Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations. |
Certain of the matters discussed in this document and in documents incorporated by reference herein, including matters discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operation,” may constitute forward-looking statements for purposes of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended, and as such may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance, or achievements of the Company to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. The words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate,” and similar expressions are intended to identify such forward-looking statements.
The Company’s actual results may differ materially from the results anticipated in these forward-looking statements due to a variety of factors, including, without limitation (a) the effects of future economic conditions on the Company and its customers; (b) the costs and effects of litigation and of unexpected or adverse outcomes in such litigation; (c) governmental monetary and fiscal policies, as well as legislative and regulatory changes; (d) the effect of changes in accounting policies and practices, as may be adopted by the regulatory agencies, as well as the Financial Accounting Standards Board and other accounting standard setters; (e) the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities and interest rate protection agreements, as well as interest rate risks; (f) the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in the Company’s market area and elsewhere, including institutions operating locally, regionally, nationally, and internationally, together with such competitors offering banking products and services by mail, telephone, computer, and the Internet; (g) technological changes; (h) acquisitions and integration of acquired businesses; (i) the failure of assumptions underlying the establishment of reserves for loan losses and estimations of values of collateral and various financial assets and liabilities; and (j) acts of war or terrorism. All written or oral forward-looking statements attributable to the Company are expressly qualified in their entirety by these cautionary statements. The company undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in other documents that are filed periodically with the SEC.
The following financial review of First National Community Bancorp, Inc. is presented on a consolidated basis and is intended to provide a comparison of the financial performance of the company, including its wholly-owned subsidiary, First National Community Bank for the years ended December 31, 2007, 2006 and 2005. The information presented below should be read in conjunction with the company’s consolidated financial statements and accompanying notes appearing elsewhere in this report. All share and per share information reflects the retroactive effect of the 25% stock dividend paid December 27, 2007 and the 10% stock dividend paid March 31, 2006.
SUMMARY
Net Income totaled $14,696,000 in 2007 which was $1.2 million, or 9%, higher than the $13,509,000 earned last year. The 2006 earnings were $2.3 million, or 20%, higher than the $11,225,000 reported for 2005. Basic earnings per share increased 7% in 2007 from the $0.88 per share reported in 2006 to $0.94. In 2006, basic earnings per share improved 19% from $0.74 in 2005 to $0.88. The weighted average number of shares outstanding used to calculate basic earnings per share was 15,601,377 in 2007, 15,352,406 in 2006 and 15,125,382 in 2005.
The earnings improvement recorded in 2007 included a $3.8 million, or 11%, increase in net interest income before providing for credit losses due to the growth of the balance sheet. Other income increased $1.5 million over 2006 which includes a $724,000 increase from service charges and fees and a $724,000 increase in net gains from the sale of assets. Operating expenses increased $3.0 million in comparison to 2006 which includes the expansion of the branch network by two offices and costs associated with additional growth. The annual provision for credit losses was $120,000 higher than in the prior period, and federal income taxes expense increased $949,000 due to the overall improvement in earnings.
Total interest income improved $15.3 million in 2006, while total interest expense increased $10.8 million, resulting in a $4.5 million increase in net interest income before the provision for credit losses. Balance sheet growth and the positive impact of repricing on interest-sensitive assets and liabilities contributed to the improvement over the prior year. Income generated from service charges on deposits and other sources of fee income increased $634,000
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compared to the 2005 total, and gains from the sale of assets were $359,000 higher than the previous year, resulting in a $1.0 million increase in other income. Operating expenses increased $1.8 million, or 10%, in 2006 and the company increased the provision for credit losses by $220,000 to cover losses. Federal income tax expense increased $1.2 million due to the improvement in pre-tax income.
The company’s return on assets for the years ended December 31, 2007, 2006 and 2005 was 1.18%, 1.26%, and 1.18%, respectively while the return on average equity was 14.32%, 15.30%, and 13.96%.
NET INTEREST INCOME
Net interest income, the difference between interest income and fees on earning assets and interest expense on deposits and borrowed funds, is the largest component of the company’s operating income and as such is the primary determinant of profitability. Changes in net interest income occur due to fluctuations in the balances and/or mixes of interest-earning assets and interest-bearing liabilities, and changes in their corresponding interest yields and costs. Before providing for future credit losses, net interest income increased $3,832,000 in 2007 due to growth in loans and investment securities which were funded by deposits and other borrowed funds. Changes in non-performing assets, together with interest lost and recovered on those assets, also impact comparisons of net interest income. In the following schedules, net interest income is analyzed on a tax-equivalent basis, thereby increasing interest income on certain tax-exempt loans and investments by the amount of federal income tax savings realized. In this manner, the true economic impact on earnings from various assets and liabilities can be more accurately compared.
During 2007, tax-equivalent net interest income improved $4,172,000, or 11%, compared to the 2006 total. Significant loan growth once again had a major impact on the company’s improved earnings. Higher yields earned on loans and securities also contributed to the increased income. Effective asset-liability management strategies allowed the company to avoid significant margin compression while positioning for the next cycle of interest rates. The net interest margin decreased fourteen basis points from the 3.73% reported in 2006 to 3.59% in 2007.
Average loans outstanding increased $119 million, or 15%, over the 2006 level and the average yield earned on total loans improved .17% in 2007, resulting in a $10.4 million increase in earnings from the portfolio. Commercial lending provided the majority of the growth, adding almost $82 million of balances on average and $7.4 million of the earnings improvement. Average consumer loans outstanding increased $37 million in 2007 primarily due to growth in indirect auto loans and home equity lending; while providing an additional $3.0 million improvement in earnings.
Average investment securities were $39 million higher than the prior year, and the higher yields recorded on new purchases contributed to a .39% increase in the average yield earned, resulting in $3.3 million of additional interest income. Money market balances decreased $2.1 million on average, resulting in a $100,000 reduction in earnings from these low yielding assets.
Average deposit growth was also significant in 2007, due primarily to increased municipal relationships and the full year’s impact from the deposits acquired in 2006. Average interest-bearing deposit balances grew $135 million in 2007. Municipal growth contributed to a $38 million increase in interest-bearing demand balances and also factored into the .22% increase in the cost of these funds. Time deposits greater than $100,000 increased $31 million on average as commercial customers took advantage of rising interest rates and moved monies into these higher earning deposits. Overall, the company’s cost of deposits increased .40% in 2007. Borrowed funds and other interest-bearing liabilities increased $18 million on average, and this growth combined with a .24% increase in the cost of these borrowings added $1.3 million of interest expense in 2007.
As a result, the positive growth of the balance sheet offset the impact of rising liability costs; while the net interest margin decreased from the 3.73% reported in 2006 to 3.59% in 2007. Another factor affecting the company’s net interest margin was investment leveraging transactions which match assets with liabilities at various points in the interest rate cycles. These transactions provided over $800,000 of net interest income in 2007, but the interest spread of 1.24% had a negative impact on the company’s overall net interest margin. Exclusive of these transactions, the 2007 margin would have been 3.73% which is .15% lower than the comparable 3.88% recorded in 2006.
In 2006, tax-equivalent net interest income improved $4.8 million, or 15%, when compared to the prior year. Growth of the balance sheet, effective asset-liability management strategies and the positive impact due to re-pricing all contributed to earnings improvement.
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Average loans outstanding increased $101 million, or 15%, in 2006. The average yield earned on the loan portfolio improved ninety-eight basis points, resulting in a $14.2 million increase in income earned on total loans. Commercial loans provided the majority of the increase as balances grew $79 million, or 15%, and earnings improved $12.3 million, or 34%. The significant growth in earnings can be attributed to the volume of variable rate loans in the portfolio which benefited from rising interest rates in 2006. Retail loans outstanding increased $22 million in 2006, which represents a 16% increase. Earnings on retail loans improved $1.9 million, or 24%. The majority of the increase was generated from installment loans, including indirect auto loans, while income from residential mortgage loans and home equity lending also improved.
Average securities increased $15 million in 2006 as excess funds generated from the acquisition of a community office were utilized in the investment portfolio. The increased balances combined with a thirty-nine basis point improvement in the yield earned provided an additional $1.7 million of interest income over the prior year. Money market balances decreased $7.6 million on average as funds were utilized in higher earning assets. Earnings on this category of assets decreased $233,000 in 2006 due to the reduced balances.
Average interest-bearing deposit balances increased $92 million, or 14%, in 2006. Interest-bearing demand deposits grew $34 million during the year due to activity in large commercial accounts and municipal relationships as well as deposits purchased while average savings deposits decreased $9 million. Average time deposits increased $67 million, or 20%, as many customers invested funds as interest rates paid on certificates of deposit increased. The average cost of interest-bearing deposits increased 1.07% over the 2005 rate. Average borrowed funds outstanding increased $7 million in 2006, and the average rate paid on these borrowings was twenty-five basis points higher than the rate paid in 2005.
Overall, growth of the balance sheet offset a one basis point decrease in the spread earned, resulting in the $4.8 million increase in tax-equivalent net interest income. The net interest margin improved nine basis points to 3.73% during the year due to the changing mix of the balance sheet and the positive impact of repricing. Investment leveraging transactions continued to add to the predictability of the company in 2006, contributing almost $700,000 to pre-tax earnings, but the average spread earned on the transactions was 1.15% which negatively impacted the net interest margin. Exclusive of these transactions, the company’s 2006 net interest margin would have been 3.88% which was six basis points higher than the 3.82% recorded in the previous year.
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Yield Analysis |
(dollars in thousands-taxable equivalent basis)(1) |
| | 2007 | 2006 | 2005 |
| | | Interest | Average | | Interest | Average | | Interest | Average |
| | Average | Income/ | Interest | Average | Income/ | Interest | Average | Income/ | Interest |
| | Balance | Expense | Rate | Balance | Expense | Rate | Balance | Expense | Rate |
ASSETS: | | | | | | | | | |
Earning Assets:(2) | | | | | | | | | |
| Commercial loans-taxable | $650,679 | $52,276 | 8.03% | $576,002 | $45,461 | 7.89% | $498,014 | $33,343 | 6.70% |
| Commercial loans-tax free | 38,229 | 2,874 | 7.52% | 31,085 | 2,256 | 7.26% | 30,208 | 2,141 | 7.09% |
| Mortgage loans | 34,695 | 2,352 | 6.78% | 29,642 | 1,961 | 6.62% | 22,576 | 1,483 | 6.57% |
| Installment loans | 163,729 | 10,574 | 6.46% | 131,767 | 7,994 | 6.07% | 116,767 | 6,538 | 5.60% |
| Total Loans | 887,332 | 68,076 | 7.67% | 768,496 | 57,672 | 7.50% | 667,565 | 43,505 | 6.52% |
| Securities-taxable | 211,139 | 11,446 | 5.42% | 177,315 | 8,338 | 4.70% | 173,529 | 7,330 | 4.22% |
| Securities-tax free | 74,817 | 5,142 | 6.87% | 69,313 | 4,996 | 7.21% | 58,119 | 4,302 | 7.40% |
| Total Securities | 285,956 | 16,588 | 5.80% | 246,628 | 13,334 | 5.41% | 231,648 | 11,632 | 5.02% |
| Interest-bearing deposits with banks | 0 | 0 | 0.00% | 1,279 | 55 | 4.30% | 2,059 | 70 | 3.40% |
| Federal funds sold | 544 | 28 | 5.15% | 1,406 | 73 | 5.19% | 8,246 | 291 | 3.53% |
| Total Money Market Assets | 544 | 28 | 5.15% | 2,685 | 128 | 4.77% | 10,305 | 361 | 3.50% |
| Total Earning Assets | 1,173,832 | 84,692 | 7.22% | 1,017,809 | 71,134 | 6.99% | 909,518 | 55,498 | 6.10% |
Non-earning assets | 81,529 | | | 59,947 | | | 52,003 | | |
Allowance for credit losses | (8,357) | | | (7,873) | | | (7,748) | | |
| Total Assets | $1,247,004 | | | $1,069,883 | | | $953,773 | | |
| | | | | | | | | | |
LIABILITIES AND STOCKHOLDERS' EQUITY: |
Interest-Bearing Liabilities: | | | | | | | | | |
| Interest-bearing demand deposits | $292,134 | $8,064 | 2.76% | $254,065 | $6,453 | 2.54% | $220,373 | $3,499 | 1.59% |
| Savings deposits | 71,444 | 868 | 1.21% | 72,889 | 960 | 1.32% | 81,899 | 868 | 1.06% |
| Time deposits over $100,000 | 193,834 | 9,271 | 4.78% | 162,559 | 7,143 | 4.39% | 126,855 | 3,863 | 3.05% |
| Other time deposits | 314,469 | 15,413 | 4.90% | 246,993 | 10,959 | 4.44% | 215,338 | 7,176 | 3.33% |
| Total Interest-Bearing Deposits | 871,881 | 33,616 | 3.86% | 736,506 | 25,515 | 3.46% | 644,465 | 15,406 | 2.39% |
| Borrowed funds and other | | | | | | | | | |
| Interest-bearing liabilities | 177,537 | 8,956 | 5.04% | 159,714 | 7,671 | 4.80% | 152,748 | 6,951 | 4.55% |
| Total Interest-Bearing Liabilities | 1,049,418 | 42,572 | 4.06% | 896,220 | 33,186 | 3.70% | 797,213 | 22,357 | 2.80% |
| Demand deposits | 80,515 | | | 73,637 | | | 68,572 | | |
| Other liabilities | 14,429 | | | 11,746 | | | 7,574 | | |
| Stockholders' equity | 102,642 | | | 88,280 | | | 80,414 | | |
| Total Liabilities and | | | | | | | | | |
| Stockholders' Equity | $1,247,004 | | | $1,069,883 | | | $953,773 | | |
| | | | | | | | | | |
| Net Interest Income Spread | | $42,120 | 3.16% | | $37,948 | 3.29% | | $33,141 | 3.30% |
| | | | | | | | | | |
| Net Interest Margin | | | 3.59% | | | 3.73% | | | 3.64% |
| | | | | | | | | | |
(1) In this schedule and other schedules presented on a tax-equivalent basis, income that is exempt from federal income taxes, i.e. interest on state and municipal securities, has been adjusted to a tax-equivalent basis using a 35% federal income tax rate. |
(2) Excludes non-performing loans. |
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RATE VOLUME ANALYSIS
The most significant impact on net income between periods is derived from the interaction of changes in the volume and rates earned or paid on interest-earning assets and interest-bearing liabilities. The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods. Components of interest income and interest expense are presented on a tax-equivalent basis using the statutory federal income tax rate of 35%.
The following table shows the effect of changes in volume and interest rates on net interest income. The variance in interest income or expense due to the combination of rate and volume has been allocated proportionately.
Rate/Volume Variance Report(1) |
(in thousands-taxable equivalent basis) |
| | | | | | | | | | | | | | | | | | |
| | 2007 vs 2006 | | 2006 vs 2005 |
| | | | Increase(Decrease) | | | | Increase(Decrease) |
| | Total Change | | Due to
Volume | | Due to
Rate | | Total Change | | Due to
Volume | | Due to
Rate |
| | | | | | | | | | | | | | | | | | |
Interest Income: | | | | | | | | | | | | | | | | | |
| Commercial loans-taxable | $ | 6,815 | | $ | 6,032 | | $ | 783 | | $ | 12,118 | | $ | 5,252 | | $ | 6,866 |
| Commercial loans-tax free | | 618 | | | 518 | | | 100 | | | 115 | | | 63 | | | 52 |
| Mortgage loans | | 391 | | | 334 | | | 57 | | | 478 | | | 464 | | | 14 |
| Installment loans | | 2,580 | | | 1,939 | | | 641 | | | 1,456 | | | 889 | | | 567 |
| Total Loans | | 10,404 | | | 8,823 | | | 1,581 | | | 14,167 | | | 6,668 | | | 7,499 |
| Securities-taxable | | 3,108 | | | 1,591 | | | 1,517 | | | 1,008 | | | 176 | | | 832 |
| Securities-tax free | | 146 | | | 396 | | | (250) | | | 694 | | | 829 | | | (135) |
| Total Securities | | 3,254 | | | 1,987 | | | 1,267 | | | 1,702 | | | 1,005 | | | 697 |
| Interest-bearing deposits with banks | | (55) | | | (55) | | | 0 | | | (15) | | | (27) | | | 12 |
| Federal funds sold | | (45) | | | (45) | | | 0 | | | (218) | | | (241) | | | 23 |
| Total Money Market Assets | | (100) | | | (100) | | | 0 | | | (233) | | | (268) | | | 35 |
| Total Interest Income | | 13,558 | | | 10,710 | | | 2,848 | | | 15,636 | | | 7,405 | | | 8,231 |
| | | | | | | | | | | | | | | | | | |
Interest Expense: | | | | | | | | | | | | | | | | | |
| Interest-bearing demand deposits | | 1,611 | | | 967 | | | 644 | | | 2,954 | | | 459 | | | 2,495 |
| Savings deposits | | (92) | | | (19) | | | (73) | | | 92 | | | (96) | | | 188 |
| Time deposits over $100,000 | | 2,128 | | | 1,374 | | | 754 | | | 3,280 | | | 1,087 | | | 2,193 |
| Other time deposits | | 4,454 | | | 2,995 | | | 1,459 | | | 3,783 | | | 1,256 | | | 2,527 |
| Total Interest-Bearing Deposits | | 8,101 | | | 5,317 | | | 2,784 | | | 10,109 | | | 2,706 | | | 7,403 |
| Borrowed funds and other interest-bearing liabilities | | 1,285 | | | 437 | | | 848 | | | 720 | | | 223 | | | 497 |
| Total Interest Expense | | 9,386 | | | 5,754 | | | 3,632 | | | 10,829 | | | 2,929 | | | 7,900 |
Net Interest Income | $ | 4,172 | | $ | 4,956 | | $ | (784) | | $ | 4,807 | | $ | 4,476 | | $ | 331 |
| | | | | | | | | | | | | | | | | | |
(1) Changes in interest income and interest expense attributable to changes in both volume and rate have been allocated proportionately to changes due to volume and changes due to rate. |
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CURRENT YEAR
In 2007, tax-equivalent net interest income was $4.2 million higher than the 2006 total. Growth of the balance sheet added $5.0 million to earnings in 2007 as the $10.7 million of interest income earned on new loans and securities exceeded the $5.8 million of additional cost from growth in deposits and borrowed funds. Loan growth added $8.8 million of income while new security purchases provided an increase of $2.0 million. A decrease in the average balances of money market assets resulted in a $100,000 reduction in earnings in this category. Total interest expense increased $5.8 million due to volume primarily from growth in interest-bearing deposits, but also due to higher levels of borrowed funds to meet liquidity needs. Interest rate targets set by the Federal Reserve remained stable throughout much of 2007, but a 100% reduction in key rates during the last four months of the year and growth in higher costing funding sources led to a negative variance due to rates. Higher yields on loans provided a $1.6 million increase in earnings, while new security purchases at the top of the interest rate cycle contributed to the $1.3 million of additional income. Interest expense was impacted by the type of growth recorded in 2007, as 84% of the increased cost was generated in higher costing certificates of deposit and borrowed funds. The $3.6 million increase in the cost of liabilities due to pricing led to a $784,000 reduction in net interest income due to rates.
PRIOR YEAR
During 2006, tax-equivalent net interest income increased $4.8 million over the prior year total. Balance sheet growth was profitable as evidenced by the $4.5 million of improvement related to volume. The repricing of interest sensitive assets and liabilities combined with growth at current market levels contributed to a positive variance due to rate for a second consecutive year.
Interest income recognized on loans increased $14.2 million in 2006. The $101 million increase in average loans outstanding led to a $6.7 million increase in interest income, while repricing resulting from Federal Reserve interest rate increases combined with growth at higher rates contributed to the $7.5 million improvement due to rate. Investment securities added $1.7 million more interest income in 2006 due to the $15.0 million increase in average balances and the repositioning of the taxable securities portfolio into higher earning assets. Earnings from money market assets were $233,000 less than the prior year as funds were utilized in higher earning asset categories.
New deposits added $2.7 million of interest expense in 2006, but rising interest rates led to an additional $7.4 million of interest expense. The $10.1 million of additional cost on deposits combined with a $700,000 increase in the cost of borrowings resulted in a $10.8 million rise in interest expense.
PROVISION FOR CREDIT LOSSES
The provision for credit losses varies from year to year based on management's evaluation of the adequacy of the allowance for credit losses in relation to the risks inherent in the loan portfolio. In its evaluation, management considers credit quality, changes in loan volume, composition of the loan portfolio, past experience, delinquency trends, and the economic conditions. Consideration is also given to examinations performed by regulatory authorities and the company's independent auditors. The provision for credit losses was $2,200,000 in 2007, $2,080,000 in 2006, and $1,860,000 in 2005. The ratio of the loan loss reserve to total loans was .84% at December 31, 2007 and .90% at December 31, 2006.
OTHER INCOME
Other Income | 2007 | | 2006 | | 2005 |
| (in thousands) |
Service charges | $2,840 | | $2,645 | | $2,240 |
Net gain/(loss) on the sale of securities | 721 | | (201) | | (250) |
Net gain on the sale of loans | 310 | | 240 | | 210 |
Net gain on the sale of other real estate | 0 | | 297 | | 14 |
Net gain/(loss) on the sale of other assets | 26 | | (3) | | 0 |
Other | 2,448 | | 1,919 | | 1,690 |
Total Other Income | $6,345 | | $4,897 | | $3,904 |
The company’s other income category can be separated into three distinct sub-categories; service charges make up the core component of this area of earnings while net gains (losses) from the sale of assets and other fee income
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comprise the balance.
In 2007, other income increased $1,448,000 compared to the prior year due to improvement in each category. Service charges improved $195,000, or 7%, due primarily to fees generated on accounts acquired with a branch office in November, 2006. Gains from the sale of assets increased $724,000 over 2006 as securities were sold during the year to reposition the portfolio for improved performance in future periods and residential mortgages were sold to reduce the company’s exposure to interest rate risk. Other income increased $529,000 over last year due to a significant increase in letter of credit fees.
During 2006, total other income increased $1.0 million, or 25%, over the 2005 total due to improvement in all three components. Service charges improved $405,000, or 18%, due primarily to a $364,000 increase in overdraft privilege fees. Income generated from the sale of assets increased $359,000 compared to 2005. Securities were sold to reposition the portfolio for future benefits and residential mortgages were sold to reduce the company’s exposure to interest rate risk. Additionally, a $297,000 gain was recognized from the sale of several properties which were previously classified as Other Real Estate Owned. Other fee income also increased $229,000, or 13%, due to a $229,000 increase in fees recognized on outstanding letters of credit.
OTHER EXPENSES
Other Expenses | 2007 | | 2006 | | 2005 |
| (in thousands) |
Salary expense | $ 9,628 | | $ 8,494 | | $ 7,775 |
Employee benefit expense | 2,289 | | 2,090 | | 1,877 |
Occupancy expense | 2,116 | | 1,626 | | 1,676 |
Equipment expense | 1,577 | | 1,388 | | 1,293 |
Directors fees | 890 | | 705 | | 706 |
Data processing expense | 1,682 | | 1,560 | | 1,435 |
Other operating expenses | 5,615 | | 4,910 | | 4,181 |
Total Other Expenses | $23,797 | | $20,773 | | $18,943 |
| | | | | | |
In 2007, total other expenses increased $3.0 million, or 15%, from the 2006 level. Employee costs increased $1.3 million, or 43% of the total while occupancy and equipment costs rose $679,000. All other expenses increased $1.0 million, or 33% of the total increase. The company’s overhead ratio, which measures non-interest expense as a percentage of average assets, was 1.91% in 2007 compared to 1.94% in 2006, reflecting the stringent controls over expenses in spite of the significant growth recorded during the year.
Salaries increased $1,134,000 in 2007, which includes $364,000 from new offices that opened during 2006 and 2007. The balance of the increase, $770,000 or 9% was due to merit increases and staff additions necessitated by the growth of the company. Employee benefit costs increased $199,000 over the 2006 level and includes a $68,000 increase in health benefits, a $70,000 increase in the company’s contribution to the Employees’ Profit Sharing Plan, and a $61,000 increase in other payroll related benefits. At December 31, 2007, the company had 276 full-time equivalent employees on staff compared to the 257 reported on December 31, 2006.
Occupancy costs increased $490,000, or 30%, in 2007 due to the new offices opened during the past two years in addition to general maintenance.
Equipment costs increased $189,000, or 14%, due to growth and increased maintenance expenses. All other operating expenses increased $1,012,000, or 14%, including a 26% increase in advertising costs, rising data processing costs and the increased cost of goods and services.
In 2006, total other expenses increased $1.8 million, or 10%, from the prior year total. Employee costs rose $932,000, which accounted for 50% of the increase, while data processing and shares tax expense increased approximately $100,000 each. All other expenses increased $683,000, or 9%. The company’s overhead ratio was 1.94% in 2006 compared to 1.99% in 2005.
Salary and benefit costs accounted for 51% of total operating expenses in 2006. The $932,000 increase in employee costs includes a $719,000 increase in salaries and a $213,000 increase in employee benefits as new employees were added to support growth. The addition of the new community office in Honesdale and higher contributions to the
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Employee’s Profit Sharing Plan and deferred compensation plans also contributed to the increase. As of December 31, 2006, the company had 257 full-time equivalent employees on staff, an 8% increase over the 238 reported on December 31, 2005.
Occupancy and equipment costs rose a mere $45,000 in 2006. The increase in all other operating expenses includes a $135,000 increase in legal fees related to loan work-outs and branch expansion.
PROVISION FOR INCOME TAXES
In 2007, federal income tax expense increased $949,000 compared to 2006. The $2.1 million increase in income before taxes added $904,000 to the book provision while benefits received from tax-exempt income and other differences were $45,000 less than 2006. The company’s effective tax rate was 25.3% in 2007 and 22.9% in 2006.
Federal income tax expense increased $1.2 million in 2006 due primarily to the $3.5 million improvement in income before taxes. Benefits derived from tax-exempt income and other permanent differences had a positive impact in 2006. The company’s effective tax rate was 22.9% in 2006 and 20.1% in 2005.
FINANCIAL CONDITION
Total assets increased $111 million, or 9%, during 2007 due to continued growth in loans and securities. Loan growth of $69 million and a $36 million increase in securities was funded by a $25 million increase in total deposits and a $75 million increase in borrowed funds.
SECURITIES
The primary objectives in managing the company’s securities portfolio are to maintain the necessary flexibility to meet liquidity and asset and liability management needs and to provide a stable source of interest income.
Total securities increased $36 million in 2007 as the company purchased securities which are expected to provide protection during a declining interest rate environment. A large portion of the securities purchased were funded with the sale of the other bonds to help improve future performance, while other purchases were funded with borrowed funds in anticipation of excess liquidity from loan payoffs.
During 2007, the company added $20 million of investment leveraging transactions which are projected to add over $200,000 of net income annually, but will negatively impact the company’s net interest margin due to the spreads earned. As of December 31, 2007, the company had $82 million of these leveraged transactions outstanding. Management remains committed to strategies which limit purchases to those that are virtually free of credit risk and will help to meet the objectives of the company’s investment and asset/liability management policies. Investment sales were executed to shed the portfolio of low earning bonds, bonds which were projected to be called prior to maturity in the near future, and bonds which had been reduced in size by principal prepayments to below portfolio parameters.
| The following table sets forth the carrying value of securities at the dates indicated: |
| December 31, |
| 2007 | | 2006 | | 2005 |
| (in thousands) |
U.S. Treasury securities and obligations of U.S. government agencies | $52,504 | | $59,347 | | $48,175 |
Obligations of state and political subdivisions | 74,627 | | 77,128 | | 65,226 |
Collateralized mortgage obligations | 78,871 | | 63,288 | | 47,368 |
Mortgage-backed securities | 62,143 | | 42,501 | | 48,682 |
Corporate debt securities | 28,308 | | 20,006 | | 20,008 |
Equity securities | 10,077 | | 8,163 | | 8,764 |
Total | $306,530 | | $270,433 | | $238,223 |
The following table sets forth the maturities of securities at December 31, 2007 (in thousands) and the weighted average yields of such securities calculated on the basis of the cost and effective yields weighted for the scheduled
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maturity of each security. Tax-equivalent adjustments, using a 35% rate, have been made in calculating yields on obligations of state and political subdivisions.
| Within One Year | 2 - 5 Years | 6 - 10 Years | Over 10 Years | Mortgage- Backed Securities | No Fixed Maturity | Total |
U.S. Treasury securities | $ 502 | $ 503 | $ 0 | $ 0 | $ 0 | $ 0 | $ 1,005 |
Yield | 4.39% | 4.48% | | | | | 4.44% |
Obligations of U.S. government agencies | | 997 | 11,708 | 38,670 | | | 51,375 |
Yield | | 5.48% | 5.40% | 6.27% | | | 6.06% |
Obligations of state and political subdivisions (1) | | 1,327 | 5,262 | 69,649 | | | 76,238 |
Yield | | 5.18% | 6.04% | 6.32% | | | 6.28% |
Corporate debt securities | | 986 | 1,577 | 26,994 | | | 29,557 |
Yield | | 4.99% | 4.84% | 6.20% | | | 6.09% |
Collateralized mortgage obligations | | | | | 79,186 | | 79,186 |
Yield | | | | | 5.53% | | 5.53% |
Mortgage-backed securities | | | | | 62,447 | | 62,447 |
Yield | | | | | 5.28% | | 5.28% |
Equity securities (2) | | | | | | 10,091 | 10,091 |
Yield | | | | | | 5.62% | 5.62% |
Total maturities | $ 502 | $3,813 | $18,547 | $135,313 | $141,633 | $10,091 | $309,899 |
Weighted yield | 4.39% | 5.12% | 5.53% | 6.28% | 5.42% | 5.62% | 5.80% |
(1) Yields on state and municipal securities have been adjusted to a tax-equivalent basis using a 35% federal income tax rate.
(2) | Yield presented represents 2007actual return. |
LOANS
Net loans increased $69 million, or 8%, in 2007. The majority of the growth was concentrated in commercial lending, as growth in real estate loans was limited due to a significant level of payoffs received during the year. The $10 million of growth recorded in installment loans can be attributed to activity in the company’s indirect auto lending portfolio.
| Details regarding the loan portfolio for each of the last five years ending December 31 are as follows: |
Loans Outstanding (in thousands) |
| 2007 | | 2006 | | 2005 | | 2004 | | 2003 |
Commercial and Financial | $202,665 | | $157,837 | | $132,838 | | $130,937 | | $132,319 |
Real Estate | 579,851 | | 567,030 | | 478,582 | | 402,792 | | 337,423 |
Installment | 91,052 | | 80,770 | | 73,217 | | 69,027 | | 66,981 |
Other | 32,136 | | 31,591 | | 30,139 | | 30,136 | | 22,052 |
Total Loans Gross | 905,704 | | 837,228 | | 714,776 | | 632,892 | | 558,775 |
Unearned Discount | (470) | | (569) | | 0 | | 0 | | 0 |
Allowance for Credit Losses | (7,569) | | (7,538) | | (7,528) | | (7,100) | | (6,578) |
Net Loans | $897,665 | | $829,121 | | $707,248 | | $625,792 | | $552,197 |
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The following schedule shows the repricing distribution of loans outstanding as of December 31, 2007. Also provided are these amounts classified according to sensitivity to changes in interest rates.
Loans Outstanding - Repricing Distribution (in thousands) |
| | Within One Year | | One to Five Years | | Over Five Years | | Total |
Commercial and Financial | | $142,678 | | $53,638 | | $6,349 | | $202,665 |
Real Estate | | 320,036 | | 178,982 | | 80,833 | | 579,851 |
Installment | | 3,371 | | 79,237 | | 8,444 | | 91,052 |
Other | | 4,945 | | 3,816 | | 23,375 | | 32,136 |
Total | | $471,030 | | $315,673 | | $119,001 | | $905,704 |
| | | | | | | | |
Loans with predetermined interest rates | | $ 29,836 | | $143,834 | | $104,276 | | $277,946 |
Loans with floating rates | | 441,194 | | 171,839 | | 14,725 | | 627,758 |
Total | | $471,030 | | $315,673 | | $119,001 | | $905,704 |
ASSET QUALITY
The company manages credit risk through the application of policies and procedures designed to foster sound underwriting and credit monitoring practices, although, as is the case with any financial institution, a certain degree of credit risk is dependent in part on local and general economic conditions that are beyond the company’s control.
The company's risk management committee meets quarterly or more often as required and makes recommendations to the board of directors regarding provisions for credit losses. The committee reviews individual problem credits and ensures that ample reserves are established considering both general allowances and specific allocations.
The following schedule reflects various non-performing categories as of December 31 for each of the last five years:
| 2007 | | 2006 | | 2005 | | 2004 | | 2003 |
| (in thousands) |
Nonaccrual: | | | | | | | | | |
Impaired | $ 0 | | $ 0 | | $ 0 | | $ 0 | | $ 0 |
Other | 3,106 | | 2,299 | | 70 | | 303 | | 844 |
Loans past due 90 days or more and still accruing | 904 | | 412 | | 721 | | 539 | | 622 |
Other Real Estate Owned | 2,588 | | 2,188 | | 0 | | 0 | | 0 |
Total Non-Performing Assets | $6,598 | | $4,899 | | $791 | | $842 | | $1,466 |
During 2007, total non-performing assets increased $1.7 million including an $807,000 increase in non-accrual loans, a $492,000 increase in loans past due ninety days or more, and a $400,000 increase in other real estate owned. The increase in nonaccrual loans is due primarily to the addition of one large credit caused by the borrowers’ inability to make scheduled payments. The company has not experienced any loss on this credit and based on the collateral valuation, no future loss is expected. During 2007, losses totaling $387,000 were recognized on loans carried as nonaccrual on December 31, 2006, although the majority of the loss is projected to be recovered through the sale of property. Any future losses from other loans carried in nonaccrual status at December 31, 2007 is expected to be minimal after accounting for the sale of collateral.
Other Real Estate Owned increased $400,000 in 2007 due to the addition of one property. The company expects to recover the entire balance during 2008 from the sale of the property. The remaining $2.1 million outstanding balance carried in Other Real Estate Owned consists of one property which was transferred in 2006 in lieu of foreclosure. Title to this property is subject to a future lease option payment payable in 2008.
In 2006, total non-performing assets increased $4.1 million. Nonaccrual loans increased $2.2 million due to the addition of three credits caused by the borrowers’ inability to make scheduled payments. As of December 31, 2006, the company has recognized a loss of $902,000 on these credits. Any future losses from loans carried as nonaccrual is expected to be minimal after accounting for the sale of the collateral. Other Real Estate Owned increased $2.1 million in
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2006 due to the addition of one property obtained in lieu of foreclosure. Title to this property is subject to a future lease option payment payable in 2008. As of December 31, 2006, the company has recognized a loss of $953,000 on this credit. Any future loss is expected to be minimal based on the market value of the property and the carrying value of the asset. No losses were recognized in 2006 on loans carried as nonaccrual on December 31, 2005.
On December 31, 2007, the company’s ratio of nonaccrual loans to total loans was .34% compared to the .27% reported in 2006. We continue to rank well ahead of peer banks in measurements of delinquency. The company continues to acknowledge the weakness in local real estate markets, emphasizing strict underwriting standards to minimize the negative impact of the current environment.
ALLOWANCE FOR CREDIT LOSSES
The following table presents an allocation of the allowance for credit losses as of the end of each of the last five years (in thousands):
Loan Loss Reserve Allocation |
| 12/31/07 | | 12/31/06 | | 12/31/05 | | 12/31/04 | | 12/31/03 |
| Amount | Percentage of Loans in Each Category to Total Loans | | Amount | Percentage of Loans in Each Category to Total Loans | | Amount | Percentage of Loans in Each Category to Total Loans | | Amount | Percentage of Loans in Each Category to Total Loans | | Amount | Percentage of Loans in Each Category to Total Loans | |
Commercial and Financial | $7,019 | 77% | | $6,995 | 77% | | $6,933 | 79% | | $4,028 | 79% | | $5,303 | 76% | |
Real Estate | 91 | 4% | | 114 | 4% | | 55 | 4% | | 44 | 3% | | 53 | 4% | |
Installment | 405 | 19% | | 377 | 19% | | 427 | 17% | | 292 | 18% | | 276 | 20% | |
Unallocated | 54 | - | | 52 | - | | 113 | - | | 2,736 | - | | 946 | - | |
| $7,569 | 100% | | $7,538 | 100% | | $7,528 | 100% | | $7,100 | 100% | | $6,578 | 100% | |
| | | | | | | | | | | | | | | | |
The following schedule presents an analysis of the allowance for credit losses for each of the last five years (in thousands):
| Year Ended December 31, |
| 2007 | | 2006 | | 2005 | | 2004 | | 2003 |
Balance, January 1 | $7,538 | | $7,528 | | $7,100 | | $6,578 | | $6,140 |
Charge-Offs: | | | | | | | | | |
Commercial and Financial | 329 | | 83 | | 64 | | 293 | | 314 |
Real Estate | 2,615 | | 1,802 | | 1,523 | | 412 | | 109 |
Installment | 452 | | 535 | | 435 | | 423 | | 579 |
Total Charge-Offs | 3,396 | | 2,420 | | 2,022 | | 1,128 | | 1,002 |
Recoveries on Charged-Off Loans: | | | | | | | | | |
Commercial and Financial | 6 | | 8 | | 257 | | 51 | | 13 |
Real Estate | 1,023 | | 110 | | 108 | | 66 | | 7 |
Installment | 198 | | 232 | | 225 | | 133 | | 220 |
Total Recoveries | 1,227 | | 350 | | 590 | | 250 | | 240 |
Net Charge-Offs | 2,169 | | 2,070 | | 1,432 | | 878 | | 762 |
Provision for Credit Losses | 2,200 | | 2,080 | | 1,860 | | 1,400 | | 1,200 |
Balance, December 31 | $7,569 | | $7,538 | | $7,528 | | $7,100 | | $6,578 |
| | | | | | | | | |
Net Charge-Offs during the period as a percentage of average loans outstanding during the period | .24% | | .27% | | .21% | | .15% | | .15% |
Allowance for credit losses as a percentage of net loans outstanding at end of period | .84% | | .90% | | 1.05% | | 1.12% | | 1.18% |
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Net charge-offs total $2.2 million in 2007 due primarily to deterioration in four relationships. Based on management’s evaluation of the borrowers’ ability to make future payments and the value of the underlying collateral, charge-offs totaling $3.0 million were recommended and processed in the fourth quarter. As a result of these charge-offs, the company determined that additional provisions were necessary to maintain the strength of the reserve and provided an additional $1,000,000 in December. Other activity is consistent with prior periods and includes writedowns on credits incurred in the normal course of business. The installment loan charge-offs include $301,000 of indirect auto loans, of which $179,000 was recovered in 2007 through sales of the vehicles. During 2007, losses totaling $387,000 were recognized on loans carried as nonaccrual on December 31, 2006, although the majority of this loss is expected to be recovered through the sale of the property in 2008. The company’s ratio of net charge-offs to average loans is comparable to its national peer groups while the ratio of the allowance for credit losses to total loans is adequate considering current delinquency levels.
DEPOSITS
The primary source of funds to support the company’s growth is its deposit base, and emphasis has been placed on accumulating new deposits while making every effort to retain current relationships. Competition from other banks and non-bank institutions has made deposit growth extremely challenging. Total deposits increased $25 million in 2007 comprised of a $37 million increase in time deposit balances and a $12 million decrease in lower costing savings and demand accounts.
The average daily amount of deposits and rates paid on such deposits is summarized for the periods indicated in the following table (in thousands):
| Year Ended December 31, |
| 2007 | | 2006 | | 2005 |
| Amount | | Rate | | Amount | | Rate | | Amount | | Rate |
Noninterest bearing demand deposits | $80,515 | | | | $73,637 | | | | $68,572 | | |
Interest-bearing demand deposits | 292,134 | | 2.76% | | 254,065 | | 2.54% | | 220,373 | | 1.59% |
Savings deposits | 71,444 | | 1.21% | | 72,889 | | 1.32% | | 81,899 | | 1.06% |
Time deposits | 508,303 | | 4.86% | | 409,552 | | 4.42% | | 342,193 | | 3.23% |
Total | $952,396 | | | | $810,143 | | | | $713,037 | | |
Maturities of time deposits of $100,000 or more outstanding at December 31, 2007, are summarized as follows (in thousands):
3 months or less | $ 84,029 |
Over 3 through 6 months | 26,408 |
Over 6 through 12 months | 39,147 |
Over 12 months | 26,665 |
Total | $176,249 |
CAPITAL
A strong capital base is essential to the continued growth and profitability of the company and is therefore a management priority. The company’s principal capital planning goals are to provide an adequate return to shareholders while retaining a sufficient base from which to provide for future growth, while at the same time complying with all regulatory standards. As more fully described in Note 15 to the financial statements, regulatory authorities have prescribed specified minimum capital ratios as guidelines for determining capital adequacy to help insure the safety and soundness of financial institutions.
The following schedules present information regarding the company’s risk-based capital at December 31, 2007, 2006 and 2005 and selected other capital ratios.
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CAPITAL ANALYSIS (in thousands) |
| December 31, |
| 2007 | | 2006 | | 2005 |
Tier I Capital: | | | | | |
Total Tier I Capital | $ 109,732 | | $ 97,048 | | $ 84,943 |
Tier II Capital: | | | | | |
Allowable portion of allowance for credit losses | $ 7,569 | | $ 7,538 | | $ 7,528 |
Total Risk-Based Capital | $117,301 | | $104,586 | | $ 92,471 |
Total Risk-Weighted Assets | $1,045,008 | | $980,201 | | $819,339 |
CAPITAL RATIOS |
| Regulatory Minimum | 2007 | 2006 | 2005 |
Total Risk-Based Capital | 8.00% | 11.22% | 10.67% | 11.29% |
Tier I Risk-Based Capital | 4.00% | 10.50% | 9.90% | 10.37% |
Tier I Leverage Ratio | 4.00% | 8.87% | 9.16% | 8.91% |
Return on Assets | N/A | 1.18% | 1.26% | 1.18% |
Return on Equity* | N/A | 14.32% | 15.30% | 13.96% |
Equity to Assets Ratio* | N/A | 8.43% | 8.18% | 8.37% |
Dividend Payout Ratio | N/A | 45.01% | 42.75% | 40.20% |
| | | | |
* Includes the effect of SFAS 115 in the amount of $(2,190,000) in 2007, $(70,000) in 2006 and $(524,000) in 2005. |
During 1999, the company implemented a Dividend Reinvestment Plan which has resulted in an influx to capital of $17.1 million to date. The company also adopted stock option plans for directors and senior officers. New capital generated from the exercise of stock options is $4.3 million at December 31, 2007. In November, the company declared a 5-for-4 stock split effected in the form of a 25% stock dividend, payable December 27, 2007 resulting in the issuance of 3,149,133 new shares. In February 2006, the company declared a 10% stock dividend payable March 31, 2006, resulting in the issuance of 1,391,085 new shares. The company has also paid 100% stock dividends on September 30, 2004 and January 31, 2003 which resulted in 5,423,425 and 2,603,838 new shares, respectively. At the 2005 Annual Meeting, shareholders approved management’s proposal to increase the number of authorized shares of common stock from 20,000,000 to 50,000,000 shares.
In 2007, regulatory capital increased $12.7 million comprised of an $8.0 million increase in retained earnings after paying cash dividends of $6.6 million and accounting for the 25% stock dividend paid December 27, 2007, a $3.8 million increase due to the company’s dividend reinvestment plan, a $.5 million increase due to the issuance of shares from the company’s stock option plans and a $.4 million increase due to the impact of intangible assets on regulatory capital. As of December 31, 2007, there were 32,151,914 shares of stock available for future sale or stock dividends. The number of shareholders of record at December 31, 2007 was 1,596. Quarterly market highs and lows, dividends paid and known market makers are highlighted in the Investor Information section of this Annual Report. Refer to Note 15 to the financial statements for further discussion of capital requirements and dividend limitations.
ECONOMIC CONDITIONS AND FORWARD OUTLOOK
Economic conditions affect financial institutions, as they do other businesses, in a number of ways. Rising inflation affects all businesses through increased operating costs but affects banks primarily through the manner in which they manage their interest sensitive assets and liabilities in a rising rate environment. Economic recession can also have a material effect on financial institutions as the assets and liabilities affected by a decrease in interest rates must be managed in a way that will maximize the largest component of a bank’s income, that being net interest income. Recessionary periods may also tend to decrease borrowing needs and increase the uncertainty inherent in the borrowers’ ability to pay previously advanced loans. Additionally, reinvestment of investment portfolio maturities can pose a
27
problem as attractive rates are not as available. Management closely monitors the interest rate risk of the balance sheet and the credit risk inherent in the loan portfolio in order to minimize the effects of fluctuations caused by changes in general economic conditions.
While we are optimistic about the prospect of continued growth and earnings improvement, any forward-looking statements by their nature are subject to assumptions, risks and uncertainties. Actual results could vary from those implied for a variety of reasons including:
• A change in interest rates which is more immediate or more significant than anticipated. |
• The demand for new loans and the ability of borrowers to repay outstanding debt. |
• The timing of expansion plans could be altered by forces beyond our control such as weather or regulatory approvals. |
• Our ability to continue to attract new deposits from our marketplace to meet the daily liquidity needs of the company. |
As of this writing, the company was not aware of any pronouncements or legislation that would have a material impact on the results of operations.
Item 7A. | Quantitative and Qualitative Disclosures About Market Risk. |
ASSET AND LIABILITY MANAGEMENT
| The major objectives of the company’s asset and liability management are to: | |
| (1) | manage exposure to changes in the interest rate environment to achieve a neutral interest sensitivity position within reasonable ranges, |
| (2) | ensure adequate liquidity and funding, |
| (3) | maintain a strong capital base, and |
| (4) | maximize net interest income opportunities. |
| | | | |
The company manages these objectives through its Senior Management and Asset and Liability Management Committees (ALCO). Members of the committees meet regularly to develop balance sheet strategies affecting the future level of net interest income, liquidity and capital. Items that are considered in asset and liability management include balance sheet forecasts, the economic environment, the anticipated direction of interest rates and the company’s earnings sensitivity to changes in these rates.
INTEREST RATE SENSITIVITY
The company analyzes its interest sensitivity position to manage the risk associated with interest rate movements through the use of gap analysis and simulation modeling. Interest rate risk arises from mismatches in the repricing of assets and liabilities within a given time period. Gap analysis is an approach used to quantify these differences. A positive gap results when the amount of interest-sensitive assets exceeds that of interest-sensitive liabilities within a given time period. A negative gap results when the amount of interest-sensitive liabilities exceeds that of interest-sensitive assets.
While gap analysis is a general indicator of the potential effect that changing interest rates may have on net interest income, the gap report has some limitations and does not present a complete picture of interest rate sensitivity. First, changes in the general level of interest rates do not affect all categories of assets and liabilities equally or simultaneously. Second, assumptions must be made to construct a gap table. For example, non-maturity deposits are assigned a repricing interval based on internal assumptions. Management can influence the actual repricing of these deposits independent of the gap assumption. Third, the gap table represents a one-day position and cannot incorporate a changing mix of assets and liabilities over time as interest rates change.
Because of the limitations of the gap reports, the company uses simulation modeling to project future net interest income streams incorporating the current gap position, the forecasted balance sheet mix, and the anticipated spread relationships between market rates and bank products under a variety of interest rate scenarios.
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INTEREST RATE GAP
The following schedule illustrates the company’s interest rate gap position as of December 31, 2007 which measures sensitivity to interest rate fluctuations for certain interest sensitivity periods.
Interest Rate Sensitivity Analysis |
as of December 31, 2007 |
(in thousands) |
| | | | | | | |
| | | Rate Sensitive | | Not | |
| 1 to 90 | 91 to 180 | 181 to 365 | 1 to 5 | Beyond | Rate | |
| Days | Days | Days | Years | 5 Years | Sensitive | Total |
| | | | | | | |
Commercial loans | $390,947 | $32,500 | $22,811 | $210,376 | $40,874 | $ 0 | $697,508 |
Mortgage loans | 2,220 | 2,382 | 4,482 | 21,710 | 6,770 | 0 | 37,564 |
Installment loans | 14,424 | 9,770 | 29,540 | 94,289 | 22,139 | 0 | 170,162 |
Total Loans | 407,591 | 44,652 | 56,833 | 326,375 | 69,783 | 0 | 905,234 |
| | | | | | | |
Securities-taxable | 37,143 | 17,433 | 22,910 | 102,511 | 41,531 | 10,091 | 231,619 |
Securities-tax free | 715 | 2,020 | 500 | 10,655 | 61,021 | 0 | 74,911 |
Total Securities | 37,858 | 19,453 | 23,410 | 113,166 | 102,552 | 10,091 | 306,530 |
| | | | | | | |
Interest-bearing deposits with banks | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
Federal funds sold | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
Total Money Market Assets | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
| | | | | | | |
Total Earning Assets | 445,449 | 64,105 | 80,243 | 439,541 | 172,335 | 10,091 | 1,211,764 |
Non-earning assets | 0 | 0 | 0 | 0 | 0 | 92,008 | 92,008 |
Allowance for credit losses | 0 | 0 | 0 | 0 | 0 | (7,569) | (7,569) |
| | | | | | | |
Total Assets | $445,449 | $64,105 | $80,243 | $439,541 | $172,335 | $94,530 | $1,296,203 |
| | | | | | | |
| | | | | | | |
Interest-bearing demand deposits | $288,879 | $ 0 | $ 0 | $ 0 | $ 0 | $ 0 | $288,879 |
Savings deposits | 69,555 | 0 | 824 | 0 | 0 | 0 | 70,379 |
Time deposits $100,000 and over | 106,077 | 20,414 | 31,396 | 18,100 | 262 | 0 | 176,249 |
Other time deposits | 124,032 | 62,133 | 61,742 | 80,068 | 2,201 | 0 | 330,176 |
Total Interest-Bearing Deposits | 588,543 | 82,547 | 93,962 | 98,168 | 2,463 | 0 | 865,683 |
| | | | | | | |
Borrowed funds and other interest-bearing liabilities | 83,154 | 843 | 11,639 | 103,614 | 28,582 | 0 | 227,832 |
| | | | | | | |
Total Interest-Bearing Liabilities | 671,697 | 83,390 | 105,601 | 201,782 | 31,045 | 0 | 1,093,515 |
Demand deposits | 0 | 0 | 0 | 0 | 0 | 79,834 | 79,834 |
Other liabilities | 0 | 0 | 0 | 0 | 0 | 15,712 | 15,712 |
Stockholders' equity | 0 | 0 | 0 | 0 | 0 | 107,142 | 107,142 |
| | | | | | | |
Total Liabilities and Stockholders' Equity | $671,697 | $83,390 | $105,601 | $201,782 | $31,045 | $202,688 | $1,296,203 |
| | | | | | | |
Interest Rate Sensitivity gap | $(226,248) | $(19,285) | $(25,358) | $237,759 | $141,290 | $(108,158) | |
| | | | | | | |
Cumulative gap | $(226,248) | $(245,533) | $(270,891) | $(33,132) | $108,158 | | |
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EARNINGS AT RISK AND ECOMONIC VALUE AT RISK SIMULATIONS
The company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet beyond static gap analysis. Although it will continue to measure its static gap position, the company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.
EARNINGS AT RISK
Earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities reprice equally and simultaneously with market rates (i.e., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in the interest rate simulation model.
ECONOMIC VALUE AT RISK
Earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the company’s existing assets and liabilities. The ALCO examines this ratio monthly utilizing a rate shock of +200 basis points in the interest rate simulation model. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.
The following table illustrates the simulated impact of a 200 basis point upward or downward movement in interest rates on net interest income, and the change in economic value. This analysis assumed that interest-earning asset and interest-bearing liability levels at December 31, 2007 remained constant. The impact of the rate movements were developed by simulating the effect of rates changing over a twelve-month period from the December 31, 2007 levels.
| RATES + 200 | RATES – 200 |
Earnings at risk: | | |
Percent change in net interest income | (6.69)% | .10% |
| | |
Economic value at risk: | | |
Percent change in economic value of equity | (31.41)% | 34.33% |
| | |
Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may change beyond the company’s policy guideline for a short period of time as long as the risk-based capital ratio is greater than 10%.
LIQUIDITY
The term liquidity refers to the ability of the company to generate sufficient amounts of cash to meet its cash-flow needs. Liquidity is required to fulfill the borrowing needs of the company’s credit customers and the withdrawal and maturity requirements of its deposit customers, as well as to meet other financial commitments. Cash and cash equivalents (cash and due from banks and federal funds sold) are the company’s most liquid assets. At December 31, 2007 cash and cash equivalents totaled $24.7 million, compared to the December 31, 2006 level of $28.7 million. Financing activities provided $97.0 million and operating activities provided $16.1 million of cash and cash equivalents during the year while investing activities utilized $117.1 million. The cash flows provided by financing activities is due primarily to an increase in borrowed funds to meet short-term liquidity needs, while the funds provided by operating activities pertains to interest payments received on loans and investments. The cash used in investing activities consists of loan proceeds and security purchases.
Core deposits, which represent the company’s primary source of liquidity, averaged $759 million in 2007, an increase of $111 million, or 17%, from the $648 million average in 2006. This increase in average core deposits includes the full year’s effect of the $74 million acquired in 2006 with a branch purchase and was supplemented with a
30
$31 million increase in average jumbo certificates and an $18 million increase in average borrowed funds and other interest-bearing liabilities.
The company has other potential sources of liquidity, including repurchase agreements. Additionally, the company can borrow on credit lines established at several correspondent banks, the Federal Home Loan Bank of Pittsburgh and the Federal Reserve Discount Window.
Item 8. | Financial Statements and Supplementary Data. |
The information required by this item is set forth on pages 34-49 of the Company’s 2007 Annual Report to Shareholders, which pages are included as Exhibit 13 hereto, and incorporated herein by reference.
Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. |
Not Applicable
Item 9A. | Controls and Procedures. |
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures - The company carried out an evaluation, under the supervision and with the participation of the company’s management, including the company’s Chief Executive Officer along with the company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a – 15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based upon that evaluation, the company’s Chief Executive Officer along with the company’s Chief Financial Officer concluded that as of December 31, 2007 the company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the company (including its consolidated subsidiaries) required to be included in the company’s periodic SEC filings.
Changes in Internal Controls over Financial Reporting – There were no changes in our internal control over financial reporting that occurred during the period covered by this annual report that have materially affected, or are, reasonably likely to materially affect, the company’s internal controls over financial reporting.
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Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting for First National Community Bancorp, Inc. (the “Company”). Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Internal control over financial reporting includes those policies and procedures that pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are only being made in accordance with authorizations of management and directors of the Company; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on the financial statements.
Any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of a control system inherently has limitations, and the benefits of controls must be weighed against their costs. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Therefore, no assessment of a cost-effective system of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, will be detected.
As of December 31, 2007, management of the company conducted an assessment of the effectiveness of the company’s internal control over financial reporting based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has concluded that the company’s internal control over financial reporting was effective as of December 31, 2007.
Management’s assessment of the effectiveness of the company’s internal control over financial reporting as of December 31, 2007, has been audited by Demetrius and Company, L.L.C., the independent registered public accounting firm that audited the company’s financial statements for the period covered. A copy of the Demetrius and Company, L.L.C. report is included in this annual report.
/s/ J. David Lombardi | /s/ William Lance |
J. David Lombardi | William S. Lance |
President and Chief Executive Officer | Principal Financial Officer |
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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and
Stockholders of First National Community Bancorp, Inc.
We have audited First National Community Bancorp, Inc.'s ("Company") internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). First National Community Bancorp, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit.
We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, First National Community Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets as of December 31, 2007 and 2006 and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007 of First National Community Bancorp, Inc., and subsidiaries, and our report dated March 12, 2008 expressed an unqualified opinion on those consolidated financial statements.
DEMETRIUS & COMPANY, L.L.C.
Wayne, New Jersey
March 12, 2008
Item 9B. | Other Information. |
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FIRST NATIONAL COMMUNITY BANCORP, INC.
PART III
Item 10. | Directors, Executive Officers and Corporate Governance. |
Information regarding directors, nominees, principal officers, audit committees and audit committee financial experts required by this item is set forth under the captions “Information as to Nominees and Directors”, “Principal Officers of the Company”, “Principal Officers of the Bank”, “Information about the Company’s Audit Committee and its Charter”, "Report of the Audit Committee", and “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
The company has adopted a Code of Ethics that applies to directors, officers and employees of the company and the bank. A copy of the Code of Ethics was included as an exhibit to the company’s Form 10-K for the year ended December 31, 2005 and filed with the Securities and Exchange Commission. A request for the Company’s Code of Ethics can be made either in writing to William Lance, First National Community Bancorp, Inc., 102 East Drinker Street, Dunmore, Pennsylvania, 18512 or by email at fncb@fncb.com.
Item 11. | Executive Compensation. |
The information required by this item is set forth under the captions “Executive Compensation”, "Compensation Discussion and Analysis", “Option Grants in 2007”, "Equity Compensation Plan Information", "Deferred Compensation Plan Information", “Compensation of Directors”, “Potential Payments Upon Termination or Change-in-Control”, “Compensation Committee Report”, and “Board of Directors Interlocks and Insider Participation” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. |
The information required by this item regarding security ownership of certain beneficial owners and management is set forth under the caption “Principal Beneficial Owners of the Company’s Common Stock” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
Information regarding the Company’s compensation plans under which equity securities of the registrant are authorized for issuance as of December 31, 2007 is set forth under the caption “Equity Compensation Plan Information” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
Item 13. | Certain Relationships and Related Transactions, and Director Independence. |
The information required by this item is set forth under the captions “Certain Relationships and Related Transactions” and “Governance of the Company” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
Item 14. | Principal Accountant Fees and Services. |
The information required by this item is set forth under the caption “Independent Auditors” in the Proxy Statement filed for the annual meeting of shareholders to be held on May 21, 2008 and is incorporated herein by reference.
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PART IV
Item 15. | Exhibits and Financial Statement Schedules. |
| The following financial statements are included by reference in Part II, Item 8 hereof: |
| Report of Independent Registered Public Accounting Firm |
| Consolidated Balance Sheet |
| Consolidated Statement of Income |
| Consolidated Statement of Stockholders’ Equity |
| Consolidated Statement of Cash Flows |
| Notes to Consolidated Financial Statements |
| 2. | Financial Statement Schedules |
Financial Statement Schedules are omitted because the required information is either not applicable, not required or is shown in the respective financial statements or in the notes thereto.
| 3. | The following Exhibits are filed herewith or incorporated by reference: |
| |
EXHIBIT 3.1 | Articles of Incorporation – filed as Exhibit 3.1 to the Company’s Form 10-K for the year ended December 31, 2005 is hereby incorporated by reference |
| |
EXHIBIT 3.2 | By –laws - filed as Exhibit 3.2 to the Company’s Form 10-K for the year ended December 31, 2005 is hereby incorporated by reference |
| |
EXHIBIT 10.1 | Dividend Reinvestment Plan – filed as Exhibit 99.1 to the Company’s Registration Statement on Form S-3 as filed on August 1, 2007 is hereby incorporated by reference |
| |
EXHIBIT 10.2 | Stock Incentive Plan - filed as Exhibit 10.2 to the Company’s Form 10-K for the year ended December 31, 2004 is hereby incorporated by reference |
| |
EXHIBIT 10.3 | Stock Option Plan - filed as Exhibit 10.3 to the Company’s Form 10-K for the year ended December 31, 2004 is hereby incorporated by reference |
| |
EXHIBIT 10.4 | Deferred Compensation Plan - filed as Exhibit 10.4 to the Company’s Form 10-K for the year ended December 31, 2004 is hereby incorporated by reference |
| |
EXHIBIT 13 | Annual Report |
| |
EXHIBIT 14 | Code of Ethics - filed as Exhibit 14 to the Company’s Form 10-K for the year ended December 31, 2005 is hereby incorporated by reference |
| |
EXHIBIT 21 | Subsidiaries |
| |
EXHIBIT 31.1 | Certification of Chief Executive Officer |
| |
EXHIBIT 31.2 | Certification of Chief Financial Officer |
| |
EXHIBIT 32.1 | Section 1350 Certification – Chief Executive Officer |
| |
EXHIBIT 32.2 | Section 1350 Certification – Chief Financial Officer |
| |
35
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:
Registrant: | FIRST NATIONAL COMMUNITY BANCORP, INC. |
| /s/ J. David Lombardi J. David Lombardi, President and Chief Executive Officer |
| /s/ William Lance William Lance, Treasurer Principal Financial Officer and Principal Accounting Officer |
| /s/ Linda D'Amario Linda D’Amario Comptroller |
Pursuant to the requirements of the Securities 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:
Directors:
/s/ Michael G. Cestone | | 3/12/08 | | | | |
Michael G. Cestone | | Date | | Louis A. DeNaples | | Date |
| | | | | | |
| | | | | | |
| | | | /s/ Louis A. DeNaples, Jr. | | 3/12/08 |
Michael J. Cestone, Jr. | | Date | | Louis A. DeNaples, Jr. | | Date |
| | | | | | |
| | | | | | |
/s/ Joseph Coccia | | 3/12/08 | | /s/ Joseph J. Gentile | | 3/12/08 |
Joseph Coccia | | Date | | Joseph J. Gentile | | Date |
| | | | | | |
| | | | | | |
/s/ William P. Conaboy | | 3/12/08 | | /s/ Joseph O. Haggerty | | 3/12/08 |
William P. Conaboy | | Date | | Joseph O. Haggerty | | Date |
| | | | | | |
| | | | | | |
/s/ Michael T, Conahan | | 3/12/08 | | /s/ J. David Lombardi | | 3/12/08 |
Michael T. Conahan | | Date | | J. David Lombardi | | Date |
| | | | | | |
| | | | | | |
/s/ Dominick L. DeNaples | | 3/12/08 | | /s/ John P. Moses | | 3/12/08 |
Dominick L. DeNaples | | Date | | John P. Moses | | Date |
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