage, age of bank charter requirements, and other restrictions. Federal law also permits national and state-chartered banks to branch interstate through acquisitions of banks in other states. Under Tennessee law, in order for an out-of-state bank or bank holding company to establish a branch in Tennessee, the bank or bank holding company must purchase an existing bank, bank holding company, or branch of a bank in Tennessee which has been in existence for at least three years. De novo interstate branching is permitted under Tennessee law on a reciprocal basis. The Bank is eligible to be acquired by any bank or bank holding company, whether inter-or intrastate, since it has been in existence for more than three years.
Under the Dodd-Frank Act and previously under Federal Reserve policy a bank holding company is required to act as a source of financial strength and to take measures to preserve and protect bank subsidiaries in situations where additional investments in a troubled bank may not otherwise be warranted. In addition, under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), where a bank holding company has more than one bank or thrift subsidiary, each of the bank holding company’s subsidiary depository institutions are responsible for any losses to the FDIC as a result of an affiliated depository institution’s failure. As a result, a bank holding company may be required to loan money to its subsidiaries in the form of capital notes or other instruments that qualify as capital under regulatory rules. However, any loans from the holding company to such subsidiary banks likely will be unsecured and subordinated to such bank’s depositors and perhaps to other creditors of the bank.
Bank Regulation
The Bank is subject to supervision, regulation, and examination by the OCC which monitors all areas of the operations of the Bank, including reserves, loans, mortgages, issuances of securities, payment of dividends, establishment of branches, capital adequacy, and compliance with laws. The Bank is a member of the FDIC and, as such, its deposits are insured by the FDIC to the maximum extent provided by law. See “FDIC Insurance Assessments”.
While the OCC has authority to approve branch applications, national banks are required by the National Bank Act to adhere to branching laws applicable to state chartered banks in the states in which they are located. With prior regulatory approval, Tennessee law permits banks based in the state to either establish new or acquire existing branch offices throughout Tennessee and in other states on a reciprocal basis. Mountain National and any other national or state-chartered bank generally may branch across state lines by merging with banks in other states if allowed by the applicable states’ laws. Tennessee law, with limited exceptions, currently permits branching across state lines either through interstate merger or branch acquisition. Tennessee, however, only permits an out-of-state bank, short of an interstate merger, to branch into Tennessee through branch acquisition if the home state of the out-of-state bank permits Tennessee-based banks to acquire branches there.

 

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The OCC has adopted a series of revisions to its regulations, including expanding the powers exercisable by operating subsidiaries of the Bank. These changes also modernize and streamline corporate governance, investment and fiduciary powers. The OCC also has the ability to preempt state laws purporting to regulate the activities of national banks.
The OCC has adopted the Federal Financial Institutions Examination Council’s (“FFIEC”) rating system and assigns each financial institution a confidential composite rating based on an evaluation and rating of six essential components of an institution’s financial condition and operations including Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity to market risk, as well as the quality of risk management practices. For most institutions, the FFIEC has indicated that market risk primarily reflects exposures to changes in interest rates. When regulators evaluate this component, consideration is expected to be given to: (i) management’s ability to identify, measure, monitor, and control market risk; (ii) the institution’s size; (iii) the nature and complexity of its activities and its risk profile; and (iv) the adequacy of its capital and earnings in relation to its level of market risk exposure. Market risk is rated based upon, but not limited to, an assessment of the sensitivity of the financial institution’s earnings or the economic value of its capital to adverse changes in interest rates, foreign exchange rates, commodity prices, or equity prices; management’s ability to identify, measure, monitor, and control exposure to market risk; and the nature and complexity of interest rate risk exposure arising from nontrading positions.
As a result of a regulatory examination conducted during the first quarter of 2009, the Bank has entered into a formal written agreement in which it made certain commitments to the OCC, including commitments to, among other things, implement a written program to reduce the high level of credit risk in the Bank including strengthening credit underwriting and problem loan workouts and collections, reduce its level of criticized assets, implement a concentration risk management program related to commercial real estate lending, improve procedures related to the maintenance of the Bank’s allowance for loan and lease losses (“ALLL”), strengthen the Bank’s internal loan review program, strengthen the Bank’s loan workout department, and develop a liquidity plan that improves the Bank’s reliance on wholesale funding sources. The Company has taken action to comply with these requirements and does not believe compliance with these commitments will have a materially adverse impact on its operations.
In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. The OCC imposed this requirement to maintain capital at higher levels than those required by applicable federal regulations because the OCC believed that the Bank’s capital levels were less than satisfactory given the level of credit risk in the Bank, specifically the high level of nonperforming assets and provision for loan losses. As noted below under “Capital,” the Bank had 8.41% of Tier 1 capital to average assets and 13.23% of total capital to risk-weighted assets ratio at December 31, 2010 and thus failed to satisfy its minimum Tier 1 capital to average assets ratio. Failure to satisfy such requirement could result in further enforcement action by the OCC.

 

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In the fourth quarter of 2010, the OCC informed the Bank that, because the OCC does not believe that the Bank has fully satisfied the requirements of the formal written agreement, it will be requested to replace the formal written agreement with a consent order (the “Consent Order”) containing commitments for further improvements in the Bank’s operations. While the requirements of the Consent Order are not currently known to the Bank, the OCC has informed the Bank’s management that the Consent Order will likely contain provisions similar to those currently contained in the existing minimum capital commitment that the Bank made to the OCC in connection with the Bank’s entering into the formal written agreement, requiring the Bank to maintain a minimum Tier 1 leverage capital ratio of 9% and a minimum total risk-based capital ratio of 13%. If the Bank fails to comply with the requirements of the Consent Order, the OCC may impose additional limitations, restraints, commitments or conditions on the Bank.
The GLB Act requires banks and their affiliated companies to adopt and disclose privacy policies regarding the sharing of personal information they obtain from their customers with third parties. The GLB Act also permits bank subsidiaries to engage in “financial activities” through subsidiaries similar to those permitted to financial holding companies. See the discussion regarding the GLB Act in “Bank Holding Company Regulation” above.
Community Reinvestment Act
The Company and the Bank are subject to the CRA and the federal banking agencies’ regulations. Under the CRA, all banks and thrifts have a continuing and affirmative obligation, consistent with their safe and sound operation to help meet the credit needs for their entire communities, including low and moderate income neighborhoods. The CRA requires a depository institution’s primary federal regulator, in connection with its examination of the institution, to assess the institution’s record of assessing and meeting the credit needs of the communities served by that institution, including low- and moderate-income neighborhoods. The regulatory agency’s assessment of the institution’s record is made available to the public. Further, such assessment is required of any institution which has applied to: (i) charter a national bank; (ii) obtain deposit insurance coverage for a newly-chartered institution; (iii) establish a new branch office that accepts deposits; (iv) relocate an office; (v) merge or consolidate with, or acquire the assets or assume the liabilities of, a federally regulated financial institution, or (vi) expand other activities, including engaging in financial services activities authorized by the GLB Act. A less than satisfactory CRA rating will slow, if not preclude, expansion of banking activities and prevent a company from becoming a financial holding company. The Bank has a satisfactory CRA rating.
The GLB Act and federal bank regulations have made various changes to the CRA. Among other changes, CRA agreements with private parties must be disclosed and annual CRA reports must be made to a bank’s primary federal regulator. A bank holding company will not be permitted to become or remain a financial holding company and no new activities authorized under the GLB Act may be commenced by a holding company or by a bank financial subsidiary if any of its bank subsidiaries received less than a “satisfactory” CRA rating in its latest CRA examination. Under current OCC regulations, the Bank has intermediate small bank status. The requirements for an intermediate small bank to meet its CRA objectives are more stringent than those for a small bank, but less so than those for large banks.
The Dodd-Frank Act also creates a new Bureau of Consumer Financial Protection (the “CFPB”) that will take over responsibility for the federal consumer financial protection laws. The CFPB will be an independent bureau within the FRB and will have broad rule-making, supervisory and examination authority to set and enforce rules in the consumer protection area over financial institutions that have assets of $10.0 billion or more. The Dodd-Frank Act also gives the CFPB expanded data collecting powers for fair lending purposes for both small business and mortgage loans, as well as expanded authority to prevent unfair, deceptive and abusive practices. The consumer complaint function will also be consolidated into the CFPB.

 

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Several major regulatory and legislative initiatives recently adopted and revised by the Dodd-Frank Act, will have significant future impacts on our business and financial results. Amendments to Regulation E, which implement the Electronic Fund Transfer Act (the “EFTA”), involve changes to the way banks may charge overdraft fees by limiting our ability to charge an overdraft fee for ATM and one-time debit card transactions that overdraw a consumer’s account, unless the consumer affirmatively consents to payment of overdrafts for those transactions. Additional amendments to the EFTA include the “Durbin Act,” which mandates limiting debit card interchange fees that banks may charge merchants.
The Bank is also subject to, among other things, the provisions of the Equal Credit Opportunity Act (the “ECOA”) and the Fair Housing Act (the “FHA”), both of which prohibit discrimination based on race or color, religion, national origin, sex, and familial status in any aspect of a consumer or commercial credit or residential real estate transaction. In 1994, the Department of Housing and Urban Development, the Department of Justice (the “DOJ”), and the federal banking agencies issued an Interagency Policy Statement on Discrimination in Lending in order to provide guidance to financial institutions in determining whether discrimination exists, how the agencies will respond to lending discrimination, and what steps lenders might take to prevent discriminatory lending practices. The DOJ has also increased its efforts to prosecute what it regards as violations of the ECOA and FHA.
Sarbanes-Oxley Act
We are required to comply with various corporate governance and financial reporting requirements under the Sarbanes-Oxley Act of 2002, as well as rules and regulations adopted by the SEC and the Public Company Accounting Oversight Board thereunder. In particular, we are required to include management reports on internal controls as part of our annual report for the year ended December 31, 2010, pursuant to Section 404 of the Sarbanes-Oxley Act. We have spent significant amounts of time and money on compliance with these rules and anticipate a similar burden going forward. We completed our assessment of our internal controls in a timely manner and management’s report on internal controls is included in Item 9A of this report. Our failure to comply with these internal control rules may materially adversely affect our reputation, our ability to obtain the necessary certifications to our financial statements, and the values of our securities.
Payments of Dividends
The Company is a legal entity separate and distinct from the Bank. The prior approval of the OCC is required if the total of all dividends declared by a national bank (such as the Bank) in any calendar year will exceed the sum of such bank’s net profits for the year and its retained net profits for the preceding two calendar years, less any required transfers to surplus. Federal law also prohibits any national bank from paying dividends that would be greater than such bank’s undivided profits after deducting statutory bad debts in excess of such bank’s allowance for possible loan losses.

 

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In addition, the Company and the Bank are subject to various general regulatory policies and requirements relating to the payment of dividends, including requirements to maintain adequate capital above regulatory minimums. The appropriate federal regulatory authority is authorized to determine under certain circumstances relating to the financial condition of a national or state member bank or a bank holding company that the payment of dividends would be an unsafe or unsound practice and to prohibit payment thereof. The OCC and the Federal Reserve have indicated that paying dividends that deplete a national or state member bank’s capital base to an inadequate level would be an unsound and unsafe banking practice. The OCC and the Federal Reserve have each indicated that depository institutions and their holding companies should generally pay dividends only out of current operating earnings.
Given the losses experienced by the Bank during 2009 and 2010, the Bank may not, without the prior approval of the OCC, pay any dividends to the Company until such time that current year profits exceed the net losses and dividends of the prior two years. Generally, federal regulatory policy discourages payment of holding company or bank dividends if the holding company or its subsidiaries are experiencing losses. Accordingly, until such time as it may receive dividends from the Bank, the Company must service its interest payment on its subordinated indebtedness from its available cash balances, if any.
On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.
Supervisory guidance from the Federal Reserve Board indicates that bank holding companies that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries. The Company has informally committed to the Federal Reserve Board that it will not (1) declare or pay dividends on the Company’s common or preferred stock, or (2) incur any additional indebtedness without in each case, the prior written approval of the Federal Reserve Board.
Capital
The Federal Reserve and the OCC have risk-based capital guidelines for bank holding companies and national banks, respectively. These guidelines require a minimum ratio of capital to risk-weighted assets (including certain off-balance-sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must consist of common equity, retained earnings, noncumulative perpetual preferred stock and a limited amount of cumulative perpetual preferred stock, less goodwill and other specified intangible assets (“Tier 1 capital”). Additionally, qualified trust preferred securities, for certain eligible companies, and other restricted capital elements such as minority interests in the equity accounts of consolidated subsidiaries are permitted to be included as Tier 1 capital up to 25% of core capital, net of goodwill and intangibles. Following passage of the Dodd-Frank Act, trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to

 

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count as Tier 1 capital. Accordingly, the Company expects that it will continue to treat its $13 million of trust preferred securities as Tier 1 capital subject to the limits listed above. Voting common equity must be the predominant form of capital. The remainder may consist of non-qualifying preferred stock, qualifying subordinated, perpetual, and/or mandatory convertible debt, up to 45% of pretax unrealized holding gains on available for sale equity securities with readily determinable market values that are prudently valued, and a limited amount of any loan loss allowance (“Tier 2 capital” and, together with Tier 1 capital, “Total Capital”).
In addition, the Federal Reserve and the OCC have established minimum leverage ratio guidelines for bank holding companies and national banks, which provide for a minimum leverage ratio of Tier 1 capital to adjusted average quarterly assets (“leverage ratio”) equal to 3%, plus an additional cushion of 1.0% to 2.0%, if the institution has less than the highest regulatory rating. The guidelines also provide that institutions experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels without significant reliance on intangible assets. Higher capital may be required in individual cases depending upon a bank holding company’s risk profile. All bank holding companies and banks are expected to hold capital commensurate with the level and nature of their risks, including the volume and severity of their problem loans. Lastly, the Federal Reserve’s guidelines indicate that the Federal Reserve will continue to consider a “tangible Tier 1 leverage ratio” (deducting all intangibles) in evaluating proposals for expansion or new activity.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), among other things, requires the federal banking agencies to take “prompt corrective action” regarding depository institutions that do not meet minimum capital requirements. FDICIA establishes five capital tiers: “well capitalized”, “adequately capitalized”, “undercapitalized”, “significantly undercapitalized”, and “critically undercapitalized”. A depository institution’s capital tier will depend upon how its capital levels compare to various relevant capital measures and certain other factors, as established by regulation.
All of the federal banking agencies have adopted regulations establishing relevant capital measures and relevant capital levels. The relevant capital measures are the Total Capital ratio, Tier 1 capital ratio, and the leverage ratio. Under the regulations, a national bank will be (i) well capitalized if it has a Total Capital ratio of 10% or greater, a Tier 1 capital ratio of 6% or greater, and a leverage ratio of at least 5%, and is not subject to any written agreement, order, capital directive, or prompt corrective action directive by a federal bank regulatory agency to meet and maintain a specific capital level for any capital measure, (ii) adequately capitalized if it has a Total Capital ratio of 8% or greater, a Tier 1 capital ratio of 4% or greater, and a leverage ratio of 4% or greater (3% in certain circumstances), (iii) undercapitalized if it has a Total Capital ratio of less than 8%, or a Tier 1 capital ratio of less than 4% (3% in certain circumstances), (iv) significantly undercapitalized if it has a total capital ratio of less than 6% or a Tier I capital ratio of less than 3%, or a leverage ratio of less than 3%, or (v) critically undercapitalized if its tangible equity is equal to or less than 2% of average quarterly tangible assets.

 

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In December 2009, the Basel Committee on Banking Supervision (the “BCBS”) released a comprehensive list of proposals for changes to capital, leverage and liquidity requirements for banks (commonly referred to as “Basel III”). On December 15, 2010, the BCBS released its final framework for strengthening international capital and liquidity regulation. When fully phased in on January 1, 2019, Basel III requires banks to maintain the following new standards and introduces a new capital measure “Common Equity Tier 1”, or “CET1”. Basel III increases the CET1 to risk-weighted assets to 4.5%, and introduces a capital conservation buffer of an additional 2.5% of common equity to risk-weighted assets, raising the target CET1 to risk-weighted assets ratio to 7%. It requires banks to maintain a minimum ratio of Tier 1 capital to risk weighted assets of at least 6.0%, plus the capital conservation buffer effectively resulting in Tier 1 capital ratio of 8.5%. Basel III increases the minimum total capital ratio to 8.0% plus the capital conservation buffer, increasing the minimum total capital ratio to 10.5%. Basel III also introduces a non-risk adjusted tier 1 leverage ratio of 3%, based on a measure of total exposure rather than total assets, and new liquidity standards. The Basel III capital and liquidity standards will be phased in over a multi-year period, but the implementation of the new framework will commence January 1, 2013. On that date, banks will be required to meet the following minimum capital ratios: 3.5% CET1 to risk-weighted assets, 4.5% Tier 1 capital to risk-weighted assets and 8.0% total capital to risk-weighted assets. Although the Basel III framework is not directly binding on the U.S. bank regulatory agencies, the regulatory agencies will likely implement changes to the capital adequacy standards applicable to the insured depository institutions and their holding companies in light of Basel III.
Failure to meet statutorily mandated capital guidelines or more restrictive ratios separately established for a financial institution could subject a bank or bank holding company to a variety of enforcement remedies, including issuance of a capital directive, the termination of deposit insurance by the FDIC, a prohibition on accepting or renewing brokered deposits, limitations on the rates of interest that the institution may pay on its deposits and other restrictions on its business. As described above, significant additional restrictions can be imposed on FDIC-insured depository institutions that fail to meet applicable capital requirements.
During the first quarter of 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%.
As of December 31, 2010, the consolidated capital ratios of the Company and Bank were as follows:
                               
    Regulatory Minimum to     Regulatory Minimum              
    be Adequately Capitalized     to be Well Capitalized     Company     Bank  
Tier 1 capital ratio
  4.0 %     6.0 %     11.87 %     11.97 %
Total capital ratio
  8.0 %     10.0 %     13.27 %     13.23 %
Leverage ratio
  3.0-5.0 %     5.0 %     8.34 %     8.41 %
FDICIA
FDICIA directs that each federal banking regulatory agency prescribe standards for depository institutions and depository institution holding companies relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth compensation, a maximum ratio of classified assets to capital, minimum earnings sufficient to absorb losses, a minimum ratio of market value to book value for publicly traded shares, and such other standards as the federal regulatory agencies deem appropriate.

 

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FDICIA generally prohibits a depository institution from making any capital distribution (including payment of a dividend) or paying any management fee to its holding company if the depository institution would thereafter be undercapitalized. Undercapitalized depository institutions are subject to growth limitations and are required to submit a capital restoration plan for approval. For a capital restoration plan to be acceptable, the depository institution’s parent holding company must guarantee that the institution will comply with such capital restoration plan. The aggregate liability of the parent holding company is limited to the lesser of 5% of the depository institution’s total assets at the time it became undercapitalized and the amount necessary to bring the institution into compliance with applicable capital standards.
FDICIA also contains a variety of other provisions that may affect the operations of the Company and the Bank, including reporting requirements, regulatory standards for real estate lending, “truth in savings” provisions, the requirement that a depository institution give 90 days’ prior notice to customers and regulatory authorities before closing any branch, and a prohibition on the acceptance or renewal of brokered deposits by depository institutions that are not well capitalized or are adequately capitalized and have not received a waiver from the FDIC. The Company and the Bank are considered “well capitalized.” Although brokered deposits are not currently restricted, we believe that our board of directors will be asked to execute a stipulation and consent to the issuance of a consent order by the OCC during the second or third quarter of 2011, pursuant to which the Bank may be required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits. See “Item 1A-Risk Factors” and “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a more detailed discussion. In addition, the Bank generally will not be able to offer interest rates on deposits more than 75 basis points above the FDIC determined “national rate.”
Enforcement Policies and Actions
The Federal Reserve and the OCC monitor compliance with laws and regulations. Violations of laws and regulations, or other unsafe and unsound practices, may result in these agencies imposing fines or penalties, cease and desist orders, or taking other enforcement actions. Under certain circumstances, these agencies may enforce these remedies directly against officers, directors, employees and others participating in the affairs of a bank or bank holding company.
Fiscal and Monetary Policy
Banking is a business that depends on interest rate differentials. In general, the difference between the interest paid by a bank on its deposits and its other borrowings, and the interest received by a bank on its loans and securities holdings, constitutes the major portion of a bank’s earnings. Thus, the earnings and growth of Mountain National and the Bank are subject to the influence of economic conditions generally, both domestic and foreign, and also to the monetary and fiscal policies of the United States and its agencies, particularly the Federal Reserve. The Federal Reserve regulates the supply of money through various means, including open market dealings in United States government securities, the discount rate at which banks may borrow from the Federal Reserve, and the reserve requirements on deposits. The nature and timing of any changes in such policies and their effect on Mountain National and its subsidiary cannot be predicted. During 2008, the Federal Reserve reduced the target federal funds rate seven times for a total of 4.00 — 4.25%. The year-end target federal funds rate was expressed as a range from 0.00 - 0.25%. During 2008, the Federal Reserve also reduced the discount rate eight times for a total of 4.25%. The Federal Reserve increased the discount rate 0.25% during the first quarter of 2010. The target federal funds rate in effect at December 31, 2008 was unchanged throughout 2009 and 2010.

 

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FDIC Insurance Assessments
The Deposit Insurance Fund (“DIF”) of the FDIC insures deposit accounts in the Bank up to a maximum amount per separately insured depositor. Under the Dodd-Frank Act, the maximum amount of federal deposit insurance coverage has been permanently increased from $100,000 to $250,000 per depositor, per institution. On November 9, 2010, the FDIC issued a final rule to implement a provision of the Dodd-Frank Act that provides temporary unlimited deposit insurance coverage for noninterest-bearing transaction accounts at all FDIC-insured depository institutions. Institutions cannot opt out of this coverage, nor will the FDIC charge a separate assessment for the insurance. On December 29, 2010, President Obama signed into law an amendment to the Federal Deposit Insurance Act to include Interest on Lawyers Trust Accounts (“IOLTA”) within the definition of noninterest-bearing transaction accounts. This amendment will provide IOLTAs with the same temporary, unlimited insurance coverage afforded to noninterest-bearing transaction accounts under the Dodd-Frank Act. This unlimited coverage for noninterest-bearing transaction accounts became effective on December 31, 2010 and terminates on December 31, 2012.
The FDIC did not extend its Transaction Account Guarantee Program beyond its sunset date of December 31, 2010, which provided a full guarantee of certain Negotiable Order of Withdrawal accounts (“NOW accounts”). The FDIC insures NOW accounts up to the standard maximum deposit insurance amount as noted above.
FDIC-insured depository institutions are required to pay deposit insurance premiums based on the risk an institution poses to the DIF. In order to restore reserves and ensure that the DIF will be able to adequately cover losses from future bank failures, the FDIC approved new deposit insurance rules in November 2009. These new rules required insured depository institutions to prepay their estimated quarterly risk-based assessments for all of 2010, 2011, and 2012. On December 30, 2009, the Bank prepaid its assessment in the amount of approximately $4 million related to years 2010 through 2012. As of December 31, 2010 the remaining balance of our prepaid FDIC assessment was approximately $3 million. Continuing declines in the DIF may result in the FDIC imposing additional assessments in the future, which could adversely affect the Company’s capital levels and earnings.
As required by the Dodd-Frank Act, on February 7, 2011, the FDIC finalized new rules which would redefine the assessment base as “average consolidated total assets minus average tangible equity.” The new rate schedule and other revisions to the assessment rules will become effective April 1, 2011, to be used to calculate the June 2011 assessments which will be due in September 2011. The FDIC’s final rules will also eliminate risk categories and debt ratings from the assessment calculation for large banks (over $10 billion) and will instead use scorecards that the FDIC believes better reflect risks to the DIF. We continue to assess the impact that these changes will have on our deposit insurance premiums in future periods.

 

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In addition to DIF assessments, all FDIC-insured depository institutions must pay an annual assessment to provide funds for the repayment of debt obligations of the Financing Corporation (“FICO”). The FICO is a government-sponsored entity that was formed to borrow the money necessary to carry out the closing and ultimate disposition of failed thrift institutions by the Resolution Trust Corporation. The FICO assessments are set quarterly.
During the two years ended December 31, 2010 and 2009, the Bank paid approximately $65,000 and $55,000, respectively, in FICO assessments. The Bank paid approximately $1,114,000 during 2010 for FDIC deposit insurance premiums, including approximately $13,000 for premiums related to the transaction account guarantee program.
Other Laws and Regulations
The International Money Laundering Abatement and Anti-Terrorism Funding Act of 2001 specifies “know your customer” requirements that obligate financial institutions to take actions to verify the identity of the account holders in connection with opening an account at any U.S. financial institution. Banking regulators will consider compliance with this Act’s money laundering provisions in acting upon acquisition and merger proposals, and sanctions for violations of this Act can be imposed in an amount equal to twice the sum involved in the violating transaction, up to $1 million.
Under the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA PATRIOT Act”), financial institutions are subject to prohibitions against specified financial transactions and account relationships as well as to enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps:
   
to conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transaction;
   
to ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions;
   
to ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and
   
to ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information.

 

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The USA PATRIOT Act requires financial institutions to establish anti-money laundering programs, and sets forth minimum standards for these programs, including:
   
the development of internal policies, procedures, and controls;
   
the designation of a compliance officer;
   
an ongoing employee training program; and
   
an independent audit function to test the programs.
In addition, the USA PATRIOT Act authorizes the Secretary of the Treasury to adopt rules increasing the cooperation and information sharing between financial institutions, regulators, and law enforcement authorities regarding individuals, entities and organizations engaged in, or reasonably suspected based on credible evidence of engaging in, terrorist acts or money laundering activities.
The Dodd-Frank Act, certain aspects of which have been described above, will have a broad impact on the financial services industry, imposing significant regulatory and compliance changes, including the designation of certain financial companies as systemically significant, the imposition of increased capital, leverage, and liquidity requirements, and numerous other provisions designed to improve supervision and oversight of, and strengthen safety and soundness within, the financial services sector. Additionally, the Dodd-Frank Act establishes a new framework of authority to conduct systemic risk oversight within the financial system to be distributed among new and existing federal regulatory agencies, including the Financial Stability Oversight Council, the Federal Reserve, the OCC and the FDIC.
The following items provide a brief description of certain provisions of the Dodd-Frank Act that may have an effect on us:
 The Dodd-Frank Act makes permanent the general $250,000 deposit insurance limit for insured deposits. The Dodd-Frank Act also extends until January 1, 2013, federal deposit coverage for the full net amount held by depositors in non-interest bearing transaction accounts. Amendments to the FDICIA also revise the assessment base against which an insured depository institution’s deposit insurance premiums paid to DIF will be calculated. Under the amendments, the assessment base will no longer be the institution’s deposit base, but rather its average consolidated total assets less its average tangible equity. Additionally, the Dodd-Frank Act makes changes to the minimum designated reserve ratio of the DIF, increasing the minimum from 1.15 percent to 1.35 percent of the estimated amount of total insured deposits, and eliminating the requirement that the FDIC pay dividends to depository institutions when the reserve ratio exceeds certain thresholds. We continue to assess the impact that these changes will have on our deposit insurance premiums in future periods.
The Dodd-Frank Act generally enhances the restrictions on transactions with affiliates under Section 23A and 23B of the Federal Reserve Act, including an expansion of the definition of “covered transactions” and an increase in the amount of time for which collateral requirements regarding covered credit transactions must be satisfied. Insider transaction limitations are expanded through the strengthening of loan restrictions to insiders and the expansion of the types of transactions subject to the various limits, including derivatives transactions, repurchase agreements, reverse repurchase agreements and securities lending or borrowing transactions. Restrictions are also placed on certain asset sales to and from an insider to an institution, including requirements that such sales be on market terms and, in certain circumstances, approved by the institution’s board of directors.

 

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 The Dodd-Frank Act strengthens the existing limits on a depository institution’s credit exposure to one borrower. Federal banking law currently limits a federal thrift’s ability to extend credit to one person (or group of related persons) in an amount exceeding certain thresholds. The Dodd-Frank Act expands the scope of these restrictions to include credit exposure arising from derivative transactions, repurchase agreements, and securities lending and borrowing transactions.
 The Dodd-Frank Act authorizes the establishment of the CFPB, which has the power to issue rules governing all financial institutions that offer financial services and products to consumers. The CFPB has the authority to monitor markets for consumer financial products to ensure that consumers are protected from abusive practices. Financial institutions will be subject to increased compliance and enforcement costs associated with regulations established by the CFPB.
 The Dodd-Frank Act addresses many investor protection, corporate governance and executive compensation matters that will affect most U.S. publicly traded companies, including ours, in certain circumstances. The Dodd-Frank Act (1) grants stockholders of U.S. publicly traded companies an advisory vote on executive compensation; (2) enhances independence requirements for compensation committee members; (3) requires companies listed on national securities exchanges to adopt incentive-based compensation clawback policies for executive officers; (4) provides the SEC with authority to adopt proxy access rules that would allow stockholders of publicly traded companies to nominate candidates for election as a director and have those nominees included in a company’s proxy materials; (5) prohibits uninstructed broker votes on election of directors, executive compensation matters (including say on pay advisory votes), and other significant matters, and (6) requires disclosure on board leadership structure.
Many of the requirements of the Dodd-Frank Act will be implemented over time and most will be subject to regulations implemented over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on our operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make any changes necessary to comply with new statutory and regulatory requirements. Failure to comply with the new requirements may negatively impact our results of operations and financial condition. While we cannot predict what effect any presently contemplated or future changes in the laws or regulations or their interpretations would have on us, these changes could be materially adverse to our investors.

 

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ITEM 1A.  
RISK FACTORS
We have incurred significant losses in the last two years and could continue to sustain losses if our asset quality declines.
We incurred substantial losses in 2009 and 2010, resulting primarily from substantially higher provisions for loan losses related to real estate related loans, reductions in net interest income and, in 2010, the establishment of a reserve for a significant portion of our deferred tax asset. A significant portion of our loans are real estate based or made to real estate based borrowers, and the credit quality of such loans has deteriorated and could deteriorate further if real estate market conditions continue to decline or fail to stabilize in our market areas. We have sustained losses, and could continue to sustain losses if we incorrectly assess the creditworthiness of our borrowers or fail to detect or respond to further deterioration in asset quality in a timely manner.
Our business is highly dependent upon conditions in the local real estate market and has been adversely impacted by adverse developments in those markets.
Adverse market or economic conditions in East Tennessee have disproportionately increased the risk our borrowers will be unable to timely make their loan payments. The market value of the real estate securing loans as collateral has been adversely affected by unfavorable changes in market and economic conditions. As of December 31, 2010, approximately 92.0% of our loans were secured by real estate. Of this amount, approximately 38.9% were commercial real estate loans, 36.8% were residential real estate loans and 24.3% were construction and development loans. We have experienced increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in our markets and such conditions will continue to adversely affect the value of our assets, our revenues, results of operations and financial condition.
We have entered into a written agreement with, and are subject to a capital requirement from, the OCC.
On June 2, 2009, the Bank’s board of directors entered into a formal written agreement with the OCC. The agreement requires the Bank to take certain actions and implement action plans with respect to, among other things, a compliance committee, strategic and liquidity planning, loan review and problem loan identification, loan workout management and procedures, credit and collateral exceptions, other real estate owned, the allowance for loan and lease losses, criticized assets, credit concentrations risk management and liquidity risk management.
In addition to the agreement, the OCC has required the Bank to meet and maintain a minimum Tier 1 leverage ratio of 9% and a minimum total risk-based capital ratio of 13%. These ratios are significantly higher than those required to be considered “well-capitalized” under OCC regulations. At December 31, 2010, the Bank’s Tier 1 leverage ratio was 8.41% and its Total risk-based capital ratio was 13.23%. Because of its non-compliance with the Tier 1 leverage ratio, the Bank could become subject to additional enforcement action by the OCC.

 

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We anticipate that we will become subject to a cease and desist order with the OCC during the second or third quarter of 2011.
We believe that our board of directors will be asked to execute a stipulation and consent to the issuance of a cease and desist order by the OCC, during the second or third quarter of 2011. Although we do not yet know what terms the consent order will include we have been informed by the OCC that the minimum capital maintenance requirements that we have informally committed to the OCC that we will maintain (a minimum Tier 1 to average assets ratio of 9% and a minimum total risk-based ratio of 13%) will be included in the consent order. Even if the Bank’s capital levels exceed these higher levels, upon the issuance of the consent order, the Bank will be deemed to not be “well capitalized” under the applicable federal regulations for so long as the consent order is in place. As a result, the Bank will be required to seek approval of the FDIC before it can accept, renew or roll over brokered deposits or pay interest on deposits above certain federally established rates. The Bank’s regulators have considerable discretion in whether to grant required approvals, and we may not be able to obtain approvals if requested. We expect that the consent order will also include other operational and supervisory provisions requiring the Bank to take certain actions.
Additionally, if the Bank fails to comply with the requirements of the consent order, it may be subject to further regulatory action. The OCC also has broad authority to take additional actions against the Bank, including assessing civil fines and penalties, issuing additional consent or cease and desist orders, removing officers and directors, requiring us to sell or merge the Bank.
Our inability to accept, renew or roll over brokered deposits without the prior approval of the FDIC could adversely affect our liquidity.
As of December 31, 2010, we had approximately $27 million in brokered certificates of deposit which represented approximately 6.01% of our total deposits. Because we anticipate that the consent order will establish specific capital amounts to be maintained by the Bank, the Bank may not be considered better than “adequately capitalized” under capital adequacy regulations, even if the Bank exceeds the levels of capital set forth in the consent order and the normal requirements for “well capitalized” status. As long as it is considered an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2010, brokered deposits maturing in the next 24 months totaled approximately $18.8 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities. Because the Bank will not be considered “well capitalized” following issuance of the consent order, it will also not be permitted to offer to pay interest on deposits at rates that are more than 75 basis points above the “national rate” unless the FDIC determines we are in a “high rate area.” These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers. The limitations on our ability to accept, renew or roll over brokered deposits, or pay more than 75 basis points above the “national rate” could adversely affect our liquidity.

 

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We may need to raise additional capital that may not be available to us.
As a result of our continuing losses, we may need to raise additional capital in the future if we continue to incur additional losses or due to regulatory mandates. The ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control, and on our financial performance. Accordingly, additional capital may not be raised, if and when needed, on terms acceptable to us, or at all. If we cannot raise additional capital when needed, our ability to maintain our capital ratios could be materially impaired, and we could face additional regulatory challenges.
If our allowance for loan losses is not sufficient to cover actual loan losses, our losses will continue.
If loan customers with significant loan balances fail to repay their loans according to the terms of these loans, our losses will continue. We make various assumptions and judgments about the collectability of our loan portfolio, including the creditworthiness of our borrowers and the value of any collateral securing the repayment of our loans. We maintain an allowance for loan losses in an attempt to cover probable incurred losses inherent to the risks associated with lending. In determining the size of this allowance, we rely on an analysis of our loan portfolio based on volume and types of loans, internal loan classifications, trends in classifications, volume and trends in delinquencies, nonaccruals and charge-offs, loss experience of various loan categories, national and local economic conditions, other factors and other pertinent information. If our assumptions are inaccurate, our current allowance may not be sufficient to cover probable incurred loan losses, and additional provisions may be necessary which would decrease our earnings.
In addition, federal and state regulators periodically review our loan portfolio and may require us to increase our provision for loan losses or recognize loan charge-offs. Their conclusions about the quality of a particular borrower of ours or our entire loan portfolio may be different than ours. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory agencies could have a negative effect on our operating results. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our management’s control. These additions may require increased provision expense which would negatively impact our results of operations.
We have increased levels of other real estate owned, primarily as a result of foreclosures, and we anticipate higher levels of foreclosed real estate expense.
As we have begun to resolve non-performing real estate loans, we have increased the level of foreclosed properties, primarily those acquired from builders and from residential land developers. Foreclosed real estate expense consists of three types of charges: maintenance costs, valuation adjustments to appraisal values and gains or losses on disposition. These charges will likely remain at above historical levels as our level of other real estate owned remains elevated, and also if local real estate values continue to decline, negatively affecting our results of operations.

 

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Our loan portfolio includes a meaningful amount of real estate construction and development loans, which have a greater credit risk than residential mortgage loans.
The percentage of real estate construction and development loans in the Company’s portfolio was approximately 22.3% of total loans at December 31, 2010, and these loans make up approximately 45.0% of our non-performing loans at December 31, 2010. This type of lending is generally considered to have relatively high credit risks because the principal is concentrated in a limited number of loans with repayment dependent on the successful completion and operation of the related real estate project. Consequently, the credit quality of many of these loans has deteriorated as a result of the current adverse conditions in the real estate market. Throughout 2009 and 2010, the number of newly constructed homes or lots sold in our market areas continued to decline, negatively affecting collateral values and contributing to increased provision expense and higher levels of non-performing assets. A continued reduction in residential real estate market prices and demand could result in further price reductions in home and land values adversely affecting the value of collateral securing the construction and development loans that we hold. These adverse economic and real estate market conditions may lead to further increases in non-performing loans and other real estate owned, increased losses and expenses from the management and disposition of non-performing assets, increases in provision for loan losses, and increases in operating expenses as a result of the allocation of management time and resources to the collection and work out of loans, all of which would negatively impact our financial condition and results of operations
We are geographically concentrated in Sevier County and Blount County, Tennessee, and changes in local economic conditions, particularly the tourism industry, impact our profitability.
We operate primarily in Sevier County and Blount County, Tennessee, and substantially all of our loan customers and most of our deposit and other customers live or have operations in Sevier and Blount Counties. Accordingly, our success significantly depends upon the growth in population, income levels, deposits and housing starts in both counties, along with the continued attraction of business ventures to the area. Economic conditions in our area weakened during 2008 and 2009 and remained weak throughout 2010, negatively affecting our operations, particularly the real estate construction and development segment of our loan portfolio. We cannot assure you that economic conditions in our market will improve during 2011 or thereafter, and continued weak economic conditions could cause us to continue to further reduce our asset size, affect the ability of our customers to repay their loans and generally affect our financial condition and results of operations.
Due to the predominance of the tourism industry in Sevier County, Tennessee, which is adjacent to the Great Smoky Mountains National Park and the home of the Dollywood theme park, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks in other market areas. The Bank maintains twelve primary concentrations of credit by industry, of which seven are directly related to the tourism industry. At December 31, 2010, approximately $192 million in loans, representing approximately 51.2% of our total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve. We also have additional loans that would be considered related to the tourism industry in addition to the seven categories included in the industry concentration amounts noted above. The tourism industry in Sevier County has remained relatively stable during recent years and we do not anticipate any significant changes in this trend; however, if the tourism industry does experience an economic slowdown and, as a result, borrowers in this industry are unable to perform their obligations under their existing loan agreements, owe could incur additional losses.

 

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We are less able than a larger institution to spread the risks of unfavorable local economic conditions across a large number of diversified economies. Moreover, we cannot give any assurance that we will benefit from any market growth or return of more favorable economic conditions in our primary market areas if they do occur.
A portion of our loan portfolio is secured by homes that are being built for sale as vacation homes or as second homes for out of market investors or homes that are used to generate rental income.
A significant portion of our borrowers rely to some extent upon rental income to service real estate loans secured by rental properties, or they rely upon sales of the property for construction and development loans secured by homes that have been built for sale to investors living outside of our market area as investment properties, second homes or as vacation homes. If tourism levels in our market area or the rates that visitors are willing to pay for lodging were to decline significantly, the rental income that some of our borrowers utilize to service their obligations to us may decline as well and these borrowers may have difficulty meeting their obligations to us which would adversely impact our results of operations. In addition, sales of vacation homes and second homes to investors living outside of our market area have slowed and are expected to remain at reduced levels at least throughout 2011. Borrowers that are developers or builders whose loans are secured by these vacation and second homes and whose ability to repay their obligations to us is dependent on the sale of these properties have had, and may continue to have, difficulty meeting their obligations to us if these properties are not sold timely or at values in excess of their loan amount which could adversely impact our results of operations.
If the value of real estate in our markets were to decline further or if appraisals do not accurately reflect real estate values, a significant portion of our loan portfolio could become under-collateralized, which could have a material adverse effect on us.
In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral. At December 31, 2010, approximately 92% of our loans had real estate as a primary or secondary component of collateral. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower but may deteriorate in value during the time the credit is extended. If the value of real estate in our markets were to decline further, a significant portion of our loan portfolio could become under-collateralized. As a result, if we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected.

 

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Also, in considering whether to make a loan secured by real property, we generally require an appraisal of the property. However, an appraisal is only an estimate of the value of the property at the time the appraisal is made, and, as real estate values in our market area have experienced changes in value in relatively short periods of time, this estimate might not accurately describe the net value of the real property collateral after the loan has been closed. If the appraisal does not reflect the amount that may be obtained upon any sale or foreclosure of the property, we may not realize an amount equal to the indebtedness secured by the property. The valuation of the property may negatively impact the continuing value of such loan and could adversely affect our operating results and financial condition.
Negative publicity about financial institutions, generally, or about us or the Bank, specifically, could damage the Bank’s reputation and adversely impact its liquidity, business operations or financial results.
Reputation risk, or the risk to our business from negative publicity, is inherent in our business. Negative publicity can result from the actual or alleged conduct of financial institutions, generally, or us or the Bank, specifically, in any number of activities, including leasing and lending practices, corporate governance, and actions taken by government regulators in response to those activities. Negative publicity can adversely affect our ability to keep and attract customers and can expose us to litigation and regulatory action, any of which could negatively affect our liquidity, business operations or financial results.
The costs and effects of litigation, investigations or similar matters, or adverse facts and developments related thereto, could materially affect our business, operating results and financial condition.
We may be involved from time to time in a variety of litigation, investigations or similar matters arising out of our business. Our insurance may not cover all claims that may be asserted against it and indemnification rights to which we are entitled may not be honored, and any claims asserted against us, regardless of merit or eventual outcome, may harm our reputation. Should the ultimate judgments or settlements in any litigation or investigation significantly exceed our insurance coverage, they could have a material adverse effect on our business, financial condition and results of operations. In addition, premiums for insurance covering the financial and banking sectors are rising. We may not be able to obtain appropriate types or levels of insurance in the future, nor may we be able to obtain adequate replacement policies with acceptable terms or at historic rates, if at all.
We may be required to pay significantly higher FDIC premiums or remit special assessments that could adversely affect our earnings.
A downgrade in our regulatory condition, along with our current level of brokered deposits, could cause our assessment to materially increase. In addition, market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. As a result, the entire industry may be required to pay significantly higher premiums or additional special assessments that could adversely affect our earnings. It is possible that the FDIC may impose additional special assessments in the future as part of its restoration plan.

 

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We reported a material weakness in our internal control over financial reporting, and if we are unable to improve our internal controls, our financial results may not be accurately reported.
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2010 identified a material weakness in its internal control over financial reporting, as described in “Item 9A-Controls and Procedures.” This material weakness, or difficulties encountered in implementing new or improved controls or remediation, could prevent us from accurately reporting our financial results, result in material misstatements in our financial statements or cause us to fail to meet our reporting obligations. Failure to comply with Section 404 of the Sarbanes-Oxley Act of 2002 could negatively affect our business, the price of our common stock and market confidence in our reported financial information.
Negative developments in the U.S. and local economy and in local real estate markets have adversely impacted our operations and results and may continue to adversely impact our results in the future.
Economic conditions in the markets in which we operate deteriorated significantly between early 2008 and 2010. As a result, we incurred losses in 2009 and 2010, resulting primarily from provisions for loan losses related to declining collateral values in our construction and development loan portfolio. Although economic conditions showed signs of stabilization in our markets in the second half of 2010 with the exception of real estate values, we believe that we will continue to experience a challenging and volatile economic environment in 2011. Accordingly, we expect that our results of operations will continue to be negatively impacted in 2011. There can be no assurance that the economic conditions that have adversely affected the financial services industry, and the capital, credit and real estate markets generally or us in particular, will improve, materially or at all, in which case we could continue to experience losses, write-downs of assets, capital and liquidity constraints or other business challenges.
Environmental liability associated with commercial lending could result in losses.
In the course of business, we may acquire, through foreclosure, properties securing loans it has originated or purchased which are in default. Particularly in commercial real estate lending, there is a risk that hazardous substances could be discovered on these properties. In this event, we, or the Bank, might be required to remove these substances from the affected properties at our sole cost and expense. The cost of this removal could substantially exceed the value of affected properties. We may not have adequate remedies against the prior owner or other responsible parties and could find it difficult or impossible to sell the affected properties. These events could have a material adverse effect on our business, results of operations and financial condition.
Competition with other banking institutions could adversely affect our profitability.
We face significant competition in our primary market areas from a number of sources, currently including eight commercial banks and one savings institution in Sevier County and twelve commercial banks and one savings institution in Blount County. As of June 30, 2010, there were 57 commercial bank branches and three savings institutions branches located in Sevier County and 49 commercial bank branches and one savings institution branch located in Blount County.

 

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Liquidity needs could adversely affect our results of operations and financial condition.
We rely on dividends from the Bank, which are currently limited as a result of the Bank’s losses in 2009 and 2010, as our primary source of funds, and the Bank relies on customer deposits and loan repayments as its primary source of funds. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The ability of borrowers to repay loans can be adversely affected by a number of factors, including changes in economic conditions, adverse trends or events affecting business industry groups, reductions in real estate values or markets, business closings or lay-offs, inclement weather, natural disasters, and international instability. Additionally, deposit levels may be affected by a number of factors, including rates paid by competitors, general interest rate levels, returns available to customers on alternative investments, and general economic conditions. We have relied to a significant degree on national time deposits and brokered deposits, which may be more volatile than local time deposits. We have committed to the OCC to reduce our dependence on such sources and have sought to improve our asset and liability liquidity. However, actions to improve liquidity may adversely affect our profitability. We may be required from time to time to rely on secondary sources of liquidity to meet withdrawal demands or otherwise fund operations. Such sources include FHLB of Cincinnati advances and federal funds lines of credit from correspondent banks. The availability of these sources may be restricted because of the Bank’s financial performance. To utilize brokered deposits and national market time deposits without additional regulatory approvals, the Bank must remain well capitalized and must not become subject to a formal enforcement action that requires the Bank to maintain capital levels above those required to be well capitalized under the prompt corrective action provisions of the Federal Deposit Insurance Corporation Improvement Act of 1991. While we believe that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. We may be required to continue to reduce our asset size, slow or discontinue capital expenditures or other investments or liquidate assets should such sources not be adequate.
Fluctuations in interest rates could reduce our profitability.
Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense, our largest recurring expenditure. Interest rate fluctuations are caused by many factors which, for the most part, are not under our direct control. For example, national monetary policy plays a significant role in the determination of interest rates. Additionally, competitor pricing and the resulting negotiations that occur with our customers also impact the rates we collect on loans and the rates we pay on deposits.
As interest rates change, we expect that we will periodically experience “gaps” in the interest rate sensitivities of our assets and liabilities (usually deposits and borrowings), meaning that either our interest-bearing liabilities will be more sensitive to changes in market interest rates than our interest-earning assets (usually loans and investment securities), or vice versa. In either event, if market interest rates should move contrary to our position, this “gap” may work against us, and our earnings may be negatively affected.
Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and our ability to realize gains from the sale of our assets, all of which ultimately affect our earnings.

 

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Our common stock is currently traded on the over-the-counter, or OTC, bulletin board and has substantially less liquidity than the average stock quoted on a national securities exchange.
Although our common stock is publicly traded on the OTC bulletin board, our common stock has substantially less daily trading volume than the average trading market for companies quoted on the Nasdaq Global Market, or any national securities exchange. A public trading market having the desired characteristics of depth, liquidity and orderliness depends on the presence in the marketplace of willing buyers and sellers of our common stock at any given time. This presence depends on the individual decisions of investors and general economic and market conditions over which we have no control.
The market price of our common stock has fluctuated significantly, and may fluctuate in the future. These fluctuations may be unrelated to our performance. General market or industry price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices.
Our business is dependent on technology, and an inability to invest in technological improvements may adversely affect our results of operations and financial condition.
The financial services industry is undergoing rapid technological changes with frequent introductions of new technology-driven products and services. In addition to better serving customers, the effective use of technology increases efficiency and enables financial institutions to reduce costs. We have made significant investments in data processing, management information systems and internet banking accessibility. Our future success will depend in part upon our ability to create additional efficiencies in our operations through the use of technology. Many of our competitors have substantially greater resources to invest in technological improvements. There can be no assurance that our technological improvements will increase our operational efficiency or that we will be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to our customers.
Consumer protection initiatives related to the foreclosure process could affect our remedies as a creditor.
Consumer protection initiatives proposed related to the foreclosure process, including voluntary and/or mandatory programs intended to permit or require lenders to consider loan modifications or other alternatives to foreclosure, could increase our credit losses or increase our expense in pursuing our remedies as a creditor.

 

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National or state legislation or regulation may increase our expenses and reduce earnings.
Federal bank regulators are increasing regulatory scrutiny, and additional restrictions (including those originating from the Dodd-Frank Act) on financial institutions have been proposed or adopted by regulators and by Congress. Changes in tax law, federal legislation, regulation or policies, such as bankruptcy laws, deposit insurance, consumer protection laws, and capital requirements, among others, can result in significant increases in our expenses and/or charge-offs, which may adversely affect our earnings. Changes in state or federal tax laws or regulations can have a similar impact. Many state and municipal governments, including the State of Tennessee, are under financial stress due to the economy. As a result, these governments could seek to increase their tax revenues through increased tax levies which could have a meaningful impact on our results of operations. Furthermore, financial institution regulatory agencies are expected to continue to be very aggressive in responding to concerns and trends identified in examinations, including the continued issuance of additional formal or informal enforcement or supervisory actions. These actions, whether formal or informal, could result in our agreeing to limitations or to take actions that limit our operational flexibility, restrict our growth or increase our capital or liquidity levels. Failure to comply with any formal or informal regulatory restrictions, including informal supervisory actions, could lead to further regulatory enforcement actions. Negative developments in the financial services industry and the impact of recently enacted or new legislation in response to those developments could negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and adversely impact our financial performance. In addition, industry, legislative or regulatory developments may cause us to materially change our existing strategic direction, capital strategies, compensation or operating plans.
Implementation of the various provisions of the Dodd-Frank Act may increase our operating costs or otherwise have a material affect on our business, financial condition or results of operations.
On July 21, 2010, President Obama signed the Dodd-Frank Act. This landmark legislation includes, among other things, (i) the creation of a Financial Services Oversight Counsel to identify emerging systemic risks and improve interagency cooperation; (ii) the elimination of the Office of Thrift Supervision and the transfer of oversight of federally chartered thrift institutions and their holding companies to the Office of the Comptroller of the Currency and the Federal Reserve; (iii) the creation of a Consumer Financial Protection Agency authorized to promulgate and enforce consumer protection regulations relating to financial products that would affect banks and non-bank finance companies; (iv) the establishment of new capital and prudential standards for banks and bank holding companies; (v) the termination of investments by the U.S. Treasury under TARP; (vi) enhanced regulation of financial markets, including the derivatives, securitization and mortgage origination markets; (vii) the elimination of certain proprietary trading and private equity investment activities by banks; (viii) the elimination of barriers to de novo interstate branching by banks; (ix) a permanent increase of the previously implemented temporary increase of FDIC deposit insurance to $250,000; (x) the authorization of interest-bearing transaction accounts; and (xi) changes in how the FDIC deposit insurance assessments will be calculated and an increase in the minimum designated reserve ratio for the Deposit Insurance Fund.
Certain provisions of the legislation are not immediately effective or are subject to required studies and implementing regulations. Further, community banks with less than $10 billion in assets (like us) are exempt from certain provisions of the legislation. We cannot predict how this significant new legislation may be interpreted and enforced or how implementing regulations and supervisory policies may affect us. There can be no assurance that these or future reforms will not significantly increase our compliance or operating costs or otherwise have a significant impact on our business, financial condition and results of operations.

 

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If the federal funds rate remains at current extremely low levels, our net interest margin, and consequently our net earnings, may be negatively impacted.
Because of significant competitive deposit pricing pressures in our market and the negative impact of these pressures on our cost of funds, coupled with the fact that a significant portion of our loan portfolio has variable rate pricing that moves in concert with changes to the Federal Reserve Board of Governors’ federal funds rate (which is at an extremely low rate as a result of current economic conditions), our net interest margin continues to be negatively affected. Because of these competitive pressures, we have been unable to lower the rate that we pay on interest-bearing liabilities to the same extent and as quickly as the yields we charge on interest-earning assets. Additionally, the amount of non-accrual loans and other real estate owned has been and may continue to be elevated. As a result, our net interest margin, and consequently our profitability, has been and may continue to be negatively impacted.
We have a significant deferred tax asset and cannot give any assurance that it will be fully realized.
During 2010, the Company reached a three-year pre-tax cumulative loss position. Under GAAP, a cumulative loss position is considered significant negative evidence which makes it very difficult for the Company to rely on future earnings as a reliable source of future taxable income to realize deferred tax assets. We had net deferred tax assets of approximately $1.4 million as of December 31, 2010. We established a valuation allowance against our net deferred tax assets as of December 31, 2010 totaling approximately $7.4 million because we believe that it is not more likely than not that all of these assets will be realized. In determining the amount of the valuation allowance, we considered the reversal of deferred tax liabilities and the ability to carryback losses to prior years. This process required significant judgment by management about matters that are by nature uncertain. We may need to increase our valuation allowance because of changes in the amounts of deferred tax assets and liabilities, which could have a material adverse effect on our results of operations and financial condition.
Holders of the Company’s junior subordinated debentures have rights that are senior to those of the Company’s common shareholders.
At December 31, 2010, we had outstanding trust preferred securities from special purpose trusts and accompanying junior subordinated debentures totaling $13 million. Payments of the principal and interest on the trust preferred securities of these trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures we issued to the trusts are senior to our shares of common stock and preferred stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock. We have the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid on our common stock. Because of the losses the Bank incurred in 2009 and 2010, it is not permitted to pay dividends to us without the consent of the OCC. As a result, we must use cash on hand to pay our obligations on the subordinated debentures related to our trust preferred securities.

 

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On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.
If a change in control or change in management is delayed or prevented, the market price of our common stock could be negatively affected.
Certain federal and state regulations may make it difficult, and expensive, to pursue a tender offer, change in control or takeover attempt that our board of directors opposes. As a result, our shareholders may not have an opportunity to participate in such a transaction, and the trading price of our stock may not rise to the level of other institutions that are more vulnerable to hostile takeovers.
An investment in the Company’s common stock is not an insured deposit.
Our common stock is not a bank deposit and, therefore, is not insured against loss by the FDIC, any other deposit insurance fund or by any other public or private entity. Investment in our common stock is inherently risky for the reasons described in this “Risk Factors” section and elsewhere in this report and is subject to the equity market forces like other common stocks. As a result, if you acquire our stock, you could lose some or all of your investment.
ITEM 2.  
PROPERTIES
The Bank currently operates from its main office in Sevierville, Tennessee, its Blount County regional headquarters in Maryville, Tennessee, and ten branch offices located in Gatlinburg, Pigeon Forge, Seymour, Kodak and Maryville, Tennessee. The main office, which is located at 300 East Main, Sevierville, Tennessee 37862, contains approximately 24,000 square feet and is owned by the Bank.
The Blount County regional headquarters opened for business during the first quarter of 2009 and is located at 1820 W. Broadway, Maryville, Tennessee. The building contains approximately 12,000 square feet and is owned by the Bank.
The first Gatlinburg branch was built in 1999 and is located at 960 E. Parkway. It contains approximately 4,800 square feet. The Bank leases the land at this location. The lease expires in 2013 and includes renewal options for twelve additional five-year terms.
The second Gatlinburg branch is a walk-up branch leased by the Bank located at 745 Parkway, which lies in the heart of the Gatlinburg tourist district. The lease expires in 2015 and includes one five-year renewal option through 2020.
The Pigeon Forge branch, owned by the Bank, contains approximately 3,800 square feet and is located at 3104 Teaster Lane, Pigeon Forge, Tennessee.
The second Pigeon Forge branch, owned by the Bank, contains approximately 3,800 square feet and is located at 242 Wears Valley Road, Pigeon Forge, Tennessee.
The Seymour branch, owned by the Bank, contains approximately 3,800 square feet and is located on Chapman Highway, Seymour, Tennessee.

 

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The Kodak branch, owned by the Bank, contains approximately 3,800 square feet and is located on Winfield Dunn Parkway – Highway 66, Sevierville, Tennessee.
The Collier Drive branch, owned by the Bank, contains approximately 3,800 square feet and is located at 470 Collier Drive, Sevierville, Tennessee.
The West Maryville branch, owned by the Bank, contains approximately 4,800 square feet and is located at 2403 US Highway 411 South, Maryville, Tennessee.
The Justice Center branch is located on land leased by the Bank at 1002 E. Lamar Alexander Parkway, Maryville, Tennessee. The branch contains approximately 3,900 square feet. The lease expires in 2013 and includes renewal options for six additional five-year terms.
The Newport Highway branch opened for business during the second quarter of 2009 and is located at 305 New Riverside Drive, Sevierville, Tennessee on land owned by the Bank. The branch contains approximately 3,800 square feet.
The Operations Center, owned by the Bank, contains approximately 40,000 square feet and is located on Red Bank Road in Sevierville, Tennessee. We completed construction of a 16,000 square foot addition, which is included in the 40,000 square foot total, during the first quarter of 2009.
In addition to our thirteen existing locations including the Operations Center, we hold one property in Knox County, Tennessee, which we intend to use as a future branch site.
Management believes that the physical facilities maintained by the Bank are suitable for its current operations and that all properties are adequately covered by insurance.
ITEM 3.  
LEGAL PROCEEDINGS
The Company is not aware of any material pending legal proceedings to which the Company or the Bank is a party or to which any of their properties are subject, other than ordinary routine legal proceedings incidental to the business of the Bank.
ITEM 4.  
REMOVED AND RESERVED

 

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PART II
ITEM 5.  
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
There is not a large market for the Company’s shares, which are quoted on the OTC Bulletin Board under the symbol “MNBT” and are not traded on any national exchange. Trading is generally limited to private transactions and, therefore, there is limited reliable information available as to the number of trades or the prices at which our stock has traded. Management has reviewed the limited information available regarding the range of prices at which the Company’s common stock has been sold. The following table sets forth, for the calendar periods indicated, the range of high and low reported sales prices. This data is provided for information purposes only and should not be viewed as indicative of the actual or market value of our common stock:
                 
    Market Price Range  
    Per Share  
Year/Period   High     Low  
2010:
  $ 8.10     $ 4.00  
First Quarter
    8.10       5.75  
Second Quarter
    6.75       5.10  
Third Quarter
    5.75       5.00  
Fourth Quarter
    5.00       4.00  
 
               
2009:
  $ 16.75     $ 8.00  
First Quarter
    16.75       11.00  
Second Quarter
    16.50       12.50  
Third Quarter
    15.00       9.00  
Fourth Quarter
    10.50       8.00  
These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission, and may not represent actual transactions.
As of the date of this filing, the Company has approximately 2,000 holders of record of its common stock. The Company has no other class of securities issued or outstanding.
Dividends from the Bank are the Company’s primary source of funds to pay dividends on its capital stock. Under the National Bank Act, the Bank may, in any calendar year, without the approval of the OCC, pay dividends to the extent of net profits for that year, plus retained net profits for the preceding two years (less any required transfers to surplus). Given the losses incurred by the Bank in 2009 and 2010, the Bank’s ability to pay dividends to the Company beginning on January 1, 2010 was limited. The need to maintain adequate capital in the Bank also limits dividends that may be paid to the Company. The OCC and Federal Reserve have the general authority to limit the dividends paid by insured banks and bank holding companies, respectively, if such payment may be deemed to constitute an unsafe or unsound practice. If, in the particular circumstances, the OCC determines that the payment of dividends would constitute an unsafe or unsound banking practice, the OCC may, among other things, issue a cease and desist order prohibiting the payment of dividends. Additional information regarding restrictions on the ability of the Bank to pay dividends to the Company is contained in this report under “Item 1 — Business- Supervision and Regulation.”
Issuer Purchases of Equity Securities
The Company made no repurchases of its Common Stock during the fourth quarter of 2010.

 

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ITEM 7.  
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
To better understand financial trends and performance, our management analyzes certain key financial data in the following pages. This analysis and discussion reviews our results of operations for the two-year period ended December 31, 2010, and our financial condition at December 31, 2009 and 2010. We have provided comparisons of financial data as of and for the fiscal years ended December 31, 2009 and 2010, to illustrate significant changes in performance and the possible results of trends revealed by that historical financial data. The following discussion should be read in conjunction with our consolidated audited financial statements, including the notes thereto, and the selected consolidated financial data presented elsewhere in this Annual Report on Form 10-K.
Overview
We conduct our business, which consists primarily of traditional commercial banking operations, through our wholly owned subsidiary, Mountain National Bank. Through the Bank we offer a broad range of traditional banking services from our corporate headquarters in Sevierville, Tennessee, our regional headquarters in Maryville, TN, and through ten additional branches in Sevier County and Blount County, Tennessee. Our banking operations primarily target individuals and small businesses in Sevier and Blount Counties and the surrounding area. The retail nature of the Bank’s commercial banking operations allows for diversification of depositors and borrowers, and we believe that the Bank is not dependent upon a single or a few customers. But, due to the predominance of the tourism industry in Sevier County, a significant portion of the Bank’s commercial loan portfolio is concentrated within that industry, including the residential real estate segment of that industry. The predominance of the tourism industry also makes our business more seasonal in nature, particularly with respect to deposit levels, than may be the case with banks in other market areas. The tourism industry in Sevier County has remained relatively stable during the past couple of years, particularly with respect to overnight rentals and hospitality services, and management does not anticipate any significant changes in that trend in the future.
Critical Accounting Policies
Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices accepted within the banking industry. Our significant accounting policies are described in the notes to our consolidated financial statements. Certain accounting policies require management to make significant estimates and assumptions that have a material impact on the carrying value of certain assets and liabilities, and we consider these to be critical accounting policies. The estimates and assumptions used are based on historical experience and other factors that management believes to be reasonable under the circumstances. Actual results could differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and on our results of operations for the reporting periods.
We believe the following are the critical accounting policies that require the most significant estimates and assumptions and that are particularly susceptible to a significant change in the preparation of our financial statements.

 

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Valuation of Investment Securities
Management conducts regular reviews to assess whether the values of our investments are impaired and whether any such impairment is other than temporary. The determination of whether other-than-temporary impairment has occurred involves significant assumptions, estimates and judgments by management. Changing economic conditions — global, regional or related to industries of specific issuers — could adversely affect these values.
On May 1, 2009, Silverton Bank, the bank subsidiary of Silverton Financial Services, Inc. (“Silverton”), was placed into receivership by the OCC after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009, and on June 5, 2009 Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368, which represents the Company’s full investment in the securities, during the first quarter of 2009.
We recorded no additional other-than-temporary impairment of our investment securities during 2009 and 2010.
Allowance and Provision for Loan Losses
The allowance and provision for loan losses are based on management’s assessments of amounts that it deems to be adequate to absorb probable incurred losses inherent in our existing loan portfolio. The allowance for loan losses is established through a provision for losses based on management’s evaluation of current economic conditions, volume and composition of the loan portfolio, the fair market value or the estimated net realizable value of underlying collateral, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. The evaluation includes a review of all loans on which full collection may not be reasonably assumed. Should the factors that are considered in determining the allowance for loan losses change over time, or should management’s estimates prove incorrect, a different amount may be reported for the allowance and the associated provision for loan losses. For example, because economic conditions in our market area have undergone an unexpected and adverse change in the last two years, we have had to increase our allowance for loan losses by taking a charge against earnings in the form of additional provisions for loan losses.
Valuation of Other Real Estate Owned
Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure. The fair value of other real estate is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to fair value less cost to sell. Other real estate owned also includes excess Bank property not utilized when subdividing land acquired for the construction of Bank branches. Costs of significant property improvements are capitalized. Costs relating to holding property are expensed.

 

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Deferred Tax Asset Valuation
A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion or the entire deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of its increased credit losses, the Company entered into a three-year cumulative pre-tax loss position during 2010. A cumulative loss position is considered significant negative evidence in assessing the realizability of a deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on the scheduled reversal of deferred tax liabilities and taxable income available in prior carry back years. We did not consider future taxable income in determining the realizability of our deferred tax assets, and as such, recorded a valuation allowance to reduce our net deferred tax asset to approximately $1.4 million. When the Company’s profitability returns and continues to a point that is considered sustainable, some or all of the valuation allowance may be reversed. The timing of the reversal of the valuation allowance is dependent on an assessment of future events and will be based on the circumstances that exist as of that future date.
Results of Operations for the Years Ended December 31, 2010 and 2009
General Discussion of Our Results
Our principal source of revenue is net interest income at the Bank. Net interest income is the difference between:
   
income received on interest-earning assets, such as loans and investment securities; and
   
payments we make on our interest-bearing sources of funds, such as deposits and borrowings.
The level of net interest income is determined primarily by the average balances, or volume, of interest-earning assets and interest-bearing liabilities and the various rate spreads between the interest-earning assets and the Company’s funding sources. Changes in our net interest income from period to period result from, among other things:
   
increases or decreases in the volumes of interest-earning assets and interest-bearing liabilities;
   
increases or decreases in the average rates earned and paid on those assets and liabilities;
   
our ability to manage our interest-earning asset portfolio, which includes loans;
   
the availability and costs of particular sources of funds, such as non-interest bearing deposits; and
   
our ability to “match” liabilities to fund assets of similar maturities at a profitable spread of rates earned on assets over rates paid on liabilities.
In 2010 and 2009, our other principal sources of revenue were service charges on deposit accounts and credit/debit card related income.

 

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Net Income (Loss)
The following is a summary of our results of operations (dollars in thousands except per share amounts):
                                 
    Years Ended December 31,     Dollar Change     Percent Change  
    2010     2009     2010 to 2009     2010 to 2009  
Interest income
  $ 23,456     $ 31,369     $ (7,913 )     -25.23 %
Interest expense
    10,702       13,358       (2,656 )     -19.88 %
 
                         
Net interest income
    12,754       18,011       (5,257 )     -29.19 %
Provision for loan losses
    7,727       11,673       (3,946 )     -33.80 %
 
                         
Net interest income after provision for loan losses
    5,027       6,338       (1,311 )     -20.68 %
Noninterest income
    5,750       4,863       887       18.24 %
Noninterest expense
    17,490       19,217       (1,727 )     -8.99 %
 
                         
Net income (loss) before income taxes
    (6,713 )     (8,016 )     1,303       -16.25 %
Income tax expense (benefit)
    3,738       (3,788 )     7,526       -198.68 %
 
                         
Net income (loss)
  $ (10,451 )   $ (4,228 )   $ (6,223 )     147.19 %
 
                         
 
                               
Total revenues
  $ 29,206     $ 36,232                  
Total expenses
    39,657       40,460                  
 
                               
Basic earnings (loss) per share
    (3.97 )     (1.61 )                
Diluted earnings (loss) per share
    (3.97 )     (1.61 )                
The net loss for 2010 was primarily attributable to the provision for loan losses, the continued compression in the Company’s net interest margin and the disallowance of the deferred tax asset. The provision for loan losses reflects the continued elevated levels of net loans charged-off and increased probable losses as a result of the slowdown in economic conditions, primarily with respect to the real estate construction and development segment of our portfolio and is discussed in more detail under “Provision for Loan Losses.” Total average loans, our largest interest earning-asset, decreased approximately $17,928,000 during 2010. More significantly, the average balance of nonaccrual loans increased approximately $38,311,000 during the year from approximately $21,444,000 at December 31, 2009 to approximately $59,755,000 at December 31, 2010. The interest associated with these loans that was excluded and reversed from income throughout 2010 was a significant factor contributing to the decrease in interest income, the 83 basis point reduction of the yield earned on loans and the continued compression of our net interest margin. Nonaccrual loans and interest income are discussed in more detail under “Allowance for Loan Losses” and “Net Interest Income.” During 2010, we established a valuation allowance against our deferred tax assets in order to adjust the net carrying amount to what we believe is currently realizable. The deferred tax valuation allowance and related tax expense is described in more detail under “Income Taxes.” The net loss during 2010 was lessened by the decrease in noninterest expense which was primarily related to the decrease in salaries and employee benefits from personnel cutbacks, as described in more detail under “Noninterest Expenses.”

 

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Basic and diluted loss per share was ($3.97) and ($3.97), respectively, for 2010, compared to ($1.61) and ($1.61), respectively, for 2009 reflecting the increased net loss from 2009 to 2010. The average number of shares outstanding was unchanged during 2010.
The Bank’s net interest margin, the difference between the yields on earning assets, including loan fees, and the rate paid on funds to support those assets, declined 73 basis points from 3.07% at December 31, 2009, to 2.34% at December 31, 2010. The increasing volume of nonaccrual loans has caused a more prolonged and significant compression in the Bank’s margin than expected. See the section titled “Net Interest Income,” below for a more detailed discussion.
The following chart illustrates our net income (loss) for the periods indicated. The changes below were impacted by changes in rate as well as changes in volume:
                 
    2010     2009  
First Quarter
  $ 329,113     $ (673,634 )
Second Quarter
    142,286       (789,050 )
Third Quarter
    350,893       1,028,162  
Fourth Quarter
    (11,273,470 )     (3,793,873 )
 
           
Annual Total
  $ (10,451,178 )   $ (4,228,395 )
 
           
The following discussion and analysis describes, in greater detail, the specific changes in each income statement component.
Net Interest Income
Average Balances, Interest Income, and Interest Expense
The following table contains condensed average balance sheets for the years indicated. In addition, the amount of our interest income and interest expense for each category of interest-earning assets and interest-bearing liabilities and the related average interest rates, net interest spread and net yield on average interest earning assets are included.

 

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Average Balance Sheet and Analysis of Net Interest Income
for the Years Ended December 31, 2010 and 2009

(in thousands, except rates)
                                                 
    Average Balance     Income/Expense     Yield/Rate  
    2010     2009     2010     2009     2010     2009  
 
Interest-earning assets:
                                               
Loans (1)(2)
  $ 397,594     $ 415,522     $ 20,674     $ 25,072       5.20 %     6.03 %
Investment Securities: (3)
                                               
Available for sale
    111,784       151,729       2,456       5,994       2.20 %     3.95 %
Held to maturity
    1,362       2,156       61       87       4.48 %     4.04 %
Equity securities
    3,837       3,895       189       191       4.93 %     4.90 %
 
                                   
Total securities
    116,983       157,780       2,706       6,272       2.31 %     3.98 %
Federal funds sold and other
    29,310       13,295       76       25       0.26 %     0.19 %
 
                                   
Total interest-earning assets
    543,887       586,597       23,456       31,369       4.31 %     5.35 %
Nonearning assets
    74,544       72,816                                  
 
                                           
Total Assets
  $ 618,431     $ 659,413                                  
 
                                           
 
Interest-bearing liabilities:
                                               
Interest bearing deposits:
                                               
Interest bearing demand deposits
    119,547       150,384       1,309       1,856       1.09 %     1.23 %
Savings deposits
    22,790       17,340       245       241       1.08 %     1.39 %
Time deposits
    302,494       304,715       6,283       8,151       2.08 %     2.67 %
 
                                   
Total interest bearing deposits
    444,831       472,439       7,837       10,248       1.76 %     2.17 %
Securities sold under agreements to repurchase
    1,535       4,284       24       91       1.56 %     2.12 %
Federal Home Loan Bank advances and other borrowings
    61,657       68,442       2,497       2,627       4.05 %     3.84 %
Subordinated debt
    13,403       13,403       344       392       2.57 %     2.92 %
 
                                   
Total interest-bearing liabilities
    521,426       558,568       10,702       13,358       2.05 %     2.39 %
Noninterest-bearing deposits
    46,237       45,761                              
 
                                       
Total deposits and interest-bearings liabilities
    567,663       604,329       10,702       13,358       1.89 %     2.21 %
 
                                           
Other liabilities
    2,890       3,143                                  
Shareholders’ equity
    47,878       51,941                                  
 
                                           
 
  $ 618,431     $ 659,413                                  
 
                                           
Net interest income
                  $ 12,754     $ 18,011                  
 
                                           
Net interest spread (4)
                                    2.26 %     2.96 %
Net interest margin (5)
                                    2.34 %     3.07 %
 
     
(1)  
Interest income from loans includes total fee income of approximately $889,000 and $1,134,000 for the years ended December 31, 2010 and 2009, respectively.
 
(2)  
For the purpose of these computations, non-accrual loans are included in average loans.
 
(3)  
Tax-exempt income from investment securities is not presented on a tax-equivalent basis.
 
(4)  
Yields realized on interest-earning assets less the rates paid on interest-bearing liabilities.
 
(5)  
Net interest margin is the result of net interest income divided by average interest-earning assets for the period.

 

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The large volume of nonaccrual loans as well as a securities portfolio that, at certain times during 2010, contained comparatively low-rate investments resulted in the continued compression of our net interest margin as we experienced reduced yields on a significant portion of our earning asset base. Rate and volume variances during 2010 caused a decrease in interest income and interest expense as well as net interest income which decreased approximately $5,257,000 in 2010 compared to 2009. The Company’s net interest margin decreased by 73 basis points in 2010 compared to 2009. Yields on our loan portfolio decreased by 83 basis points in 2010 compared to 2009, reflecting the approximately $38 million increase in average nonaccrual loans during the year as well as the continuing very low rate environment. As discussed in more detail under “Securities,” we shifted a significant portion of our investment portfolio to shorter-term securities in preparation for their liquidation. This shift caused the yield on our investment securities portfolio to decrease 167 basis points during 2010 when compared to 2009. Partially offsetting the decrease in yields earned on our average earning assets was a corresponding decrease in our funding costs. Rates paid on our interest-bearing deposits decreased by 41 basis points in 2010 compared to 2009, reflecting the continued effects of a decreasing interest rate environment. The average rate paid on time deposits, in particular, takes longer to adjust to current market rates due to the varied and sometimes extended repricing speed of these deposits. Also contributing to our lower funding costs was a 35 basis point decrease in rates paid on subordinated debt in 2010.
Average balances of our earning assets decreased by approximately $43 million in 2010 compared to 2009, primarily due to a reduction in average securities and average loans which decreased approximately $41 million and $18 million, respectively, in 2010. The liquidity created by the reduction in securities and loans was used to fund the withdrawal of certain municipal deposits during the year as discussed in more detail under “Deposits.” The remaining funds were used to pre-pay an FHLB advance and invested in federal funds sold.
Our net interest margin, the difference between the yield on earning assets, including loan fees, and the rate paid on funds to support those assets, averaged 2.34% during 2010 versus 3.07% in 2009, a decrease of 73 basis points. The decrease in our net interest margin reflects a decrease in the average spread in 2010 between the rates we earned on our interest-earning assets, which had a decrease in overall yield of 104 basis points to 4.31% at December 31, 2010, as compared to 5.35% at December 31, 2009, and the rates we paid on interest-bearing liabilities, which had a less substantial decrease of 34 basis points in the overall rate to 2.05% at December 31, 2010, versus 2.39% at December 31, 2009. Our interest-earning assets, including approximately $163,000,000 in loans tied to prime that reprice more quickly than our interest-bearing liabilities, particularly time deposits and borrowings with a fixed rate and term. Therefore, during the declining and low interest rate environments experienced over the last two years, our net interest margin has been compressed as our interest-sensitive assets and liabilities reprice at their expected speeds. Additionally, the approximately $38 million increase in average nonaccrual loans and reduction in the average rate earned on our investment securities portfolio negatively impacted our net interest margin. The negative effect of nonaccrual loans will continue as long as and to the extent that the balance of nonaccrual loans is elevated. The yield earned on investment securities will likely not fully recover for some time as new investments obtained during the current economic environment typically do not carry the same yield as those that we sold during 2010. When market interest rates begin to increase, our net interest margin will likely remain compressed until interest rates exceed the established rate floors.

 

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The interest income we earn on loans is the largest component of net interest income and the Bank’s net interest margin. The average balance of our loan portfolio decreased approximately $17.9 million during 2010 and, as mentioned above, the yield we earned on these loans decreased as well. Both of these factors contributed to the approximately $4.4 million reduction in loan related interest income. While management separately deals with the nonperforming loans that accounted for a considerable portion of the decline in yield and income during 2010, measures to offset the impact of the ongoing depressed rate environment, including certain terms and conditions applicable to performing loans such as repricing frequency, rate floors and fixed interest rates, have been used by the Bank in an attempt to reduce the impact of low interest rates.
Interest income on investment securities decreased approximately $3.6 million from 2009 to 2010 due to the 167 basis point decrease in the yield earned on these securities as well as the approximately $40.8 million decrease in volume of securities owned.
The decrease in interest expense during 2010 as compared to 2009 was primarily due to the general decrease in interest rates paid on deposits, primarily demand deposit accounts and time deposits (including brokered deposits), as well as subordinated debt. The decreases in the average balance of time deposits of approximately $2 million and interest-bearing demand deposits of approximately $31 million also contributed to the decrease in interest expense from 2009 to 2010. As a result of the approximately $3.6 million decrease in average federal funds purchased during 2010, the average rate paid on combined FHLB advances and other borrowings during 2010 was higher than the average rate paid during 2009. The rates paid to borrow federal funds are based on current market rates and are significantly lower than the average rates paid on our FHLB borrowings which are generally fixed rates obtained at various times under different market conditions. FHLB advances are typically subject to prepayment penalties that severely limit any interest rate advantages gained from early payment if current market rates are lower than rates applicable to outstanding advances. In spite of the 2010 average rate increase, interest expense on borrowed funds decreased approximately $130,000, reflecting the approximately $6.8 million decrease in average borrowed funds. In addition to the decrease in average federal funds purchased, we prepaid a $7.5 million FHLB advance during the third quarter of 2010 which is discussed in more detail under “Noninterest Expense” as well as “Note 7. FHLB Advances.” Interest expense on subordinated debt decreased during 2010 due exclusively to the 35 basis point decrease in the average rate paid on this debt which is priced at a spread above 3-month LIBOR.
Even as our cost of interest-bearing deposits has declined due to the actions of the Federal Open Markets Committee (“FOMC”) in recent years, the local competition for deposits, in some instances, has and could continue to cause interest rates paid on deposits to remain above market levels during 2010.
Rate and Volume Analysis
The following table sets forth the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected our interest income and interest expense during the years indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) change in volume (change in volume multiplied by previous year rate); (2) change in rate (change in rate multiplied by current year volume); and (3) a combination of change in rate and change in volume. The changes in interest income and interest expense attributable to both volume and rate have been allocated proportionately to the change due to volume and the change due to rate.

 

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ANALYSIS OF CHANGES IN NET INTEREST INCOME
FOR THE YEARS ENDED DECEMBER 31, 2010 AND 2009

(dollars in thousands)
                         
    2010 Compared to 2009  
    Increase (decrease)  
    due to change in  
    Rate     Volume     Total  
 
                       
Income from interest-earning assets:
                       
Interest and fees on loans
  $ (3,313 )   $ (1,085 )   $ (4,398 )
Interest on securities
    (1,948 )     (1,618 )     (3,566 )
Interest on Federal funds sold and other
    21       30       51  
 
                 
Total interest income
    (5,240 )     (2,673 )     (7,913 )
 
                       
Expense from interest-bearing liabilities:
                       
Interest on interest-bearing deposits
    (227 )     (316 )     (543 )
Interest on time deposits
    (1,808 )     (60 )     (1,868 )
Interest on other borrowings
    100       (345 )     (245 )
 
                 
Total interest expense
    (1,935 )     (721 )     (2,656 )
 
                 
 
                       
Net interest income
  $ (3,305 )   $ (1,952 )   $ (5,257 )
Provision for Loan Losses
The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses and is based on management’s evaluation of economic conditions, volume and composition of the loan portfolio, historical charge-off experience, the level of nonperforming and past due loans, and other indicators derived from reviewing the loan portfolio. Management performs such reviews quarterly and makes appropriate adjustments to the level of the allowance for loan losses as a result of these reviews.
As discussed in more detail under “Discussion of Financial Condition – Allowance for Loan Losses,” management determined it was necessary to increase the allowance for loan loss account through the provision for loan losses. Although total loans decreased approximately $33 million during 2010, the continuing increased level of provision for loan loss expense during 2010, as well as 2009, was due to increased charge-offs and delinquencies, related primarily to deterioration in the real estate segment of the Company’s loan portfolio, particularly construction and land development, as well as increased probable losses as the result of the slowdown in economic conditions. Continuing reductions in property values and the reduced volume of sales of developed and undeveloped land has led to an increase of impaired loans determined to be collateral dependent. As the collateral value for these land loans has declined significantly during 2010 and into 2011, related charge-offs and provision expense have been incurred. Management has continued its ongoing review of the loan portfolio with particular emphasis on construction and land development loans and we believe we have identified and adequately provided for losses present in the loan portfolio; however, due to the necessarily approximate and imprecise nature of the allowance for loan loss estimate, certain projected scenarios may not occur as anticipated. Additionally, further deterioration of factors relating to the loan portfolio, such as conditions in the local and national economy and the local real estate market, could have an added adverse impact and require additional provision expense and higher allowance levels.

 

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Noninterest Income
The following table presents the major components of noninterest income for 2010 and 2009 (dollars in thousands).
                                 
    Years Ended December 31,     Dollar Change     Percent Change  
    2010     2009     2010 to 2009     2010 to 2009  
Service charges on deposit accounts
  $ 1,642     $ 2,327     $ (685 )     -29.44 %
Other fees and commissions
    1,473       1,262       211       16.72 %
Gain on sale of mortgage loans
    191       147       44       29.93 %
Gain on sale of securities, net
    1,511       2,558       (1,047 )     -40.93 %
Loss on impairment of securities
          (347 )     347       -100.00 %
Gain (loss) on other real estate, net
    34       (1,479 )     1,513       -102.30 %
Other noninterest income
    899       395       504       127.59 %
 
                       
Total noninterest income
  $ 5,750     $ 4,863     $ 887       18.24 %
 
                       
The principal components of noninterest income during both 2009 and 2010 were service charges on deposits, fees associated with credit/debit cards included in “other fees and commissions”, and income resulting from the increase in the cash surrender value of bank owned life insurance (“BOLI”). Additionally, during 2009 and 2010, we sold approximately $90 million and $104 million, respectively, of our available-for-sale investment securities in order to reposition our bond portfolio for asset liability management purposes. As a result of the sale of these securities, during 2010 we realized a $1.5 million net gain and during 2009 we realized a $2.6 million net gain, excluding the securities impairment loss described below. Also during 2009, we recorded an approximately $1.5 million net loss on OREO, which includes valuation adjustments as well as gains and losses on disposal. We recorded a small net gain on OREO in 2010. The reduction in service charges on deposit accounts was primarily the result of a decrease in overdraft fees. During January 2009, we implemented an authorized overdraft program that led to increased overdraft fee income when compared to prior years. However, during 2010 these fees decreased as compared to 2009 due, in part, to regulatory changes that became effective during 2010 which are discussed in the following paragraph, as well as general consumer behavior. The increase in other fees and commissions from 2009 to 2010 was the result of increases in credit/debit card fees. The increase in other noninterest income was attributable to increases in the following areas: approximately $208,000 increase in OREO income related to rental of certain of our OREO properties, approximately $158,000 increase in income generated by our investment in the Appalachian Fund for Growth partnership and approximately $130,000 increase in income generated by the increased cash surrender value of BOLI.

 

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In November 2009, the Federal Reserve Board issued a final rule that, effective July 1, 2010, prohibited financial institutions from charging customers fees for paying overdrafts on automated teller machine and debit card transactions, unless a consumer consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the service, and the consumers’ choices. This rule had a negative impact on insufficient funds income during 2010.
In the first quarter of 2009, the Company experienced losses of $347,368 related to impairment of common stock held by the Bank and issued by Silverton and trust preferred securities held by the Bank and issued by a trust affiliated with Silverton which are guaranteed by Silverton. On May 1, 2009, Silverton’s bank subsidiary, Silverton Bank, was placed into receivership by the OCC after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009. On June 5, 2009, Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368 during the first quarter of 2009, which represents the Company’s full investment in the securities.
Noninterest Expenses
The following table presents the major components of noninterest expense for 2010 and 2009 (dollars in thousands).
                                 
    Years Ended December 31,     Dollar Change     Percent Change  
    2010     2009     2010 to 2009     2010 to 2009  
Salaries and employee benefits
  $ 8,322     $ 9,670     $ (1,348 )     -13.94 %
Occupancy expenses
    1,759       1,699       60       3.53 %
FDIC assessment expense
    1,161       1,537       (376 )     -24.46 %
Other operating expenses
    6,248       6,311       (63 )     -1.00 %
 
                       
Total noninterest expense
  $ 17,490     $ 19,217     $ (1,727 )     -8.99 %
 
                       
The largest component of our noninterest expense continues to be the cost of salaries and employee benefits, which decreased by approximately $1,348,000 during 2010, and was the most significant factor contributing to the overall decrease in noninterest expense. Other operating expenses decreased slightly as a whole, however; this decrease was negatively affected by an approximately $350,000 FHLB pre-payment penalty incurred during the third quarter of 2010 as well as the approximately $118,000 increase in OREO expense related to maintenance and upkeep of our foreclosed properties. These increases were offset by the effects of several cost cutting initiatives enacted during the first quarter of 2010 in an effort to improve its profitability during 2010. These measures included, but were not limited to, areas such as employee related expenses, business travel and other discretionary spending, equipment and supply expenses and marketing expenses. In total, these initiatives reduced the Company’s expenses by approximately $1.5 million during 2010. The decrease in noninterest expense was also attributable to the decrease in FDIC assessment expense during 2010 related to the overall decrease in deposits.

 

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Income Taxes
Our provision for income taxes and effective tax rates for 2010 and 2009 were as follows:
Provision for Income Taxes and Effective Tax Rates
(dollars in thousands)
                 
    Provision     Effective  
    Expense/(Benefit)     Tax Rates  
2010
  $ 3,738       -55.68 %
2009
  $ (3,788 )     47.26 %
The effective income tax rate for the year ended December 31, 2010 was approximately (55.68%), compared to an income tax benefit rate of 47.26% for the year ended December 31, 2009. Our income tax expense rate for 2010 was principally impacted by the recognition of a valuation allowance during 2010 as more fully discussed in “Note 6. Income Taxes.” Establishing a valuation allowance required us to record a significant tax expense which, when applied to a pretax loss, caused a negative effective tax rate. Additionally, tax exempt income has the effect of increasing a taxable loss, therefore increasing effective tax rates as a percentage of pretax income. This is the opposite effect on tax rates when a company has pretax income.
During 2009 and 2010, the effective tax rate was positively impacted by the continuing tax benefits generated from MNB Real Estate, Inc., which is a real estate investment trust subsidiary formed during the second quarter of 2005. The income generated from tax-exempt municipal bonds and bank owned life insurance also improved our effective tax rate in both years. Additionally, during 2006, the Bank became a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership has invested in a program that generated a federal tax credit in the amount of approximately $200,000 per year during 2009 and 2010. The program is also expected to generate a one-time state tax credit in the amount of $200,000 to be utilized over a maximum of 20 years to offset state tax liabilities.

 

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Discussion of Financial Condition
General Discussion of Our Financial Condition
The following is a summary comparison of selected major components of our financial condition for the periods ended December 31, 2010 and 2009 (dollars in thousands):
                                 
    2010     2009     $ change     % change  
Cash and equivalents
  $ 32,576     $ 14,105     $ 18,471       130.95 %
Loans
    374,355       407,704       (33,349 )     -8.18 %
Allowance for loan losses
    10,942       11,353       (411 )     -3.62 %
Investment securities
    87,635       146,534       (58,899 )     -40.19 %
Premises and equipment
    32,601       33,709       (1,108 )     -3.29 %
Other real estate owned
    13,141       14,575       (1,434 )     -9.84 %
 
                       
 
                               
Total assets
    557,207       639,739       (82,532 )     -12.90 %
 
                               
Noninterest-bearing demand deposits
    47,639       47,601       38       0.08 %
Interest-bearing demand and savings deposits
    130,779       173,769       (42,990 )     -24.74 %
Time deposits
    271,173       289,244       (18,071 )     -6.25 %
 
                       
 
                               
Total deposits
    449,591       510,614       (61,023 )     -11.95 %
 
                               
Federal Home Loan Bank advances
    55,200       62,900       (7,700 )     -12.24 %
Subordinated debentures
    13,403       13,403             0.00 %
 
                       
 
                               
Total liabilities
    521,532       592,370       (70,838 )     -11.96 %
 
                               
Accumulated other comprehensive income (loss)
    (1,065 )     283       (1,348 )     -476.33 %
Total shareholders’ equity
  $ 35,674     $ 47,369     $ (11,695 )     -24.69 %
Loans
At December 31, 2009 and 2010, loans comprised 74.2% and 77.4% of our total earning assets, respectively. While both loans and securities decreased during 2010, the increase in loans as a percent of total earning assets was caused by the relatively more significant decrease in our investment securities portfolio as discussed under “Securities.” Total earning assets as a percent of total assets, were 86.8% at December 31, 2010, compared to 86.3% at December 31, 2009. This slight increase in total earning assets relative to total assets in 2010 was attributable to decreases in nonearning assets including deferred tax assets, OREO and prepaid expenses associated with the Bank’s FDIC assessment. The increase in total earning assets as a percent of total assets was offset by decreases in loans and securities.

 

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Loan Portfolio. Our loan portfolio consisted of the following loan categories and amounts as of the dates indicated:
                                         
    At December 31,  
    2010     2009     2008     2007     2006  
    (in thousands)  
Commercial, financial, agricultural
  $ 24,944     $ 30,387     $ 37,632     $ 35,929     $ 26,062  
Real estate — construction, development
    83,543       99,771       142,370       150,844       137,989  
Real estate — mortgage
    260,738       270,622       231,999       201,011       173,085  
Consumer and other
    5,130       6,924       8,428       9,890       7,572  
 
                                       
Less allowance for loan losses
    10,942       11,353       5,292       3,974       3,524  
Loans, net
  $ 363,413     $ 396,351     $ 415,137     $ 393,700     $ 341,184  
Commercial and consumer loans tend to be more risky than loans that are secured by real estate; however, the Bank seeks to control this risk with adherence to quality underwriting standards. Still, as reflected in our 2009 and 2010 results of operations and described in more detail under “Allowance for Loan Losses,” real estate construction and development loans do involve risk and if the underlying collateral, which in the case of acquisition and development loans may involve large parcels of real property, is not equal to the value of the loan, we may suffer losses if the borrower defaults on its obligation to us.
Maturities and Sensitivities of Loan Portfolio to Changes in Interest Rates. Total loans as of December 31, 2010 are classified in the following table according to maturity or scheduled repricing:
                                 
    One year     Over one year     Over three years     Over five  
    or less     through three years     through five years     years  
    (in thousands)  
Commercial, financial, agricultural
  $ 10,825     $ 8,117     $ 3,170     $ 2,832  
Real estate — construction, development
    57,116       22,620       2,170       1,637  
Real estate — mortgage
    139,028       77,980       21,524       22,206  
Consumer and other
    3,102       1,490       422       116  
 
                               
Total
  $ 210,071     $ 110,207     $ 27,286     $ 26,791  
Of our loans maturing more than one year after December 31, 2010, approximately $80,696,000 had fixed rates of interest and approximately $83,588,000 had variable rates of interest. At December 31, 2010, loans to sub-dividers/developers were 17.7% of total loans and loans to franchise hotels & motels were 11.2% of total loans. No other concentrations of credit exceeded ten percent of our total loans.

 

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Past Due Loans and Non-Performing Assets
The following table presents performing loans that were past due at least 30 days but less than 90 days as of December 31, 2010 and 2009:
                                 
    December 31,  
    2010     2009  
    Balance     % of total loans     Balance     % of total loans  
    ($ in thousands)  
 
Construction, land development and other land loans
  $ 265       0.07 %   $ 656       0.16 %
Commercial real estate
    541       0.14 %     126       0.03 %
Consumer real estate
    1,130       0.30 %     1,125       0.28 %
Commercial loans
          0.00 %     138       0.03 %
Consumer loans
    68       0.02 %     81       0.02 %
 
                           
Total
  $ 2,004       0.54 %   $ 2,126       0.52 %
 
                           
Due to management’s ongoing efforts to identify and enter into workout arrangements with borrowers experiencing financial difficulty, delinquent loans at December 31, 2010 remained stable and were slightly lower than delinquent loans at December 31, 2009. Developers that do not have adequate cash flow or cash reserves to sustain the required interest payments on their loans during this period of economic stress have been unable to continue their developments. As a result, the Bank has classified a significant portion of these loans as non-performing assets.

 

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The Bank’s non-performing assets consist of loans past due 90 days or more and still accruing, nonaccrual loans and OREO. Loans that have been restructured and remain on accruing status are not included in non-performing assets. The following table presents the Bank’s non-performing assets for the periods indicated:
                                                 
    Past due 90 days                             Other real     Total  
    or more and     % of total     Nonaccrual     % of total     estate     non-performing  
    still accruing     loans     loans     loans     owned     assets  
    ($ in thousands)  
 
                                               
As of December 31, 2010
                                               
Construction, land development and other land loans
  $       0.00 %   $ 27,929       7.46 %   $ 2,595     $ 30,524  
Commercial real estate
    413       0.11 %     6,362       1.70 %     2,107       8,882  
Consumer real estate
          0.00 %     18,647       4.98 %     8,439       27,086  
Commercial loans
          0.00 %     67       0.02 %           67  
Consumer loans
    19       0.01 %           0.00 %           19  
 
                                       
Total
  $ 432       0.12 %   $ 53,005       14.16 %   $ 13,141     $ 66,578  
 
                                       
 
                                               
Total non-performing loans to total loans
                            14.27 %                
Total non-performing assets to total loans plus other real estate owned
                            17.18 %                
 
                                               
As of December 31, 2009
                                               
Construction, land development and other land loans
  $ 43       0.01 %   $ 21,596       5.30 %   $ 5,834     $ 27,473  
Commercial real estate
          0.00 %     11,003       2.70 %     1,093       12,096  
Consumer real estate
          0.00 %     7,864       1.93 %     7,648       15,512  
Commercial loans
          0.00 %     75       0.02 %           75  
Consumer loans
    25       0.01 %     10       0.00 %           35  
 
                                       
Total
  $ 68       0.02 %   $ 40,548       9.95 %   $ 14,575     $ 55,191  
 
                                       
 
                                               
Total non-performing loans to total loans
                            9.96 %                
Total non-performing assets to total loans plus other real estate owned
                            13.07 %                
Delinquent and nonaccrual loans at both December 31, 2010 and December 31, 2009 consisted primarily of construction and land development loans and commercial and consumer real estate loans. Approximately $27,929,000 of the nonaccrual loans, or 52.7% of the approximate $53,005,000 total at December 31, 2010, are construction and land development loans while commercial real estate and consumer real estate make up approximately $6,362,000 and $18,647,000, or 12.1% and 35.2%, respectively, of nonaccrual loans at that date.
Notwithstanding the general favorable trends in tourism in Sevier County, residential and commercial real estate sales continued to be weak during 2010, following the same pattern that began during the second half of 2008 and continued throughout 2009. The reduced sales have negatively impacted past due, nonaccrual and charged-off loans. Price declines during 2009 and 2010 have had an adverse impact on overall real estate values. These trends have had the greatest effect on the construction and development and commercial real estate portfolios resulting in the significant increase in nonaccrual loans during 2009 and continuing during 2010. Many of the borrowers in these categories are dependent upon real estate sales to generate the cash flows used to service their debt. Since real estate sales have been depressed, many of these borrowers have experienced greater difficulty meeting their obligations, and to the extent that sales remain depressed, these borrowers may continue to have difficulty meeting their obligations.

 

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The following table sets forth the reduction in interest income we experienced in 2009 and 2010 as a result of non-performance of certain loans during the year:
                 
    2010     2009  
    (in thousands)  
 
               
Interest income that would have been recorded on nonaccrual loans under original terms
  $ 3,164     $ 1,359  
 
               
Interest income that was recorded on nonaccrual loans
    603       45  
The purpose of placing a loan on nonaccrual is to prevent the Bank from overstating its income. The decision to place a loan on nonaccrual is made by management based on a monthly review. Management also reviews any loans placed on nonaccrual that are: (1) being maintained on a cash basis because of deterioration in the financial position of the borrower; or (2) for which payment in full of interest or principal is not expected.
Generally, the Bank does not accrue interest on any loan when principal or interest are in default for 90 days or more unless the loan is well secured and in the process of collection. Consumer loans and residential real estate loans secured by 1-4 family dwellings are ordinarily not subject to those guidelines.
Management may restore a non-accruing loan to an accruing status when principal and interest is no longer due and unpaid, or it otherwise becomes both well secured and in the process of collection. All loans on non-accrual are reported on the Bank’s watch loan list.
The Bank’s OREO decreased approximately $1,435,000 during 2010. One property, an operating nightly condo rental operation located in Pigeon Forge, Tennessee, which previously secured a loan for approximately $5,116,000, represents approximately $4,640,000, or 36%, of the OREO balance at December 31, 2010 (included in consumer real estate in the table above). The condos are currently under management contract with an experienced nightly rental management company as we seek to market the sale of the condo units.
Potential problem loans, which are not included in nonperforming loans, amounted to approximately $58.9 million, or 15.72% of total loans outstanding at December 31, 2010, compared to approximately $27.2 million, or 6.66% of total loans outstanding at December 31, 2009. Potential problem loans represent those loans with a well-defined weakness and where information about possible credit problems of borrowers has caused management to have serious doubts about the borrower’s ability to comply with present repayment terms. This definition is believed to be substantially consistent with the standards established by the OCC, the Bank’s primary regulator, for loans classified as substandard or worse, excluding the impact of nonperforming loans. The large increase in potential problem loans was caused primarily by the downgrade of additional residential construction and development loans, commercial and industrial loans, and commercial real estate loans due to the continuing deterioration in the economy. Loans past due 30 days or longer have been excluded from potential problem loans.

 

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During 2009, the Bank formed a Special Assets department. This department was significantly expanded during 2010 and it is dedicated to oversight of non-performing assets. The Special Assets department focuses on relationships that represent current and potential performance problems related to the Bank’s loan portfolio. The department also handles administration of the Bank’s OREO properties including incorporating new information and data as it becomes available and applying that information to the recorded value of assets.
Allowance for Loan Losses
The allowance for loan losses represents management’s assessment and estimates of the risks associated with extending credit and its evaluation of the quality of our loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provision required to maintain the allowance for loan losses at a level believed to be adequate to absorb probable incurred loan losses. In assessing the adequacy of the allowance, management reviews the size, quality and risk of loans in the portfolio. Management also considers such factors as the Bank’s loan loss experience, the amount of past due and nonperforming loans, impairment of loans, specific known risks, the status, amounts and values of nonperforming assets (including loans), underlying collateral values securing loans, current and anticipated economic conditions and other factors which affect the allowance for potential credit losses. Based on an analysis of the credit quality of the loan portfolio prepared by the Bank’s risk officer, the CFO presents a quarterly analysis of the adequacy of the allowance for loan losses for review by our board of directors.
During 2010, management sought to enhance its assessment of the allowance for loan losses by incorporating the results of a comprehensive historic loss rates migration analysis. The study provided more precise historical loss trends and percentages attributable to specific loan grades and types than were previously available. Consideration was given to recent charge off experience which management believes is a more reliable basis due to current economic conditions. The study did not have a material effect on the outcome of the allowance calculation; rather this data was used to narrow and refine management’s calculation and supported management’s previous estimation of the adequacy of the allowance for loan loss balance.
Our allowance for loan losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the level of risk in the loan portfolio. During their routine examinations of banks, regulatory agencies may advise a bank to make additional provisions to its allowance for loan losses, which would negatively impact a bank’s results of operations, when the opinion of the regulators regarding credit evaluations and allowance for loan loss methodology differ materially from those of the bank’s management. During the regular safety and soundness examination conducted by the Bank’s regulatory agency during the first quarter of 2011, significant increases were incurred due to required provisions to the allowance based on loans determined to be collateral dependent by the OCC. These changes have been recognized and incorporated into the results of operations as of December 31, 2010.

 

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Concentrations of credit risk typically involve loans to one borrower, an affiliated group of borrowers, borrowers engaged in or dependent upon the same industry, or a group of borrowers whose loans are secured by the same type of collateral. Our most significant concentration of credit risks lies in the high proportion of our loans to businesses and individuals dependent on the tourism industry and loans to subdividers and developers of land. The Bank assesses loan risk by primary concentrations of credit by industry and loans directly related to the tourism industry are monitored carefully. At December 31, 2010, approximately $192 million in loans, or 51% of total loans, were to businesses and individuals whose ability to repay depends to a significant extent on the tourism industry in the markets we serve as compared to approximately $200 million in loans, or 49% of total loans, at December 31, 2009. The most significant decreases in this category were display advertising, full service restaurants and overnight rentals by owner which decreased approximately $5 million, $3 million and $1 million, respectively.
While it is the Bank’s policy to charge off in the current period loans for which a loss is considered confirmed, there are additional risks of losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because the risk of loss includes unpredictable factors, such as the state of the economy and conditions affecting individual borrowers, management’s judgments regarding the appropriate size of the allowance for loan losses is necessarily approximate and imprecise, and involves numerous estimates and judgments that may result in an allowance that is insufficient to absorb all incurred loan losses.
Management is not aware of any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been identified and sufficiently provided for in the allowance for loan losses which (1) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (2) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.
Individually impaired loans are loans that the Bank does not expect to collect all amounts due according to the contractual terms of the loan agreement and include any loans that meet the definition of a troubled debt restructuring (“TDR”), as discussed in more detail below. In some cases, collection of amounts due becomes dependent on liquidating the collateral securing the impaired loan. Collateral dependent loans do not necessarily result in the loss of principal or interest amounts due; rather the cash flow is disrupted until the underlying collateral can be liquidated. As a result, the Bank’s impaired loans may exceed nonaccrual loans which are placed on nonaccrual status when questions arise about the future collectability of interest due on these loans. The status of impaired loans is subject to change based on the borrower’s financial position.
Problem loans are identified and monitored by the Bank’s watch list report which is generated during the loan review process. This process includes review and analysis of the borrower’s financial statements and cash flows, delinquency reports and collateral valuations. The watch list includes all loans determined to be impaired. Management determines the proper course of action relating to these loans and receives monthly updates as to the status of the loans.

 

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The following table presents impaired loans as of December 31, 2010 and December 31, 2009:
                                 
    December 31, 2010     December 31, 2009  
    Impaired     % of total     Impaired     % of total  
    Loans     loans     Loans     loans  
    ($ in thousands)  
       
Construction, land development and other land loans
  $ 41,517       11.09 %   $ 27,213       6.67 %
Commercial real estate
    21,529       5.75 %     13,224       3.24 %
Consumer real estate
    29,182       7.80 %     22,616       5.55 %
Other loans
    128       0.03 %     94       0.02 %
 
                           
Total
  $ 92,356       24.67 %   $ 63,147       15.49 %
 
                           
The increase in impaired loans during 2010 was primarily related to the continued weakening of the residential and commercial real estate market in the Bank’s market areas. Within this segment of the portfolio, the Bank has traditionally made loans to, among other borrowers, home builders and developers of land. These borrowers have continued to experience stress during the current real estate recession due to a combination of declining demand for residential real estate, excessive volume of properties available and the resulting price and collateral value declines. In addition, housing starts in the Bank’s market areas continue to be at historically low levels. An extended recessionary period in real estate will likely cause the Bank’s real estate mortgage loans, which include construction and land development loans, to continue to underperform and may result in increased levels of impaired loans and non-performing assets, which may negatively impact the Company’s results of operations.
Thirty-six impaired loans with a total balance of approximately $28,804,000 were considered to be collateral dependent at December 31, 2010, and of this amount approximately $22,804,000 are trouble debt restructurings discussed in more detail below. Collateral dependent loans are recorded at the lower of cost or the appraised value net of estimated selling costs. It is generally determined these loans will be repaid by the liquidation of the collateral securing the loans. Management obtains independent appraisals of the collateral securing collateral dependent loans at least annually from independent licensed real estate appraisers and the carrying amount of the loans that exceed the appraised value net of estimated selling costs is taken as a charge against the allowance for loan losses and may result in additional charges to the provision expense. At the date of this filing, seven of the thirty-six collateral dependent loans were pending receipt of a current reviewed appraisal (an appraisal within the past twelve months). It is anticipated these appraisals, when received, will result in additional charge off to be recorded during the first quarter of 2011 totaling approximately $1,400,000. Management believes the anticipated losses on these loans have been adequately provided as of December 31, 2010 and there is a specific reserve relating to these loans equal to the estimated loss to be recorded. All loans considered collateral dependent are nonaccrual loans and included in the nonperforming loan balances. Management has recorded partial charge offs on these collateral dependent loans totaling $5,545,331 as of December 31, 2010.

 

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Due to the weakening credit status of a borrower, we may elect to formally restructure certain loans to facilitate a repayment plan that minimizes the potential losses, if any, that we might incur. All restructured loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. At December 31, 2010 and 2009, there were $36.0 million and $21.8 million, respectively, of accruing restructured loans that remain in a performing status.
TDRs at December 31, 2010 totaled approximately $82,443,000 which is 89.3% of total impaired loans. The TDRs related primarily to construction and development loans totaling approximately $36,661,000, or 39.7% of impaired loans, 1-4 family residential loans totaling approximately $25,630,000, or 27.8% of impaired loans and commercial real estate loans totaling approximately $20,023,000, or 21.7% of impaired loans. The TDRs are due to lack of real estate sales and weak or insufficient cash flows of the guarantors of the loans due to the current economic climate. The majority of the TDRs are for a limited term, in most instances, of one to two years, and include an interest rate reduction during this term.
Our allowance for loan losses at December 31, 2010 was approximately $10,942,000, a net decrease of approximately $411,000 for the year. The allowance for loan losses as a percentage of total loans, non-accrual loans and non-performing assets at December 31, 2010 was 2.92%, 20.64% and 20.48%, respectively, compared to 2.78%, 28.00% and 27.95%, respectively, at December 31, 2009. Net charge-offs during 2010 increased from approximately $5,612,000 in 2009 to approximately $8,138,000 in 2010, representing a net charge-off ratio of 2.05% in 2010 compared to 1.35% in 2009. Management continues to evaluate and adjust our allowance for loan losses, and presently believes the allowance for loan losses is adequate to provide for probable losses inherent in the loan portfolio. Management believes the loans, including those loans that were delinquent at December 31, 2010, that will result in additional charge-offs have been identified and adequate provision has been made in the allowance for loan loss balance. No assurance can be given, however, that adverse economic circumstances, declines in real estate values or other events or changes in borrowers’ financial conditions, particularly borrowers in the real estate construction and development business, will not result in increased losses in the Bank’s loan portfolio or in the need for increases in the allowance for loan losses through additional provision expense in future periods.

 

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The following table summarizes our loan loss experience and related adjustments to the allowance for loan losses as of the dates and for the periods indicated:
                                         
    At December 31,  
    2010     2009     2008     2007     2006  
    (dollars in thousands)  
Average balance of loans outstanding
  $ 397,594     $ 415,522     $ 417,124     $ 373,237     $ 292,950  
 
                                       
Balance of allowance for loan losses at beginning of year
    11,353       5,292       3,974       3,524       2,634  
Charge-offs:
                                       
Commercial, financial, agricultural
    225       328       198       43        
Real estate — construction, development
    5,439       3,054       686       158       1  
Real estate — mortgage
    2,652       2,220       41       250       25  
Consumer and other
    278       289       98       110       23  
 
                                       
Recoveries:
                                       
Commercial, financial, agricultural
    13       1       43              
Real estate — construction, development
    390                         1  
Real estate — mortgage
    4       251       11       15       18  
Consumer and other
    49       27       12       14       5  
 
                                       
Net charge-offs
    8,138       5,612       957       532       25  
Additions to allowance charges to operations
    7,727       11,673       2,275       982       915  
Balance of allowance for loan losses at end of year
    10,942       11,353       5,292       3,974       3,524  
Ratio of net loan charge-offs during the year to average loans outstanding during the year
    2.05 %     1.35 %     0.23 %     0.14 %     0.01 %
The following table presents our allocation of the allowance for loan losses to the categories of loans in our loan portfolio as of the dates indicated:
                                                                                 
    At December 31,  
    2010     2009     2008     2007     2006  
            Loan             Loan             Loan             Loan             Loan  
            Category as             Category as             Category as             Category as             Category as  
            % of Total             % of Total             % of Total             % of Total             % of Total  
    Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans     Amount     Loans  
    (dollars in thousands)  
Commercial
  $ 396       6.65 %   $ 557       7.45 %   $ 1,289       8.95 %   $ 968       9.03 %   $ 418       7.56 %
Real estate — construction, development
    3,614       22.31 %     5,844       24.47 %     2,131       33.86 %     1,600       37.93 %     1,331       40.03 %
Real estate — mortgage
    6,713       69.67 %     4,798       66.38 %     1,599       55.18 %     1,201       50.55 %     1,669       50.21 %
Consumer, other
    219       1.37 %     154       1.70 %     273       2.01 %     205       2.49 %     106       2.20 %
 
                                                           
Total
  $ 10,942       100.00 %   $ 11,353       100.00 %   $ 5,292       100.00 %   $ 3,974       100.00 %   $ 3,524       100.00 %
Securities
Our investment securities portfolio consists primarily of mortgage-backed securities and municipal securities. The investment securities portfolio is the second largest component of our earning assets and represented 18.11% of total earning assets and 15.73% of total assets at year-end 2010. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. We also use our investment securities portfolio to meet pledging requirements for deposits and borrowings. The average yield on our investment securities portfolio during 2010 was 2.31% versus 3.98% for 2009, a decrease of 167 basis points. Net unrealized gains (losses) on securities available for sale, included in accumulated other comprehensive income (loss), decreased from a net unrealized gain of $283,014 for the year ended December 31, 2009 to a net unrealized loss of ($1,064,678) at December 31, 2010.

 

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The approximately $59 million decrease in investment securities during 2010 was primarily liquidated through U.S. Treasury securities that matured during the second and third quarters of 2010 and is primarily attributable to decreased pledging requirements related to the reduction in municipal deposits discussed in more detail below and under “Deposits.” Municipal deposits, which are secured by a portion of the Bank’s investment securities and are currently required to be over-collateralized by such securities, decreased approximately $60 million, or 60%, during 2010 from approximately $100 million at December 31, 2009 to approximately $40 million at December 31, 2010. Pledging requirements for municipal deposits have decreased approximately $67 million from approximately $115 million to approximately $48 million at December 31, 2009 and December 31, 2010, respectively. As an integral component of our asset/liability management strategy, we manage our investment securities portfolio to maintain liquidity, balance interest rate risk and augment interest income. In addition to securing public deposits, we also use our investment securities portfolio to meet pledging requirements for borrowings.
During the third quarter of 2009, in an effort to improve the Bank’s long-term liquidity position, management developed a strategy that would reduce the size of the Bank’s assets between $50 million and $100 million. A central element of this strategy involved not bidding to retain certain public deposits as the contracts came up for renewal. These deposits are collateralized with securities representing up to 126% of the value of the deposits. In preparation to liquidate the securities pledged to secure the public funds as the funds were drawn out of the Bank, management sold substantial portions of its mortgage-backed and municipal securities and re-invested the proceeds from sales and maturities of mortgage-backed and municipal securities in short-term U.S. Treasury and government agency securities. In most cases, the securities were sold at a gain. When comparing the December 31, 2010 and 2009 portfolio balances, the significant changes that occurred in our portfolio during 2010 are not immediately evident, however; the distribution of the portfolio changed considerably throughout 2010 as funds were transferred among categories as described above. These changes caused a decrease in the yield on investment securities during 2010 as the rates earned on short-term U.S. Treasury and government agency securities are significantly lower than the rates earned on mortgage-backed and municipal securities. At December 31, 2010, the Bank’s portfolio was back to a more historically characteristic composition. However, the yield earned on investment securities will likely not fully recover for some time as new investments obtained during the current interest rate environment typically do not carry the same yield as those that we sold during 2010.
Additionally, at December 31, 2010, we had approximately $31 million in mortgage-backed and municipal securities pledged as collateral for certain federal funds lines of credit and FHLB borrowings. The average yields on these investments generally exceeded the cost of the interest-bearing deposits that funded them during 2010. However, the cost of these deposits and the lower yield associated with these securities, when compared to loans, negatively impacted our net interest margin during 2010. Included in our investment securities portfolio as of December 31, 2010, was approximately $5,519,000 in tax-exempt municipal securities.

 

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The carrying amounts of securities at the dates indicated are summarized as follows:
                         
    At December 31,  
    2010     2009     2008  
    (in thousands)  
 
Securities available for sale:
                       
U.S. Treasury and government agencies and corporations
  $ 250     $ 10,149     $ 5,751  
Corporate securities
                175  
Mortgage-backed securities — residential
    81,145       114,057       98,045  
Obligations of states and political subdivisions
    4,922       20,124       20,607  
 
                 
Total
    86,317       144,330       124,578  
Securities held to maturity:
                       
Obligations of states and political subdivisions
    1,318       2,204       2,117  
The following table contains the contractual maturity distribution, carrying value, and weighted-average yield to maturity of our investment securities.
                                                                                 
    Maturity  
            Weighted             Weighted             Weighted             Weighted             Weighted  
            Average Tax     After 1     Average Tax     After 5     Average Tax             Average Tax             Average Tax  
    1 year     Equivalent     Year - 5     Equivalent     Years - 10     Equivalent     Over 10     Equivalent             Equivalent  
    or less     Yield     Years     Yield     Years     Yield     Years     Yield     Total     Yield  
    (dollars in thousands)  
Securities available for sale:
                                                                               
U.S. Treasury and government agencies
  $ 250       0.14 %   $           $           $           $ 250       0.14 %
Mortgage-backed securities — residential
                    74,096       3.74 %     5,785       4.09 %     1,264       3.77 %     81,145       3.76 %
Obligations of states and political subdivisions
                264       2.33 %     1,189       5.68 %     3,469       4.47 %     4,922       4.65 %
 
                                                             
Total available for sale
    250       0.14 %     74,360       3.73 %     6,974       4.36 %     4,733       4.29 %     86,317       3.80 %
 
                                                                               
Securities held to maturity:
                                                                               
Obligations of states and political subdivisions
                            722       4.65 %     596       4.72 %     1,318       4.68 %
 
                                                           
Total held to maturity
                            722       4.65 %     596       4.72 %     1,318       4.68 %
 
                                                                               
Total securities
    250       0.14 %     74,360       3.73 %     7,696       4.39 %     5,329       4.33 %     87,635       3.82 %
We did not hold any securities from a single issuer that exceeded 10% of total shareholders’ equity as of December 31, 2010, except for mortgage-backed securities issued by government sponsored entities that had a carrying value of approximately $81,145,000 and $114,057,000 at December 31, 2010 and 2009, respectively.

 

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Deposits
Total deposits decreased during 2010 and the balances were distributed as follows:
                                 
    2010     2009     $ change     % change  
Noninterest-bearing demand deposits
  $ 47,638     $ 47,601     $ 37       0.08 %
 
                       
Total noninterest-bearing deposits
    47,638       47,601       37       0.08 %
NOW accounts
    57,345       112,440       (55,095 )     -49.00 %
Money market accounts
    49,701       40,809       8,892       21.79 %
Savings
    23,734       20,520       3,214       15.66 %
Brokered deposits
    27,019       69,871       (42,852 )     -61.33 %
Time deposits
    244,154       219,373       24,781       11.30 %
 
                       
Total interest-bearing deposits
    401,953       463,013       (61,060 )     -13.19 %
Total deposits
  $ 449,591     $ 510,614     $ (61,023 )     -11.95 %
The balance in NOW accounts primarily consists of public funds deposits. As discussed under Investment Securities, management anticipated the significant reduction in NOW accounts during 2010 that was the result of withdrawal of the deposits of a local municipal entity upon contract renewal. Public funds are generally obtained through a bidding process under varying terms.
The increase in money market accounts is related to the seasonality of the tourism industry in the Bank’s market area. The Bank’s customers typically experience their strongest cash inflows during the third and fourth quarter of each year.
The increase in savings deposits is the result of the continued success of our competitive rate savings product.
The increase in certificates of deposit was the result of an increase in customer deposits and acceptance of deposits through a national listing service. We offer certificate of deposit accounts on a wide range of terms in order to achieve sustained growth in a market area where there is strong competition for new deposits.
Brokered deposits are certificates of deposit acquired from approved brokers on terms that are substantially similar to deposits acquired in the local market. Brokered deposits decreased approximately $43 million during 2010, and represented approximately 6.01% and 13.68% of total deposits at December 31, 2010 and 2009, respectively. The Bank significantly reduced its reliance on brokered deposits during 2010 and management intends to seek to further reduce the level of brokered deposits during 2011. The average cost of our brokered deposits at December 31, 2010 was 1.70%. During 2010, the average cost of these deposits was 1.81%. We have not and do not intend to replace any maturing brokered deposits during 2011.
Because we anticipate that we will be required to enter into an OCC Consent Order that will establish specific capital amounts to be maintained by the Bank, the Bank cannot be considered better than “adequately capitalized” under capital adequacy regulations, even if the Bank exceeds the levels of capital set forth in the Consent Order and the normal requirements for “well capitalized” status. As long as it is considered an adequately capitalized institution, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC. As of December 31, 2010, brokered deposits maturing in the next 24 months totaled approximately $18.8 million. Funding sources for the maturing brokered deposits include, among other sources: our cash account at the Federal Reserve Bank of Atlanta; growth, if any, of core deposits from current and new retail and commercial customers; scheduled repayments on existing loans; and the possible pledge or sale of investment securities.

 

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Because the Bank will not be considered “well capitalized” following issuance of the Consent Order, it will also not be permitted to pay interest on deposits at rates that are more than 75 basis points above the national rate as determined by the FDIC. These interest rate limitations may limit the ability of the Bank to increase or maintain core deposits from current and new deposit customers.
The average balances of deposit accounts by category and the average rates paid thereon are presented below for the periods indicated:
                                                 
    2010     2009     2008  
    Amount     Rate     Amount     Rate     Amount     Rate  
    (dollars in thousands)  
Noninterest-bearing demand deposits
  $ 46,237       0 %   $ 45,761       0 %   $ 48,331       0 %
Interest-bearing demand deposits
    119,547       1.09 %     150,384       1.23 %     142,020       2.16 %
Savings deposits
    22,790       1.08 %     17,340       1.39 %     13,815       1.95 %
Time deposits
    302,494       2.08 %     304,715       2.67 %     224,055       4.28 %
 
                                         
 
                                               
Total
  $ 491,068             $ 518,200             $ 428,221          
 
                                         
The balances in time certificates of deposit issued in amounts of $100,000 or more as of December 31, 2010, are shown below by time remaining until maturity:
         
    (dollars in thousands)  
 
         
Three months or less
  $ 73,289  
Over three months through six months
    30,097  
Over six months through 12 months
    80,470  
Over 12 months
    87,317  
 
     
Total
  $ 271,173  
The average balance of interest-bearing demand and savings deposits decreased approximately $25,387,000 during 2010. The average rate paid on these interest-bearing demand and savings deposits in 2010 was 1.09%, down from 1.25% in 2009.
Our total average cost of interest-bearing deposits (including demand, savings and certificate of deposit accounts) for 2010 was 1.76%, down from 2.17% in the prior year.

 

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Shareholders’ Equity
The decrease in shareholders’ equity was primarily the result of the 2010 net loss of approximately $10,451,000. Accumulated other comprehensive income (loss) represents the net unrealized gain (losses) on securities available-for-sale. The decrease in accumulated comprehensive income from a net gain of $283,014 at December 31, 2009 to a net loss of $1,064,678 at December 31, 2010 also contributed to the decrease in shareholders’ equity during 2010.
Interest Rate Sensitivity Management
Interest rate risk is the risk to earnings or market value of equity from the potential movement in interest rates. The primary purpose of managing interest rate risk is to reduce the effects of interest rate volatility and achieve reasonable stability of earnings from changes in interest rates and preserve the value of our equity. Changes in interest rates affect, among other things, our net interest income, volume of loan production and the fair value of financial instruments and our loan portfolio. A key component of our interest rate risk management policy is the maintenance of an appropriate mix of assets and liabilities.
Our earnings are affected not only by general economic conditions, but also by the monetary and fiscal policies of the U.S. and its agencies, particularly the Federal Reserve. The monetary policies of the Federal Reserve can influence the overall growth of loans, investment securities, and deposits and the level of interest rates earned on assets and paid for liabilities. The nature and impact of future changes in monetary policies are generally not predictable.
It is our objective to manage assets and liabilities to control the impact of interest rate fluctuations on earnings and to provide a satisfactory, consistent level of profitability within the framework of established cash, loan, investment, borrowing, and capital policies. Certain officers within the Bank are charged with the responsibility for monitoring policies and procedures that are designed to ensure acceptable composition of the asset/liability mix.
The Bank’s asset/liability mix is monitored on a regular basis and a report reflecting the interest rate sensitive assets and interest rate sensitive liabilities is prepared and presented to our Board of Directors and management’s asset/liability committee on a quarterly basis. The key objective of our asset/liability management policy is to monitor and adjust the mix of interest rate sensitive assets and liabilities so as to minimize the impact of substantial movements in interest rates on earnings by matching rates and maturities of our interest-earning assets to those of our interest-bearing liabilities. An asset or liability is considered to be interest rate-sensitive if it will reprice or mature within the time period analyzed, usually one year or less.

 

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We use interest rate sensitivity gap analysis to achieve the appropriate mix of interest rate-sensitive assets and liabilities. The interest rate-sensitivity gap is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a given time period. A gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. A gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. Conversely, during a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to adversely affect net interest income. If our assets and liabilities were equally flexible and moved concurrently, the impact of any increase or decrease in interest rates on net interest income would be minimal.
A simple interest rate “gap” analysis by itself may not be an accurate indicator of how net interest income will be affected by changes in interest rates. Accordingly, we also evaluate how the repayment of particular assets and liabilities is impacted by changes in interest rates. Income associated with interest-earning assets and costs associated with interest-bearing liabilities may not be affected uniformly by changes in interest rates. In addition, unpredictable variables such as the magnitude and duration of changes in interest rates may have a significant impact on net interest income. For example, although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. Interest rates on certain types of assets and liabilities fluctuate in advance of changes in general market rates, while interest rates on other types of assets and liabilities may lag behind changes in general market rates. In addition, certain assets, such as adjustable rate mortgage loans, have features (generally referred to as “interest rate caps”), that limit changes in interest rates. Prepayment and early withdrawal levels also could deviate significantly from those assumed in calculating the interest rate gap.

 

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The following table summarizes our interest-sensitive assets and liabilities as of December 31, 2010. Adjustable rate loans are included in the period in which their interest rates are scheduled to adjust. Fixed rate loans are included in the periods in which they are anticipated to be repaid based on scheduled maturities and anticipated prepayments. Investment securities are included in the period in which they are scheduled to mature while mortgage backed securities are included according to expected repayment. Certificates of deposit are presented according to contractual maturity dates.
Analysis of Interest Sensitivity
As of December 31, 2010

(dollars in thousands)
                                         
    0 - 3     3 - 12     1 - 3     Over three        
    months     months     years     years     Total  
Federal funds sold
  $ 2,536     $     $     $     $ 2,536  
Securities
    3,031       9,426       24,000       51,178       87,635  
Loans (1)
    181,404       78,123       82,277       32,551       374,355  
 
                             
Total interest-earning assets
    186,971       87,549       106,277       83,729       464,526  
 
                             
 
                                       
Interest-bearing liabilities:
                                       
Interest-bearing demand deposits
    107,046                         107,046  
Savings
    23,734                         23,734  
Time deposits
    72,495       110,187       77,820       10,671       271,173  
Other borrowings
                5,200       50,000       55,200  
 
                             
Total interest-bearing liabilities
    203,275       110,187       83,020       60,671       457,153  
 
                             
 
                                       
Interest rate sensitivity gap
  $ (16,304 )   $ (22,638 )   $ 23,257     $ 23,058     $ 7,373  
 
                             
 
                                       
Cumulative interest rate sensitivity gap
  $ (16,304 )   $ (38,942 )   $ (15,685 )   $ 7,373          
 
                               
 
                                       
Interest rate sensitivity gap ratio
    -8.72 %     -25.86 %     21.88 %     27.54 %        
 
                                       
Cumulative interest rate sensitivity gap ratio
    -8.72 %     -14.19 %     -4.12 %     1.59 %        
 
     
(1)  
Includes nonaccrual loans
At December 31, 2010, the Bank’s cumulative one-year interest rate sensitivity gap ratio was (14.19%), which would tend to indicate that our interest-earning assets will re-price during this period at a rate slower than our interest-bearing liabilities. The effects of certain categories of interest-bearing liabilities, primarily interest-bearing demand deposits and overnight federal funds purchased, tend to be overstated in our gap analysis and we believe that the spread between our interest-earning assets and interest-bearing liabilities will not be affected as much by the repricing period for these deposits as they will by the current interest rate environment. Currently, due to the extended period of low interest rates, our short term interest-sensitive assets and liabilities are likely close to their floors. Certain longer term interest-sensitive assets and liabilities, particularly fixed rate loans, time deposits and long-term borrowings, have more potential for repricing adjustments as they mature and are replaced at current rate levels. Additionally, when interest rates increase, our cumulative interest rate sensitivity gap indicates that a larger volume of our interest-bearing liabilities will reprice more quickly than our interest-earning assets. This could cause further compression of our net interest margin until the volume of interest-sensitive assets earning higher rates of interest gets closer to the volume of interest-sensitive liabilities already bearing higher rates of interest.

 

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Return on Assets and Equity
The following table summarizes our return on average assets and return on average equity as well as our dividend payout ratio for the years ended December 31, 2010, 2009 and 2008:
                         
    For the Years Ended  
    At December 31,  
    2010     2009     2008  
Return on average assets
    -1.69 %     -0.64 %     0.56 %
Return on average equity
    -21.83 %     -8.14 %     6.48 %
Average equity as a percentage of average assets
    7.74 %     7.88 %     8.68 %
Cash dividend payout ratio
    0.00 %     0.00 %     30.65 %
Capital Adequacy and Liquidity
Our funding sources primarily include customer-based core deposits and customer repurchase accounts. The Bank, being situated in a market that relies on tourism as its principal industry, can be subject to periods of reduced deposit funding because tourism in Sevier County is seasonably slow in the winter months. The Bank manages seasonal deposit outflows through its secured Federal Funds lines of credit at various correspondent banks. Available lines totaled $33 million with $10 million secured and accessible as of December 31, 2010, and are available on one day’s notice. The Bank also has a cash management line of credit in the amount of $100 million from the FHLB of Cincinnati as well as a line of credit totaling approximately $24 million at December 31, 2010 from the Federal Reserve Discount Window that the Bank uses to meet short-term liquidity demands, none of which was borrowed as of that date. The borrowing capacity can be increased based on the amount of collateral pledged.
Capital adequacy is important to the continued financial safety and soundness and growth of the Bank and the Company. Our banking regulators have adopted risk-based capital and leverage guidelines to measure the capital adequacy of national banks and bank holding companies. Based on these guidelines, management believes the Bank and the Company met the current regulatory definitions for “well capitalized” at December 31, 2010. However, as noted below, the Bank anticipates that it will be required to enter into a Consent Order which will contain higher capital standards which will result in it being deemed to be “adequately capitalized” for regulatory purposes, including being subject to broker deposit restrictions.
Regulatory Capital Requirements
The Bank and Company are subject to minimum capital standards as set forth by federal bank regulatory agencies.
Capital for regulatory purposes differs from equity as determined under generally accepted accounting principles. Generally, “Tier 1” regulatory capital will equal capital as determined under generally accepted accounting principles together with eligible trust preferred securities and less any unrealized gains or losses on securities available for sale, while “Tier 2” capital includes the allowance for loan losses up to certain limitations. Total risk based capital is the sum of Tier 1 and Tier 2 capital.
Total capital at the Bank also has an important effect on the amount of FDIC insurance premiums paid. Institutions not considered well capitalized are subject to higher rates for FDIC insurance.

 

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The Bank is subject to the supervision, examination and reporting requirements of the National Bank Act and the regulations of the OCC. In the first quarter of 2010, the Bank agreed to an OCC individual minimum capital requirement (“IMCR”) to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. As of December 31, 2010, the Tier 1 capital to average assets ratio for the Bank was below the agreed upon 9% minimum. As a result, it is subject to further enforcement action.
The table below sets forth the Bank’s capital ratios as of the periods indicated:
                 
    December 31,  
    2010     2009  
Tier 1 Leverage
    8.41 %     9.14 %
Adequately capitalized regulatory minimum
    4.00 %     4.00 %
Well-capitalized regulatory minimum
    5.00 %     5.00 %
Required by IMCR
    9.00 %     N/A  
 
               
Tier 1 Risk-Based Capital
    11.97 %     12.75 %
Adequately capitalized regulatory minimum
    4.00 %     4.00 %
Well-capitalized regulatory minimum
    6.00 %     6.00 %
 
               
Total Risk-Based Capital
    13.23 %     14.02 %
Adequately capitalized regulatory minimum
    8.00 %     8.00 %
Well-capitalized regulatory minimum
    10.00 %     10.00 %
Required by IMCR
    13.00 %     N/A  
The table below sets forth the Company’s capital ratios as of the periods indicated:
                 
    December 31,  
    2010     2009  
Tier 1 Leverage
    8.34 %     9.23 %
Regulatory minimum
    4.00 %     4.00 %
 
               
Tier 1 Risk-Based Capital
    11.87 %     12.89 %
Regulatory minimum
    4.00 %     4.00 %
 
               
Total Risk-Based Capital
    13.27 %     14.16 %
Regulatory minimum
    8.00 %     8.00 %

 

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In November 2003, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust I. This subsidiary issued approximately $5.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. In June 2006, the Company formed a wholly owned Delaware statutory trust subsidiary, MNB Capital Trust II. This subsidiary issued approximately $7.5 million in trust preferred securities, guaranteed by the Company on a junior subordinated basis. The Company obtained the proceeds from the trusts’ sale of trust preferred securities by issuing junior subordinated debentures to the trusts. Under the Financial Accounting Standards Board’s revised Interpretation No. 46 (“FIN 46R”), the trust subsidiaries must be deconsolidated with the Company for accounting purposes. As a result of this accounting pronouncement, the Federal Reserve adopted changes to its capital rules with respect to the regulatory capital treatment afforded to trust preferred securities. The Federal Reserve’s current rules permit qualified trust preferred securities and other restricted capital elements to be included as Tier 1 capital up to 25% of core capital, net of goodwill and intangibles. Additionally, following passage of the Dodd-Frank Act, trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. The Company believes that its trust preferred securities qualify under both of these revised regulatory capital rules and accordingly, expects that it will continue to treat its $13 million of trust preferred securities as Tier 1 capital subject to the limits listed above.
Liquidity is the ability of a company to convert assets into cash or cash equivalents without significant loss. Our liquidity management involves maintaining our ability to meet the day-to-day cash flow requirements of our customers, whether they are depositors wishing to withdraw funds or borrowers requiring funds to meet their credit needs. Without proper liquidity management, we would not be able to perform the primary function of a financial intermediary and would, therefore, not be able to meet the production and growth needs of the communities we serve.
The primary function of asset and liability management is not only to assure adequate liquidity in order for us to meet the needs of our customer base, but also to maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities so that we can also meet the investment objectives of our shareholders. For additional information relating to our interest rate sensitivity management, refer to the discussion above under the heading “Interest Rate Sensitivity Management.” Daily monitoring of the sources and uses of funds is necessary to maintain an acceptable cash position that meets both the needs of our customers and the objectives of our shareholders. In a banking environment, both assets and liabilities are considered sources of liquidity funding and both are therefore monitored on a daily basis.
Off-Balance Sheet Arrangements
Our only material off-balance sheet arrangements consist of commitments to extend credit and standby letters of credit issued in the ordinary course of business to facilitate customers’ funding needs or risk management objectives.
Commitments and Lines of Credit
In the ordinary course of business, the Bank has granted commitments to extend credit and standby letters of credit to approved customers. Generally, these commitments to extend credit have been granted on a temporary basis for seasonal or inventory requirements and have been approved by the Bank’s loan committee. These commitments are recorded in the financial statements as they are funded. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitment amounts expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

 

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The following is a summary of the Bank’s commitments outstanding at December 31, 2010 and 2009.
                 
    2010     2009  
    (dollars in thousands)  
Commitments to extend credit
  $ 41,155     $ 50,702  
Standby letters of credit
    5,288       5,801  
 
           
Totals
  $ 46,443     $ 56,503  
Commitments to extend credit include unused commitments for open-end lines secured by 1-4 family residential properties, commitments to fund loans secured by commercial real estate, construction loans, land development loans, and other unused commitments. Commitments to fund commercial real estate, construction, and land development loans decreased approximately $6,369,000 during 2010, reflecting current economic conditions in our market.
Effects of Inflation
Our consolidated financial statements and related data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operational results in terms of historic dollars, without considering changes in the relative purchasing power of money over time due to inflation.
Inflation generally increases the costs of funds and operating overhead, and to the extent loans and other assets bear variable rates, the yields on such assets. Unlike most industrial companies, virtually all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant effect on the performance of a financial institution than the effects of general levels of inflation. In addition, inflation affects financial institutions’ cost of goods and services purchased, the cost of salaries and benefits, occupancy expense, and similar items. Inflation and related increases in interest rates generally decrease the market value of investments and loans held and may adversely affect liquidity, earnings, and stockholders’ equity. Mortgage originations and refinancings tend to slow as interest rates increase, and likely will reduce the Bank’s volume of such activities and the income from the sale of residential mortgage loans in the secondary market.
Significant Accounting Changes
The information appearing under “Note 18. Recent Accounting Pronouncements” in the 2010 notes to the financial statements is incorporated herein by reference.
ITEM 8.  
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company, including notes thereto, and the reports of the Company’s independent registered public accounting firm are included in this Annual Report on Form 10-K beginning at page F-1 and are incorporated herein by reference.

 

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ITEM 9.  
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.  
CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports and other information filed with the Commission, under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms, and that such information is accumulated and communicated to the management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
The Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon the foregoing, the Chief Executive Officer along with the Chief Financial Officer concluded that certain deficiencies identified in internal controls and procedures created a material weakness and resulted in the Company’s disclosure controls and procedures not being effective to ensure that information required to be disclosed in the Company’s reports under the Exchange Act was recorded, summarized and reported within the time periods specified in the Commission’s rules and forms as of the end of the period covered by this report. Based on this determination of the existence of a material weakness, which began during the fourth quarter of 2010 and continued into the first quarter of 2011, management identified certain areas requiring internal control and procedure improvements.
Management’s Annual Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining effective internal control over financial reporting. Internal control is designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation of reliable published financial statements. Internal control over financial reporting includes self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified.
Because of inherent limitations in any system of internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.

 

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Management assessed the Company’s internal control over financial reporting as of December 31, 2010. This assessment was based on criteria for effective internal control over financial reporting described in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment the Chief Executive Officer and Chief Financial Officer concluded that, as of December 31, 2010, the Company’s system of internal control over financial reporting was not effective as it relates to certain internal controls over the special assets function. See “Changes in Internal Control over Financial Reporting” for further information.
This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting because that requirement under Section 404 of the Sarbanes Oxley Act of 2002 was permanently removed for non-accelerated filers pursuant to the provisions of Section 989(G) set forth in the Dodd-Frank Act.
Changes in Internal Control over Financial Reporting
During Management’s assessment of the Company’s internal control over financial reporting at December 31, 2010, the following deficiencies were noted: 1) Loans determined to be collateral dependent were not properly identified in a timely manner which created a material internal control deficiency. Procedures have been put in place by the Bank’s Special Assets Department to ensure loans that are dependent upon the sale of the underlying collateral for repayment are properly identified and documented when the determination is made the loan is collateral dependent and this information is incorporated in the allowance for loan loss calculation. 2) Appraisals and appraisal reviews from an independent third-party appraiser or collateral valuations performed internally for loans determined to be collateral dependent were not ordered, received or reviewed prior to the reporting date which could result in overstatement of loans and income and understatement of the provision for loan losses, charge off and the allowance for loan losses. The Special Assets Department has created procedures and updated the Appraisal Policy to address this deficiency. The remediation plan for these internal control deficiencies is noted below. Other than the items noted above, during the fourth quarter of 2010 there were no other changes in the Company’s internal control over financial reporting that have materially affected, or that are reasonably likely to materially affect, the Company’s internal control over financial reporting.
During and subsequent to the fourth quarter of 2010, management took the following remediation actions regarding the above referenced internal control deficiencies:
  1)  
During the first quarter of 2011, the OCC, during their regular safety and soundness exam, determined several loans were not properly identified by the Bank as collateral dependent as of December 31, 2010. Collateral dependent loans require a charge off of the loan balance if the recorded investment in the loan exceeds the underlying collateral value net of cost to sell. To make the determination the proper recorded investment has been recorded, the current appraised value of the collateral must be obtained. The Special Assets Department, formed during 2009, is in charge of complying with these requirements. During the first quarter of 2011, procedures were put in place in the Special Assets Department to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.

 

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  2)  
As noted in item 1, collateral dependent loans require the Bank to obtain a current appraisal or collateral valuation performed internally to allow for the determination as to whether there is sufficient collateral securing the loan. In addition to the requirement of obtaining the appraisal, the appraisal must be reviewed by an independent third-party appraiser charged with determining the appraisal has been properly performed. After the review, the Bank determines if the appraisal is acceptable, then provides the documentation to the Accounting Department to incorporate the results into the calculation of the allowance for loan losses. Failure to comply with any of these steps could result in the overstatement of both assets and income. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.
  3)  
During the first quarter of 2011, Management ensured proper controls are in place when evidence of impairment of a loan exists or prior to the annual appraisal date, the Special Assets Department will order appraisals or collateral valuations in a timely manner to allow for proper review and implementation of the results into the allowance for loan loss calculation. Proper controls have also been developed and incorporated into the process to assure a potential impairment is recorded when appraisal or valuation and review process is not complete as of a reporting date.
  4)  
The Bank has revised its policy and procedures to require independent third-party appraisals or collateral valuations performed internally for all loans considered to be impaired, classified or worse. The Special Assets Department, as noted in item 1, is in charge of complying with these requirements and during the first quarter of 2011, procedures were put in place to comply with these requirements and the results of their efforts have been incorporated into the financial statements as of December 31, 2010.
The identified material weakness in our internal controls over financial reporting will not be considered remediated until the new controls are fully implemented, in operation for a sufficient period of time, tested, and concluded by management to be operating effectively.
ITEM 9B.  
OTHER INFORMATION
None.
PART III
ITEM 10.  
DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information appearing under the headings “Proposal #1 Election of Directors,” “Additional Information Concerning the Company’s Board of Directors and Committees” and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement (the “2011 Proxy Statement”) relating to the annual meeting of shareholders of the Company is incorporated herein by reference.
ITEM 11.  
EXECUTIVE COMPENSATION
The information appearing under the heading “Compensation of Named Executive Officers and Directors” in the 2011 Proxy Statement is incorporated herein by reference.

 

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ITEM 12.  
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information appearing under the heading “Outstanding Voting Securities of the Company and Principal Holders Thereof” in the 2011 Proxy Statement is incorporated herein by reference.
The information appearing under “Note 14. Stock Options and Warrants” in the 2010 notes to the financial statements is incorporated herein by reference.
ITEM 13.  
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information appearing under the headings “Certain Relationships and Transactions” and “Proposal #1 Election of Directors” in the 2011 Proxy Statement is incorporated herein by reference.
ITEM 14.  
PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information appearing under the caption “Proposal #2 — Ratification of the Appointment of Independent Registered Public Accounting Firm” in the 2011 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 15.  
EXHIBITS, FINANCIAL STATEMENT SCHEDULES
  (a)(1)  
Financial statements. See Item 8.
  (a)(2)  
Financial statement schedules. Inapplicable.
  (a)(3)  
The following exhibits are filed as a part of or incorporated by reference in this report:
         
Exhibit No.   Description of Exhibit
       
 
  2.1    
Plan of Reorganization dated March 28, 2003, by and between the Company and Mountain National Bank (included as Exhibit 2.1 to the Report on Form 8-K12G3 of the Company, dated July 12, 2003 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference).
       
 
  2.2    
Amendment to Plan of Reorganization dated July 1, 2003 (included as Exhibit 2.2 to the Report on Form 8-K12G3 of the Company, dated July 12, 2003 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference).
       
 
  3.1    
Charter of Incorporation of the Company, as amended (Restated for SEC filing purposes only) (included as Exhibit 3.1 to the Company’s Registration Statement on Form S-1 (File No. 333-168281), previously filed with the Commission and incorporated by reference herein).

 

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Exhibit No.   Description of Exhibit
       
 
  3.2    
Amended and Restated Bylaws of the Company, as amended (included as Exhibit 3.1 to the Report on Form 8-K of the Company, dated March 31, 2010 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference).
       
 
  10.1    
Stock Option Plan of the Company, as amended (included as Exhibit 10.1 to the Report on Form 8-K of the Company, dated May 19, 2006 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference)*
       
 
  10.2    
Stock Option Agreement of Dwight B. Grizzell (assumed by Company) (included as Exhibit 10.3 to the Company’s Form 10-KSB for the year ended December 31, 2002 and incorporated herein by reference)*
 
  10.3    
Summary Description of Director and Named Executive Officer Compensation Arrangements*
       
 
  10.4    
Form of Warrant Agreement (included as Exhibit 10.5 to the Company’s Form SB-2/A filed with the Commission on August 23, 2005)
       
 
  10.5    
Employment Agreement dated as of May 15, 2009 by and among Mountain National Bank, Mountain National Bancshares, Inc. and Grace McKinzie (included as Exhibit 10.1 to the Report on Form 8-K of the Company, dated March 31, 2010 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference)*
       
 
  10.6    
Employment Agreement dated as of May 28, 2009 by and among Mountain National Bank, Mountain National Bancshares, Inc. and Michael Brown (included as Exhibit 10.2 to the Report on Form 8-K of the Company, dated March 31, 2010 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference)*
       
 
  10.7    
Employment Agreement dated as of May 18, 2009 by and among Mountain National Bank, Mountain National Bancshares, Inc. and Richard Hubbs (included as Exhibit 10.3 to the Report on Form 8-K of the Company, dated March 31, 2010 (File No. 000-49912), previously filed with the Commission and incorporated herein by reference)*
       
 
  10.8    
Amended and Restated Salary Continuation Agreement, dated January 19, 2007, by and between Mountain National Bank and Dwight Grizzell. (included as Exhibit 10.8 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*
       
 
  10.9    
Amendment, dated November 19, 2007, to Amended and Restated Salary Continuation Agreement, by and between Mountain National Bank and Dwight Grizzell. (included as Exhibit 10.9 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*

 

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Exhibit No.   Description of Exhibit
       
 
  10.10    
Amended and Restated Salary Continuation Agreement, dated January 19, 2007, by and between Mountain National Bank and Michael Brown. (included as Exhibit 10.10 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*
       
 
  10.11    
Amendment, dated November 19, 2007, to Amended and Restated Salary Continuation Agreement, by and between Mountain National Bank and Michael Brown. (included as Exhibit 10.11 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*
       
 
  10.12    
Amended and Restated Salary Continuation Agreement, dated January 19, 2007, by and between Mountain National Bank and Grace McKinzie. (included as Exhibit 10.12 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*
       
 
  10.13    
Amendment, dated November 19, 2007, to Amended and Restated Salary Continuation Agreement, by and between Mountain National Bank and Grace McKinzie. (included as Exhibit 10.13 to the Company’s Form 10-K for the year ended December 31, 2007 and incorporated herein by reference)*
       
 
  10.14    
Agreement, dated June 2, 2009, by and between Mountain National Bank and the Office of the Comptroller of the Currency. (included as Exhibit 10.1 to the Report on Form 8-K of the Company, dated June 5, 2009, (File No. 000-49912), previously filed with the Commission and incorporated herein by reference)
       
 
  21    
Subsidiaries of the Company
       
 
  23    
Consent of Independent Registered Public Accounting Firm
       
 
  31.1    
Certificate of CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  31.2    
Certificate of CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
       
 
  32.1    
Certificate of CEO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
       
 
  32.2    
Certificate of CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
     
*  
Denotes management contract or compensatory plan or arrangement.

 

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The Company is a party to certain agreements entered into in connection with the offering by MNB Capital Trust I of an aggregate of $5,500,000 in trust preferred securities and the offering by MNB Capital Trust II of an aggregate of $7,500,000 in trust preferred securities, as more fully described in this Annual Report on Form 10-K. In accordance with Item 601(b)(4)(iii) of Regulation S-K, and because the total amount of the trust preferred securities is not in excess of 10% of the Company’s total assets, the Company has not filed the various documents and agreements associated with the trust preferred securities herewith. The Company has, however, agreed to furnish copies of the various documents and agreements associated with the trust preferred securities to the Commission upon request.

 

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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
         
  MOUNTAIN NATIONAL BANCSHARES, INC.
(Registrant)
 
 
  By:   /s/ Dwight B. Grizzell    
    Dwight B. Grizzell   
    President and Chief Executive Officer
Date: April 13, 2011
 
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
     
/s/ Dwight B. Grizzell
 
Dwight B. Grizzell, President,
  Date: April 13, 2011 
Chief Executive Officer and Director
   
 
   
/s/ Richard A. Hubbs
 
Richard A. Hubbs, Senior Vice President and
  Date: April 13, 2011 
Chief Financial Officer (Principal Financial
   
and Accounting Officer)
   
 
   
/s/ Gary A. Helton
 
Gary A. Helton, Director
  Date: April 13, 2011 
 
   
/s/ Charlie R. Johnson
 
Charlie R. Johnson, Director
  Date: April 13, 2011 
 
   
/s/ Sam L. Large
 
Sam L. Large, Director
  Date: April 13, 2011 
 
   
/s/ Jeffrey J. Monson
 
Jeffrey J. Monson, Director
  Date: April 13, 2011 
 
   
/s/ Linda N. Ogle
 
Linda N. Ogle, Director
  Date: April 13, 2011 
 
   
/s/ Michael C. Ownby
 
Michael C. Ownby, Director
  Date: April 13, 2011 
 
   
/s/ John M. Parker
 
John M. Parker, Director
  Date: April 13, 2011 
 
   
/s/ Ruth Reams
 
Ruth Reams, Director
  Date: April 13, 2011 

 

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Mountain National Bancshares, Inc. and Subsidiaries
Consolidated Financial Report
December 31, 2010

 

 


Table of Contents

CONTENTS
         
    Page  
 
       
    F-1  
 
       
CONSOLIDATED FINANCIAL STATEMENTS
       
 
       
    F-2  
 
       
    F-3  
 
       
    F-4  
 
       
    F-5  
 
       
    F-6 – F-57  

 

 


Table of Contents

Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Mountain National Bancshares, Inc.
We have audited the accompanying consolidated balance sheets of Mountain National Bancshares, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2010 and 2009, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 15 of the consolidated financial statements, the Corporation’s bank subsidiary is not in compliance with an existing commitment it made to maintain revised minimum regulatory capital levels in connection with a formal regulatory agreement which has imposed limitations on certain operations. Failure to comply with the regulatory agreement and the commitment may result in additional regulatory enforcement actions.
/s/ Crowe Horwath LLP
Brentwood, Tennessee
April 13, 2011

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 2010 and 2009
                 
    2010     2009  
ASSETS                
Cash and due from banks
  $ 30,039,647     $ 11,750,723  
Federal funds sold
    2,536,173       2,353,913  
 
           
 
               
Total cash and cash equivalents
    32,575,820       14,104,636  
 
               
Securities available for sale
    86,316,591       144,330,068  
Securities held to maturity, fair value $1,303,080 at December 31, 2010 and $2,208,236 at December 31, 2009
    1,317,951       2,204,303  
Restricted investments, at cost
    3,843,150       3,816,050  
Loans, net of allowance for loan losses of $10,942,414 at December 31, 2010 and $11,353,438 at December 31, 2009
    363,413,050       396,351,008  
Investment in partnership
    4,303,600       4,198,675  
Premises and equipment
    32,600,673       33,709,282  
Accrued interest receivable
    1,495,869       3,045,290  
Cash surrender value of company owned life insurance
    11,774,605       11,366,270  
Other real estate owned
    13,140,698       14,575,368  
Other assets
    6,424,504       12,038,080  
 
           
 
               
Total assets
  $ 557,206,511     $ 639,739,030  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY                
Deposits:
               
Noninterest-bearing demand deposits
  $ 47,638,792     $ 47,600,944  
NOW accounts
    57,344,798       112,440,413  
Money market accounts
    49,701,122       40,808,892  
Savings accounts
    23,733,795       20,519,998  
Time deposits
    271,172,901       289,243,894  
 
           
 
               
Total deposits
    449,591,408       510,614,141  
 
           
 
               
Securities sold under agreements to repurchase
    432,016       1,776,402  
Accrued interest payable
    719,133       605,936  
Subordinated debentures
    13,403,000       13,403,000  
Federal Home Loan Bank advances
    55,200,000       62,900,000  
Other liabilities
    2,186,784       3,070,396  
 
           
 
               
Total liabilities
    521,532,341       592,369,875  
 
           
 
               
Commitments and contingencies
               
 
               
Shareholders’ equity:
               
Preferred stock, no par value; 1,000,000 shares authorized; 0 shares issued and outstanding
           
Common stock, $1.00 par value; 10,000,000 shares authorized; 2,631,611 issued and outstanding
    2,631,611       2,631,611  
Additional paid-in capital
    42,229,713       42,125,828  
Retained earnings (deficit)
    (8,122,476 )     2,328,702  
Accumulated other comprehensive income (loss)
    (1,064,678 )     283,014  
 
           
 
               
Total shareholders’ equity
    35,674,170       47,369,155  
 
           
 
               
Total liabilities and shareholders’ equity
  $ 557,206,511     $ 639,739,030  
 
           
See accompanying Notes to Consolidated Financial Statements

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 2010 and 2009
                 
    2010     2009  
 
               
INTEREST INCOME
               
Loans
  $ 20,674,310     $ 25,072,166  
Taxable securities
    2,454,381       5,219,060  
Tax-exempt securities
    250,898       1,053,433  
Federal funds sold and deposits in other banks
    76,371       24,710  
 
           
 
               
Total interest income
    23,455,960       31,369,369  
 
               
INTEREST EXPENSE
               
Deposits
    7,837,187       10,247,527  
Federal funds purchased
    3,063       36,020  
Repurchase agreements
    24,250       91,022  
Federal Reserve and Federal Home Loan Bank advances
    2,493,511       2,592,048  
Subordinated debentures
    343,850       392,016  
 
           
 
               
Total interest expense
    10,701,861       13,358,633  
 
           
 
               
Net interest income
    12,754,099       18,010,736  
 
               
Provision for loan losses
    7,727,200       11,672,802  
 
           
 
               
Net interest income after provision for loan losses
    5,026,899       6,337,934  
 
           
 
               
NONINTEREST INCOME
               
Service charges on deposit accounts
    1,642,058       2,326,614  
Other fees and commissions
    1,473,616       1,262,244  
Gain on sale of mortgage loans
    191,163       146,913  
Investment gains and losses, net
    1,511,005       2,558,612  
Other than temporary loss
               
Total impairment loss
          (405,846 )
Loss recognized in other comprehensive income (loss)
          (58,478 )
 
           
Net impairment recognized in earnings (loss)
          (347,368 )
Other real estate gains and losses, net
    34,591       (1,478,877 )
Other noninterest income
    897,972       395,248  
 
           
 
               
Total noninterest income
    5,750,405       4,863,386  
 
           
 
               
NONINTEREST EXPENSE
               
Salaries and employee benefits
    8,322,173       9,670,008  
Occupancy expenses
    1,759,196       1,698,987  
FDIC assessment expense
    1,161,330       1,537,439  
Other operating expenses
    6,247,956       6,311,308  
 
           
 
               
Total noninterest expense
    17,490,655       19,217,742  
 
           
 
               
Loss before income tax expense (benefit)
    (6,713,351 )     (8,016,422 )
 
               
Income tax expense (benefit)
    3,737,827       (3,788,027 )
 
           
 
               
Net loss
  $ (10,451,178 )   $ (4,228,395 )
 
           
 
               
LOSS PER SHARE
               
Basic
  $ (3.97 )   $ (1.61 )
Diluted
  $ (3.97 )   $ (1.61 )
See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
Years Ended December 31, 2010 and 2009
                                                 
                                    Accumulated        
                    Additional     Retained     Other     Total  
    Comprehensive     Common     Paid-in     Earnings     Comprehensive     Shareholders’  
    Income (Loss)     Stock     Capital     (Deficit)     Income/(Loss)     Equity  
 
                                               
BALANCE, January 1, 2009
          $ 2,631,611     $ 41,952,632     $ 6,557,097     $ (147,587 )   $ 50,993,753  
Share-based compensation
                    102,500                       102,500  
Tax benefit from exercise of options
                    70,696                       70,696  
Comprehensive income (loss):
                                               
Net loss
  $ (4,228,395 )                     (4,228,395 )             (4,228,395 )
Other comprehensive income, net of tax:
                                               
Change in unrealized gains (losses) on securities available-for-sale for which a portion of an other-than-temporary- impairment has been recognized in earnings, net of reclassification
    58,478                               58,478       58,478  
Change in unrealized gains (losses) on securities available-for-sale, net of reclassification
    372,123                               372,123       372,123  
 
                                             
Total comprehensive income (loss)
    (3,797,794 )                                        
 
                                   
BALANCE, December 31, 2009
            2,631,611       42,125,828       2,328,702       283,014       47,369,155  
 
                                     
Share-based compensation
                    103,885                       103,885  
Comprehensive income (loss):
                                               
Net loss
    (10,451,178 )                     (10,451,178 )             (10,451,178 )
Other comprehensive income, net of tax:
                                               
Change in unrealized gains (losses) on securities available-for-sale, net of reclassification
    (1,347,692 )                             (1,347,692 )     (1,347,692 )
 
                                             
Total comprehensive income (loss)
  $ (11,798,870 )                                        
 
                                   
BALANCE, December 31, 2010
          $ 2,631,611     $ 42,229,713     $ (8,122,476 )   $ (1,064,678 )   $ 35,674,170  
 
                                     
See accompanying Notes to Consolidated Financial Statements

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2010 and 2009
                 
    2010     2009  
CASH FLOWS FROM OPERATING ACTIVITIES
               
Net loss
  $ (10,451,178 )   $ (4,228,395 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
               
Depreciation
    1,653,848       1,430,157  
Net realized gains on securities available for sale
    (1,499,481 )     (2,558,612 )
Net realized gains on securities held to maturity
    (11,524 )      
Securities impairment loss recognized in earnings
          347,368  
Net amortization on available for sale securities
    818,917       790,954  
Increase in held to maturity due to accretion
    (61,220 )     (87,259 )
Provision for loan losses
    7,727,200       11,672,802  
Net (gain) loss on other real estate
    (34,591 )     1,478,877  
Deferred income taxes, net of change in valuation allowance
    (3,737,827 )     (3,877,978 )
Gross mortgage loans originated for sale
    (15,340,608 )     (20,078,046 )
Gross proceeds from sale of mortgage loans
    15,315,271       20,413,759  
Gain on sale of mortgage loans
    (191,163 )     (146,913 )
Increase in cash surrender value of life insurance
    (408,335 )     (287,562 )
Investment in partnership
    (104,925 )     (80,713 )
Share-based compensation
    103,885       102,500  
Tax benefit from exercise of options
          (70,696 )
Change in operating assets and liabilities:
               
Accrued interest receivable
    1,549,421       (307,471 )
Accrued interest payable
    113,197       (416,985 )
Other assets and liabilities
    7,952,384       (6,620,253 )
 
           
 
               
Net cash provided by (used in) operating activities
    3,393,271       (2,524,466 )
 
           
 
               
CASH FLOWS FROM INVESTING ACTIVITIES
               
Activity in available-for-sale securities:
               
Proceeds from sales
    103,501,336       89,957,394  
Proceeds from maturities, prepayments and calls
    339,012,432       142,591,220  
Purchases
    (384,212,916 )     (250,277,064 )
Activity in held-to-maturity securities:
               
Proceeds from sales
    520,000        
Purchases of restricted investments
    (27,100 )     (125,900 )
Loan originations and principal collections, net
    24,475,863       1,436,719  
Purchase of premises and equipment
    (325,339 )     (3,655,206 )
Proceeds from sale of other real estate
    2,200,756       1,228,836  
 
           
 
               
Net cash provided by (used in) investing activities
    85,145,032       (18,844,001 )
 
           
 
               
CASH FLOWS FROM FINANCING ACTIVITIES
               
Net (decrease) increase in deposits
    (61,022,733 )     55,948,195  
Proceeds from Federal Reserve/Federal Home Loan Bank advances
    43,000,000       31,000,000  
Matured Federal Reserve/Federal Home Loan Bank advances
    (50,700,000 )     (41,000,000 )
Net decrease in federal funds purchased
          (22,580,000 )
Net decrease in securities sold under agreements to repurchase
    (1,344,386 )     (2,555,463 )
Tax benefit from exercise of options
          70,696  
 
           
 
               
Net cash (used in) provided by financing activities
    (70,067,119 )     20,883,428  
 
           
 
               
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
    18,471,184       (485,039 )
 
               
CASH AND CASH EQUIVALENTS, beginning of period
    14,104,636       14,589,675  
 
           
 
               
CASH AND CASH EQUIVALENTS, end of period
  $ 32,575,820     $ 14,104,636  
 
           
 
               
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
               
Cash paid for:
               
Interest
  $ 10,588,664     $ 13,775,618  
Income taxes
    165,000       520,000  
Non-cash investing and financing activities:
               
Transfers from loans to other real estate owned
    3,245,233       13,359,756  
Loans advanced for sales of other real estate
    2,293,838       7,871,855  
See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies
The accounting and reporting policies of Mountain National Bancshares, Inc. and its subsidiaries (the “Company”) conform to U.S. generally accepted accounting principles and practices within the banking industry. The policies that materially affect financial position and results of operations are summarized as follows:
Nature of operations and geographic concentration:
The Company is a bank-holding company which owns all of the outstanding common stock of Mountain National Bank (the “Bank”). The Bank provides a variety of financial services through its branch offices located in Sevier and Blount Counties, Tennessee. The Bank’s primary deposit products are demand deposits, savings accounts, and certificates of deposit. Its primary lending products are commercial loans, real estate loans, and installment loans.
Principles of consolidation:
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. The Company’s principal subsidiary is Mountain National Bank. All material inter-company accounts and transactions have been eliminated in consolidation.
Use of estimates:
The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates and such differences could be material to the financial statements. The allowance for loan losses, other real estate owned, deferred tax assets and fair values of financial instruments are particularly subject to change.
The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.
The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets. Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Due to the predominance of the tourism industry in Sevier County, a significant portion of our commercial loan portfolio is concentrated within that industry. The predominance of the tourism industry also makes our business more seasonal in nature than may be the case with banks and financial institutions in other market areas.
While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions. In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans. Such agencies may advise the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination. Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term. However, the amount of the change that is reasonably possible cannot be estimated.
Statements of cash flows:
The Company considers all cash and amounts due from depository institutions with maturities under 90 days and Federal Funds sold to be cash equivalents for purposes of the statements of cash flows. Net cash flows are reported for customer loan and deposit transactions, interest bearing deposits in other financial institutions, federal funds purchased and repurchase agreements.
Investment Securities:
Debt securities are classified as held to maturity when the Bank has the positive intent and ability to hold the securities to maturity. Securities held to maturity are carried at amortized cost.
Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value with unrealized gains and losses, net of taxes, reported in other comprehensive income (loss). Realized gains (losses) on securities available for sale are included in other income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income (loss). Realized gains and losses on sales of securities are recorded in non-interest income on the trade date and are determined on the specific-identification method.
The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the level-yield method over the period to maturity, without anticipating prepayments, except for mortgage backed securities where prepayments are anticipated.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Restricted equity securities include common stock of the Federal Home Loan Bank of Cincinnati and Federal Reserve Bank stock. These securities are carried at cost.
Management evaluates securities for other-than-temporary impairment (“OTTI”) at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For securities in an unrealized loss position, management considers the extent and duration of the unrealized loss, and the financial condition and near-term prospects of the issuer. Management also assesses whether it intends to sell, or it is more likely than not that it will be required to sell, a security in an unrealized loss position before recovery of its amortized cost basis. If either of the criteria regarding intent or requirement to sell is met, the entire difference between amortized cost and fair value is recognized as impairment through earnings. For debt securities that do not meet the aforementioned criteria, the amount of impairment is split into two components as follows: 1) OTTI related to credit loss, which must be recognized in the statement of operations and 2) OTTI related to other factors, which is recognized in other comprehensive income (loss). The credit loss is defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis. For equity securities, the entire amount of impairment is recognized through earnings.
Securities sold under agreements to repurchase:
The Bank enters into sales of securities under agreements to repurchase identical securities the next day.
Loans:
Loans are stated at unpaid principal balances, less the allowance for loan losses. The “recorded investment” in loans presented throughout the Notes to the Consolidated Financial Statements is defined as the outstanding principal balance of loans. Interest income is accrued on the unpaid principal balance.
The accrual of interest on real estate and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection. Installment loans and other personal loans are typically charged off no later than 90 days past due. Past due status is based on the contractual terms of the loan. In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.
All interest accrued but not collected for loans that are placed on nonaccrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Generally, loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured, which usually requires a minimum of six months sustained repayment performance.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Loans held for sale:
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or fair value, as determined by outstanding commitments from investors. Net unrealized losses, if any, are recorded as a valuation allowance and charged to earnings. Mortgage servicing rights are sold with the related loan. Loans held for sale totaled $216,500 and $0 at December 31, 2010 and 2009, respectively, and are included with loans on the balance sheet.
Allowance for loan losses:
The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb probable incurred credit losses inherent in the loan portfolio. The amount of the allowance is based on management’s evaluation of the collectability of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio. Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows. Allocations of the allowance may be made for specific loans, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries. Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses.
During 2010, management sought to enhance its assessment of the allowance for loan losses by incorporating the results of a comprehensive historic loss rates migration analysis. The study provided more precise historical loss trends and percentages attributable to specific loan grades and types than were previously available. Consideration was given to recent charge off experience which management believes is a more reliable basis due to current economic conditions. The study did not have a material effect on the outcome of the allowance calculation; rather this data was used to narrow and refine management’s calculation and supported management’s previous estimation of the adequacy of the allowance for loan loss balance.
The allowance consists of specific and general components. The specific component relates to loans that are individually classified as impaired or loans otherwise classified as substandard or doubtful.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans, for which the terms have been modified, and for which the borrower is experiencing financial difficulties, are considered troubled debt restructurings and classified as impaired. Factors considered by management in determining impairment include payment status, collateral value and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record and the amount of the shortfall in relation to the principal and interest owed.
Loans over $100,000 that are graded special mention or worse according to the Company’s internal credit risk rating system, which is described in more detail under “Note 3. Loans and Allowance for Loan Losses,” are individually evaluated for impairment. If a loan is impaired, a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment, and accordingly, they are not separately identified for impairment disclosures. Troubled debt restructurings are separately identified for impairment disclosures and are measured at the present value of estimated future cash flows using the loan’s effective rate at inception. If a troubled debt restructuring is considered to be a collateral dependent loan, the loan is reported, net, at the fair value of the collateral. For troubled debt restructurings that subsequently default, the Company determines the amount of reserve in accordance with the accounting policy for the allowance for loan losses.
The general component of the allowance covers non-impaired loans and is based on historical loss experience adjusted for current factors. The historical loss experience is determined by portfolio segment and is based on the actual loss history experienced by the Company over the most recent three years for loans secured by real estate and five years for all other loans. This actual loss experience is supplemented with other economic and qualitative factors based on the risks present for each portfolio segment. These economic and qualitative factors include consideration of the following: levels of and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards; other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; changes in loan review; national and local economic trends and conditions; changes in value of underlying collateral; industry conditions; and effects of changes in credit concentrations.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Portfolio segments are defined as the level at which an entity develops and documents a systematic methodology to determine its allowance. As part of management’s quarterly assessment of the allowance, management divides the loan portfolio into six segments: construction and land development, commercial real estate, commercial, residential real estate, consumer and credit cards. Each segment, described in more detail below, is then analyzed such that an allocation of the allowance is estimated for each loan segment. Both quantitative and qualitative factors are used by management at the portfolio segment level in determining the adequacy of the allowance for the Company. During 2010, we incorporated the results of a historical loan loss migration analysis into our determination of the allowance for loan losses. We believe the increased emphasis on our historical loss experience metrics provides a better estimate of losses inherent in our portfolio. This refinement of our methodology did not result in a material change in our allowance.
Construction and land development loans include loans to finance the process of improving land preparatory to erecting new structures or the on-site construction of industrial, commercial or residential buildings. Construction and land development loans also include loans secured by vacant land, except land known to be used or usable for agricultural purposes. Construction loans generally are made for relatively short terms. They generally are more vulnerable to changes in economic conditions. Further, the nature of these loans is such that they are more difficult to evaluate and monitor. The risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value upon completion of the project and the estimated cost (including interest) of the project. Periodic site inspections are made on construction loans.
Commercial real estate loans include loans secured by non-residential real estate, including farmland and improvements thereon. Often these loans are made to single borrowers or groups of related borrowers, and the repayment of these loans largely depends on the results of operations and management of these properties. Adverse economic conditions may affect the repayment ability of these loans.
Commercial loans include loans for commercial or industrial purposes to business enterprises that are not secured by real estate. Commercial loans are typically made on the basis of the borrower’s ability to repay from the cash flow of the borrower’s business. Commercial loans are generally secured by accounts receivable, inventory and equipment. The collateral securing loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. The Company seeks to minimize these risks through its underwriting standards.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Residential real estate loans include loans secured by residential real estate, including single-family and multi-family dwellings. Mortgage title insurance and hazard insurance are normally required. Adverse economic conditions in the Company’s market area may reduce borrowers’ ability to repay these loans and may reduce the collateral securing these loans.
Consumer loans include loans to individuals for household, family and other personal expenditures that are not secured by real estate. Consumer loans are generally secured by vehicles and other household goods. The collateral securing consumer loans may depreciate over time. The Company seeks to minimize these risks through its underwriting standards.
Credit Card loans include revolving lines of credit issued for commercial and consumer purposes. These lines are generally unsecured. Several factors including adverse economic conditions and unfavorable circumstances relative to individual customers may affect repayment of these loans.
Classes of loans and leases are a disaggregation of a Company’s portfolio segments. Classes are defined as a group of loans and leases which share similar initial measurement attributes, risk characteristics, and methods for monitoring and assessing credit risk. Management has determined that the Company has eight classes of loans and leases (construction and land development, commercial mortgage, commercial and industrial, residential mortgage, home equity and junior liens, multi-family, other consumer and credit cards). The “other consumer” class of loans is comprised of both revolving credit and installment loans.
The assessment also includes an unallocated component. We believe that the unallocated amount is warranted for inherent factors that cannot be practically assigned to individual loan categories, such as the imprecision in the overall loss allocation measurement process, the volatility of the local economies in the markets we serve and imprecision in our credit risk ratings process.
Reserve for unfunded commitments:
The reserve for unfunded commitments represents the estimate for probable credit losses inherent in these commitments to extend credit. Unfunded commitments to extend credit include standby letters of credit and commitments to fund available lines of credit. The process used to determine the reserve for unfunded commitments is consistent with the process for determining the allowance for loan losses and the reserve, if any, is included in other liabilities.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Investment in Partnership:
The Bank is a partner in Appalachian Fund for Growth II, LLC with three other Tennessee banking institutions. This partnership involves a “new markets tax credit” which is generated from a tax credit allocation from the Community Development Financial Institutions Fund (“CDFI”). The purposes of the partnership are (a) to have the primary mission of providing investment capital, solely in the form of loans, to low-income communities in accordance with the New Markets Tax Credit Program and (b) to make loans that are qualified low-income community investment loans. This partnership is accounted for using the equity method of accounting.
Premises and equipment:
Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line and the declining balance methods based on the estimated useful lives of the assets. Useful lives range from three to forty years for premises and improvements, and from three to ten years for furniture and equipment. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations.
Other real estate owned:
Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the fair value less estimated selling cost at the date of foreclosure, establishing a new cost basis. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to fair value less cost to sell. Other real estate owned (“ORE”) also includes excess Bank property not utilized when subdividing land acquired for the construction of Bank branches. Costs of significant property improvements are capitalized. Costs relating to holding property are expensed.
Income taxes:
The Company files consolidated federal and state income tax returns with the Bank and its subsidiaries. Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred income taxes related primarily to differences between the basis of the allowance for loan losses and accumulated depreciation. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected using enacted income tax rates. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. A valuation allowance, if needed, reduces deferred tax assets to the amount expected to be realized.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
A tax position is recognized as a benefit only if it is “more likely than not” that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the “more likely than not” test, no tax benefit is recorded.
Advertising costs:
The Company expenses all advertising costs as incurred. Advertising expense was $122,670 and $276,129 for the years ended December 31, 2010 and 2009, respectively.
Company owned life insurance:
The Company has purchased life insurance policies on certain key executives. Company owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement.
Long-term assets:
Premises and equipment and other long-term assets are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value.
Loan commitments and related financial instruments:
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Retirement plans:
Employee 401(k) and profit sharing plan expense is the amount of matching contributions made by the Company pursuant to the Company’s 401(k) benefit plan. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Earnings (losses) per common share:
Basic earnings (losses) per common share is net income (loss) divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options and stock warrants. Any shares having an antidilutive effect are excluded from the calculation. Earnings (loss) and dividends per share are restated for all stock splits and dividends through the date of issue of the financial statements.
Comprehensive income (loss):
Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss). Other comprehensive income (loss) includes unrealized gains and losses on securities available for sale, which is also recognized as a separate component of equity.
Loss contingencies:
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there are now such matters that will have a material effect on the financial statements.
Restrictions on cash:
Cash on hand or on deposit with the Federal Reserve Bank was required to meet regulatory reserve and clearing requirements. Beginning October 1, 2008, the Federal Reserve was authorized to pay interest on these balances based on a spread to the average target federal funds rate. These balances did not earn interest prior to that date.
Equity:
Stock dividends in excess of 20% of the Company’s outstanding shares are reported by transferring the par value of the stock issued from retained earnings to common stock. Stock dividends for 20% or less of the Company’s outstanding shares are reported by transferring the fair value, as of the ex-dividend date, of the stock issued from retained earnings to common stock and additional paid-in capital. Fractional share amounts are paid in cash with a reduction in retained earnings.
Dividend restriction:
Banking regulations require maintaining certain capital levels and may limit the dividends paid by the bank to the holding company or by the holding company to shareholders. Banking regulations also limit the ability of banks that are incurring losses to pay dividends without prior regulatory approval. (See “Note 15 — Regulatory Matters” for more specific disclosure.)

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 1 — Summary of Significant Accounting Policies (continued)
Fair value of financial instruments:
Fair values of financial instruments are estimated using relevant market information and other assumptions, as more fully disclosed in “Note 13 — Fair Value.” Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayments and other factors, especially in the absence of broad markets for particular items. Changes in assumptions or in market conditions could significantly affect these estimates.
Stock-based compensation:
Compensation cost is recognized for stock options and restricted stock awards issued to employees, based on the fair value of these awards at the date of grant. A Black-Scholes model is utilized to estimate the fair value of stock options, while the market price of the Company’s common stock at the date of grant is used for restricted stock awards. Compensation cost is recognized over the required service period, generally defined as the vesting period. At December 31, 2010, the Company has a stock-based compensation plan, which is described more fully in “Note 14 — Stock Options.”
Segment reporting:
While the chief decision-makers monitor the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. In the Company’s operations, each branch is viewed by management as being a separately identifiable business or segment from the perspective of monitoring performance and allocation of financial resources. Although the branches operate independently and are managed and monitored separately, each is substantially similar in terms of business focus, type of customers, products and services. Accordingly, the Company’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.
Reclassifications:
Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net income or shareholders’ equity.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 — Securities
Securities have been classified in the balance sheet according to management’s intent as securities held to maturity or securities available for sale. The amortized cost and approximate fair value of securities at December 31, 2010 and 2009 are as follows:
                                 
    2010  
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
Securities available for sale:
                               
U. S. Government securities
  $ 249,879     $     $ (13 )   $ 249,866  
Obligations of states and political subdivisions
    5,201,492       17,407       (296,786 )     4,922,113  
Mortgage-backed securities — residential
    81,754,184       134,557       (744,129 )     81,144,612  
 
                       
 
  $ 87,205,555     $ 151,964     $ (1,040,928 )   $ 86,316,591  
 
                       
 
                               
Securities held to maturity:
                               
Obligations of states and political subdivisions
  $ 1,317,951     $     $ (14,871 )   $ 1,303,080  
 
                       
                                 
    2009  
            Gross     Gross        
    Amortized     Unrealized     Unrealized     Fair  
    Cost     Gains     Losses     Value  
Securities available for sale:
                               
U. S. Government securities
  $ 3,250,638     $     $ (87 )   $ 3,250,551  
U. S. Government agencies
    6,997,816       89       (99,536 )     6,898,369  
Obligations of states and political subdivisions
    19,977,724       257,496       (111,291 )     20,123,929  
Mortgage-backed securities — residential
    113,645,162       1,065,493       (653,436 )     114,057,219  
 
                       
 
  $ 143,871,340     $ 1,323,078     $ (864,350 )   $ 144,330,068  
 
                       
 
                               
Securities held to maturity:
                               
Obligations of states and political subdivisions
  $ 2,204,303     $ 63,980     $ (60,047 )   $ 2,208,236  
 
                       

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 — Securities (continued)
The proceeds from sales of securities and the associated gains and losses are listed below:
                 
    2010     2009  
Proceeds
  $ 103,501,336     $ 89,957,394  
Gross gains
    1,570,376       2,562,423  
Gross losses
    (59,371 )     (3,811 )
During the first quarter of 2010, the Bank sold one security classified as held-to-maturity. The remaining held-to-maturity security in the Bank’s portfolio was reclassified as available for sale. The approximately $1.3 million residual balance in held-to-maturity securities at December 31, 2010 represents securities held in the portfolio of MNB Investments, Inc., a consolidated subsidiary of the Bank. MNB Investments, Inc. does not intend and it is not more likely than not that it would be required to sell these securities prior to maturity.
The amortized cost and fair value of securities at December 31, 2010, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.
                                 
    Securities Available for Sale     Securities Held to Maturity  
    Amortized     Fair     Amortized     Fair  
    Cost     Value     Cost     Value  
Within one year
  $ 249,879     $ 249,866     $     $  
One to five years
    268,535       263,624              
Five to ten years
    1,184,661       1,189,545       722,012       710,900  
Beyond ten years
    3,748,296       3,468,944       595,939       592,180  
Mortgage-backed securities — residential
    81,754,184       81,144,612              
 
                       
 
                               
 
  $ 87,205,555     $ 86,316,591     $ 1,317,951     $ 1,303,080  
 
                       
At December 31, 2010 and 2009, securities with a carrying value of approximately $78,019,000 and $131,039,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law. At December 31, 2010 and 2009, the carrying amount of securities pledged to secure repurchase agreements was approximately $1,064,000 and $2,293,000, respectively.
The Company did not hold any securities from a single issuer that exceeded 10% of total shareholders’ equity as of December 31, 2010, other than securities of the U.S. Government and its agencies and mortgage-backed securities issued by government sponsored entities that had a carrying value of approximately $81,145,000 and $114,057,000 at December 31, 2010 and 2009, respectively.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 — Securities (continued)
The following table summarizes the investment securities with unrealized losses at December 31, 2010 and 2009 aggregated by major security type and length of time in a continuous unrealized loss position:
December 31, 2010:
                                                 
    Less than 12 Months     12 Months or More     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
Description of Securties   Value     Loss     Value     Loss     Value     Loss  
 
                                               
U. S. Government securities
  $ 249,866     $ (13 )   $     $     $ 249,866     $ (13 )
 
                                               
Obligations of states and political subdivisions
    3,632,820       (112,755 )     1,571,970       (198,902 )     5,204,790       (311,657 )
 
                                               
Mortgage-backed securities — residential
    57,369,268       (744,129 )                 57,369,268       (744,129 )
 
                                   
 
                                               
Total temporarily impaired
  $ 61,251,954     $ (856,897 )   $ 1,571,970     $ (198,902 )   $ 62,823,924     $ (1,055,799 )
 
                                   
December 31, 2009:
                                                 
    Less than 12 Months     12 Months or More     Total  
    Fair     Unrealized     Fair     Unrealized     Fair     Unrealized  
Description of Securties   Value     Loss     Value     Loss     Value     Loss  
 
                                               
U. S. Government securities
  $ 252,373     $ (87 )   $     $     $ 252,373     $ (87 )
 
                                               
U. S. Government agencies
    4,899,769       (99,536 )                 4,899,769       (99,536 )
 
                                               
Obligations of states and political subdivisions
    4,797,788       (171,338 )                 4,797,788       (171,338 )
 
                                               
Mortgage-backed securities — residential
    46,712,247       (653,436 )                 46,712,247       (653,436 )
 
                                   
 
                                               
Total temporarily impaired
  $ 56,662,177     $ (924,397 )   $     $     $ 56,662,177     $ (924,397 )
 
                                   
As of December 31, 2010, the Company’s security portfolio consisted of 76 securities, 56 of which were in an unrealized loss position. The majority of unrealized losses are related to the Company’s obligations of states and political subdivisions and mortgage-backed securities, as discussed below.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 — Securities (continued)
Mortgage-Backed Securities
At December 31, 2010, 100% of the mortgage-backed securities held by the Company were issued by U.S. government-sponsored entities and agencies, primarily Fannie Mae, Freddie Mac and Ginnie Mae, institutions which the government has affirmed its commitment to support. Because the decline in fair value is attributable to changes in interest rates and illiquidity, and not credit quality, and because the Company does not have the intent to sell these mortgage-backed securities and it is likely that it will not be required to sell the securities before their anticipated recovery, the Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Obligations of States and Political Subdivisions
Unrealized losses on obligations of states and political subdivisions have not been recognized in income because the issuer(s)’ bonds are of high credit quality, the decline in fair value is largely due to changes in interest rates and other market conditions, and because the Company does not have the intent to sell these securities and it is likely that it will not be required to sell the securities before their anticipated recovery. The Company does not consider these securities to be other-than-temporarily impaired at December 31, 2010.
Other-Than-Temporary-Impairment
Management evaluates securities for OTTI at least on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. In determining OTTI, management considers many factors, including: (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, (3) whether the market decline was affected by macroeconomic conditions, and (4) whether the entity has the intent to sell the debt security or more likely than not will be required to sell the debt security before its anticipated recovery. The assessment of whether an other-than-temporary decline exists involves a high degree of subjectivity and judgment and is based on the information available to management at a point in time.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 2 — Securities (continued)
When OTTI occurs, the amount of the OTTI recognized in earnings depends on whether an entity intends to sell the debt security or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss. If an entity intends to sell or it is more likely than not it will be required to sell the security before recovery of its amortized cost basis, less any current-period credit loss, the OTTI shall be recognized in earnings equal to the entire difference between the investment’s amortized cost basis and its fair value at the balance sheet date. Otherwise, the OTTI shall be separated into the amount representing the credit loss and the amount related to all other factors. The amount of the total OTTI related to the credit loss is determined based on the present value of cash flows expected to be collected and is recognized in earnings. The amount of the total OTTI related to other factors is recognized in other comprehensive income (loss), net of applicable taxes. The previous amortized cost basis less the OTTI recognized in earnings becomes the new amortized cost basis of the investment.
Other Securities
On May 1, 2009, Silverton Bank, the bank subsidiary of Silverton Financial Services, Inc. (“Silverton”), was placed into receivership by the Office of the Comptroller of the Currency after Silverton Bank’s capital deteriorated significantly in the first quarter of 2009, and on June 5, 2009 Silverton filed a petition for bankruptcy. The Company does not anticipate that it will recover any of the Bank’s investment in either the common securities or trust preferred securities issued by Silverton or its affiliated trust. As a result, the Company recorded an impairment charge of $347,368, which represents the Company’s full investment in the securities, during the first quarter of 2009.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses
At December 31, 2010 and 2009, the Bank’s loans consisted of the following:
                 
    2010     2009  
Mortgage loans on real estate:
               
Residential 1-4 family
  $ 86,402,948     $ 88,491,997  
Residential multifamily
    6,146,427       7,259,301  
Commercial
    133,917,383       138,374,082  
Construction
    83,543,331       99,771,212  
Second mortgages
    8,879,885       7,127,228  
Equity lines of credit
    25,391,414       29,370,304  
 
           
 
               
 
    344,281,388       370,394,124  
 
           
 
               
Commercial loans
    24,944,178       30,386,527  
 
           
 
               
Consumer installment loans:
               
Personal
    2,854,531       4,512,571  
Credit cards
    2,275,367       2,411,224  
 
           
 
               
 
    5,129,898       6,923,795  
 
           
 
               
Total loans
    374,355,464       407,704,446  
Less: Allowance for loan losses
    (10,942,414 )     (11,353,438 )
 
           
 
               
Loans, net
  $ 363,413,050     $ 396,351,008  
 
           

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
A summary of transactions in the allowance for loan losses for the years ended December 31, 2010 and 2009 is as follows:
                 
    2010     2009  
Balance, beginning of year
  $ 11,353,438     $ 5,292,028  
Provision for loan losses
    7,727,200       11,672,802  
Loans charged-off
    (8,593,679 )     (5,890,874 )
Recoveries of loans previously charged-off
    455,455       279,482  
 
           
 
               
Balance, end of year
  $ 10,942,414     $ 11,353,438  
 
           
The Bank had a concentration of credit at December 31, 2010 in real estate loans, which totaled approximately $344,281,000. Real estate loans accounted for 92% of total loans and were primarily commercial loans secured by commercial properties and residential mortgage loans. Additionally, a large portion of the Bank’s real estate loans were for construction, land acquisition and development. Substantially all real estate loans are secured by properties located in Tennessee.
Loans to executive officers, principal shareholders and directors and their affiliates were approximately $13,448,000 and $17,933,000 at December 31, 2010 and 2009, respectively. For the year ended December 31, 2010, the activity in these loans included new borrowings of approximately $1,352,000 and repayments of approximately $5,837,000. None of these loans to executive officers, principal shareholders and directors and their affiliates, were impaired at December 31, 2010 or 2009.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on impairment method as of December 31, 2010:
                                                                 
    Construction and     Residential     Commercial             Consumer /     Credit              
    Development     Real Estate     Real Estate     Commercial     Other     Cards     Unallocated     Total  
Allowance for loan losses:
                                                               
Ending allowance balance attributable to loans:
                                                               
Individually evaluated for impairment
  $ 1,647,319     $ 2,444,296     $ 617,123     $ 623     $ 480     $     $     $ 4,709,841  
Collectively evaluated for impairment
    1,444,541       1,653,029       1,444,301       395,080       97,188       121,268       1,077,166       6,232,573  
 
                                               
Total ending allowance balance
  $ 3,091,860     $ 4,097,325     $ 2,061,424     $ 395,703     $ 97,668     $ 121,268     $ 1,077,166     $ 10,942,414  
 
                                               
 
                                                               
Loans:
                                                               
Loans individually evaluated for impairment
  $ 41,517,256     $ 29,181,876     $ 21,528,757     $ 113,250     $ 15,189     $     $     $ 92,356,328  
Loans collectively evaluated for impairment
    42,026,075       97,638,798       112,388,626       24,830,928       2,839,342       2,275,367             281,999,136  
 
                                               
Total ending loan balance
  $ 83,543,331     $ 126,820,674     $ 133,917,383     $ 24,944,178     $ 2,854,531     $ 2,275,367     $     $ 374,355,464  
 
                                               
Individually impaired loans were as follows:
                 
    2010     2009  
Year-end loans with allocated allowance for loan losses
  $ 69,501,838     $ 37,952,662  
Year-end loans with no allocated allowance for loan losses
    22,854,490       25,194,329  
 
           
Total impaired loans
    92,356,328       63,146,991  
 
               
Allowance for loan losses on impaired loans
    4,709,841       5,367,678  
 
               
Average of individually impaired loans during the year
  $ 83,699,963       54,479,634  
 
               
Amount of partial charge-offs related to impaired loans above
    5,051,238       2,218,029  

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
The following table presents loans individually evaluated for impairment by class of loans as of December 31, 2010:
                         
    Unpaid             Allowance for  
    Principal     Recorded     Loan Losses  
    Balance     Investment     Allocated  
With no related allowance recorded:
                       
Construction and development
  $ 18,005,132     $ 13,216,014     $  
 
                       
Commercial real estate
                       
Commercial mortgage
    5,559,433       4,834,417        
 
                       
Residential real estate
                       
Residential mortgage
    4,357,820       4,336,359        
Home equity and junior liens
    467,700       467,700        
 
                 
Total residential real estate
    4,825,520       4,804,059        
 
                 
 
                       
Total with no related allowance recorded
  $ 28,390,085     $ 22,854,490     $  
 
                 
 
                       
With an allowance recorded:
                       
Construction and development
  $ 28,504,574     $ 28,301,242     $ 1,647,319  
 
                       
Commercial real estate
                       
Commercial mortgage
    16,742,796       16,694,340       617,123  
 
                       
Commercial
                       
Commercial and industrial
    113,250       113,250       623  
 
                       
Residential real estate
                       
Residential mortgage
    22,349,306       22,297,635       2,334,970  
Home equity and junior liens
    388,063       388,063       17,283  
Multi-family
    1,692,119       1,692,119       92,043  
 
                 
Total residential real estate
    24,429,488       24,377,817       2,444,296  
 
                       
Consumer
                       
Other
    15,189       15,189       480  
 
                 
 
                       
Total with an allowance recorded
  $ 69,805,297     $ 69,501,838     $ 4,709,841  
 
                 
 
                       
Total impaired loans
  $ 98,195,382     $ 92,356,328     $ 4,709,841  
 
                 

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
At December 31, 2010 and 2009, the Bank had certain impaired loans on nonaccruing interest status. The principal balance of these nonaccrual loans amounted to approximately $53,005,000 and $39,587,000 at December 31, 2010 and 2009, respectively. In most cases, at the date such loans were placed on nonaccrual status, the Bank reversed all previously accrued interest income against the current year earnings. Had nonaccruing loans been on accruing status, interest income would have been higher by approximately $3,164,000 and $1,358,000 for the years ended December 31, 2010 and 2009, respectively.
Nonperforming loans were as follows:
                 
    2010     2009  
Loans past due over 90 days still on accrual
  $ 432,438     $ 67,634  
 
               
Nonaccrual loans
    53,005,380       40,548,546  
Nonperforming loans include both smaller balance homogeneous loans that are collectively evaluated for impairment and individually classified as impaired loans.
The following table presents the recorded investment in nonperforming loans by class of loans as of December 31, 2010:
                 
            Loans Past Due  
            Over 90 Days  
    Nonaccrual     Still Accruing  
Construction and development
  $ 27,929,095     $  
 
               
Commercial real estate
               
Commercial mortgage
    6,362,017       413,283  
 
               
Commercial
               
Commercial and industrial
    67,234        
 
               
Residential real estate
               
Residential mortgage
    17,446,374        
Home equity and junior liens
    1,200,660       84  
 
           
Total residential real estate
    18,647,034       84  
 
               
Credit cards
          19,071  
 
           
 
               
Total nonperforming loans
  $ 53,005,380     $ 432,438  
 
           

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
The following table presents the aging of the recorded investment in past due loans, including the payment status of loans on non-accrual which have been incorporated into the table, as of December 31, 2010 by class of loans:
                                                 
    30-59     60-89     Greater Than                      
    Days     Days     90 Days     Total             Total  
    Past Due     Past Due     Past Due     Past Due     Current     Loans  
Construction and development
  $ 264,762     $ 49,071     $ 394,151     $ 707,984     $ 82,835,347     $ 83,543,331  
 
                                               
Commercial real estate
                                               
Commercial mortgage
    214,642       326,019       2,573,021       3,113,682       130,803,701       133,917,383  
 
                                               
Commercial
                                               
Commercial and industrial
                            24,944,178       24,944,178  
 
                                               
Residential real estate
                                               
Residential mortgage
    947,887       2,579,749             3,527,636       82,875,312       86,402,948  
Home equity and junior liens
          408,909       61,800       470,709       33,800,590       34,271,299  
Multi-family
                            6,146,427       6,146,427  
 
                                   
Total residential real estate
    947,887       2,988,658       61,800       3,998,345       122,822,329       126,820,674  
 
                                               
Consumer
                                               
Other
    13,685       10,601             24,286       2,830,245       2,854,531  
 
                                               
Credit cards
    42,996       1,082       19,071       63,149       2,212,218       2,275,367  
 
                                   
 
                                               
Total
  $ 1,483,972     $ 3,375,431     $ 3,048,043     $ 7,907,446     $ 366,448,018     $ 374,355,464  
 
                                   
Troubled Debt Restructurings:
Impaired loans also include loans that the Bank may elect to formally restructure due to the weakening credit status of a borrower such that the restructuring may facilitate a repayment plan that minimizes the potential losses, if any, that the Bank may have to otherwise incur. These loans are classified as impaired loans and, if on nonaccruing status as of the date of restructuring, the loans are included in the nonperforming loan balances noted below. Not included in nonperforming loans are loans that have been restructured that were performing as of the restructure date. The Company has allocated $3,699,700 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of December 31, 2010. The Company has $82,442,903 outstanding to customers whose loans are classified as a troubled debt restructuring. The Company has committed to lend additional amounts totaling $1,241,287 related to loans classified as troubled debt restructurings. At December 31, 2010 and 2009, there were $35,751,985 and $21,797,811, respectively, of accruing restructured loans that remain in a performing status.

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
Credit Quality Indicators:
The Company uses several credit quality indicators, which are updated at least annually, to manage credit risk in an ongoing manner. The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. The Company uses an internal credit risk rating system that categorizes loans into pass, special mention or classified categories. Credit risk ratings are applied to all loans individually with the exception of credit cards.
The following are the definitions of the Company’s risk ratings:
     
Pass:
  Loans that are not adversely rated, are contractually current as to principal and interest and are otherwise in compliance with the contractual terms of the loan or lease agreement. Management believes that there is a low likelihood of loss related to those loans that are considered pass.
 
   
Special Mention:
  Loans classified as special mention have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or of the institution’s credit position at some future date.
 
   
Substandard/
Accruing:
  Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.
 
   
Substandard/
Nonaccrual:
  A loan classified as nonaccrual has all the deficiencies of a loan graded substandard but collection of the full amount of principal and interest owed is uncertain or unlikely and collateral support, if any, may be weak.
 
   
Doubtful:
  Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing estimations, facts, conditions and values, highly questionable and improbable. Doubtful loans include only the portion of each specific loan deemed uncollectible and the classification can change as certain current information and facts are ascertained.

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 3 — Loans and Allowance for Loan Losses (continued)
The following tables presents by class and by risk category, the recorded investment in the Company’s loans as of December 31, 2010.
                                                 
    Not             Special     Substandard     Substandard        
    Rated     Pass     Mention     Accruing     Nonaccrual     Doubtful  
Construction and development
  $     $ 36,085,885     $ 283,817     $ 19,244,534     $ 26,977,265     $ 951,830  
 
                                               
Commercial real estate
                                               
Commercial mortgage
          99,648,357       1,044,251       26,862,758       6,362,017        
 
                                               
Commercial
                                               
Commercial and industrial
          24,274,283       207,244       395,417       67,234        
 
                                               
Residential real estate
                                               
Residential mortgage
          54,331,450       2,905,416       11,719,708       17,446,374        
Home equity and junior liens
          30,841,092       668,456       1,561,091       1,200,660        
Multi-family
          4,454,308             1,692,119              
 
                                   
Total residential real estate
          89,626,850       3,573,872       14,972,918       18,647,034        
 
                                               
Consumer
                                               
Other
          2,755,139       40,627       58,765              
 
                                   
 
                                               
Credit cards
    2,275,367                                
 
                                   
 
                                               
Total
  $ 2,275,367     $ 252,390,514     $ 5,149,811     $ 61,534,392     $ 52,053,550     $ 951,830  
 
                                   

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 4 — Bank Premises and Equipment
A summary of Bank premises and equipment at December 31, 2010 and 2009, is as follows:
                 
    2010     2009  
Land
  $ 9,694,709     $ 9,694,709  
Buildings and improvements
    22,865,665       22,753,470  
Furniture, fixtures and equipment
    9,056,630       8,934,486  
 
           
 
    41,617,004       41,382,665  
Accumulated depreciation
    (9,016,331 )     (7,673,383 )
 
           
 
  $ 32,600,673     $ 33,709,282  
 
           
Depreciation expense for the years ended December 31, 2010 and 2009 amounted to $1,433,948 and $1,430,157, respectively.
Note 5 — Deposits
The aggregate amount of time deposits in denominations of $100,000 or more at December 31, 2010 and 2009, was approximately $121,566,000 and $168,252,000, respectively, including brokered deposits of approximately $27,019,000 and $69,955,000, respectively, for each time period.
At December 31, 2010, the scheduled maturities of time deposits for each of the five years subsequent to December 31, 2010 were as follows:
         
2011
  $ 183,855,611  
2012
    58,105,369  
2013
    18,647,603  
2014
    1,404,456  
2015
    9,159,862  
 
     
Total
  $ 271,172,901  
 
     
Deposits of employees, officers and directors totaled approximately $6,200,000 at December 31, 2010 and $8,482,000 at December 31, 2009.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 — Income Taxes (Benefits)
Income tax expense (benefit) in the statements of income for the years ended December 31, 2010 and 2009 consists of the following:
                 
    2010     2009  
Current tax expense
  $     $ 89,951  
Deferred tax expense (benefit)
    (3,737,827 )     (3,877,978 )
 
           
Income tax expense (benefit)
  $ (3,737,827 )   $ (3,788,027 )
 
           
Income tax expense (benefit) differs from amounts computed by applying the Federal income tax statutory rate of 34% in 2010 and 2009 to income before income taxes. A reconciliation of the differences for the years ended December 31, 2010 and 2009 is as follows:
                 
    2010     2009  
Expected tax at statutory rates
  $ (2,283,000 )   $ (2,726,000 )
Increase (decrease) resulting from tax effect of:
               
State income taxes, net of federal tax
    (377,063 )     (544,004 )
Increase in cash surrender value of life insurance
    (138,834 )     (94,601 )
Tax exempt interest
    (64,204 )     (347,420 )
General business credits, net of basis reduction
    (158,400 )     (132,000 )
Other
    (97,785 )        
Valuation allowance change
    6,857,113       55,998  
 
           
 
               
Income tax expense (benefit)
  $ 3,737,827     $ (3,788,027 )
 
           

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 — Income Taxes (Benefits) (continued)
Significant components of the Company’s deferred tax assets and liabilities at December 31, 2010 and 2009 were as follows:
                 
    2010     2009  
Deferred tax assets:
               
Allowance for loan losses
  $ 4,107,907     $ 4,214,292  
Deferred compensation
    562,754       419,399  
Unrealized loss on securities available for sale
    339,693        
Net operating loss
    2,637,959       371,065  
Nonaccrual loans
    1,110,990       472,359  
Tax credits
    610,516       150,816  
Other real estate owned
    417,928       488,685  
Other
    336,903       315,770  
 
           
 
               
Total deferred tax assets
    10,124,650       6,432,386  
 
           
 
               
Deferred tax liabilities:
               
Accelerated depreciation
    (552,177 )     (604,553 )
Unrealized gain on securities available for sale
          (175,714 )
Income from subsidiary
          (49,823 )
Investment in partnership
    (367,200 )     (72,000 )
Other
    (400,324 )     (358,491 )
 
           
 
               
Total deferred tax liabilities
    (1,319,701 )     (1,260,581 )
 
           
 
               
Valuation allowance
    (7,372,520 )      
 
           
 
               
Total net deferred tax assets
  $ 1,432,429     $ 5,171,805  
 
           
A valuation allowance is recognized for a deferred tax asset if, based on the weight of available evidence, it is more-likely-than-not that some portion of the entire deferred tax or asset will not be realized. In making such judgments, significant weight is given to evidence that can be objectively verified. As a result of increased credit losses, the Company entered into a three-year cumulative pre-tax loss position in 2010. A cumulative loss position is considered significant negative evidence in assessing the reliability deferred tax asset which is difficult to overcome. The Company’s estimate of the realization of its deferred tax assets was based on future reversals of existing taxable temporary differences and taxable income in prior carry back years. The Company did not consider future taxable income in determining the reliability of its deferred assets. During 2010, we recorded a valuation allowance of $7,372,520. The timing of the reversal of the valuation allowance is dependent on our assessment of future events and will be based on the circumstances that exist as of that future date.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 6 — Income Taxes (Benefits) (continued)
During 2010 and per ASC 740-20-45, the Company had income tax expense related to changes in the unrealized gains and losses on investment securities available for sale totaling approximately $515,000. This expense was recorded through accumulated other comprehensive income and increased our deferred tax valuation allowance.
The Bank has a federal net operating loss carryforward of approximately $1,578,000 which will expire in 2030. The Bank has a Tennessee net operating loss carryforward of which approximately $1,590,000 will expire in 2021, $1,630,000 which will expire in 2022, $1,563,000 which will expire in 2023, $3,748,000 which will expire in 2024 and $5,818,000 which will expire in 2025 if not offset by future taxable income.
The Bank has a minimum tax credit of $130,000 that can be carried forward indefinitely.
The Company currently has no unrecognized tax benefits that, if recognized, would favorably affect the effective income tax rate in future periods. The Company does not expect any unrecognized tax benefits to significantly increase or decrease in the next twelve months. It is the Company’s policy to recognize any interest accrued related to unrecognized tax benefits in interest expense, with any penalties recognized as operating expenses.
The Company and its subsidiaries are subject to U.S. federal income tax as well as income tax of the state of Tennessee. The Company is no longer subject to examination by taxing authorities for tax years before 2007.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 7 — Federal Home Loan Bank Advances
The Bank has an agreement with the Federal Home Loan Bank of Cincinnati (“FHLB”) that provides short-term and long-term funding to the Bank in an amount up to $100,000,000. The Bank’s portfolio of one to four single-family mortgages, commercial real estate, home equity lines of credit, multi-family mortgages and junior mortgages have been pledged as collateral for any advances under a blanket lien arrangement requiring a collateral-to-loan ratio of 145%, 210%, 200%, 230% and 195%, respectively. At year end, advances from the FHLB were as follows:
                 
    2010     2009  
Long-term advance requiring monthly interest payments at 4.32% fixed, principal due in June 2010
  $     $ 200,000  
 
               
Long-term callable advance requiring monthly interest payments at 4.39% fixed, principal due in November 2011
          7,500,000  
 
               
Long-term advance requiring monthly interest payments at 4.47% fixed, principal due in June 2012
    200,000       200,000  
 
               
Long-term callable advance requiring monthly interest payments at 4.25% fixed, principal due in January 2017
    10,000,000       10,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 4.15% fixed, principal due in April 2017
    10,000,000       10,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 4.27% fixed, principal due in May 2017
    10,000,000       10,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 4.68% fixed, principal due in June 2017
    10,000,000       10,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 3.36% fixed, principal due in December 2012
    5,000,000       5,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 3.46% fixed, principal due in December 2014
    5,000,000       5,000,000  
 
               
Long-term callable advance requiring monthly interest payments at 3.13% fixed, principal due in January 2015
    5,000,000       5,000,000  
 
           
 
               
 
  $ 55,200,000     $ 62,900,000  
 
           
Each advance is payable at its maturity date, with prepayment penalties that vary according to the type of advance. Maturities of the notes payable for each of the years subsequent to December 31, 2010 are as follows:
         
2012
    5,200,000  
2014
    5,000,000  
2015
    5,000,000  
2017
    40,000,000  
 
     
Total
  $ 55,200,000  
 
     

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 7 — Federal Home Loan Bank Advances (continued)
During the third quarter of 2010, the Bank elected to pre-pay a $7,500,000 FHLB advance that was scheduled to mature in November 2011. The pre-payment resulted in a penalty of approximately $350,000 which essentially accelerated payment of the interest that would have been due on the advance through its maturity. Management chose to pay off the advance early due to increasing collateralization requirements associated with the Bank’s outstanding FHLB debt and difficulty finding pledgeable collateral with a yield sufficient to cover or exceed the cost of the debt. Additionally, management chose to pay off the advance in order to reduce a non-core funding source. The pre-payment penalty is included in other non-interest expense in the Company’s 2010 statement of operations.
Note 8 — Subordinated Debentures
On November 7, 2003, we established MNB Capital Trust I and on June 9, 2006, we established MNB Capital Trust II (“Trust I” and “Trust II” or collectively, the “Trusts”). The Company is the sole sponsor of the Trusts and acquired each Trust’s common securities for $171,000 and $232,000, respectively. The Trusts were created for the exclusive purpose of issuing 30-year capital trust preferred securities (“Trust Preferred Securities”) in the aggregate amount of $5,500,000 for Trust I and $7,500,000 for Trust II and using the proceeds to acquire junior subordinated debentures (“Subordinated Debentures”) issued by the Company. The sole assets of the Trusts are the Subordinated Debentures. Both are wholly-owned statutory business trusts, however; the Company is not considered the primary beneficiary of Trust I or Trust II (variable interest entities), therefore the Trusts are not consolidated in the Company’s financial statements. The Company’s aggregate $403,000 investment in the Trusts is included in other assets in the accompanying consolidated balance sheets and the $13,403,000 obligation of the Company is reflected as subordinated debt.
The Trust I Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR and was 3.340% at December 31, 2010 which is set each quarter and mature on December 31, 2033. The Trust II Preferred Securities bear a floating interest rate based on a spread over 3-month LIBOR and was 1.889% at December 31, 2010 which is set each quarter and mature on July 7, 2036. Distributions are payable quarterly. The Trust Preferred Securities are subject to mandatory redemption upon repayment of the Subordinated Debentures at their stated maturity date or their earlier redemption in an amount equal to their liquidation amount plus accumulated and unpaid distributions to the date of redemption. The Company guarantees the payment of distributions and payments for redemption or liquidation of the Trust Preferred Securities to the extent of funds held by the Trusts. The Company’s obligations under the Subordinated Debentures together with the guarantee and other back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of the Trusts under the Trust Preferred Securities.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 8 — Subordinated Debentures (continued)
The Subordinated Debentures are unsecured, bear interest at a rate equal to the rates paid by the Trusts on the Trust Preferred Securities and mature on the same dates as those noted above for the Trust Preferred Securities. Interest is payable quarterly. The Company may defer the payment of interest at any time for a period not exceeding 20 consecutive quarters without default provided that deferral period does not extend past the stated maturity. During any such deferral period, distributions on the Trust Preferred Securities will also be deferred and the Company’s ability to pay dividends on its common shares will be restricted.
On December 14, 2010, the Company exercised its rights to defer regularly scheduled interest payments of $84,680 on all of its issues of junior subordinated debentures relating to outstanding trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes.
Subject to approval by the Federal Reserve Bank of Atlanta, if then required, the Trust Preferred Securities may be redeemed prior to maturity at the Company’s option on or after December 31, 2008, for Trust I and on or after July 7, 2011, for Trust II. The Trust Preferred Securities may also be redeemed at any time in whole (but not in part) in the event of unfavorable changes in laws or regulations that result in (1) the Trusts becoming subject to federal income tax on income received on the Subordinated Debentures, (2) interest payable by the Company on the Subordinated Debentures becoming non-deductible for federal tax purposes, (3) the requirement for the Trusts to register under the Investment Company Act of 1940, as amended, or (4) loss of the ability to treat the Trust Preferred Securities as “Tier 1 capital” under the Federal Reserve capital adequacy guidelines.
Following passage of the Dodd Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”), bank holding companies like the Company must be subject to capital requirements that are at least as severe as those imposed on banks under current federal regulations. Trust preferred and cumulative preferred securities will no longer be deemed Tier 1 capital for bank holding companies following passage of the Reform Act, but trust preferred securities issued by bank holding companies with under $15 billion in total assets at December 31, 2009 will be grandfathered in and continue to count as Tier 1 capital. Accordingly, the Company’s trust preferred securities will continue to count as Tier 1 capital.
The Company’s investments in Trust I and Trust II are included in other assets. These investments are accounted for under the equity method and consist of 100% of the common stock of Trust I and Trust II.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 9 — Securities Sold Under Agreements to Repurchase
Securities sold under agreements to repurchase are variable rate financing arrangements with no fixed maturity. Upon cancellation of the agreement, the securities underlying the agreements are returned to the Company. Information concerning securities sold under agreements to repurchase is summarized as follows:
                 
    2010     2009  
Weighted average borrowing rate at year-end
    2.08 %     1.52 %
Weighted average borrowing rate during the year
    1.58 %     2.12 %
Average daily balance during the year
  $ 1,535,058     $ 4,283,833  
Maximum month-end balance during the year
    3,198,689       7,872,502  
Balance at year-end
    432,016       1,776,402  
Note 10 — Employee Benefit Plans
The Bank sponsors a 401(k) employee benefit plan covering substantially all employees who have completed at least six months of service and met minimum age requirements. The Bank’s contribution to the plan is discretionary and was $15,181 for 2010 and $111,373 for 2009. During the first quarter of 2010, the Bank elected to suspend its 401(k) matching contributions indefinitely.
The Company also has salary continuation agreements in place with certain key officers. Such agreements are structured with differing benefits based on the participants overall position and responsibility. These agreements provide the participants with a supplemental income upon retirement at age 65, additional incentive to remain with the Company in order to receive these deferred retirement benefits and a compensation package that is competitive in the market. These agreements vest over a ten year period, require a minimum number of years of service and contain change of control provisions. All benefits would cease in the event of termination for cause, and if the participant’s employment were to end due to disability, voluntary termination or termination without cause, the participant would be entitled to receive certain reduced benefits based on vesting and other conditions.
The estimated cost of this obligation is being accrued over the service period for each officer. The Company recognized expense of $374,393 and $301,943 during 2010 and 2009, respectively, related to these agreements. The total amount accrued at December 31, 2010 and 2009 was $1,469,716 and $1,095,323, respectively.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 11 — Leases
The Bank is leasing the land on which its Gatlinburg branch is located under a non-cancelable lease agreement that expires in 2013. This lease agreement contains renewal options for twelve additional five-year terms.
The Bank is also leasing the land on which its Justice Center branch is located under a non-cancelable lease agreement that expires in 2013. This lease agreement contains renewal options for six additional five-year terms.
In addition, the Bank is leasing the building in which its Gatlinburg walk-up facility is located and the property on which it has placed certain automated teller machines. These leases expire at various dates through 2015 and contain various renewal options. Total rental expense under all operating leases was $189,180 in 2010 and $182,330 in 2009.
The following is a schedule by years of future minimum rental payments required under operating leases that have initial or remaining non-cancelable lease terms in excess of one year as of December 31, 2010:
         
2011
  $ 178,277  
2012
    160,501  
2013
    135,402  
2014
    57,132  
2015
    33,327  
Thereafter
     
 
     
 
       
Total
  $ 564,639  
 
     

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 12 — Financial Instruments with Off-Balance Sheet Risk
In the normal course of business, the Bank has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Bank uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet. At December 31, 2010, commitments under standby letters of credit and undisbursed loan commitments, substantially all of which are carried at variable rates, were as follows:
                 
    2010     2009  
    (dollars in thousands)  
Commitments to extend credit
  $ 41,155     $ 50,702  
Standby letters of credit
    5,288       5,801  
 
           
Totals
  $ 46,443     $ 56,503  
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.
Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Standby letters of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit.
The Bank was not required to perform on any financial guarantees and did not incur any losses on its commitments during 2010 or 2009.
Note 13 — Fair Value
Fair value is the exchange price that would be received for an asset or paid to transfer a liability (exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. There are three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
The Company used the following methods and significant assumptions to estimate the fair value of each type of financial instrument:
Investment Securities Available for Sale — Securities classified as available for sale are reported at fair value utilizing Level 2 inputs. For these securities, the Company obtains fair value measurements from an independent service provider. The fair value measurements consider observable data that may include dealer quotes, market spreads, cash flows, the U. S. Treasury yield curve, live trading levels, trade execution data, market consensus prepayments speeds, credit information and the securities’ terms and conditions, among other things.
Impaired Loans — The fair value of impaired loans with specific allocations of the allowance for loan losses may be based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. If the recorded investment in an impaired loan exceeds the measure of fair value, a valuation allowance may be established as a component of the allowance for loan losses or the expense is recognized as a charge-off. As a result of partial charge-offs, certain impaired loans are carried at fair value with no allocation. Certain impaired loans are not measured at fair value, which generally includes troubled debt restructurings that are measured for impairment based upon the present value of expected cash flows discounted at the loan’s original effective interest rate, and are excluded from the assets measured on a nonrecurring basis.
Other Real Estate — The fair value of ORE is generally based on current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Gains or losses on sale and any subsequent adjustments to the value are recorded as a gain or loss on ORE. ORE is classified within Level 3 of the hierarchy.

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
Assets and Liabilities Measured on a Recurring Basis
   
The following table summarizes assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and December 31, 2009, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:
                 
            Fair Value Measurements at  
            December 31, 2010 Using:  
            Significant Other  
            Observable Inputs  
    Carrying Value     (Level 2)  
Assets:
               
Available for sale securities:
               
U. S. Government securities
  $ 249,866     $ 249,866  
Obligations of states and political subdivisions
    4,922,113       4,922,113  
Mortgage-backed securities -residential
    81,144,612       81,144,612  
 
           
Total available for sale securities
  $ 86,316,591     $ 86,316,591  
 
           
                 
            Fair Value Measurements at  
            December 31, 2009 Using:  
            Significant Other  
            Observable Inputs  
    Carrying Value     (Level 2)  
Assets:
               
Available for sale securities:
               
U. S. Government securities
  $ 3,250,551     $ 3,250,551  
U. S. Government sponsored entities and agencies
    6,898,369       6,898,369  
Obligations of states and political subdivisions
    20,123,929       20,123,929  
Mortgage-backed securities -residential
    114,057,219       114,057,219  
 
           
Total available for sale securities
  $ 144,330,068     $ 144,330,068  
 
           
   
There were no significant transfers between Level 1 and Level 2 during 2010.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
Assets and Liabilities Measured on a Non-Recurring Basis
   
Certain assets and liabilities are measured at fair value on a nonrecurring basis, that is, the instruments are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The following table summarizes assets and liabilities measured at fair value on a non-recurring basis as of December 31, 2010 and December 31, 2009, segregated by the level of the valuation inputs within the fair value hierarchy utilized to measure fair value:
                 
            Fair Value Measurements at  
            December 31, 2010 Using:  
            Significant  
            Unobservable Inputs  
    Carrying Value     (Level 3)  
Assets:
               
Impaired loans:
               
Construction and development
  $ 8,826,040     $ 8,826,040  
Commercial real estate
    3,378,152       3,378,152  
Residential real estate
    4,045,756       4,045,756  
 
           
Total impaired loans
    16,249,948       16,249,948  
 
               
Other real estate:
               
Construction and development
    2,229,161       2,229,161  
Commercial real estate
    1,404,833       1,404,833  
Residential real estate
    7,518,670       7,518,670  
 
           
Total other real estate
    11,152,664       11,152,664  
 
           
Total Assets Measured at Fair Value on a Non-Recurring Basis
  $ 27,402,612     $ 27,402,612  
 
           
                 
            Fair Value Measurements at  
            December 31, 2009 Using:  
            Significant  
            Unobservable Inputs  
    Carrying Value     (Level 3)  
Assets:
               
Impaired Loans
  $ 8,512,991     $ 8,512,991  
Other real estate
    12,019,079       12,019,079  
 
           
Total Assets Measured at Fair Value on a Non-Recurring Basis
  $ 20,532,070     $ 20,532,070  
 
           

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
At December 31, 2010, impaired loans measured at fair value, which are evaluated for impairment using the fair value of collateral, had a carrying amount of $17,718,189, with a valuation allowance of $1,468,241 resulting in an additional provision for loan losses of $4,514,585 for the year ended December 31, 2010. At December 31, 2009, impaired loans measured at fair value had a carrying amount of $8,512,991, with no valuation allowance. During 2009, $2,218,028 of outstanding principal was charged off on these loans resulting in an additional provision for loan losses of $2,218,028 for the year ended December 31, 2009. Impaired loans carried at fair value include loans that have been written down to fair value through the partial charge-off of principal balance. Accordingly, these loans do not have a specific valuation allowance as their balances represent fair value.
   
The December 31, 2010 carrying amount of ORE includes net valuation adjustments of approximately $1,211,000. The December 31, 2009 carrying amount of ORE includes net valuation adjustments of approximately $938,000. Valuation adjustments include both charge offs and holding gains and losses. The fair value of ORE is based upon appraisals performed by qualified, licensed appraisers.
Fair Value of Financial Instruments
   
Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. Accordingly, the aggregate fair value amounts presented are not intended to represent the underlying value of the Company.
   
Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:
   
Cash and cash equivalents:
   
For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
Investment Securities:
   
The fair value of securities is estimated as previously described for securities available for sale, and in a similar manner for securities held to maturity.
   
Restricted investments:
   
Restricted investments consist of Federal Home Loan Bank and Federal Reserve Bank stock. It is not practicable to determine the fair value due to restrictions placed on the transferability of the stock.
   
Loans:
   
The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs. The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions. The allowance for loan losses is considered a reasonable discount for credit risk.
   
Deposits:
   
The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.
   
Federal funds purchased and securities sold under agreements to repurchase:
   
The estimated value of these liabilities, which are extremely short term, approximates their carrying value.
   
Subordinated debentures:
   
For the subordinated debentures with a floating interest rate tied to LIBOR, the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the most recent offering rates available for subordinated debentures of similar amounts and remaining maturities.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
Federal Home Loan Bank advances:
   
For FHLB advances the fair value is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for FHLB advances of similar amounts and remaining maturities.
   
Accrued interest receivable and payable:
   
The carrying amounts of accrued interest receivable and payable approximate their fair value.
   
Commitments to extend credit, letters of credit and lines of credit:
   
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair values of these commitments are insignificant and are not included in the table below.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 13 — Fair Value (continued)
   
The carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2010 and December 31, 2009, not previously presented, are as follows (in thousands):
                                 
    December 31, 2010     December 31, 2009  
    Carrying     Estimated     Carrying     Estimated  
    Amount     Fair Value     Amount     Fair Value  
Assets:
                               
Cash and cash equivalents
  $ 32,576     $ 32,576     $ 14,105     $ 14,105  
Investment securities held to maturity
    1,318       1,303       2,204       2,208  
Restricted investments
    3,843       N/A       3,816       N/A  
Loans, net
    363,413       358,587       396,351       396,254  
Accrued interest receivable
    1,496       1,496       3,045       3,045  
 
                               
Liabilities:
                               
Noninterest-bearing demand deposits
  $ 47,639     $ 47,639     $ 47,601     $ 47,601  
NOW accounts
    57,345       57,345       112,440       112,440  
Savings and money market accounts
    73,435       73,435       61,329       61,329  
Time deposits
    271,173       272,304       289,244       290,534  
Subordinated debentures
    13,403       7,276       13,403       6,922  
Federal funds purchased and securities sold under agreements to repurchase
    432       432       1,776       1,776  
Federal Reserve/Federal Home Loan Bank advances
    55,200       61,136       62,900       67,989  
Accrued interest payable
    719       719       606       606  

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 14 — Stock Options
   
The Company has a stock option plan that is administered by the Board of Directors and provides for both incentive stock options and nonqualified stock options. The exercise price of each option shall not be less than 100 percent of the fair market value of the common stock on the date of grant. All options have been granted at the fair market value of the shares at the date of grant. The maximum term for each option is ten years. The maximum number of shares that can be issued under the plan is 724,239. The following table provides certain information about the Company’s equity compensation plan as of December 31, 2010:
                         
                    Number of  
    Number of             securities remaining  
    securities to be             available for  
    issued upon             future issuance under  
    exercise of     Weighted average     equity compensation  
    outstanding     exercise price of     plans (excluding  
    options, warrants     options, warrants     securities reflected  
    and rights     and rights     in column (a))  
Plan Category   (a)     (b)     (c)  
Equity compensation plans approved by security holders
    122,133     $ 21.50       381,264  
Equity compensation plans not approved by security holders
                 
   
The Company has granted incentive stock options to certain key officers and employees. The Company has also granted nonqualified stock options to non-employee organizers of the Bank. The stock option agreements state that upon termination of employment, employees have 90 days to exercise any stock options vested as of the termination date.
   
The Company issues new shares to satisfy option exercises from the authorized shares allocated to the employee stock option plan.
   
A summary of activity in the Company’s stock option plan for the year ended December 31, 2010 is as follows:
                                 
                    Weighted Average        
            Weighted     Remaining        
    Number     Average     Contractual Term     Aggregate  
    of Options     Exercise Price     (in years)     Intrinsic Value  
Options outstanding, December 31, 2009
    125,086     $ 21.44                  
Options granted
                           
Options exercised
                           
Options forfeited
    (2,953 )     18.80                  
 
                           
 
                               
Options outstanding, December 31, 2010
    122,133     $ 21.50       5.42     $  
 
                         
Fully vested and expected to vest
    122,133     $ 21.50       5.42     $  
 
                         
Exercisable at December 31, 2010
    66,867     $ 19.06       4.52     $  
 
                         

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 14 — Stock Options (continued)
   
Information related to the stock option plan during each year follows:
                 
    2010     2009  
Intrinsic value of options exercised
  $     $  
Cash received from option exercises
           
Tax benefit realized from option exercises
          70,696  
Weighted average fair value of options granted
          5.82  
   
As of December 31, 2010, there was $248,036 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the stock option plan. The cost is expected to be recognized over a weighted-average period of 2.04 years.
   
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the following table for years in which options were granted. Expected volatilities are based on historical exercise patterns, employee terminations and historical stock prices. The expected life of options granted represents the period of time that options granted are expected to be outstanding. The U.S. Treasury 10 year constant maturity rate in effect at the date of grant is used to derive the risk-free interest rate for the contractual period of the options.
         
    2009  
Dividend yield
    0.00 %
Expected life
  9.5 years  
Expected volatility
    18 %
Risk-free interest rate
    2.96 %
Note 15 — Regulatory Matters
   
The Bank and Company are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action applicable to the Bank, the Bank and Company must meet specific capital guidelines that involve quantitative measures of assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 — Regulatory Matters (continued)
   
Quantitative measures established by regulation to ensure capital adequacy require the Bank and Company to maintain minimum amounts and ratios (set forth in the table below) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). In addition, the Company’s and the Bank’s regulators may impose additional capital requirements on financial institutions and their bank subsidiaries, like the Company and the Bank, beyond those provided for statutorily, which standards may be in addition to, and require higher levels of capital, than the general capital adequacy guidelines. As discussed below, the Bank has agreed to maintain certain of its capital ratios above statutory levels. As of December 31, 2010 and discussed below, the Bank failed to meet all capital adequacy requirements to which it is subject.
   
As of December 31, 2010, the most recent notification from the Office of the Comptroller of the Currency (“OCC”) categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. However, as noted below, the Bank anticipates that it will be required to enter into a Consent Order which will contain higher capital standards which will result in it being deemed to be “adequately capitalized” for regulatory purposes.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 — Regulatory Matters (continued)
   
The actual capital amounts and ratios are presented in the table. Dollar amounts are presented in thousands.
                                                                 
                    Adequately Capitalized     Well-Capitalized     Required by  
    Actual     Regulatory Minimum     Regulatory Minimum     IMCR  
    Amount     Ratio     Amount     Ratio     Amount     Ratio     Amount     Ratio  
As of December 31, 2010:
                                                               
Total capital to risk-weighted assets:
                                                               
Consolidated
  $ 54,973       13.27 %   $ 33,147       8.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    54,764       13.23 %     33,110       8.00 %     41,388       10.00 %     53,804       13.00 %
 
                                                               
Tier I capital to risk-weighted assets:
                                                               
Consolidated
    49,174       11.87 %     16,574       4.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    49,526       11.97 %     16,555       4.00 %     24,833       6.00 %     N/A       N/A  
 
                                                               
Tier I capital to average assets:
                                                               
Consolidated
    49,174       8.34 %     23,585       4.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    49,526       8.41 %     23,549       4.00 %     29,436       5.00 %     52,984       9.00 %
 
                                                               
As of December 31, 2009:
                                                               
Total capital to risk-weighted assets:
                                                               
Consolidated
  $ 65,993       14.16 %   $ 37,290       8.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    65,287       14.02 %     37,260       8.00 %     46,574       N/A       N/A       N/A  
 
                                                               
Tier I capital to risk-weighted assets:
                                                               
Consolidated
    60,098       12.89 %     18,645       4.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    59,397       12.75 %     18,630       4.00 %     27,945       N/A       N/A       N/A  
 
                                                               
Tier I capital to average assets:
                                                               
Consolidated
    60,098       9.23 %     26,049       4.00 %     N/A       N/A       N/A       N/A  
Mountain National Bank
    59,397       9.14 %     26,007       4.00 %     32,509       N/A       N/A       N/A  
   
As a result of a regulatory examination conducted during the first quarter of 2009, the Bank has entered into a formal written agreement in which it made certain commitments to the OCC, including commitments to, among other things, implement a written program to reduce the high level of credit risk in the Bank including strengthening credit underwriting and problem loan workouts and collections, reduce its level of criticized assets, implement a concentration risk management program related to commercial real estate lending, improve procedures related to the maintenance of the Bank’s ALLL, strengthen the Bank’s internal loan review program, strengthen the Bank’s loan workout department, and develop a liquidity plan that improves the Bank’s reliance on wholesale funding sources. The Company has taken action to comply with these requirements and does not believe compliance with these commitments will have a materially adverse impact on its operations.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 — Regulatory Matters (continued)
   
In February 2010, the Bank agreed to an OCC requirement to maintain a minimum Tier 1 capital to average assets ratio of 9% and a minimum total capital to risk-weighted assets ratio of 13%. The OCC imposed this requirement to maintain capital at higher levels than those required by applicable federal regulations because the OCC believed that the Bank’s capital levels were less than satisfactory given the level of credit risk in the Bank, specifically the high level of nonperforming assets and provision for loan losses. As noted above, the Bank had 8.41% of Tier 1 capital to average assets and 13.25% of total capital to risk-weighted assets ratio at December 31, 2010 and thus failed to satisfy its minimum Tier 1 capital to average assets ratio. Failure to satisfy such requirement could result in further enforcement action by the OCC.
   
In the fourth quarter of 2010, the OCC informed the Bank that, because the OCC does not believe that the Bank has fully satisfied the requirements of the formal written agreement, it will be requested to replace the formal written agreement with a consent order (the “Consent Order”) containing commitments for further improvements in the Bank’s operations. While the requirements of the Consent Order are not currently known to the Bank, the OCC has informed the Bank’s management that the Consent Order will likely contain provisions similar to those currently contained in the existing minimum capital commitment that the Bank made to the OCC in connection with the Bank’s entering into the formal written agreement, requiring the Bank to maintain a minimum Tier 1 leverage capital ratio of 9% and a minimum total risk-based capital ratio of 13%. If the Bank fails to comply with the requirements of the Consent Order, the OCC may impose additional limitations, restraints, commitments or conditions on the Bank. Once the Consent Order is effective, the Bank will be deemed to be “adequately capitalized” even if the Bank’s capital ratios exceed those minimum amounts necessary to be considered “well capitalized” under federal banking regulations as well as the minimum ratios set forth in the Consent Order.
   
Since the Bank agreed to the capital requirement, certain actions have been taken, and are ongoing, that are designed to ensure the required capital levels are maintained. The reduction of total assets of the Bank can have a significant impact on the Tier 1 capital ratio. Since December 31, 2009 the Bank has reduced total assets approximately $83,000,000 from approximately $640,000,000 to approximately $557,000,000 at December 31, 2010. This reduction in assets was accomplished by reducing wholesale funding including brokered deposits and Federal Home Loan Bank advances as well as the reduction of public funds deposits. Additionally, loans outstanding and the bond investment portfolio were reduced subsequent to the capital requirement. Expense reduction measures were put in place during the second quarter of 2010 which included a significant reduction of salaries and benefits. As a result of and the continuation of these efforts, management expects the Bank’s Tier 1 capital ratio will meet the minimum requirement as of March 31, 2011.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 15 — Regulatory Matters (continued)
   
Dividend restrictions:
   
The Company’s principal source of funds for dividend payments is dividends received from the Bank. The Bank is subject to limitations on the payment of dividends to the Company under federal banking laws and the regulations of the OCC. The Company is also subject to limits on payment of dividends to its shareholders by the rules, regulations and policies of federal banking authorities. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net profits, combined with the retained net profits of the preceding two years, subject to the capital requirements described above.
   
As of December 31, 2010, pursuant to federal banking regulations and due to losses incurred during 2009 and 2010, the Company and Bank may not, without the prior approval of their respective banking authorities, pay any dividends until such time that current year profits exceed the net losses and dividends of the prior two years. Generally, federal regulatory policy discourages payment of holding company or bank dividends if the holding company or its subsidiaries are experiencing losses.
   
Supervisory guidance from the Federal Reserve Board indicates that bank holding companies that are experiencing financial difficulties generally should eliminate, reduce or defer dividends on Tier 1 capital instruments including trust preferred securities, preferred stock or common stock, if the holding company needs to conserve capital for safe and sound operation and to serve as a source of strength to its subsidiaries. The Company has informally committed to the Federal Reserve Board that it will not (1) declare or pay dividends on the Company’s common or preferred stock, or (2) incur any additional indebtedness without in each case, the prior written approval of the Federal Reserve Board.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 16 — Other Comprehensive Income (Loss)
   
Other comprehensive income (loss) consists of unrealized holding gains and losses on securities available for sale. A summary of other comprehensive income (loss) and the related tax effects for the years ended December 31, 2010 and 2009 is as follows:
                         
            Tax        
    Before-Tax     (Expense)     Net-of-Tax  
    Amount     Benefit     Amount  
Year ended December 31, 2010:
                       
Unrealized holding gains/(losses) arising during the period
  $ 163,313     $ (574,182 )   $ (410,869 )
 
                       
Less reclassification adjustment for gains realized in net income (loss)
    (1,511,005 )     574,182       (936,823 )
 
                 
 
                       
 
  $ (1,347,692 )   $     $ (1,347,692 )
 
                 
 
                       
Year ended December 31, 2009:
                       
Unrealized holding gains/(losses) arising during the period
  $ 2,919,308     $ (1,117,736 )   $ 1,801,572  
 
                       
Less reclassification adjustment for gains realized in net income (loss)
    (2,211,243 )     840,272       (1,370,971 )
 
                 
 
                       
 
  $ 708,065     $ (277,464 )   $ 430,601  
 
                 
Note 17 — Earnings (Loss) Per Common Share
   
Basic earnings (loss) per share represents income (loss) available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income (loss) that would result from the assumed issuance.
   
Potential common shares that may be issued by the Company relate to outstanding stock options, determined using the treasury stock method.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 17 — Earnings (Loss) Per Common Share (continued)
   
Earnings (loss) per common share have been computed based on the following:
                 
    2010     2009  
Net income (loss)
  $ (10,451,178 )   $ (4,228,395 )
 
           
 
               
Average number of common shares outstanding
    2,631,611       2,631,611  
Dilutive effect of stock options
           
 
           
Average number of common shares outstanding used to calculate diluted earnings (loss) per common share
    2,631,611       2,631,611  
 
           
   
At December 31, 2010 and 2009, there were options for the purchase of 122,133 and 125,086 shares, respectively, outstanding that were antidilutive.
   
Potential common shares that would have the effect of decreasing diluted loss per share are considered to be antidilutive and therefore not included in calculating diluted loss per share. During the year ended December 31, 2009, due to the net loss, there were 19,315 shares excluded from this calculation although the exercise price for such shares’ underlying options was less than the fair value of the Company’s common stock. For the year ended December 31, 2010, the exercise price of all outstanding options was greater than the fair value of the Company’s stock.
Note 18 — Recent Accounting Pronouncements
   
FASB ASC 810 Consolidation (“ASC 810”) was amended to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity’s financial statements. The new authoritative accounting guidance under ASC 810 was effective January 1, 2010 and did not have a significant impact on our financial statements.
   
FASB ASC 860 Transfers and Servicing (“ASC 860”) was amended to enhance reporting about transfers of financial assets, including securitizations, and where companies have continuing exposure to the risks related to transferred financial assets. The new authoritative accounting guidance eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. The new authoritative accounting guidance also requires additional disclosures about all continuing involvements with transferred financial assets including information about gains and losses resulting from transfers during the period. The new authoritative accounting guidance under ASC 860 was effective January 1, 2010 and did not have a significant impact on our financial statements.

 

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MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 18 — Recent Accounting Pronouncements (continued)
   
FASB ASC 310 Receivables, Sub-Topic 310-30 Loans and Debt Securities Acquired with Deteriorated Credit Quality (“Subtopic 310-30”) was amended to clarify that modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification would otherwise be considered a troubled debt restructuring. The amendments do not affect the accounting for loans under the scope of Subtopic 310-30 that are not accounted for within pools. Loans accounted for individually under Subtopic 310-30 continue to be subject to the troubled debt restructuring accounting provisions within ASC 310 Subtopic 310-40 Troubled Debt Restructurings by Creditors. The new authoritative accounting guidance under Subtopic 310-30 was effective in the third quarter of 2010. This amendment did not have a significant impact on our financial statements.
   
FASB ASC 310 Receivables (“ASC 310”) was amended to enhance disclosures about credit quality of financing receivables and the allowance for credit losses. The amendments require an entity to disclose credit quality information, such as internal risk gradings, more detailed nonaccrual and past due information, and modifications of its financing receivables. The disclosures under ASC 310, as amended, were effective for interim and annual reporting periods ending on or after December 15, 2010. We do not expect this amendment to have a significant impact on our financial results, but it will significantly expand the disclosures that we are required to provide, some of which are included in this annual filing, as required, with additional disclosures included in future filings.
   
FASB ASU No. 2010-06 Improving Disclosures About Fair Value Measurements (“ASU 2010-06”) amended guidance for fair value measurements and disclosures to clarify and provide additional disclosure requirements related to recurring and non-recurring fair value measurements. The update requires new disclosures for transfers in and out of Levels 1 and 2, and requires a reconciliation to be provided for the activity in Level 3 fair value measurements. A reporting entity should disclose separately the amounts of significant transfers in and out of Levels 1 and 2 and provide an explanation for the transfers. This guidance was effective for interim periods beginning after December 15, 2009, and did not have a material effect on the Company’s results of operations or financial position.
   
In the reconciliation for fair value measurements using observable inputs (Level 3) a reporting entity should present separately information about purchases, sales, issuances, and settlements on a gross basis rather than a net basis. Disclosures relating to purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurement will become effective beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of this standard is not expected to have a material effect on the Company’s results of operations or financial position.

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 19 — Condensed Parent Information
BALANCE SHEETS
                 
    December 31,  
    2010     2009  
ASSETS
               
Cash
  $ 52,648     $ 114,454  
Investment in subsidiary
    48,461,350       59,679,774  
Other assets
    655,999       1,015,161  
 
           
Total assets
  $ 49,169,997     $ 60,809,389  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Subordinated debentures
  $ 13,403,000     $ 13,403,000  
Accrued interest payable
    92,827       37,234  
 
           
Total liabilities
    13,495,827       13,440,234  
 
               
Shareholders’ equity
    35,674,170       47,369,155  
 
           
 
               
Total liabilities and shareholders’ equity
  $ 49,169,997     $ 60,809,389  
 
           
STATEMENTS OF INCOME (LOSS)
                 
    Year Ended December 31,  
    2010     2009  
Interest expense
  $ 343,850     $ 392,016  
Other expense
    40,295       44,114  
 
           
Loss before equity in undistributed earnings (loss) of subsidiary
    (384,145 )     (436,130 )
 
               
Equity in undistributed earnings (loss) of subsidiary
    (9,974,617 )     (3,959,259 )
Income tax expense (benefit)
    92,416       (166,994 )
 
           
Net loss
  $ (10,451,178 )   $ (4,228,395 )
 
           

 

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Table of Contents

MOUNTAIN NATIONAL BANCSHARES, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 2010 and 2009
Note 19 — Condensed Parent Information (continued)
STATEMENTS OF CASH FLOWS
                 
    Year Ended December 31,  
    2010     2009  
CASH FLOWS FROM OPERATING ACTIVITIES
               
Net loss
  $ (10,451,178 )   $ (4,228,395 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities
               
Equity in undistributed (income) loss of subsidiary
    9,974,617       3,959,259  
Other
    414,755       (80,294 )
 
           
 
               
Net cash used in operating activities
    (61,806 )     (349,430 )
 
           
 
               
NET DECREASE IN CASH AND CASH EQUIVALENTS
    (61,806 )     (349,430 )
 
               
CASH AND CASH EQUIVALENTS, beginning of year
    114,454       463,884  
 
           
 
               
CASH AND CASH EQUIVALENTS, end of year
  $ 52,648     $ 114,454  
 
           
 
               
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
               
Cash paid (received) during the year for:
               
Interest
  $ 288,258     $ 481,613  
Income taxes
    (266,746 )     (154,676 )

 

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