The Company had outstanding standby letters of credit of $2,024,000 and $1,987,000 at September 30, 2003 and December 31, 2002, respectively. Most of the Company’s outstanding standby letters of credit are performance standby letters of credit within the scope of FASB Interpretation No. 45 (“FIN 45”). These are irrevocable undertakings by the Company, as guarantor, to make payments in the event a specified third party fails to perform under a nonfinancial contractual obligation. Most of the Company’s performance standby letters of credit arise in connection with lending relationships and have terms of one year or less. The maximum potential future payments the Company could be required to make equals the face amount of the letters of credit referred to above. FIN 45 also requires the recognition, at fair value, of a liability by a guarantor at the inception of certain guarantees issued or modified after December 31, 2002. The Company’s recognized liability for performance standby letters of credit was insignificant at September 30, 2003.
In July 2003, the Board of Governors of the Federal Reserve System issued a supervisory letter instructing bank holding companies to continue to include the trust preferred securities in their Tier I capital for regulatory capital purposes until notice is given to the contrary. The Federal Reserve intends to review the regulatory implications of any accounting treatment changes and, if necessary or warranted, provide further appropriate guidance. There can be no assurance that the Federal Reserve will continue to allow institutions to include trust preferred securities in Tier I capital for regulatory capital purposes. As of September 30, 2003, if the Company is not allowed to include its $7.0 million of trust preferred securities issued by Trust I or Trust II within Tier I capital, the Company would still exceed the regulatory required minimums for capital adequacy purposes.
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In May 2003, FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. As originally issued, this statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. However, the effective date of the statement’s provisions related to the classification and measurement of certain mandatorily redeemable non-controlling interests (such as a consolidated subsidiary’s trust preferred securities) has been deferred indefinitely by the FASB, pending further Board action. The adoption of this statement is not expected to have a material impact on the Company’s consolidated financial statements.
Note 8. Other Accounting Policies
Securities. It is the Company’s intent that purchases of investment securities will be accounted for as available for sale for the foreseeable future. Trading securities, if any, are securities bought principally for the purpose of selling them in the near term. Unrealized gains and losses on trading securities are included in earnings. Securities not classified as trading securities are classified as available for sale securities and reported at fair value, with unrealized net gains or losses excluded from earnings and reported in a separate component of shareholders’ equity (accumulated other comprehensive income or loss), net of applicable taxes.
Earnings Per Share. Earnings per share are computed in accordance with SFAS No. 128, Earnings Per Share. Basic earnings per share are calculated by dividing net income by weighted average shares outstanding, plus shares issuable under the Directors’ Deferred Compensation Plan. Average additional dilutive shares are an incremental number of shares reflecting the potential dilution that could occur if outstanding stock options were converted into common stock using the treasury stock method. Dilutive shares also include all shares in the Stock Option Income Deferral Plan.
Directors’ Retirement Plan. The Tolland Bank Directors’ Retirement Plan provides payments to former directors upon retirement from the board. The Company accrues costs related to this plan over the period of service, based on various actuarial assumptions including normal director retirement expectations.
Note 9. Pending Merger Agreement
On July 16, 2003, Alliance announced that it had signed a definitive agreement to merge with New Haven Savings Bank (NHSB), pursuant to which NHSB will acquire all of the outstanding shares of Alliance. Separately, NHSB announced its intention to convert from a mutual savings bank to a stock savings bank and simultaneously merge with Alliance and Connecticut Bancshares, Inc., holding company for the Savings Bank of Manchester. The combined bank intends to operate under the name “NewAlliance Bank,” a subsidiary of the newly formed holding company, “NewAlliance Bancshares.”
Under the terms of the merger agreement, Alliance shareholders will be entitled to receive $25 per share in the form of stock issued at the conversion price, cash, or a combination thereof, subject to election and allocation procedures that are intended to ensure that, in the aggregate, at least 75% of Alliance’s shares will be exchanged for stock of the new holding company and no more than 25% will be exchanged for cash.
The transactions are expected to be completed in the first quarter of 2004. NHSB has adopted a plan for conversion to convert to a public company simultaneously with the acquisitions. As part of the conversion, NHSB formed a new holding company, NewAlliance Bancshares, and will conduct a subscription offering of its common stock to eligible depositors and others under applicable law. Remaining shares are expected to be offered for sale to the community and the general public. The conversion is subject to approval from the FDIC, the Connecticut Banking Commissioner and NHSB’s Corporators. NHSB Corporators approved the plan of conversion on September 8, 2003. The acquisition is contingent on the approvals of shareholders of the Company, the FDIC, the Federal Reserve Board, and the Connecticut Banking Commissioner.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
INTRODUCTION: Alliance Bancorp of New England, Inc. (“Alliance” or the “Company”) is the holding company for Tolland Bank (the “Bank”). The consolidated financial statements and related notes should be read in conjunction with this discussion. This discussion and analysis updates, and should be read in conjunction with, Management’s Discussion and Analysis included in the 2002 Annual Report on Form 10-K filed by Alliance on March 31, 2003. In the following discussion, income statement comparisons are against the same period of the previous year and balance sheet comparisons are against the previous fiscal year-end, unless otherwise noted. All share and per share data for the nine months ended September 30, 2002 has been adjusted to reflect the eleven-for-ten stock split effected in the form of a 10% stock dividend distributed on May 21, 2002.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS: This filing contains certain “forward–looking statements”. These forward–looking statements, which are included in Management’s Discussion and Analysis, describe future plans or strategies and include the Company’s expectations of future financial results. The words “believe,” “expect,” “anticipate,” “estimate,” “plan”, “create”, “utilize”, “project” and similar expressions identify forward–looking statements. The Company’s ability to predict results or the effect of future plans or strategies or qualitative or quantitative changes based on market risk exposure is inherently uncertain. Factors which could affect actual results include but are not limited to changes in general market interest rates, general economic conditions, legislative/regulatory changes, fluctuations of interest rates, changes in the quality or composition of the Company’s loan and investment portfolios, deposit flows, competition, demand for financial services in the Company’s markets, and changes in accounting principles. These factors should be considered in evaluating the forward–looking statements, and undue reliance should not be placed on such statements.
DISCUSSION OF CRITICAL ACCOUNTING POLICIES: The material estimates made by Management in preparing the Company’s consolidated financial statements are summarized in Note 1 to the consolidated financial statements in the most recent annual report, which should be read in conjunction with this discussion and analysis. Further discussion of the two most critical accounting estimates and their impact on the consolidated financial statements is as follows:
Loan Loss Allowance: The allowance for loan losses is based on Management’s assessment of both short and long term risk factors. Loan loss experience has been cyclical since 1990, with earlier periods of relatively high credit losses followed by much lower levels of losses in recent years. The adequacy of the allowance for loan losses is sensitive to the assessment of impaired loans and their related reserves which, in turn, is linked to the level, trend, and collateral protection of commercial substandard loans. Commercial real estate collateral values and collateral liquidity can decline quickly, particularly if accompanied by rising interest rates from current very low levels. Banking industry loan performance in general has been very strong for several years, and consensus economic forecasts do not predict destabilizing factors. However, such factors could nonetheless emerge under more adverse conditions, with a negative effect on the adequacy of the Company’s loan loss allowance.
Securities Impairment: Alliance has a portfolio of corporate debt and equity securities, all of which were purchased under investment grade guidelines. Corporate credit ratings and interest spreads have deteriorated at a nearly record rate due to factors including corporate governance issues, the impact of terrorist attacks in 2001, and the end of the decade of unprecedented economic growth in the nineties. Alliance’s portfolio includes several insurance company securities, and many large and traditionally strong insurers have repeatedly announced unexpected reserve increases and other reductions to surplus. The portfolio also includes utility company common stocks. The market index for these stocks declined by about 26% in 2002, after performing satisfactorily for several years. These market conditions have resulted in writedowns of certain debt and equity securities in recent years. The remaining unrealized losses on Alliance’s securities in these sectors are viewed as temporary, but continued unfavorable developments could change management’s view and result in future writedowns.
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SUMMARY
Alliance reported a net loss of $239 thousand ($0.09 per share) in the third quarter of 2003, compared to net income of $861 thousand ($0.32 per diluted share) in the third quarter of 2002. During the third quarter of 2003, Alliance recorded $748 thousand in charges for professional fees related to its pending merger with New Haven Savings Bank.
For the first nine months of 2003, Alliance reported net income of $1.60 million ($0.57 per share), compared to earnings of $2.58 million ($0.95 per diluted share) for the same period in 2002. Alliance announced a quarterly dividend of 7.5 cents per share, payable on November 25, 2003 to shareholders of record at the close of November 11, 2003.
Quarterly results were affected by the charges related to the merger and a security writedown, as well as by a tighter net interest margin resulting from continuing low interest rates. Third quarter results benefited from the large pipeline of mortgage loans that had built up before mortgage rates turned up sharply at the beginning of the quarter. The Company increased its loan and investment portfolios in order to help offset the impact of tighter margins. For the first six months of 2003, net income had increased by $127 thousand (7%) due primarily to the benefit of higher residential mortgage secondary market income. The nine month results declined due to the loss in the third quarter. Total assets increased to $424 million at September 30, 2003 from $415 million at December 31, 2002. Increases in residential mortgage loans and investment securities were partially offset by declines in other loan categories.
Net interest income decreased by $178 thousand (6%) in the third quarter and by $188 thousand (2%) in the first nine months of 2003, compared to the same periods in 2002. This was caused by a decline in the net interest margin to 3.00% in the third quarter of 2003 from 3.31% in the same period of 2002 due to lower interest rates. This tightening was partially mitigated by growth in total loans for the first nine months of 2003 to $279 million from $274 million at December 31, 2002. This growth was due mainly to a significant increase in residential mortgages to $96 million from $79 million at December 31, 2002, which benefited from strong demand and improvements in the Company’s origination process and product structure.
The provision for loan losses declined by $51 thousand for the third quarter and by $236 thousand for the year-to-date, reflecting lower commercial loan growth. Net loan recoveries of $5 thousand were recorded in the first nine months of 2003, compared to net charge-offs of $1 thousand in the same period of 2002. The loan loss allowance measured 1.56% of total regular loans at September 30, 2003, compared to 1.60% at the previous year-end. Nonperforming assets totaled $3.7 million (0.87% of total assets) at quarter-end, up from $3.2 million (0.78% of assets) one year ago due primarily to one commercial loan relationship. There were no foreclosed assets recorded during the first nine months of 2003.
Non-interest income decreased by $234 thousand (31%) in the third quarter due to a $504 thousand writedown on an investment security which was partially offset by a $278 thousand increase in service charges and other income. For the nine month period, non-interest income increased by $337 thousand (16%) due to a $1.22 million increase in service charges and other income, which was partially offset by an $881 thousand decrease in net gains/losses on securites and other assets. Growth in service charges and other income was primarily due to higher secondary market income related to the higher volume of residential mortgage originations and sales. Service charges and other income for the first nine months also benefited from a $209 thousand increase in non deposit investment product commissions and a $124 thousand increase in loan prepayment fees.
During the third quarter, Alliance recorded a $504 thousand securities loss representing the writedown of one equity security, a utility common stock, which was deemed to be impaired on an other than temporary basis. This unrealized loss had previously been recorded in accumulated other comprehensive income, and the third quarter charge therefore did not reduce shareholders’ equity. For the first nine months of 2003, Alliance recorded a net securities loss of $570 thousand, including gross gains of $1.11 million and gross losses of $1.68 million. Securities gains were recorded on the sale and redemption of $6 million in corporate securities which were viewed as fully valued. The securities loss also included a debt security issued by a mutual insurance company which was written down by $1.17 million to estimated fair value
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in the first half of the year. During the first quarter of 2003, Alliance eliminated the held to maturity classification of investment securities, which had decreased to a balance of $5 million at year-end 2002. These securities were transferred to the available for sale category, where security purchases will be recorded for the foreseeable future.
Non-interest expense increased by $894 thousand (35%) in the third quarter and by $1.44 million (19%) in the first nine months of 2003 compared to 2002. Total merger related expenses were $748 thousand in the third quarter and $818 thousand for the first nine months of 2003, consisting principally of legal and investment banking services. For the nine month period, total compensation related costs increased by $609 thousand (15%) due primarily to higher business volumes, including a $443 thousand increase in commissions and temporary help, along with a $111 thousand increase in pension expense. All other expenses increased by a net amount of $14 thousand. Full time equivalent staff totaled 107 at quarter-end, compared to 109 at year-end 2002. For the first nine months of 2003, the efficiency ratio (excluding merger related expenses) improved to 65.2% compared to 65.5% in the same period of 2002 despite the impact of lower interest spreads. Due to the non-deductibility of certain merger related expenses, the effective income tax rate increased to 39% for the first nine months of 2003, compared to 30% in the same period of 2002.
Shareholders’ equity totaled $29.9 million at quarter-end versus $25.6 million at the end of the 2002 fiscal year and measured 7.1% of total assets, up from 6.2% at year-end 2002. This included the benefit from the net appreciation of investment securities, reflecting the impact of lower interest rates and improved corporate spreads. The Company’s capital remained in excess of all regulatory requirements and continued to exceed the requirement for the highest regulatory capital category of “Well Capitalized”.
Alliance is giving increasing effort to working with New Haven Savings Bank in planning the rapid integration of our companies following the completion of our merger, targeted for the first quarter of 2004. It was announced at the end of the third quarter that the combined bank intends to operate under the name “NewAlliance Bank” a subsidiary of the holding company, “NewAlliance Bancshares”, when the initial public offering is completed simultaneously with the completion of the merger.
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Consolidated Selected Financial Data (Unaudited)
| | | | As of and for the three months
ended September 30, | | | As of and for the nine months
ended September 30, | |
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| | | | 2003 | | | 2002 | | | 2003 | | | 2002 | |
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| For the Period (in thousands) | | | | | | | | | | | | | |
| Net interest income | | $ | 2,912 | | $ | 3,090 | | $ | 9,165 | | $ | 9,353 | |
| Provision for loan losses | | | 13 | | | 64 | | | 65 | | | 301 | |
| Service charges and other income | | | 1,021 | | | 743 | | | 3,007 | | | 1,789 | |
| Net (loss) gain on securities and other assets | | | (504 | ) | | 8 | | | (570 | ) | | 311 | |
| Non-interest expense | | | 3,464 | | | 2,570 | | | 8,930 | | | 7,489 | |
| Net (loss) income | | $ | (239 | ) | $ | 861 | | $ | 1,603 | | $ | 2,576 | |
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| Per Share | | | | | | | | | | | | | |
| (Loss) earnings – basic | | $ | (0.09 | ) | $ | 0.33 | | $ | 0.59 | | $ | 1.00 | |
| (Loss) earnings – diluted | | | (0.09 | ) | | 0.32 | | | 0.57 | | | 0.95 | |
| Dividends declared | | | 0.07 | 5 | | 0.07 | 5 | | 0.22 | 5 | | 0.21 | 1 |
| Book value | | | 11.15 | | | 9.16 | | | 11.15 | | | 9.16 | |
| Common stock price: | | | | | | | | | | | | | |
| High | | | 33.75 | | | 15.70 | | | 33.75 | | | 15.70 | |
| Low | | | 23.05 | | | 12.94 | | | 18.51 | | | 10.68 | |
| Close | | | 33.34 | | | 15.30 | | | 33.34 | | | 15.30 | |
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| At Period End (in millions) | | | | | | | | | | | | | |
| Total assets | | $ | 423.7 | | $ | 414.4 | | $ | 423.7 | | $ | 414.4 | |
| Total loans | | | 283.4 | | | 269.3 | | | 283.4 | | | 269.3 | |
| Other earning assets | | | 112.9 | | | 120.5 | | | 112.9 | | | 120.5 | |
| Deposits | | | 327.4 | | | 335.2 | | | 327.4 | | | 335.2 | |
| Borrowings | | | 60.1 | | | 51.5 | | | 60.1 | | | 51.5 | |
| Shareholders’ equity | | | 29.9 | | | 23.7 | | | 29.9 | | | 23.7 | |
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| Operating Ratios | | | | | | | | | | | | | |
| Return on average equity | | | (3.10 | )% | | 14.47 | % | | 7.59 | % | | 15.05 | % |
| Return on average assets | | | (0.22 | ) | | 0.83 | | | 0.51 | | | 0.87 | |
| Net interest margin | | | 3.00 | | | 3.31 | | | 3.18 | | | 3.44 | |
| Efficiency ratio | | | 67.50 | | | 65.24 | | | 65.16 | | | 65.51 | |
| Equity/total assets | | | 7.05 | | | 5.72 | | | 7.05 | | | 5.72 | |
| Dividend payout ratio | | | n/a | | | 22.57 | | | 37.60 | | | 21.19 | |
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| Loan Related Ratios | | | | | | | | | | | | | |
| Net charge-offs/average regular loans | | | 0.00 | % | | 0.02 | % | | 0.00 | % | | 0.00 | % |
| Loan loss allowance/regular loans | | | 1.56 | | | 1.62 | | | 1.56 | | | 1.62 | |
| Nonperforming assets/total assets | | | 0.87 | | | 0.78 | | | 0.87 | | | 0.78 | |
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| Growth (in percent) | | | | | | | | | | | | | |
| Net income | | | n/a | | | 4.9 | % | | (37.8 | )% | | 4.4 | % |
| Regular loans | | | 8.1 | % | | 21.7 | | | 5.9 | | | 11.3 | |
| Deposits | | | (10.2 | ) | | 5.5 | | | (1.4 | ) | | 14.0 | |
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(1) All share and per share data for the nine months ended September 30, 2002 has been adjusted to reflect the eleven-for-ten stock split effected in the form of a 10% stock dividend distributed in May 2002.
(2) The efficiency ratio is non-interest expense divided by the sum of net interest income (fully taxable equivalent) and service charges and other income. The efficiency ratio excludes merger related expenses. Return, margin and charge-off ratios are annualized based on average balances for the period. The net interest margin is fully taxable equivalent.
(3) Regular loans are total loans excluding government guaranteed loans.
(4) Growth of net income is compared to the same period in the prior year. Growth was not applicable in the three months ended September 30, 2003 due to the net loss. Growth of regular loans and deposits is compared to beginning of the period, annualized.
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RESULTS OF OPERATIONS
Average Balance Sheets and Interest Rates – Fully Taxable Equivalent (FTE)
The following table sets forth, for the periods indicated, the average balances and their associated average interest rates. Average balances are based on average daily balances. The balance and yield on all securities is based on amortized cost and not on fair value.
| (dollars in thousands) | | | Average Balance | | | Rate (FTE Basis) | |
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| Quarters ended September 30 | | | 2003 | | | 2002 | | | 2003 | | | 2002 | |
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| Residential mortgage loans | | $ | 91,622 | | $ | 64,130 | | | 5.71 | % | | 6.84 | % |
| Commercial mortgage loans | | | 91,850 | | | 90,868 | | | 6.81 | | | 7.65 | |
| Other commercial loans | | | 37,683 | | | 38,696 | | | 6.04 | | | 6.49 | |
| Consumer loans | | | 36,485 | | | 41,088 | | | 4.11 | | | 4.99 | |
| Government guaranteed loans | | | 20,274 | | | 26,845 | | | 6.80 | | | 6.44 | |
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| Total loans | | | 277,914 | | | 261,627 | | | 5.99 | | | 6.70 | |
| Securities | | | 95,594 | | | 96,033 | | | 4.26 | | | 6.49 | |
| All other earning assets | | | 26,709 | | | 28,364 | | | 1.62 | | | 1.95 | |
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| Total earning assets | | | 400,217 | | | 386,024 | | | 5.29 | | | 6.32 | |
| Other assets | | | 27,631 | | | 23,921 | | | | | | | |
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| Total assets | | $ | 427,848 | | $ | 409,945 | | | | | | | |
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| NOW deposits | | $ | 40,463 | | $ | 35,105 | | | 0.36 | % | | 0.91 | % |
| Money market deposits | | | 46,535 | | | 49,800 | | | 1.22 | | | 2.02 | |
| Savings deposits | | | 81,669 | | | 72,535 | | | 0.80 | | | 1.92 | |
| Time deposits | | | 128,249 | | | 139,597 | | | 3.43 | | | 4.15 | |
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| Total interest bearing deposits | | | 296,916 | | | 297,037 | | | 1.94 | | | 2.86 | |
| Borrowings | | | 58,476 | | | 50,674 | | | 5.78 | | | 6.16 | |
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| Interest bearing liabilities | | | 355,392 | | | 347,711 | | | 2.58 | | | 3.34 | |
| Demand deposits | | | 40,354 | | | 35,542 | | | | | | | |
| Other liabilities | | | 2,481 | | | 1,110 | | | | | | | |
| Shareholders’ equity | | | 29,621 | | | 25,582 | | | | | | | |
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| Total liabilities and equity | | $ | 427,848 | | $ | 409,945 | | | | | | | |
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| Net Interest Spread | | | | | | | | | 2.71 | % | | 2.98 | % |
| Net Interest Margin | | | | | | | | | 3.00 | % | | 3.31 | % |
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| (dollars in thousands) | | | Average Balance | | | Rate (FTE Basis) | |
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| Nine months ended September 30 | | | 2003 | | | 2002 | | | 2003 | | | 2002 | |
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| Residential mortgage loans | | $ | 85,649 | | $ | 61,889 | | | 6.09 | % | | 6.98 | % |
| Commercial mortgage loans | | | 93,822 | | | 89,100 | | | 6.99 | | | 7.79 | |
| Other commercial loans | | | 39,119 | | | 38,887 | | | 6.22 | | | 6.57 | |
| Consumer loans | | | 37,903 | | | 40,530 | | | 4.30 | | | 5.23 | |
| Government guaranteed loans | | | 22,730 | | | 28,160 | | | 6.52 | | | 6.66 | |
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| Total loans | | | 279,223 | | | 258,566 | | | 6.20 | | | 6.87 | |
| Securities | | | 92,057 | | | 89,091 | | | 4.63 | | | 7.05 | |
| All other earning assets | | | 24,242 | | | 20,836 | | | 2.56 | | | 1.67 | |
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| Total earning assets | | | 395,522 | | | 368,493 | | | 5.61 | | | 6.58 | |
| Other assets | | | 27,694 | | | 29,586 | | | | | | | |
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| Total assets | | $ | 423,216 | | $ | 398,079 | | | | | | | |
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| | | | | | | | | | | | | | |
| NOW deposits | | $ | 39,502 | | $ | 35,755 | | | 0.40 | % | | 0.93 | % |
| Money market deposits | | | 45,544 | | | 44,484 | | | 1.34 | | | 2.07 | |
| Savings deposits | | | 80,162 | | | 70,716 | | | 0.95 | | | 1.99 | |
| Time deposits | | | 131,067 | | | 137,104 | | | 3.60 | | | 4.34 | |
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| Total interest bearing deposits | | | 296,275 | | | 288,059 | | | 2.11 | | | 2.99 | |
| Borrowings | | | 58,163 | | | 50,004 | | | 5.78 | | | 6.17 | |
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| Interest bearing liabilities | | | 354,438 | | | 338,063 | | | 2.71 | | | 3.46 | |
| Demand deposits | | | 37,910 | | | 32,697 | | | | | | | |
| Other liabilities | | | 2,049 | | | 1,975 | | | | | | | |
| Shareholders’ equity | | | 28,819 | | | 25,344 | | | | | | | |
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| Total liabilities and equity | | $ | 423,216 | | $ | 398,079 | | | | | | | |
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| Net Interest Spread | | | | | | | | | 2.90 | % | | 3.12 | % |
| Net Interest Margin | | | | | | | | | 3.18 | % | | 3.44 | % |
FTE basis net interest income presents earnings on tax-advantaged securities on a basis equivalent to yields on fully-taxable securities. A tax rate of 40% was used to compute the tax-equivalent adjustment for all periods presented. A reconciliation of net interest income follows:
| | | Three months ended
September 30, | | | Nine months ended
September 30, | |
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| (in thousands) | | | 2003 | | | 2002 | | | 2003 | | | 2002 | |
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Net interest income as reported in the
consolidated statements of operations | | $ | 2,912 | | $ | 3,090 | | $ | 9,165 | | $ | 9,353 | |
| Tax-equivalent adjustment | | | 91 | | | 106 | | | 277 | | | 289 | |
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| FTE basis | | $ | 3,003 | | $ | 3,196 | | $ | 9,442 | | $ | 9,642 | |
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RESULTS OF OPERATIONS – THREE MONTH AND NINE MONTH PERIODS ENDED SEPTEMBER 30, 2003 VERSUS SEPTEMBER 30, 2002
Net Interest Income: Net interest income decreased by $178 thousand (6%) in the third quarter and by $188 thousand (2%) in the first nine months of 2003, compared to the same periods in 2002. Net interest income had been nearly flat for the first six months of 2003, with growth in earning assets offsetting margin compression. There was further margin compression in the third quarter, and year-to-year growth in average earning assets declined to 4% in the third quarter, compared to 7% in the first six months of the year.
Interest rates continued to decline in 2003, following the steep declines in 2002. Short term treasury rates declined by about 0.35% in the first six months, while the ten year treasury rate declined by about 0.80% to a low of 3.11% near the end of the second quarter. The plunge in rates in the second quarter fueled demand for refinancings. A recovery in the stock market, together with the low interest rates, also muted the unusually strong deposit demand experienced in recent years. The slower deposit growth constrained opportunities to offset lower yields with higher volume. In the third quarter, long term interest rates rebounded, closing the quarter around the 4.00% level. Application volumes declined, although loan originations and payoffs remained heavy due to the lengthy processing pipelines at June 30. Alliance is asset sensitive, and net interest income tends to decline during periods of comparatively low interest rates such as those which have been experienced in 2003. Please also see the Interest Rate Sensitivity section of this Discussion and Analysis.
Average earning assets increased by $27 million (7%) for the nine month period. This growth was concentrated in average residential mortgages, which increased by $24 million (38%). Decreases of $5 million each in average short term investments and average government guaranteed loans were mostly offset by an $8 million increase in average loans held for sale. Average total commercial mortgages and loans increased by $5 million (4%), while average consumer loans decreased by $3 million (6%). Average interest bearing liabilities grew by $16 million (5%), with the increase concentrated in a $9 million (13%) increase in savings accounts. An $8 million (16%) increase in average borrowings offset a $6 million (4%) decrease in average time accounts. Total transactions accounts (demand deposit and NOW) increased by $9 million (13%).
For the first nine months of 2003, most asset yields and liability costs continued to decrease due to the ongoing effects of lower interest rates. The yield on earning assets fell to 5.29% in the third quarter, from 6.32% in the same quarter of 2002. The greatest decrease was in the securities yield, which declined to 4.26% from 6.49%, reflecting securities sales and runoff, followed by reinvestment into shorter duration government agency and mortgage backed securities. The cost of liabilities has also declined steadily, but more slowly than the yield on assets, due to the low prevailing level of interest rates. The cost of interest bearing liabilities measured 2.58% in the third quarter of 2003, compared to 3.34% in the same quarter of 2002. These changes produced a decline in the net interest margin to 3.00% in the third quarter of 2003 from 3.31% in the same period of 2002. The net interest margin improved to 3.09% in the month of September, reflecting the benefit of loan and security growth booked near the end of the quarter.
Provision for Loan Losses. The provision is made to maintain the allowance for loan losses at a level deemed adequate by Management. The provision was $65 thousand for the first nine months of the year, compared to $301 thousand in the same period of the prior year. During the third quarter of 2003 the provision was $13 thousand versus $64 thousand for the 2002 period. The higher provisioning in 2002 related to growth in commercial loans and to an increase in the impairment reserve on one loan. The allowance totaled $4.12 million, or 1.56% of regular loans at September 30, 2003, which was down slightly from 1.60% at the previous year-end due to the higher proportion of lower risk residential mortgages in 2003.
Non-Interest Income. Non-interest income decreased by $234 thousand (31%) in the third quarter due to a $504 thousand writedown on an investment security which was partially offset by a $278 thousand increase in service charges and other income. For the nine month period, non-interest income increased by $337 thousand (16%) due to a $1.22 million increase in service charges and other income, which was partially offset by an $881 thousand decrease in net gains/losses on securites and other assets.
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Service charges and other income grew by $278 thousand (37%) in the third quarter and by $1.22 million (68%) in the first nine months of 2003. This growth was mostly produced by secondary market income, (consisting principally of gains on sale of loans) which grew by $297 thousand (410%) and $1.01 million (568%) during these periods. The very low long term interest rates in the second quarter caused a surge in residential mortgage refinancings into long term fixed rate mortgages, most of which were sold to the secondary market. Proceeds from loans sold totaled $90 million for the first nine months of 2003, compared to $14 million for the same period in 2002. The volume of new applications declined in the third quarter after the sharp increase in long-term interest rates, but loan sales remained strong due to the pipeline of mortgages in process at the beginning of the quarter. Alliance also benefited from a $213 thousand increase in non deposit investment product commissions. Under a new third party agreement, Alliance records these commissions on a gross basis, rather than on a net basis. The higher income reflected this new commission structure, together with an increase in sales volume. Additionally, Alliance recorded a $124 thousand increase in loan prepayment fees, primarily related to commercial loan refinancings. Excluding the above, all other service charges and other income decreased by $124 thousand (8%) for the first nine months of 2003. This reflected a $102 thousand decrease in annuity sales income and lower checking account overdraft volumes.
For the first nine months of 2003, Alliance recorded a net securities loss of $570 thousand, including gross gains of $1.11 million and gross losses of $1.68 million. As previously noted, the losses were due to writedowns of $1.17 million in the first half of the year of an insurance company debt security and a $504 thousand third quarter writedown of an electric utility common stock. The gains were realized on the sale of fully valued corporate debt and equity securities which reflected the benefit of lower interest rates and improved corporate spreads. For the third quarter the loss was $504 thousand versus a gain of $8 thousand for the third quarter of 2002.
Non-Interest Expense and Income Tax Expense. Non-interest expense increased by $894 thousand (35%) in the third quarter and by $1.44 million (19%) in the first nine months of 2003 compared to 2002. These increases were mainly due to merger related expenses and compensation expenses. All other expenses increased by a net amount of $14 thousand. Total merger related expenses were $748 thousand in the third quarter and $818 thousand for the first nine months of 2003, consisting principally of legal and investment banking services. Compensation related expenses increased by $125 thousand (9%) for the third quarter and $609 thousand (15%) for the first nine months due primarily to higher business volumes. The nine month results included a $443 thousand increase in commissions and temporary help, along with a $111 thousand increase in pension expense. Full time equivalent staff totaled 107 at quarter-end, compared to 109 at year-end 2002. For the first nine months of 2003, the efficiency ratio (excluding merger related expenses) improved to 65.2% compared to 65.6% in the same period of 2002 despite the impact of lower interest spreads. Certain merger related expenses have been treated as non deductible for purposes of the financial statement tax provision. As a result, the effective income tax rate increased to 39% for the first nine months of 2003, compared to 30% in the same period of 2002. The effective income tax rate benefits from the dividends received deduction on equity securities, accrued increases in cash surrender value of life insurance, and the state income tax benefit of Alliance’s passive investment corporation.
Comprehensive Income. Comprehensive income includes changes (after tax) in the unrealized market gains and losses of investment securities available for sale. Comprehensive income was $4.84 million in the first nine months of 2003, compared to $2.05 million in the same period last year. The net unrealized loss on securities declined substantially in 2003 due to lower interest rates, improved market spreads on corporate debt securities, and the writedown of corporate securities discussed previously. Please see the following discussion on investment securities.
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FINANCIAL CONDITION – SEPTEMBER 30, 2003 VERSUS DECEMBER 31, 2002
Cash and Cash Equivalents. Total cash and equivalents increased by $3 million to $21 million at September 30, 2003. Total cash and equivalents had increased to $39 million at June 30, 2003. Most of this increase was reinvested into higher yielding loans and investment securities during the third quarter.
Investment Securities. As previously noted, during the first quarter of 2003, Alliance eliminated the category of securities held to maturity and transferred the outstanding balance of these securities to the available for sale category. This represented a change in intent regarding the entire balance of securities held to maturity, which consisted of ten securities with an amortized cost of $5.1 million. Subsequent to the transfer, all purchases of investment securities have been categorized as available for sale and the same treatment will be applied to all purchases for the foreseeable future.
Total investment securities increased by $10 million (11%) during the first nine months of 2003. This growth was booked to help offset runoff of government guaranteed loans ($6 million) and a decrease in the balance of loans held for sale ($8 million). Securities purchases totaled
$39 million during this period and consisted entirely of U.S. government agency and mortgage backed securities with interest rates fixed for no more than four years, and in most cases for no more than three years. Other liabilities included $5 million representing securities purchased and not settled at September 30, 2003.
At September 30, 2003, total securities of $103 million included government agency and mortgage backed securities totaling $59 million (57%). All of these securities were rated AA or AAA. Corporate debt and equity securities totaled $41 million (40%) and investments in Federal Home Loan Bank and Bankers Bank Northeast totaled $3 million (3%). All of the corporate securities had ratings by Moodys and/or Standard & Poors, except for $8 million in utility common stocks, all of which were ranked B or above by Standard & Poors and a $2.5 million ultrashort bond fund. Excluding non-investment grade rated securities (discussed below), the rated corporate debt securities had an average rating of BBB+ at September 30, 2003. This decreased from A- previously due to maturing corporate securities which were replaced with government agency securities.
The securities portfolio includes six corporate debt securities which are rated non-investment grade. Four of these securities, with a net amortized cost of $4.6 million were rated in the BB- to BB+ range with a total unrealized loss of $0.4 million (8% of amortized cost). Two securities were defaulted and had been written down to a net balance of $0.6 million at September 30, 2003; these two securities were being held without accrual of interest. The equity security portfolio had a net unrealized loss of $0.8 million, concentrated in two utility common equity securities. Management’s assessment was that these declines are temporary and the prices of these securities are expected to improve over a reasonable period of time.
The total investment securities portfolio had a $0.3 million net unrealized gain as of September 30, 2003, measuring 0.2% of amortized cost, compared to a net unrealized loss of $3.3 million at year-end 2002, measuring 3.3% of amortized cost. This improvement was due to generally lower interest rates, improved spreads on corporate securities, and the writedowns of corporate securities.
The average balance of investment securities increased by $3 million (3%) for the nine months ended 2003, compared to 2002. The third quarter yield declined to 4.26% in 2003 from 6.49% in 2002, reflecting securities sales and runoff, and by reinvestment into shorter duration government agency and mortgage backed securities.
Total Loans. Total loans increased by $5 million (2%) to $283 million for the first nine months of 2003. Total regular loans increased by
$11 million (4%) to $264 million. The growth was mostly in residential mortgage loans, which increased by $17 million (22%). Alliance actively promoted its fee-free mortgage refinance loans, with fixed rates in the 3-15 year range. Additionally, in the third quarter, Alliance retained for portfolio some conforming residential mortgages with similar interest rate characteristics. As previously noted, prepayment speeds of many loan types accelerated sharply in the second quarter until long term rates increased after quarter end. During the first nine months of 2003, Alliance closed $97 million of conforming residential mortgages, plus an additional $24 million of fee-free refinance
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mortgages. Total commercial and consumer loans decreased by $6 million (4%) in the first nine months, reflecting the impact of accelerated prepayments and a slow economy. Growth in commercial loan demand did not develop as anticipated. The balance of residential mortgage loans held for sale declined to $4 million at September 30, 2003, reflecting the lower pipeline of loans in process at that time.
The average balance of total loans increased by $21 million (8%) for the first nine months of 2003, compared to 2002. The third quarter yield on total loans decreased to 5.99% in 2003 from 6.70% in 2002 due to the continuing effects of prime rate decreases and to ongoing refinances at lower interest rates.
Nonperforming Assets. Nonperforming assets totaled $3.7 million (0.87% of total assets) at quarter-end, up from $2.4 million (0.59% of assets) at year end 2002, due primarily to one $2.2 million commercial loan relationship. Alliance initiated foreclosure proceedings on this owner occupied commercial mortgage at the end of the third quarter. There were no properties acquired through foreclosure during the first nine months of 2003.
Allowance for Loan Losses. The allowance totaled $4.12 million (1.56% of regular loans) at September 30, 2003, compared to $4.05 million (1.60% of regular loans) at year-end 2002. The allowance increased due to growth in residential mortgages, but the ratio of the allowance to total regular loans decreased due to the higher proportion of lower risk residential mortgages in 2003. Alliance recorded $5 thousand in net loan recoveries during the first nine months of 2003.
Deposits and Borrowings. Total deposits decreased by $9 million (3%) in the third quarter and by $3 million (1%) for the first nine months of 2003. Lower interest rates and an improvement in the stock market are believed to have contributed to this change. All non maturity deposit account types had increased during the first half of the year, but decreased in the third quarter, except for savings accounts, which continued to increase in the third quarter and registered total growth of $4 million (6%) for the year-to-date 2003. Time accounts continued to decline, as some maturing longer term account balances were withdrawn in the current low rate environment. For the year-to-date 2003, time accounts decreased by $8 million (6%). For the first nine months of the year, average deposits increased by $13 million (4%). The third quarter cost of interest bearing deposits decreased to 1.94% in 2003 from 2.86% in 2002, reflecting lower rates on all major account types. Alliance plans to open its tenth branch in the fourth quarter of 2003, with new deposit growth planned as a result of this expansion. Total borrowings increased by $6 million from December 31, 2002, including some medium term Federal Home Loan Bank (FHLB) borrowings which were used to offset time account runoff. An additional $2 million of short term FHLB borrowings were outstanding at September 30, 2003.
Interest Rate Sensitivity. Alliance’s interest rate sensitivity was not significantly changed at September 30, 2003, compared to the previous year-end. The one year interest rate gap remained at 10% of earning assets, which is the policy limit. Net interest income at risk was 12% and (9%) based on upward and downward rate changes evaluated in the model; the policy limit is 10% and the overlimit in an upward rate environment was viewed as minor. Equity at risk was 9% and (15%) based on upward and downward rate changes evaluated in the model; the policy limit is 15%. Alliance believes that income and equity value would increase in a rising rate environment and decrease in a decreasing rate environment, primarily due to rate adjustments in its portfolio of prime based commercial and consumer loans. With interest rates at comparatively low levels and widely forecasted to increase, Alliance generally seeks to limit the acquisition of new long term fixed rate assets in order to improve equity at risk in a rising rate environment. Due to the low and volatile nature of the interest rate environment, uncertainty in the modeling process has increased. Loan prepayment speeds had accelerated in the second quarter due to the unusually low rate environment, but were estimated to be slowing at the end of the third quarter due to the increase in long term rates in the third quarter. Future deposit flows also reflect uncertainties related to the competitiveness of other financial products in a possible rising rate environment.
Liquidity and Cash Flows. Tolland Bank’s primary net use of funds in the first nine months of 2003 was the purchase of investment securities. These purchases were funded by sales and runoff from other investment securities and government guaranteed loans, together with a decrease in loans held for sale.
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Alliance increased FHLB borrowings to fund loan growth and offset runoff of maturing time accounts. Short term investments increased by a relatively small $2 million to $6 million. Borrowings and time deposits are the primary sources of liquidity for additional balance sheet growth, along with deposits from the new Enfield branch. Short term investments and securities available for sale provide additional sources of liquidity. Further, the portfolio of government guaranteed loans represents a readily marketable pool of assets, although management has no present intent to sell these assets. Alliance’s primary source of funds is dividends received from Tolland Bank, and its primary use of funds is dividends paid to shareholders and to trust preferred security holders. Additionally, due to the planned merger, another use of funds by Alliance is merger related expenses and an anticipated source of funds in the fourth quarter of 2003 will be proceeds from the exercise of stock options in accordance with the merger agreement.
Capital Resources. Shareholders’ equity increased by $4 million to $30 million during the first nine months of 2003, benefiting from the comparatively high comprehensive income. Total equity measured 7.1% of assets at September 30, which was up from 6.2% at year-end 2002. At September 30, both Alliance and Tolland Bank continued to be capitalized in accordance with the “Well Capitalized” regulatory classification.
As discussed in Note 1 to the Alliance Consolidated Financial Statements, the adoption of FASB Interpretation No. 46 was required beginning in the third quarter of 2003, but was then postponed to December 31, 2003. This may affect the financial reporting in the consolidated financial statements for Alliance’s two statutory business trusts that have issued trust preferred securities totaling $7 million, and their continued qualification as Tier I capital for Alliance under regulatory definitions. These financial reporting and regulatory determinations are currently under review and Alliance expects that its capital will remain in excess of all regulatory requirements.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
See the discussion and analysis of quantitative and qualitative disclosures about market risk provided in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002 filed on March 31, 2003. See also the discussion of Interest Rate Sensitivity in Item 2 of this Form 10-Q.
ITEM 4. CONTROLS AND PROCEDURES
Based on their evaluation as of September 30, 2003, the Company’s Chief Executive Officer, Joseph H. Rossi and Chief Financial Officer, David H. Gonci, concluded the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed in the reports that the Company files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. There were no changes during the quarter ended September 30, 2003 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II OTHER INFORMATION
| Item 1. | LEGAL PROCEEDINGS |
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| | The Company is not involved in any material legal proceedings other than ordinary routine litigation incidental to its business. |
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| Item 2. | CHANGES IN SECURITIES AND USE OF PROCEEDS |
| Item 3. | DEFAULTS UPON SENIOR SECURITIES |
| Item 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
| Item 5. | OTHER INFORMATION |
| Item 6. | EXHIBITS AND REPORTS ON FORM 8-K |
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| | | The exhibits listed below are included with this Report. |
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| | | 31.1 | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | 31.2 | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | 32.1 | Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and 18 U.S.C. Section |
| | | | 1350. |
| | | 32.2 | Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and 18 U.S.C. Section |
| | | | 1350. |
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| | (b) | Reports on Form 8-K filed during the quarter ended September 30, 2003 |
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| | | (i) | On July 16, 2003, the Company furnished a Form 8-K reporting, under Item 5, a news release announcing that it entered into a definitive merger agreement with New Haven Savings Bank. |
| | | (ii) | On July 17, 2003, the Company furnished a Form 8-K reporting, under Item 9, an informational presentation regarding the proposed merger. |
| | | (iii) | On July 24, 2003, the Company furnished a Form 8-K reporting, under Item 9 and in satisfaction of Item 12, a news release reporting earnings for the second quarter of the 2003 fiscal year. |
| | | (iv) | On July 25, 2003, the Company filed a Form 8-K/A reporting, under Item 5, an amendment to its July 16, 2003 Form 8-K filing announcing that it had entered into a definitive merger agreement, to include the complete text of the Agreement and Plan of Merger. |
| | | (v) | On July 28, 2003, the Company furnished a Form 8-K/A reporting, under Item 9, a correction of a typographical error in the informational presentation furnished in its July 17, 2003 Form 8-K. |
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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.
| | ALLIANCE BANCORP OF NEW ENGLAND, INC. |
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| Date: November 13, 2003 | /s/ Joseph H. Rossi |
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| | Joseph H. Rossi
President/Chief Executive Officer |
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| Date: November 13, 2003 | /s/ David H. Gonci |
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| | David H. Gonci
Senior Vice President/Chief Financial Officer |
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