FRANKLIN FINANCIAL SERVICES CORPORATION and SUBSIDIARIES
UNAUDITED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 — Basis of Presentation
The consolidated financial statements include the accounts of Franklin Financial Services Corporation (the Corporation), and its wholly-owned subsidiaries, Farmers and Merchants Trust Company of Chambersburg (the Bank), Franklin Financial Properties Corp., and Franklin Future Fund Inc. Farmers and Merchants Trust Company of Chambersburg is a commercial bank that has one wholly-owned subsidiary, Franklin Realty Services Corporation. Franklin Realty Services Corporation is an inactive real-estate brokerage company. Franklin Financial Properties Corp. holds real estate assets that are leased by the Bank. Franklin Future Fund Inc. is a non-bank investment company. The activities of nonbank entities are not significant to the consolidated totals. All significant intercompany transactions and account balances have been eliminated.
In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations, and cash flows at and as of March 31, 2007, and for all periods presented have been made.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. It is suggested that these consolidated financial statements be read in conjunction with the audited consolidated financial statements and notes thereto included in the Corporation’s 2006 Annual Report on Form 10-K. The results of operations for the period ended March 31, 2007 are not necessarily indicative of the operating results for the full year.
The balance sheet at December 31, 2006 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.
For purposes of reporting cash flows, cash and cash equivalents include Cash and due from banks, Interest-bearing deposits in other banks and Federal funds sold. Generally, Federal funds are purchased and sold for one-day periods.
Earnings per share is computed based on the weighted average number of shares outstanding during each period end. A reconciliation of the weighted average shares outstanding used to calculate basic earnings per share and diluted earnings per share follows:
| | For the three months ended | |
| | March 31 | |
(Amounts in thousands) | | 2007 | | 2006 | |
Weighted average shares outstanding (basic) | | 3,838 | | 3,352 | |
Impact of common stock equivalents | | 9 | | 6 | |
Weighted average shares outstanding (diluted) | | 3,847 | | 3,358 | |
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Note 2 — Comprehensive Income
The components of other comprehensive income are as follows:
| | For the Three Months Ended | |
| | March 31 | |
| | 2007 | | 2006 | |
Net Income | | $ | 2,064 | | $ | 1,489 | |
| | | | | |
Securities: | | | | | |
Unrealized gains arising during the period | | 21 | | 21 | |
Reclassification adjustment for (gains) included in net income | | (278 | ) | (95 | ) |
Net unrealized (losses) | | (257 | ) | (74 | ) |
Tax effect | | 87 | | 25 | |
Net of tax amount | | (170 | ) | (49 | ) |
| | | | | |
Derivatives: | | | | | |
Unrealized gains arising during the period | | (3 | ) | 50 | |
Reclassification adjustment for losses included in net income | | 3 | | 21 | |
Net unrealized gains | | — | | 71 | |
Tax effect | | — | | (24 | ) |
Net of tax amount | | — | | 47 | |
| | | | | |
Total other comprehensive income | | (170 | ) | (2 | ) |
Total Comprehensive Income | | $ | 1,894 | | $ | 1,487 | |
Note 3 — Guarantees
The Corporation does not issue any guarantees that would require liability recognition or disclosure, other than its standby letters of credit. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Generally, all letters of credit, when issued have expiration dates within one year. The credit risk involved in issuing letters of credit is essentially the same as those that are involved in extending loan facilities to customers. The Bank, generally, holds collateral and/or personal guarantees supporting these commitments. The Bank had $13.8 million standby letters of credit as of March 31, 2007 and $17.0 million as of December 31, 2006. Management believes that the proceeds obtained through a liquidation of collateral and the enforcement of guarantees would be sufficient to cover the potential amount of future payments required under the corresponding guarantees.
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Note 4 — Pensions
The components of pension expense for the periods presented are as follows:
| | Three months ended | |
| | March 31 | |
(Amounts in thousands) | | 2007 | | 2006 | |
Components of net periodic benefit cost: | | | | | |
Service cost | | $ | 91 | | $ | 91 | |
Interest cost | | 181 | | 172 | |
Expected return on plan assets | | (230 | ) | (219 | ) |
Amortization of prior service cost | | 24 | | 22 | |
Net periodic benefit cost | | $ | 66 | | $ | 66 | |
Note 5 — Recent Accounting Pronouncements
FIN 48
In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, which clarified the accounting for uncertainty in income taxes recognized in the financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 provides guidance on the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures, and transition. We adopted FIN 48 effective on January 1, 2007 and this adoption did not impact our consolidated financial statements.
EITF Issue No. 06-04 “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements”
In September 2006, the FASB’s Emerging Issues Task Force (EITF) issued EITF Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements” (“EITF 06-4”). EITF 06-4 requires the recognition of a liability related to the postretirement benefits covered by an endorsement split-dollar life insurance arrangement. The consensus highlights that the employer (who is also the policyholder) has a liability for the benefit it is providing to its employee. As such, if the policyholder has agreed to maintain the insurance policy in force for the employee’s benefit during his or her retirement, then the liability recognized during the employee’s active service period should be based on the future cost of insurance to be incurred during the employee’s retirement. Alternatively, if the policyholder has agreed to provide the employee with a death benefit, then the liability for the future death benefit should be recognized by following the guidance in SFAS No. 106 or Accounting Principles Board (APB) Opinion No. 12, as appropriate. For transition, an entity can choose to apply the guidance using either of the following approaches: (a) a change in accounting principle through retrospective application to all periods presented or (b) a change in accounting principle through a cumulative-effect adjustment to the balance in retained earnings at the beginning of the year of adoption. The disclosures are required in fiscal years beginning after December 15, 2007, with early adoption permitted. The Corporation is evaluating the affect EITF 06-4 will have on its consolidated financial statements.
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SFAS No. 157 “Fair Value Measurement”
In September 2006, the Financial Accounting Standards Board (FASB) issued Statement No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The Corporation is evaluating the affect the adoption of SFAS No. 157 will have on its consolidated financial statements.
SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement 115”
In February 2007, the FASB issued SFAS No. 159 “The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. Unrealized gains and losses on items for which the fair value option has been elected will be recognized in earnings at each subsequent reporting date. The Corporation did not elect the early adoption option of SFAS No. 159. SFAS No. 159 is effective for the Corporation January 1, 2008 and it is evaluating the affect it will have on its consolidated financial statements.
Note 6 — Acquisition
On July 1, 2006, Franklin Financial Services Corporation completed its acquisition of Fulton Bancshares Corporation. In connection with the transaction, The Fulton County National Bank and Trust Company, a subsidiary of Fulton Bancshares was merged with and into Farmers and Merchants Trust Company of Chambersburg, a subsidiary of Franklin Financial Services Corporation. The acquisition added approximately $123 million in assets and 6 community-banking offices in Fulton and Huntingdon counties to Franklin Financial Services Corporation. Management believes that the acquisition gave it access to a contiguous market, via an established network, that could be expanded with the product offerings of the Corporation.
The following unaudited pro forma combined results of operations for the periods shown below give effect to the merger as if the merger had been completed on January 1, 2006. The pro forma results show the combination of Fulton Bancshares’ results into Franklin Financial Services Corporation’s consolidated statements of income. While adjustments have been made for the estimated effect of purchase accounting, the pro forma results do not reflect the actual result the combined company would have achieved had the combination occurred at the beginning of the periods presented.
| | Pro forma | |
| | Three months | |
| | ended | |
| | March 31 | |
(in thousands, except per share) | | 2006 | |
Net interest income | | $ | 5,608 | |
Other income | | 1,981 | |
Net income | | 1,356 | |
Diluted earnings per share | | 0.35 | |
| | | | |
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Note 7 — Reclassifications
Certain prior period amounts may have been reclassified to conform to the current year presentation. Such reclassifications did not affect reported net income.
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Part I, Item 2
Management’s Discussion and Analysis of Results of Operations and Financial Condition
For the Three Month Period Ended March 31, 2007 and 2006
Forward Looking Statements
Certain statements appearing herein which are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements refer to a future period or periods, reflecting management’s current views as to likely future developments, and use words such as “may,” “will,” “expect,” “believe,” “estimate,” “anticipate,” or similar terms. Because forward-looking statements involve certain risks, uncertainties and other factors over which the Corporation has no direct control, actual results could differ materially from those contemplated in such statements. These factors include (but are not limited to) the following: general economic conditions, changes in interest rates, changes in the Corporation’s cost of funds, changes in government monetary policy, changes in government regulation and taxation of financial institutions, changes in the rate of inflation, changes in technology, the intensification of competition within the Corporation’s market area, and other similar factors.
Critical Accounting Policies
Management has identified critical accounting policies for the Corporation to include Allowance for Loan Losses, Mortgage Servicing Rights, Financial Derivatives, Temporary Investment Impairment and Stock-based Compensation. There were no other changes to the critical accounting policies disclosed in the 2006 Annual Report on Form 10-K in regards to application or related judgements and estimates used. Please refer to Item 7 of the Corporation’s 2006 Annual Report on Form 10-K for a more detailed disclosure of the critical accounting policies.
Results of Operations
The results of operations for 2007 reflect the acquisition of Fulton Bancshares Corporation on July 1, 2006, which are not reflected in the first quarter 2006 results.
Summary
The Corporation reported net income for the quarter ended March 31, 2007 of $2.1 million. This is a 38.6% increase versus net income of $1.5 million for the first quarter of 2006 and was driven by an increase of net interest income. Diluted earnings per share also increased from $.44 in 2006 to $.54 in 2007. Total assets were $796.7 million at March 31, 2007, down slightly from year-end 2006. Net loans and total deposits both grew during the quarter with ending balances of $530.6 million and $609.2 million, respectively.
Other key performance ratios as of, or for the three months ended March 31 (on an annualized basis) are listed below:
| | 2007 | | 2006 | |
Return on average equity (ROE) | | 11.36 | % | 10.60 | % |
Return on average assets (ROA) | | 1.03 | % | .96 | % |
Return on average tangible average equity(1) | | 14.22 | % | 10.60 | % |
Return on average tangible average assets(1) | | 1.09 | % | .96 | % |
(1) The Corporation supplements its traditional GAAP measurements with Non-GAAP measurements. The Non-GAAP measurements include Return on Average Tangible Assets and Return on Average Tangible Equity. The purchase method of accounting was used to record the acquisition of Fulton Bancshares Corporation. As a result, intangible assets (primarily goodwill and core deposit intangibles) were created. The Non-GAAP disclosures are intended to eliminate the effects of the intangible assets and allow for better comparisons to periods when such assets did not exist. The following table shows the adjustments made between the GAAP and NON-GAAP measurements:
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GAAP Measurement | | Calculation |
Return on Average Assets | | Net Income / Average Assets |
Return on Average Equity | | Net Income / Average Equity |
Non- GAAP Measurement | | Calculation |
Return on Average Tangible Assets | | Net Income plus Intangible Amortization / |
| | Average Assets less Average Intangible Assets |
Return on Average Tangible Equity | | Net Income plus Intangible Amortization / |
| | Average Equity less Average Intangible Assets |
A more detailed discussion of the operating results for the three months ended March 31, 2007 follows:
Net Interest Income
Comparison of the three months ended March 31, 2007 to the three months ended March 31, 2006:
Net interest income for the quarter was $5.9 million and represents an increase of $1.3 million over net interest income of $4.6 million in the first quarter of 2006. Interest income increased $3.5 million (41%) during the quarter, reaching $11.9 million as compared to $8.4 million in the prior year. The majority of the increase in interest income occurred in the loan portfolio and was the result of an increase of $128.3 million in average outstanding loans quarter over quarter. The increase in the loan portfolio occurred primarily in the commercial loan portfolio.
Interest expense was $6.0 million for the quarter, an increase of $2.2 million from the prior year quarter. The largest contributor to the increase in interest expense was the Money Management product that is indexed to short-term interest rates. Interest expense on this product increased $1.1 million quarter over quarter as average balances increased $78.0 million.
The following table shows a comparative analysis of average balances, asset yields and funding costs for the three months ended March 31, 2007 and 2006. These components drive changes in net interest income.
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| | For the Three Months Ended March 31 | |
| | 2007 | | 2006 | |
| | | | Tax | | | | | | Tax | | | |
| | Average | | Equivalent | | Average | | Average | | Equivalent | | Average | |
(Dollars in thousands) | | balance | | Interest | | yield/rate | | balance | | Interest | | yield/rate | |
Interest-earning assets | | | | | | | | | | | | | |
Federal funds sold and interest bearing balances | | $ | 4,873 | | $ | 63 | | 5.17 | % | $ | 5,200 | | $ | 60 | | 4.62 | % |
Investment securities | | 186,811 | | 2,464 | | 5.35 | % | 163,301 | | 1,921 | | 4.77 | % |
Loans | | 533,780 | | 9,608 | | 7.30 | % | 405,516 | | 6,669 | | 6.67 | % |
Total interest-earning assets | | 725,464 | | 12,135 | | 6.78 | % | 574,017 | | 8,650 | | 6.11 | % |
| | | | | | | | | | | | | |
Interest-bearing liabilities | | | | | | | | | | | | | |
| | | | | | | | | | | | | |
Interest-bearing deposits | | 516,947 | | 4,564 | | 3.58 | % | 384,504 | | 2,658 | | 2.80 | % |
Securities sold under agreements to repurchase | | 73,700 | | 913 | | 5.02 | % | 52,812 | | 542 | | 4.16 | % |
Short-term borrowings | | 1,739 | | 24 | | 5.60 | % | 2,285 | | 27 | | 4.79 | % |
Long-term debt | | 37,312 | | 488 | | 5.30 | % | 47,244 | | 607 | | 5.21 | % |
Total interest-bearing liabilities | | 629,698 | | 5,989 | | 3.86 | % | 486,845 | | 3,834 | | 3.19 | % |
| | | | | | | | | | | | | |
Interest spread | | | | | | 2.92 | % | | | | | 2.92 | % |
Net interest income/Net interest margin | | | | 6,146 | | 3.44 | % | | | 4,816 | | 3.40 | % |
Tax equivalent adjustment | | | | (283 | ) | | | | | (251 | ) | | |
Net interest income | | | | $ | 5,863 | | | | | | $ | 4,565 | | | |
| | | | | | | | | | | | | | | | | |
Provision for Loan Losses
The Corporation recorded $150 thousand for the provision for loan losses during the first quarter of 2007 versus $180 thousand for the same period in 2006.
For more information concerning loan quality and the allowance for loan losses, refer to the Asset Quality discussion.
Noninterest Income
Comparison of the three months ended March 31, 2007 to the three months ended March 31, 2006:
Noninterest income, excluding security gains, was $2.2 million in the first quarter, 28.3% greater than the first quarter of 2006 total of $1.7 million. Investment and trust service fees increased $199 thousand in the first quarter of 2007 versus the prior year period. Most of this increase was due to fees from estate settlements. Service charges and fees increased $139 thousand quarter over quarter. Contributing to this increase were retail deposit fees (up $69 thousand) and fees from debit card activity (up $25 thousand). Deposit fees have been boosted by continued growth of the Bank’s overdraft protection program. Mortgage banking fees increased from 2006 as the result of the reversal of impairment of $35 thousand in 2007 versus an impairment charge of $12 thousand in 2006. The increase in income from bank owned life insurance is due solely to additional assets recorded in the acquisition. The Corporation has an investment in American Home Bank, N.A. This investment produced a loss of $57 thousand in the first quarter of 2007, compared to a loss of $76 thousand in the first quarter of 2006. Other income also increased quarter over quarter due to a settlement of $50 thousand from a class action lawsuit involving an equity security previously owned by the Bank. Securities gains of $278 thousand were recognized in the first quarter of 2007 compared to gains of $95 thousand recognized in 2006.
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Noninterest Expense
Comparison of the three months ended March 31, 2007 to the three months ended March 31, 2006:
During the first quarter of 2007, noninterest expense increased $1.2 million to $5.7 million from $4.5 million in 2006. All categories of noninterest expense increased quarter over quarter. Salaries and benefits increased $530 thousand in 2007. Within this category, employee salaries increased $375 thousand due mainly to the addition of employees from the acquisition and a $93 thousand increase in the Bank’s incentive compensation plan. For the first quarter, the Corporation recorded stock option compensation of $31 thousand versus $14 thousand in 2006. Advertising expense increased $35 thousand and was due in part to first quarter promotion of the opening of the Bank’s twenty-fourth community office on April 3, 2007. Occupancy expense was up $154 thousand due to the addition of six community offices gained in the acquisition and the opening of a new community office in the fourth quarter of 2006. The Bank’s shares tax expense also increased $47 thousand as a result of the acquisition. The Bank recorded a core deposit intangible asset in the acquisition and the amortization of this asset added $90 thousand to noninterest expense during the quarter. However, intangible amortization increased only $44 thousand over 2006 because the amortization of a prior intangible asset was completed in 2006. Other noninterest expense increased $369 thousand during the quarter and includes increases in postage and telephone, as well as nonrecurring expense of $277 thousand from a prepayment penalty on an FHLB term debt payoff.
Financial Condition
At March 31, 2007, total assets of the Corporation were $796.7 million, down slightly from $799.3 million at year-end 2006. Total cash and cash equivalents increased by $1.5 million from year-end 2006 to $23.6 million. However, the mix changed from year-end 2006 as cash and due from banks decreased by $8.3 million and Federal funds sold increased $7.8 million. The increase in Federal funds sold occurred near the end of the quarter and was significantly higher than the average balance for the quarter of $4.0 million. The balance of investment securities fell slightly since year-end as maturing cash flows were reinvested in loans or invested in federal funds sold. Net loans have increased $8.9 million since year-end. Commercial lending activity continues to be strong and these balances have increased approximately $9.4 million during the quarter. However, this growth was somewhat offset by a decrease in mortgage loans. At March 31, 2007, the balance of the core deposit intangible was $3.0 million and goodwill totaled $9.1 million.
Total deposits increased $13.9 million to $609.2 million at March 31, 2007, with the Money Management product recording an increase of $22.7 million during the three-month period. The balances in demand deposits, savings and CDs decreased from December 31, 2006 to March 31, 2007, as some of these funds moved to the Money Management product. Securities sold under agreements to repurchase (Repo) have decreased $6.6 million during the three-month period due to a reduction in one large account. Likewise, long-term debt has decreased by $4.8 million due primarily to the prepayment of a $4.1 million term loan in the first quarter. The prepayment of long-term debt was undertaken to eliminate high interest rate debt.
Total shareholders’ equity recorded a net increase of $1.2 million to $72.8 million at March 31, 2007 from $71.6 million at December 31, 2006. Cash dividends declared in the first quarter were $960 thousand.
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Capital adequacy is currently defined by regulatory agencies through the use of several minimum required ratios. At March 31, 2007, the Corporation was well capitalized as defined by the banking regulatory agencies. Regulatory capital ratios for the Corporation and the Bank are shown below:
| | | | Regulatory Ratios | |
| | | | | | Well Capitalized | |
| | March 31, 2007 | | Minimum | | Minimum | |
Total Risk Based Capital Ratio | | | | | | | |
Franklin Financial Services Corporation | | 12.02 | % | 8.0 | % | n/a | |
Farmers & Merchants Trust Company | | 10.18 | % | 8.0 | % | 10.0 | % |
| | | | | | | |
Tier 1 Capital Ratio | | | | | | | |
Franklin Financial Services Corporation | | 10.74 | % | 4.0 | % | n/a | |
Farmers & Merchants Trust Company | | 8.92 | % | 4.0 | % | 6.0 | % |
| | | | | | | |
Leverage Ratio | | | | | | | |
Franklin Financial Services Corporation | | 7.74 | % | 4.0 | % | n/a | |
Farmers & Merchants Trust Company | | 6.40 | % | 4.0 | % | 5.0 | % |
Asset Quality
Nonperforming loans decreased slightly from year-end 2006 and totaled $2.2 million at quarter-end. Likewise, the composition of nonperforming loans is nearly the same as it was at year-end 2006. The Corporation held no foreclosed real estate on March 31, 2007. The following table presents a summary of nonperforming assets:
| | March 31 | | December 31 | |
(Dollars in thousands) | | 2007 | | 2006 | |
Nonaccrual loans | | $ | 1,104 | | $ | 1,179 | |
Loans past due 90 days or more and not included above | | 1,104 | | 1,148 | |
Total nonperforming loans | | 2,208 | | 2,327 | |
Foreclosed real estate | | — | | — | |
Total nonperforming assets | | $ | 2,208 | | $ | 2,327 | |
| | | | | |
Nonperforming loans to total loans | | 0.41 | % | 0.44 | % |
Nonperforming assets to total assets | | 0.28 | % | 0.29 | % |
Allowance for loan losses to nonperforming loans | | 313.72 | % | 294.37 | % |
During the first quarter of 2007, the Bank recorded net loan charge-offs of $73 thousand, compared to net loan charge-offs of $62 thousand in the first quarter of 2006. The net charge-off ratio for the first quarter of 2007 was .05%. The majority of the charge-offs occurred in the Bank’s consumer loan portfolio. The provision for loan losses was $150 thousand for the quarter, less than the provision expense of $180 thousand in 2006. The allowance for loan losses as a percentage of loans was 1.29% on March 31, 2007 virtually unchanged from 1.30% on December 31, 2006.
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The Corporation monitors the adequacy of the allowance for loan losses on an ongoing basis and reports its adequacy assessment monthly to the Board of Directors. This assessment is used to determine the provision for loan losses and Management is confident in the adequacy of the allowance for loan losses. The following table presents an analysis of the allowance for loan losses.
Allowance for Loan Losses
| | | | | | Twelve | |
| | Three Months Ended | | Months Ended | |
| | March 31 | | December 31 | |
(amounts in thousands) | | 2007 | | 2006 | | 2006 | |
Balance at beginning of period | | $ | 6,850 | | $ | 5,402 | | $ | 5,402 | |
Charge-offs | | (147 | ) | (78 | ) | (384 | ) |
Recoveries | | 74 | | 16 | | 200 | |
Net loans (charged-off) | | (73 | ) | (62 | ) | (184 | ) |
Addition of Fulton allowance | | — | | — | | 1,392 | |
Provision for loan losses | | 150 | | 180 | | 240 | |
Balance at end of period | | $ | 6,927 | | $ | 5,520 | | $ | 6,850 | |
| | | | | | | |
Allowance as a percent of loans | | 1.29 | % | 1.36 | % | 1.30 | % |
Net loans charged-off as a percentage average loans* | | 0.05 | % | 0.06 | % | 0.04 | % |
* annualized
Economy
The Corporation operates in Franklin, Cumberland, Fulton and Huntingdon Counties, PA. The economic conditions in this market continue to be strong and unemployment rates continue to remain low in comparison to state and national levels. The Corporation is not overly dependent on any one industry within its market area and the industries located in its market area are well diversified.
Unlike many companies, the assets and liabilities of the Corporation are financial in nature. As such, interest rates and changes in interest rates may have a more significant effect on the Corporation’s financial results than on other types of industries. Because of this, the Corporation watches the actions of the Federal Reserve Open Market Committee (FOMC) as it makes decisions about interest rate changes. The FOMC’s cycle of rate increases appears to have ended; however, the yield curve remains inverted or flat. Economic forecasts now suggest that the FOMC may reduce its Federal funds target rate in late 2007 and the yield curve is expected to begin to return to a positive slope as other short-term rates fall. A decrease in short-term rates and a positively sloped yield curve should have a positive effect on the Corporation’s performance.
Liquidity
The Corporation must meet the financial needs of the customers that it serves, while providing a satisfactory return on the shareholders’ investment. In order to accomplish this, the Corporation must maintain sufficient liquidity in order to respond quickly to the changing level of funds required for both loan and deposit activity. The goal of liquidity management is to meet the ongoing cash flow
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requirements of depositors who want to withdraw funds and of borrowers who request loan disbursements. Historically, the Corporation has satisfied its liquidity needs from earnings, repayment of loans and amortizing investment securities, maturing investment securities, loan sales, deposit growth and its ability to access existing lines of credit. All investments are classified as available for sale; therefore, securities that are not pledged as collateral for borrowings are an additional source of readily available liquidity.
Another source of available liquidity for the Bank is a line of credit with the Federal Home Loan Bank of Pittsburgh (FHLB). At March 31, 2007, the Bank had approximately $201 million available on its line of credit with the FHLB that it could borrow to meet any liquidity needs. The Bank’s primary liquidity reserve at March 31, 2007 was $260.1 million. The reserve is comprised of the Bank’s unused borrowing capacity at FHLB plus its unpledged investment securities. The Bank regularly forecasts its liquidity needs through its asset/liability process and believes it can meet all anticipated liquidity demands. The Bank also has a $10 million line of credit with a correspondent bank.
Off Balance Sheet Commitments and Contractual Obligations
The Corporation’s financial statements do not reflect various commitments that are made in the normal course of business, which may involve some liquidity risk. These commitments consist mainly of unfunded loans and letters of credit made under the same standards as on-balance sheet instruments. Because these instruments have fixed maturity dates, and because many of them will expire without being drawn upon, they do not generally present any significant liquidity risk to the Corporation. Unused commitments and standby letters of credit totaled $137.2 million and $137.3 million, respectively, at March 31, 2007 and December 31, 2006.
The Corporation has also entered into interest rate swap agreements as part of its interest rate risk management strategy. At March 31, 2007, there was one open swap contract with a notional amount of $5 million and a maturity date of July 11, 2008.
The Corporation has entered into various contractual obligations to make future payments. These obligations include time deposits, long-term debt, operating leases, deferred compensation and pension payments.
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PART I, Item 3
Quantitative and Qualitative Disclosures about Market Risk
There were no material changes in the Corporation’s exposure to market risk during the first quarter ended March 31, 2007. For more information on market risk refer to the Corporation’s 2006 Annual Report on Form 10-K.
PART I, Item 4
Controls and Procedures
Evaluation of Controls and Procedures
The Corporation carried out an evaluation, under the supervision and with the participation of the Corporation’s management, including the Corporation’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of its disclosure controls and procedures, as defined in Exchange Act Rules 13a-15(e) and 15d-15(e). Based upon the evaluation, the Corporation’s Chief Executive Officer and Chief Financial Officer concluded that as of March 31, 2007, the Corporation’s disclosure controls and procedures are effective. Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in the Corporation’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.
The management of the Corporation is responsible for establishing and maintaining adequate internal control over financial reporting. The Corporation’s internal control system is 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.
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.
Changes in Internal Controls
Management assessed the effectiveness of the Corporation’s internal control over financial reporting as of December 31, 2006, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control – Integrated Framework. Based on this assessment, management concluded that, as of December 31, 2006, the Corporation’s internal control over financial reporting is effective based on those criteria.
There were no changes during the first quarter of 2007 in the Corporation’s internal control over financial reporting which materially affected, or which are reasonably likely to affect, the Corporation’s internal control over financial reporting.
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