The following is a reconciliation of the denominators of the basic and diluted per share computations for net income for the three months and six months ended June 30, 2004 and 2003. There is no required reconciliation of the numerator from the net income reported on the accompanying statements of income. All average share and per share data have been restated to reflect all stock dividends as of the earliest period presented.
The Company reports information about its operating segments in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information”. Summit Financial Corporation is the parent holding company for Summit National Bank (“Bank”), a nationally chartered bank, and Freedom Finance, Inc. (“Finance”), a consumer finance company. The Company considers the Bank and the Finance Company separate business segments.
Financial performance for each segment is detailed in the following tables. Included in the “Corporate” column are amounts for general corporate activities and eliminations of intersegment transactions.
PART I. FINANCIAL INFORMATION
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following information presents management’s discussion and analysis of the financial condition and results of operations of Summit Financial Corporation (“the Company” or “Summit Financial”), a financial holding company, and its wholly-owned subsidiaries, Summit National Bank (“the Bank” or “Summit”) and Freedom Finance, Inc. (“the Finance Company” or “Freedom”). The Bank, which is the principal subsidiary, owns all the outstanding shares of Summit Investment Services, Inc. Throughout this discussion and analysis, the term “the Company” refers to Summit Financial Corporation and its subsidiaries.
This discussion and analysis should be read in conjunction with the consolidated financial statements and related notes and with the statistical information and financial data appearing in this report as well as the Annual Report of Summit Financial Corporation (the “Company”) on Form 10K for the year ended December 31, 2003. Certain reclassifications have been made to prior years’ financial data to conform to current financial statement presentations as well as to reflect the effect of the 5% stock dividend paid in December 2003. Results of operations for the three month and six month periods ended June 30, 2004 are not necessarily indicative of results to be attained for any other period.
FORWARD-LOOKING STATEMENTS
Certain statements contained herein are “forward-looking statements” identified as such for purposes of the safe harbor provided in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but are not limited to, statements as to industry trends, future results of operations or financial position, borrowing capacity and future liquidity, future investment results, future credit exposure, future loan losses and plans and objectives for future operations, and other statements that do not relate strictly to historical facts. These statements are not historical facts, but instead are based on current expectations, estimates and projections about the Company, are subject to numerous assumptions, risks and uncertainties, and represent only management’s belief regardi ng future events, many of which, by their nature, are inherently uncertain and outside the Company’s control. Any forward-looking statements made speak only as of the date on which such statements are made. The Company disclaims any obligation to update any forward-looking statements. Forward-looking statements are not guarantees of future performance and it is possible that actual results and financial position may differ, possibly materially, from the anticipated results and financial condition indicated in or implied by these forward-looking statements.
Factors that could cause actual results to differ from those indicated by any forward-looking statements include, but are not limited to, the following:
Inflation, interest rates, market and monetary fluctuations;
Geopolitical developments and any future acts or threats of war or terrorism;
The effects of, and changes in trade, monetary and fiscal policies and laws, including interest policies of the Federal Reserve;
A decline in general economic conditions and the strength of the local economies in which the Company operates;
The financial condition of the Company’s borrowers and potential deterioration of credit quality;
Competitive pressures on loan and deposit pricing and demand;
Changes in technology and their impact on the marketing of products and services;
The timely development and effective marketing of competitive new products and services;
The impact of changes in financial service laws and regulations, including laws concerning taxes, banking, securities and insurance;
Changes in accounting principles, policies, and guidelines;
The Company’s success at managing the risks involved in the foregoing as well as other risks and uncertainties detailed from time to time in press releases and other public filings.
NON-GAAP FINANCIAL INFORMATION
This report contains certain financial information determined by methods other than in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The Company’s management uses these non-GAAP measures to analyze the Company’s performance. In particular, net interest income and net interest margin ratios are presented on a fully tax-equivalent basis. Management believes that the presentation of net interest margin on a fully tax-equivalent basis aids in the comparability of net interest margin arising from both taxable and tax-exempt sources. These disclosures should not be viewed as a substitute for GAAP measures, and furthermore, the Company’s non-GAAP measures may not necessarily be comparable to non-GAAP performance measures of other companies.
COMPANY BUSINESS
The Company is headquartered in Greenville, South Carolina. Through its primary subsidiary, the Bank, the Company offers a full range of financial products and services, including business and consumer loans, commercial and residential mortgage lending and brokerage, asset-based financing, corporate and consumer deposit services, and investment management services. The Bank currently has four full service offices in Greenville and Spartanburg, South Carolina. Freedom is a consumer finance company headquartered in Greenville, South Carolina. The Finance Company primarily makes and services installment loans to individuals with loan principal amounts generally not exceeding $2,000 and with maturities ranging from three to 18 months. Freedom operates 11 branches throughout South Carolina.
CRITICAL ACCOUNTING POLICIES
The preparation of consolidated financial statements requires management to make estimates and assumptions in the application of certain of its accounting policies about the effect of matters that are inherently uncertain. These estimates and assumptions affect the reported amounts of certain assets, liabilities, revenues and expenses. Different amounts could be reported under different conditions, or if different assumptions were used in the application of these accounting policies. The Company’s accounting policies are discussed in Note 1 under Notes to Consolidated Financial Statements included in the Company’s Form 10-K for December 31, 2003. Of these significant accounting policies, the Company has determined that accounting for the allowance for loan losses and income taxes are deemed critical because of the valuation techniques used, and the sensitivity of these fi nancial statement amounts to the methods, assumptions and estimates underlying these balances. Accounting for these critical areas requires the most subjective and complex judgments that could be subject to revision as new information becomes available.
The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. This estimate is based on the current economy’s impact on the timing and expected amounts of future cash flows on problem or impaired loans, as well as historical loss experience associated with homogenous pools of loans. The Company’s assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements.
The income tax calculations reflect the current period income tax expense for all periods shown, as well as future tax liabilities associated with differences in the timing of expenses and income recognition for book and tax accounting purposes. The income tax returns, usually filed six months after year-end, are subject to review and possible revision by the tax authorities up until the statute of limitations has expired. These statutes usually expire three years after the time the respective tax returns have been filed.
BALANCE SHEET ACTIVITY
Total assets decreased $8.9 million or 3% from December 31, 2003 to June 30, 2004 to total $335.0 million. The decrease was primarily related to a reduction in investment securities from sales, calls, and maturities totaling $26.2 million. A portion of the liquidity generated from the sales of securities was temporarily invested in overnight federal funds sold until needed for loan originations and maturing deposits or FHLB advances. This resulted in an increase in federal funds sold from year end of $12.9 million and interest-bearing deposits of $4.5 million. The decision to restructure the balance sheet through the sale of investment securities was a strategy to manage the expectations of further changes in the treasury market. The securities selected for sale were to reposition the investment portfolio to reduce the price risk and volatility, and to reduce the extension risk ari sing from increases in the treasury yield curve resulting in a slow down in cash flows from mortgage-backed securities and callable agency securities.
Deposits decreased $8.6 million or 3% during the period to total $248.4 million. A majority of the decrease in deposits was in the time deposit categories, and were primarily non-core deposit accounts from outside the local market which management made a strategic decision to let leave the Bank upon maturity. Management made the decision to not retain these deposits in order to reduce the Bank’s cost of funds, return the loan-to-deposit ratios to more historic levels in order to maximize net interest margin, and to focus on local market deposits.
In addition to the retention of earnings, total equity increased $1.3 million, or 4%, related to the exercise of stock options during the first six months of the year. Increases in equity were partially offset by cash dividend of $312,000 declared in June 2004, and the higher unrealized loss on investment securities, net of taxes, totaling $1,064,000 at June 30, 2004, compared to an unrealized gain of $28,000 at December 31, 2003. The securities contributing to the unrealized loss are considered to have a temporary impairment in value resulting primarily from the significant market shifts in the Treasury yield curve over the past year. The Company has demonstrated an ability to hold securities until maturity, thus an actual loss may not be realized. There has been no credit quality deterioration of any of the securities with unrealized losses and the agency securities carry the imp lied guarantee of the U.S. Government.
ALLOWANCE FOR LOAN LOSSES AND NON-PERFORMING ASSETS
The allowance for loan losses is established through charges in the form of a provision for loan losses based on management’s periodic evaluation of the loan portfolio. Loan losses and recoveries are charged or credited directly to the allowance. The amount of the allowance reflects management’s opinion of an adequate level to absorb probable losses inherent in the loan portfolio at June 30, 2004. In assessing the adequacy of the allowance and the amount charged to the provision, management relies predominately on its ongoing review of the loan portfolio, which is undertaken both to ascertain whether there are losses which must be charged-off, and to assess the risk characteristics of the portfolio in the aggregate as well as the credit risk associated with particular loans. The Company’s methodology for evaluating the adequacy of the allowance for loan losses incorp orates management’s current judgments about the credit quality of the loan portfolio through a disciplined and consistently applied process. The methodology includes segmentation of the loan portfolio into reasonable components based on loan purpose for calculation of the most accurate reserve. Appropriate reserve estimates are determined for each segment based on a review of individual loans, application of historical loss factors for each segment, and adjustment factors applied as considered necessary. The adjustment factors are applied consistently and are quantified for consideration of national and local economic conditions; exposure to concentrations that may exist in the portfolio; impact of off-balance sheet risk; alterations of lending policies and procedures; the total amount of and changes in trends of past due loans, nonperforming loans, problem loans and charge-offs; the total amount of and changes in trends of the Bank’s classified loans; variations in the nature, maturity, compositio n, and growth of the loan portfolio; changes in trends of collateral value; entry into new markets; and other factors which may impact the current credit quality of the loan portfolio.
Management maintains an allowance for loan losses which it believes adequate to cover probable losses in the loan portfolio. It must be emphasized, however, that the determination of the allowance for loan losses using the Company’s procedures and methods rests upon various judgments and assumptions about future economic conditions, events, and other factors affecting loans which are believed to be reasonable, but which may or may not prove valid. While it is the Company’s policy to provide for the loan losses in the current period in which a loss is considered probable, there are additional risks of future losses which cannot be quantified precisely or attributed to particular loans or classes of loans. Because these risks include the state of the economy, industry trends, and conditions affecting individual borrowers, management’s judgment of the allowance is neces sarily approximate and imprecise. No assurance can be given that the Company will not in any particular period sustain loan losses which would be sizable in relationship to the amount reserved or that subsequent evaluation of the loan portfolio, in light of conditions and factors then prevailing, will not require significant changes in the allowance for loan losses or future charges to earnings. The allowance for loan losses is also subject to review by various regulatory agencies through their periodic examinations of the Company’s subsidiaries. Such examination could result in required changes to the allowance for loan losses. No adjustment in the allowance or significant adjustments to the Bank’s internal classified loans were made as a result of the Bank’s most recent examination performed by the Office of the Comptroller of the Currency.
The following table sets forth certain information with respect to changes in the Company’s allowance for loan losses for each period presented.
(dollars in thousands) | At and Forthe Six MonthsEndedJune 30, 2004 | | At and Forthe YearEndedDecember 31, 2003 | | At and Forthe Six MonthsEndedJune 30, 2003 | |
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| Balance at beginning of period | | $ | 3,437 | | $ | 3,369 | | $ | 3,369 | |
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Charge-offs: | | | | | | | | | | |
| Commercial and industrial | | | - | | | 167 | | | 37 | |
| Commercial real estate | | | 30 | | | 388 | | | 115 | |
| Installment and consumer | | | 230 | | | 519 | | | 180 | |
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| | | | 260 | | | 1,074 | | | 332 | |
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Recoveries: | | | | | | | | | | |
| Commercial and industrial | | | 33 | | | 2 | | | - | |
| Commercial real estate | | | 115 | | | 205 | | | 151 | |
| Installment and consumer | | | 69 | | | 149 | | | 42 | |
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| | | | 217 | | | 356 | | | 193 | |
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| Net charge-offs | | | (43 | ) | | (718 | ) | | (139 | ) |
| Provision charged to expense | | | 160 | | | 786 | | | 402 | |
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| Balance at end of period | | $ | 3,554 | | $ | 3,437 | | $ | 3,632 | |
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| Net charge-offs to average loans, annualized | | | 0.04 | % | | 0.32 | % | | 0.12 | % |
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| Allowance to loans, period end | | | 1.55 | % | | 1.48 | % | | 1.63 | % |
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The Company’s nonperforming assets consist of loans on non-accrual basis, loans which are contractually past due 90 days or more on which interest is still being accrued, troubled debt restructurings, and other real estate owned (“OREO”). Generally, loans of the Bank are placed on non-accrual status at the earlier of when they are 90 days past due or when the collection of the loan becomes doubtful. Loans of the Finance Company are not classified as non-accrual, but are charged-off when such become 150 days contractually past due or earlier if the loan is deemed uncollectible. There were no loans considered to be impaired under Statement of Financial Accounting Standards (“SFAS”) 114,“Accounting by Creditors for Impairment of a Loan” for any period presented. The following table summarizes the nonper forming assets for each period presented.
(dollars in thousands) | | | June 30, 2004 | | December 31,2003 | | | June 30, 2003 | |
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| Loans past due 90 days or more, still accruing | | $ | 125 | | $ | 170 | | $ | 137 | |
| Non-accrual loans | | | 189 | | | 587 | | | 591 | |
| Troubled debt restructurings | | | - | | | - | | | - | |
| Other real estate owned | | | 230 | | | 125 | | | - | |
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| Total nonperforming assets | | $ | 544 | | $ | 882 | | $ | 728 | |
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| Nonperforming assets to total loans and OREO | | | 0.24 | % | | 0.38 | % | | 0.33 | % |
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Management maintains a list of potential problem loans which includes non-accrual loans, loans past due in excess of 90 days which are still accruing interest, and other loans which are credit graded (either graded internally, by independent review or regulatory examinations) as “watch”, “OAEM”, “substandard”, “doubtful”, or “loss”. A loan is added to the list when management becomes aware of information about possible credit problems of borrowers that causes doubts as to the ability of such borrowers to comply with the current loan repayment terms. The total amount of adversely classified loans (i.e., defined as loans with a credit grade of “substandard”, “doubtful”, or “loss”) at June 30, 2004 was $7.6 million or 3.3% of the loan portfolio at June 30, 2004, compared to $3.5 million or 1.5% of the loan portfolio at December 31, 2003, and $3.1 million or 1.4% of the loan portfolio at June 30, 2003. The amount of potential problem loans at June 30, 2004 does not represent management’s estimate of potential losses since the majority of such loans are considered adequately secured by real estate or other collateral. Although adversely classified loans have increased somewhat during the six months ended June 30, 2004, loans classified as OAEM have decreased substantially by $10.7 million since December 31, 2003. The overall decrease in the amount of classified loans in 2004 is primarily related to the significant payoffs and paydowns in loans and management proactively worked these loans to improve the quality of the portfolio, as well as an improvement in the general economic conditions during the period. Management believes that the allowance for loan losses as of June 30, 2004 is adequate to absorb any losses related to the nonperforming loans and potential problem loans as of that date. Management con tinues to monitor closely the levels of nonperforming and potential problem loans, and will address the weaknesses in these credits to enhance the amount of ultimate collection or recovery on these assets. Should increases in the overall level of nonperforming and potential problem loans accelerate from the current trend, management will adjust the methodology for determining the allowance for loan losses and will increase the provision for loan losses accordingly. This would likely decrease net income.
The allowance for loan losses totaled $3.6 million, or 1.55% of total loans, at June 30, 2004. This is compared to a $3.4 million allowance, or 1.48% of total loans, at December 31, 2003, and $3.6 million, or 1.63% of total loans at June 30, 2003. The fluctuations in the allowance for loan losses as a percent of loans between June 30, 2003, December 31, 2003 and June 30, 2004 is reflective of the factors discussed previously, as well as under the “Provision for Loan Losses” section below, primarily related to change in levels of and trends in classified loans between the periods.
EARNINGS REVIEW – COMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2004 AND 2003
GENERAL
The Company reported consolidated net income for the three months ended June 30, 2004 of $1,120,000, compared to net income of $1,059,000 for the three months ended June 30, 2003, or an improvement of approximately $61,000 or 6%. The primary contributors to increased earnings for the second three months of 2004 was the lower provision for loan losses and control of overhead expenses. The reduction in the provision for loan losses was related to the $11.2 million reduction in loans outstanding during the second quarter of 2004. Also contributing to the negative provision for the quarter, discussed further below, is the overall improvement of credit quality in the loan portfolio as demonstrated by the reduction in net charge-offs, nonperforming assets and classified loans since year end. The increases in income were somewhat offset by the 30% reduction in other income as a result of lower gains on sales of investment securities and mortgage referral fees.
NET INTEREST INCOME
Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company’s earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During both the quarters ended June 30, 2004 and June 30, 2003, the Company recorded net interest income of $3.1 million. The 2% increase in average earning assets between the two periods was offset by the 6 basis point (2%) reduction in net interest margin, thus the nominal reduction of $1,000 from the second quarter of 2003 to the second quarter of 2004.
For the three months ended June 30, 2004 and June 30, 2003, the Company’s net interest margin was 4.04% and 4.10%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The decrease in net interest margin is related primarily to the 39 basis point reduction in the average yield on assets, offset somewhat by the 35 basis point reduction in the average cost of funds. Rates on both assets and liabilities declined in 2003 and into 2004 due to the general low interest rate environment and the maturity of higher priced investments, loans, deposits and other borrowings which were reinvested or renewed at lower current market rates. During the period between the second quarter of 2003 and 2004, the average prime rate decreased 24 basis points to 4.00%.
INTEREST INCOME
For the three months ended June 30, 2004, the Company’s earning assets averaged $316.1 million and had an average yield of 5.48%. This compares to average earning assets of $308.8 million for the second quarter of 2003, yielding approximately 5.87%. Thus, the 39 basis point decrease in average yield, offset somewhat by the 2% increase in volume of average earning assets, accounts for the $226,000 (5%) decrease in interest income between the second quarters of 2003 and 2004.
Gross loans comprised approximately 74% of the Company’s average earning assets for the second quarter of 2004 and compared to 73% for the second quarter of 2003. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s loan portfolio is at floating rates at June 30, 2004), which averaged 4.00% and 4.24% for the quarters ended June 30, 2004 and 2003, respectively. During the second quarter of 2004, loans averaged $234.9 million, yielding an average of 5.87%, compared to $225.7 million, yielding an average of 6.32% for the second three months of 2003. The 45 basis point decrease in the average yield on loans is directly related to the reductions in the general interest rate environment and lower prime lending rate between 2003 and 2004, combined with the repricing and renewal of fixed rate loans at lower current market rates. The 4% incre ase in average loans was more than offset by the lower average yields and resulted in the reduction in interest income on loans of $124,000 or 3.5%.
Investment securities averaged $67.3 million or 21% of average earning assets and yielded 4.92% (tax equivalent basis) during the second quarter of 2004, compared to average securities of $76.7 million yielding 4.83% (tax equivalent basis) for the three months ended June 30, 2003. The 10 basis point increase in the average yield of the investment portfolio is related to the general increase in treasury market interest rates during 2004, sales of lower yielding investments during the period, the overall portfolio mix, and the slow down in mortgage-backed securities principal payments. As of June 30, 2004, the portfolio had a weighted average life of approximately 6.9 years and an average duration of 5.5 years. This is compared to a weighted average life of 7.7 years and an average duration of 6.0 years as of December 31, 2003. The 12% decrease in average securities, offset somewhat by the increase in yield, resulted in the net decrease of interest income on taxable and nontaxable investments of $116,000 or 14%.
INTEREST EXPENSE
The Company’s interest expense for the three months ended June 30, 2004 was $1.1 million. The decrease in interest expense of $225,000, or 17%, from the comparable quarter in 2003 of $1.4 million was related primarily to the 35 basis point decrease in the average rate on liabilities, offset by the slight increase in the level of average interest-bearing liabilities. Interest-bearing liabilities averaged $260.2 million for the second quarter of 2004 with an average rate of 1.76%. This is compared to average interest-bearing liabilities of $258.9 million with an average rate of 2.11% for the quarter ended June 30, 2003. The decrease in average rate on liabilities is directly related to the general reductions in market interest rates and the maturities of fixed rate deposits and other borrowings which were renewed at lower current market rates.
PROVISION FOR LOAN LOSSES
The provision for loan losses was a negative ($50,000) for the second quarter of 2004, compared to expense of $229,000 for the comparable period of 2003. As discussed further under the “Allowance for Loan Losses” section above, in addition to the level of net originations, other factors influencing the amount charged to the provision each period include (1) trends in and the total amount of past due, nonperforming, and classified loans; (2) trends in and the total amount of net chargeoffs, (3) concentrations of credit risk in the loan portfolio, and (4) local and national economic conditions and anticipated trends. Thus, the $279,000 or 122% decrease in the provision for loan losses is related to the net reduction in loans outstanding in the second quarter of 2004 of $11.2 million compared to net origination of $2.8 million for the second quarter of 2003. In addition, con tributing to the negative provision expense for the quarter is the overall improvement in credit quality of the loan portfolio as evidenced by the reduction in net charge-offs, past due loans, nonperforming assets and classified loans. Estimates charged to the provision for loan losses are based on management’s judgment as to the amount required to cover probable losses in the loan portfolio and are adjusted as necessary based on a calculated model quantifying the estimated required balance in the allowance.
NONINTEREST INCOME AND EXPENSES
Noninterest income, which is primarily related to service charges on customers’ deposit accounts; credit card merchant discount fees; commissions on nondeposit investment product sales and insurance product sales; mortgage origination fees; and gains on sales of investment securities, was $599,000 for the three months ended June 30, 2004 compared to $855,000 for the second quarter of 2003, or a decrease of 30%. The decrease is related to the lower gains on sales of securities, which decreased $181,000 due to the reduction in volume of sales transactions. Also contributing to the lower other income was a reduction in mortgage referral fees, which decreased $55,000 as compared to the second quarter of 2003.
For both the three months ended June 30, 2004 and 2003, noninterest expense was $2.1 million. The most significant item included in noninterest expense is salaries, wages and benefits, which totaled $1.3 million for both the three months ended June 30, 2004 and 2003. The increase of $64,000 or 5% is primarily a result of normal annual raises and higher group insurance costs, offset somewhat by lower bonus accruals in 2004.
Occupancy and furniture, fixtures, and equipment (“FFE”) expenses decreased a total of $17,000 or 5% between the second quarter of 2003 and 2004. The decrease was due primarily to an adjustment in property taxes for one of the Company’s branch locations, and lower depreciation due to assets which became fully depreciated in 2003. There were no significant changes in or additions to property and premises between the two quarterly periods.
Included in the line item “other expenses”, which decreased $89,000 or 16% from the comparable period of 2003, are charges for OCC assessments; property and bond insurance; ATM switch fees; professional services; education and seminars; advertising and public relations; and other branch and customer related expenses. The decrease is primarily related to lower advertising ($60,000), consultant fees ($31,000), and other professional fees ($28,000) in 2004 due to changes in the promotional campaigns and other programs of the Company requiring these services. Somewhat offsetting these decreases is higher loan collection costs of $50,000 related to reducing the balances in OREO, nonaccrual and other classified loans. Fluctuations in other expense categories are primarily related to deposit related expenses and are a result of normal activity of the Company and normal changes i n the volume and nature of transactions.
INCOME TAXES
For the three months ended June 30, 2004, the Company reported $483,000 in income tax expense, or an effective tax rate of 30.1%. This is compared to income tax expense of $480,000 for the same period of the prior year, or an effective tax rate of 31.2%. The slight reduction in effective tax rate is primarily related to the level of tax-free municipal securities in each period.
EARNINGS REVIEW – COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2004 AND 2003
GENERAL
The Company reported consolidated net income for the six months ended June 30, 2004 of $2,107,000, compared to net income of $1,968,000 for the six months ended June 30, 2003, or an improvement of approximately $139,000 or 7%. The primary factors in the increased earnings from the same period of the prior year were the 6% increase in average earning assets, the 15% reduction in interest expense due to lower cost of funds, and the lower provision for loan losses resulting from lower net originations during the period and the improvement in overall quality of the loan portfolio. The increases in income were somewhat offset by the 25% reduction in other income as a result of lower gains on sales of investment securities and lower mortgage referral fees.
NET INTEREST INCOME
Net interest income, the difference between the interest earned and interest paid, is the largest component of the Company's earnings and changes in it have the greatest impact on net income. Variations in the volume and mix of assets and liabilities and their relative sensitivity to interest rate movements determine changes in net interest income. During the six months ended June 30, 2004, the Company recorded consolidated net interest income of $6.3 million, a 5% increase from the net interest income of $6.0 million for the six months ended June 30, 2003. The increase in this amount is directly related to the increase in the average earning asset and interest-bearing liability volume of the Company of 6% and 5%, respectively, offset somewhat by the slight reduction in net interest margin between the comparable periods.
For the six months ended June 30, 2004 and 2003, the Company's consolidated net interest margin was 4.15% and 4.16%, respectively. The net interest margin is calculated as annualized net interest income divided by year-to-date average earning assets. The slight decrease in net interest margin is related primarily to the 39 basis point reduction in the average yield on assets, offset by the 42 basis point reduction in the average cost of funds. The average prime rate decreased 25 basis points to 4.00% for the six months ended June 30, 2004.
INTEREST INCOME
For the six months ended June 30, 2004, the Company's earning assets averaged $318.1 million and had an average tax-equivalent yield of 5.61%. This compares to average earning assets of $300.4 million for the first six months of 2003, yielding 6.00%. Thus, the 6% increase in volume of average earning assets, which was more than offset by the 39 basis point decrease in average yield, accounts for the $112,000 (1%) decrease in interest income between the comparable six month periods of 2004 and 2003.
Consolidated loans averaged approximately 74% of the Company’s average earning assets for both of the first six months of 2004 and 2003. The majority of the Company’s loans are tied to the prime rate (over 70% of the Bank’s portfolio is at floating rates at June 30, 2004), which averaged 4.00% and 4.25% for the six months ended June 30, 2004 and 2003, respectively. During the first six months of 2004, consolidated loans averaged $235.4 million, yielding an average of 5.95%, compared to $222.1 million, yielding an average of 6.47% for the first six months of 2003. The 52 basis point decrease in the average yield on loans is primarily related to the lower prime lending rate which decreased 25 basis points between 2003 and 2004, combined with the renewal and refinancing of fixed rate loans to lower current market rates. The 6% increase in average loans, offset by the de crease in average rate, resulted in a decrease in consolidated interest income on loans of $158,000 or 2%.
Investment securities averaged $73.3 million or 23% of average earning assets and yielded 4.99% (tax equivalent basis) during the first six months of 2004, compared to average securities of $68.3 million yielding 5.04% (tax equivalent basis) for the six months ended June 30, 2003. The slight decrease in average yield on the investment portfolio is related to the general decline in market interest rates, the timing and volume of security maturities, calls, and sales which were reinvested in instruments with lower current market rates, and the portfolio mix. The 7% increase in volume of investment securities, offset somewhat by the reduction in average rate, resulted in the net increase in interest income on taxable and nontaxable investments of $59,000 or 4%.
INTEREST EXPENSE
The Company's interest expense for the six months ended June 30, 2004 was $2.3 million. The decrease of 15% from the comparable six months in 2003 of $2.7 million was directly related to the 42 basis point decrease in the average rate on liabilities, offset somewhat by the 5% increase in the volume of average interest-bearing liabilities. Interest-bearing liabilities averaged $264.3 million for the first six months of 2004 with an average rate of 1.76%. This is compared to average interest-bearing liabilities of $252.7 million with an average rate of 2.18% for the six months ended June 30, 2003. The decrease in average rate on liabilities is directly related to the general low level of market interest rates and the maturities of fixed rate deposits which were renewed at lower current market rates.
PROVISION FOR LOAN LOSSES
As previously discussed under the quarterly analysis above, the amount charged to the provision for loan losses by the Bank and the Finance Company is based on management's judgment as to the amounts required to maintain an allowance adequate to provide for probable losses inherent in the loan portfolio.
