SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 10-Q /x/ QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 1999 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from______________to____________ Commission File Number 0-15137 MASSBANK Corp. (Exact name of registrant as specified in its charter) Delaware 04-2930382 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 123 HAVEN STREET Reading, Massachusetts 01867 (Address of principal executive offices, including Zip Code) Registrant's telephone number, including area code: (781) 662-0100 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] The number of shares outstanding of the issuer's classes of common stock, as of the latest practicable date is: Class: Common stock $1.00 per share. Outstanding at October 31, 1999: 3,367,025 shares. MASSBANK CORP. AND SUBSIDIARIES INDEX PART I - FINANCIAL INFORMATION Page ITEM 1. Financial Statements Consolidated Balance Sheets as of September 30, 1999 (unaudited) and December 31, 1998 3 Consolidated Statements of Income (unaudited) for the three months ended September 30, 1999 and 1998 4 and for the nine months ended September 30, 1999 and 1998 5 Consolidated Statements of Changes in Stockholders' Equity for the nine months ended September 30, 1999 (unaudited) and the year ended December 31, 1998 6 - 7 Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 1999 and 1998 8 - 9 Condensed Notes to the Consolidated Financial Statements 10 - 11 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 12 - 34 ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 34 PART II - OTHER INFORMATION ITEM 1. Legal Proceedings 35 ITEM 2. Changes in Securities 35 ITEM 3. Defaults Upon Senior Securities 35 ITEM 4. Submission of Matters to a Vote of Security Holders 35 ITEM 5. Other Information 35 ITEM 6. Exhibits and Reports on Form 8-K 35 Signature Page 36 MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands except share data) September 30, December 31, 1999 1998 (unaudited) Assets: Cash and due from banks $ 7,687 $ 7,038 Short-term investments (Note 3) 121,026 147,776 ________________________________________________________________________________ Total cash and cash equivalents 128,713 154,814 Term federal funds sold -- 25,000 Interest-bearing deposits in banks 3,790 2,033 Securities held to maturity, at amortized cost (market value of $230 in 1999 and $354 in 1998) 230 354 Securities available for sale, at market value (amortized cost of $449,818 in 1999 and $398,343 in 1998) 455,941 418,126 Trading securities, at market value 6,033 30,793 Loans: (Note 4) Mortgage loans 293,744 283,654 Other loans 36,278 21,335 Less: allowance for loan losses (2,506) (2,450) ________________________________________________________________________________ Net loans 327,516 302,539 Premises and equipment 4,234 4,320 Real estate acquired through foreclosure 58 86 Accrued interest receivable 4,957 5,058 Goodwill 1,313 1,387 Accrued income tax asset, net 320 -- Other assets 1,981 2,115 ________________________________________________________________________________ Total assets $935,086 $946,625 Liabilities and Stockholders' Equity: Deposits $825,960 $824,031 Escrow deposits of borrowers 1,517 1,438 Employee stock ownership plan liability 625 625 Accrued income taxes payable -- 723 Deferred income taxes payable 1,146 6,761 Other liabilities 2,970 2,558 ________________________________________________________________________________ Total liabilities 832,218 836,136 Stockholders' Equity: Preferred stock, par value $1.00 per share; 2,000,000 shares authorized, none issued -- -- Common stock, par value $1.00 per share; 10,000,000 shares authorized, 7,391,582 and 7,384,332 shares issued, respectively 7,392 7,384 Additional paid-in capital 60,289 60,003 Retained earnings 84,072 78,308 ________________________________________________________________________________ 151,753 145,695 Accumulated other comprehensive income: (Note 5) Net unrealized gains on securities available for sale, net of tax effect 3,541 11,691 Treasury stock at cost, 4,032,507 and 3,885,222 shares, respectively (51,801) (46,272) Common stock acquired by ESOP ( 625) ( 625) ________________________________________________________________________________ Total stockholders' equity 102,868 110,489 ________________________________________________________________________________ Total liabilities and stockholders' equity $935,086 $946,625 <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) Three months ended September 30, (In thousands except share data) 1999 1998 ______________________________________________________________________________ Interest and dividend income: Mortgage Loans $ 5,158 $ 4,927 Other loans 652 493 Securities available for sale: Mortgage-backed securities 4,944 4,958 Other securities 2,154 2,045 Trading securities 75 54 Federal funds sold 1,411 2,152 Other investments 336 366 ______________________________________________________________________________ Total interest and dividend income 14,730 14,995 ______________________________________________________________________________ Interest expense: Deposits 8,391 8,703 ______________________________________________________________________________ Total interest expense 8,391 8,703 ______________________________________________________________________________ Net interest income 6,339 6,292 Provision for loan losses 15 15 ______________________________________________________________________________ Net interest income after provision for loan losses 6,324 6,277 ______________________________________________________________________________ Non-interest income: Deposit account service fees 187 194 Gains on securities, net 752 430 Other 150 172 ______________________________________________________________________________ Total non-interest income 1,089 796 ______________________________________________________________________________ Non-interest expense: Salaries and employee benefits 1,823 1,598 Occupancy and equipment 539 522 Data processing 122 132 Professional services 97 101 Advertising and marketing 47 44 Amortization of intangibles 82 82 Other 356 392 ______________________________________________________________________________ Total non-interest expense 3,066 2,871 ______________________________________________________________________________ Income before income taxes 4,347 4,202 Income tax expense 1,564 1,507 ______________________________________________________________________________ Net income $ 2,783 $ 2,695 ______________________________________________________________________________ Weighted average common shares outstanding: Basic 3,351,825 3,548,156 Diluted 3,465,603 3,692,269 Earnings per share (in dollars): Basic $ 0.83 $ 0.76 Diluted 0.80 0.73 <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (Unaudited) Nine months ended September 30, (In thousands except share data) 1999 1998 _______________________________________________________________________________ Interest and dividend income: Mortgage Loans $15,421 $14,351 Other loans 1,573 1,529 Securities available for sale: Mortgage-backed securities 13,759 15,812 Other securities 6,519 6,400 Trading securities 420 507 Federal funds sold 4,778 5,404 Other investments 978 1,110 _______________________________________________________________________________ Total interest and dividend income 43,448 45,113 _______________________________________________________________________________ Interest expense: Deposits 24,839 25,786 _______________________________________________________________________________ Total interest expense 24,839 25,786 _______________________________________________________________________________ Net interest income 18,609 19,327 Provision for loan losses 125 105 _______________________________________________________________________________ Net interest income after provision for loan losses 18,484 19,222 _______________________________________________________________________________ Non-interest income: Deposit account service fees 543 615 Gains on securities, net 3,261 1,858 Other 604 670 _______________________________________________________________________________ Total non-interest income 4,408 3,143 _______________________________________________________________________________ Non-interest expense: Salaries and employee benefits 5,585 5,445 Occupancy and equipment 1,598 1,549 Data processing 363 385 Professional services 317 341 Advertising and marketing 142 141 Amortization of intangibles 245 219 Other 1,106 1,166 _______________________________________________________________________________ Total non-interest expense 9,356 9,246 _______________________________________________________________________________ Income before income taxes 13,536 13,119 Income tax expense 4,974 4,884 _______________________________________________________________________________ Net income $ 8,562 $ 8,235 _______________________________________________________________________________ Weighted average common shares outstanding: Basic 3,393,807 3,543,051 Diluted 3,509,139 3,699,169 Earnings per share (in dollars): Basic $ 2.52 $ 2.32 Diluted 2.44 2.23 <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For The Nine Months Ended September 30, 1999 (unaudited) (In thousands except share data) ACCUMULATED COMMON ADDITIONAL OTHER STOCK COMMON PAID-IN RETAINED TREASURY COMPREHENSIVE ACQUIRED STOCK CAPITAL EARNINGS STOCK INCOME BY ESOP TOTAL ________ __________ _________ __________ __________ _________ ________ Balance at December 31, 1998 $7,384 $60,003 $78,308 $(46,272) $11,691 $(625) $110,489 Net Income -- -- 8	,562 -- -- -- 8,562 Other comprehensive income or (loss), net of tax: Unrealized losses on securities, net of reclassification adjustment (Note 5) -- -- -- -- (8,150) -- (8,150) _____ Comprehensive income 412 Cash dividends declared and paid ($0.825 per share) -- -- (2,808) -- -- -- (2,808) Tax benefit resulting from dividends paid on unallocated shares held by the ESOP -- -- 10 -- -- -- 10 Amortization of ESOP shares committed to be released -- 130 -- -- -- -- 130 Purchase of treasury stock -- -- -- (5,529) -- -- (5,529) Exercise of stock options and related tax benefits 8 156 -- -- -- -- 164 ___________________________________________________________________________________________________________________________ Balance at September 30, 1999 $7,392 $60,289 $84,072 $(51,801) $ 3,541 $(625) $102,868 <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY For The Year Ended December 31, 1998 (unaudited) (In thousands except share data) ACCUMULATED COMMON ADDITIONAL OTHER STOCK COMMON PAID-IN RETAINED TREASURY COMPREHENSIVE ACQUIRED STOCK CAPITAL EARNINGS STOCK INCOME BY ESOP TOTAL ________ __________ _________ __________ __________ _________ ________ Balance at December 31, 1997 $7,337 $58,737 $70,984 $(41,569) $ 9,071 $(781) $103,779 Net income -- -- 10,914 -- -- -- 10,914 Other comprehensive income, net of tax: Unrealized gains on securities, net of reclassification adjustment (Note 5) -- -- -- -- 2,620 -- 2,620 ______ Comprehensive income 13,534 Cash dividends declared and paid ($1.02 per share) -- -- (3,605) -- -- -- (3,605) Tax benefit resulting from dividends paid on unallocated shares held by the ESOP -- -- 15 -- -- -- 15 Net decrease in liability to ESOP -- -- -- -- -- 156 156 Amortization of ESOP shares committed to be released -- 243 -- -- -- -- 243 Purchase of treasury stock -- -- -- (4,703) -- -- (4,703) Exercise of stock options and related tax benefits 47 1,023 -- -- -- -- 1,070 __________________________________________________________________________________________________________________________ Balance at December 31, 1998 $7,384 $60,003 $78,308 $(46,272) $11,691 $(625) $110,489 <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited) Nine Months Ended September 30, 1999 1998 ____ ____ (In thousands) Cash flows from operating activities: Net income $ 8,562 $ 8,235 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 711 687 Loan interest capitalized (42) (65) Amortization of ESOP shares committed to be released 130 199 Decrease in accrued interest receivable 101 607 Increase in other liabilities 412 357 Decrease in current income taxes payable (1,044) (1,780) Accretion of discounts on securities, net of amortization of premiums (750) (866) Net trading securities activity 25,132 21,296 Gains on securities available for sale, net (3,233) (1,804) Gains on trading securities, net (28) (54) Increase in deferred mortgage loan origination fees, net of amortization 27 187 Deferred income tax (benefit) expense (104) 349 (Decrease) increase in other assets (286) 120 Loans originated for sale -- (129) Loans sold -- 129 Provision for loan losses 125 105 Gains on sales of real estate acquired through foreclosure -- (4) Increase in escrow deposits of borrowers 79 20 Gains on sales of premises and equipment (2) -- __________________________________________________________________________________________ Net cash provided by operating activities 29,790 27,589 __________________________________________________________________________________________ Cash flows from investing activities: Purchases of term federal funds -- (30,000) Proceeds from maturities of term federal funds 25,000 30,000 Increase in interest bearing bank deposits (3,066) (581) Proceeds from maturities of interest bearing bank deposits 1,309 816 Proceeds from sales of investment securities available for sale 54,281 17,639 Proceeds from maturities of investment securities available for sale 60,800 35,650 Purchases of investment securities available for sale (130,414) (42,467) Purchases of mortgage-backed securities (88,397) -- Principal repayments of mortgage-backed securities 56,271 49,664 Principal repayments of securities held to maturity 124 14 Principal repayments of securities available for sale 43 1 Loans originated (74,648) (75,281) Loan principal payments received 49,799 50,130 Loans purchased (345) -- Purchases of premises & equipment (334) (297) Proceeds from sales of real estate acquired through foreclosure 86 262 Proceeds from sales of premises and equipment 2 -- Net advances on real estate acquired through foreclosure -- (12) __________________________________________________________________________________________ Net cash (used in) provided by investing activities (49,489) 35,538 __________________________________________________________________________________________ MASSBANK CORP. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (continued) (unaudited) Nine Months Ended September 30, 1999 1998 ____ ____ (In thousands) Cash flows from financing activities: Net increase in deposits 1,761 1,671 Payments to acquire treasury stock (5,529) (2,096) Issuance of common stock under stock option plan 120 558 Tax benefit resulting from stock options exercised 44 262 Dividends paid on common stock (2,808) (2,660) Tax benefit resulting from dividends paid on unallocated shares held by the ESOP 10 11 __________________________________________________________________________________________ Net cash used in financing activities (6,402) (2,254) __________________________________________________________________________________________ Net (decrease) increase in cash and cash equivalents (26,101) 60,873 Cash and cash equivalents at beginning of period 154,814 116,563 _________________________________________________________________________________________ Cash and cash equivalents at end of period $128,713 $177,436 _________________________________________________________________________________________ Supplemental cash flow disclosures: Cash transactions: Cash paid during the period for interest $24,844 $25,791 Cash paid during the period for taxes, net of refunds 6,071 5,717 Purchases of securities incomplete (not settled) at beginning of period which settled during the period 129 32 Sales of securities incomplete (not settled) at beginning of period which settled during the period 583 -- Non-cash transactions: SFAS 115: (Decrease) increase in accumulated other comprehensive income (8,150) 2,080 (Decrease) increase in deferred tax liabilities (5,510) 1,195 Securities reclassified from available for sale to trading securities -- 1,111 Transfers from loans to real estate acquired through foreclosure 58 299 Transfers from premises and equipment to other assets -- 9 Transfers from loans to other assets -- 19 Purchases of securities incomplete (not settled) at end of period 236 -- Sales of securities incomplete (not settled) at end of period 270 -- _________________________________________________________________________________________ <FN> See accompanying condensed notes to consolidated financial statements. MASSBANK CORP. CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (1) Basis of Presentation The financial condition and results of operations of MASSBANK Corp. (the "Company") essentially reflect the operations of its subsidiary, MASSBANK (the "Bank"). All significant intercompany balances and transactions have been eliminated in consolidation. The accompanying financial statements have been prepared in accordance with generally accepted accounting principles, and in the opinion of management, include all adjustments of a normal recurring nature necessary for the fair presentation of the financial condition of the Company as of September 30, 1999 and December 31, 1998, and its operating results for the three and nine months ended September 30, 1999 and 1998. The results of operations for any interim period are not necessarily indicative of the results to be expected for the entire year. Certain amounts in the prior year's consolidated financial statements have been reclassified to permit comparison with the current fiscal year. The information in this report should be read in conjunction with the financial statements and related notes included in the Annual Report on Form 10-K for the year ended December 31, 1998. (2) Cash and Cash Equivalents: For purposes of reporting cash flows, cash and cash equivalents consist of cash and due from banks, and short-term investments with original maturities of less than 90 days. (3) Short-Term Investments Short-term investments consist of the following: ________________________________________________________________________________ At At (In thousands) September 30, 1999 December 31, 1998 ________________________________________________________________________________ Federal funds sold (overnight) $111,096 $123,207 Money market funds 9,930 24,569 ________________________________________________________________________________ Total short-term investments $121,026 $147,776 ________________________________________________________________________________ The investments above are stated at cost which approximates market value and have original maturities of 90 days or less. (4) Commitments At September 30, 1999, the Company had outstanding commitments to originate mortgage loans and to advance funds for construction loans amounting to $2,131,000 and commitments under existing home equity lines of credit and other loans of approximately $31,822,000 which are not reflected on the consolidated balance sheet. In addition, as of September 30, 1999, the Company had a performance standby letter of credit conveyed to others in the amount of $625,000 which is also not reflected on the consolidated balance sheet. CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued) (5) Reporting Comprehensive Income The Company has adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income." This Statement establishes standards for the reporting and displaying of comprehensive income. Comprehensive income is defined as "the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources." It includes all changes in equity during a period except those resulting from investments by and distributions to shareholders. The term "comprehensive income", is used in the Statement to describe the total of all components of comprehensive income including net income. The Company's other comprehensive income and related tax effect for the nine months ended September 30, 1999 and the year ended December 31, 1998 is as follows: For the Nine Months Ended September 30, 1999 ____________________________________________________________________________________ Tax Before-Tax (Expense) Net-of-Tax (In thousands) Amount or Benefit Amount ______ __________ ______ Unrealized losses on securities: Unrealized holding losses arising during period $(10,427) $4,137 $(6,290) Less: reclassification adjustment for gains realized in net income (3,233) 1,373 (1,860) ______ ________ ______ Net unrealized losses (13,660) 5,510 (8,150) ______ ________ ______ Other comprehensive loss $(13,660) $5,510 $(8,150) ______ ________ _____ For the Year Ended December 31, 1998 ____________________________________________________________________________________ Tax Before-Tax (Expense) Net-of-Tax (In thousands) Amount or Benefit Amount ______ __________ ______ Unrealized gains on securities: Unrealized holding gains arising during period $ 7,106 $(2,864) $4,242 Less: reclassification adjustment for gains realized in net income (2,798) 1,176 (1,622) ______ ________ ______ Net unrealized gains 4,308 (1,688) 2,620 ______ ________ ______ Other comprehensive income $ 4,308 $(1,688) $2,620 ______ ________ ______ MASSBANK CORP. AND SUBSIDIARIES MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS September 30, 1999 Cautionary Statement. Certain statements contained in this report or incorporated herein by reference are "forward-looking statements." We may also make written or oral forward-looking statements in other documents we file with the Securities and Exchange Commission, in our annual reports to stockholders, in press releases and other written materials, and in oral statements made by our officers, directors or employees. You can identify forward-looking statements by the use of the words "believe," "expect," "anticipate," "intend," "estimate," "assume" and other similar expressions which predict or indicate future events and trends and which do not relate to historical matters. In addition, information concerning the costs, timing and effectiveness of Year 2000 compliance, are forward-looking statements. You should not rely on forward-looking statements, because they involve known and unknown risks, uncertainties and other factors, some of which are beyond the control of the Company. These risks, uncertainties and other factors may cause the actual results, performance or achievements of the Company to be materially different from the anticipated future results, performance or achievements expressed or implied by the forward-looking statements. Some of the factors that might cause these differences include the following: fluctuations in interest rates, price volatility in the stock and bond markets, inflation, government regulations and economic conditions and competition in the geographic and business areas in which the Company conducts its operations; and the Company and its customers and suppliers may experience unanticipated delays or expenses in achieving Year 2000 compliance. You should carefully review all of these factors, and you should be aware that there may be other factors that could cause these differences. These forward-looking statements were based on information, plans and estimates at the date of this report, and we do not promise to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events or other changes. Results of Operations for the three months ended September 30, 1999 GENERAL For the quarter ended September 30, 1999, MASSBANK Corp. reported consolidated net income of $2,783,000 or $0.83 in basic earnings per share compared to net income of $2,695,000, or $0.76 in basic earnings per share in the third quarter of 1998. Diluted earnings per share increased to $0.80 per share from $0.73 per share in the third quarter of last year, representing an increase of 9.6%. The Company's favorable earnings results for the recent quarter were attributed primarily to an increase in net securities gains of $322,000 and an increase of $47,000 in net interest income due to higher average earning assets. These improvements were partially offset by an increase of $195,000 in non- interest expense. The third quarter earnings results also reflect modest reductions in deposit account service fees and other non-interest income. AVERAGE BALANCE SHEETS Three Months Ended September 30, 1999 1998 ______________ ______________ Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (In thousands) Balance Expense Rate Balance Expense Rate (4) (4) (4) (4) __________________________________________________________________________________________ Assets: Earning assets: Federal funds sold $110,481 $ 1,411 5.07% $156,588 $ 2,152 5.45% Short-term investments (2) 26,392 334 5.02 26,213 361 5.47 Investment securities 161,175 2,192 5.44 144,386 2,094 5.80 Mortgage-backed securities 289,508 4,944 6.83 290,679 4,958 6.82 Trading securities 6,000 75 4.95 3,840 54 5.59 Mortgage loans (1) 295,165 5,158 6.99 270,208 4,927 7.29 Other loans (1) 36,164 652 7.13 21,980 493 8.91 __________________________________________________ ________________ Total earning assets 924,885 $14,766 6.37% 913,894 $15,039 6.56% Allowance for loan losses (2,521) (2,413) __________________________________________________________________________________________ Total earning assets less allowance for loan losses 922,364 911,481 Other assets 20,213 19,474 __________________________________________________________________________________________ Total assets $942,577 $930,955 __________________________________________________________________________________________ AVERAGE BALANCE SHEETS - (continued) Three Months Ended September 30, 1999 1998 ______________ ______________ Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (In thousands) Balance Expense Rate Balance Expense Rate (4) (4) (4) (4) __________________________________________________________________________________________ Liabilities: Deposits: Demand and NOW $ 75,282 $ 121 0.64% $ 70,522 $ 138 0.77% Savings 358,576 3,083 3.41 348,558 3,016 3.43 Time certificates of deposit 399,681 5,187 5.15 392,973 5,549 5.60 __________________________________________________ ________________ Total deposits 833,539 8,391 3.99 812,053 8,703 4.25 Other liabilities 5,851 8,949 __________________________________________________________________________________________ Total liabilities 839,390 821,002 Stockholders' equity 103,187 109,953 __________________________________________________________________________________________ Total liabilities and stockholders' equity $942,577 $930,955 __________________________________________________________________________________________ Net interest income (tax-equivalent basis) 6,375 6,336 Less adjustment of tax-exempt interest income 36 44 __________________________________________________________________________________________ Net interest income $ 6,339 $ 6,292 __________________________________________________________________________________________ Interest rate spread 2.38% 2.31% __________________________________________________________________________________________ Net interest margin (3) 2.76% 2.77% __________________________________________________________________________________________ (1) Loans on non-accrual status are included in the average balance. (2) Short-term investments consist of interest-bearing deposits in banks and investments in money market funds. (3) Net interest income (tax equivalent basis) before provision for loan losses divided by average interest-earning assets. (4) Includes the effects of SFAS No. 115. Net Interest Income The Company's net interest income was $6,339,000 for the third quarter of 1999, an increase of $47,000 over the same quarter a year ago. The recent quarter's improvement in net interest income reflects the positive effect of average earning asset growth exceeding the negative effect of a slightly lower net interest margin. Average earning assets for the third quarter of 1999 increased to $924.9 million, up $11.0 million from the corresponding quarter in 1998. The Company's net interest margin was 2.76% in the recent quarter, slightly below its third quarter 1998 net interest margin of 2.77%. Interest and Dividend Income Interest and dividend income on a fully taxable equivalent basis for the three months ended September 30, 1999, decreased to $14,766,000 from $15,039,000 for the three months ended September 30, 1998. The average total earning assets of the Company increased by $11.0 million, as noted above. The increase in interest income resulting from the growth in earning assets in the recent quarter, however, was more than offset by a decline in yield on earning assets. As reflected in the table on page 13, yield declines in each of the Bank's categories of earning assets, except mortgage-backed securities, resulted in an overall decline in yield on the Company's total average earning assets of 19 basis points. The weighted average yield on earning assets for the third quarter of 1999 was 6.37% compared to 6.56% in the same quarter of the prior year. Interest Expense Total interest expense for the three months ended September 30, 1999 was $8,391,000, down from $8,703,000 for the same quarter last year. The Company's average deposits, as shown in the table on page 14, increased $21.5 million or 2.6% to $833.5 million in the third quarter of 1999, from $812.0 million in the third quarter of 1998. The decrease in interest expense resulted from a decrease in average cost of funds partially offset by the additional interest expense resulting from the higher deposit volume. The Company's average cost of funds for the three months ended September 30, 1999 was 3.99%, down from 4.25% for the comparable period in 1998. Provision for Loan Losses The allowance for loan losses is increased by provisions charged to operations based on management's assessment of many factors including the risk characteristics of the portfolio, underlying collateral, current and anticipated economic conditions that may affect the borrower's ability to pay, and trends in loan delinquencies and charge-offs. Realized losses, net of recoveries, are charged directly to the allowance. While management uses the information available in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. The provision for loan losses for the third quarter of 1999 was $15,000, unchanged from the comparable quarter in 1998. Loan charge-offs net of recoveries in the recent quarter were $67,000, compared to net recoveries on loans of $5,000 in the same quarter last year. Provision for Loan Losses (continued) The reserve coverage as a percentage of the Bank's non-accrual loans increased in the recent quarter. At September 30, 1999, MASSBANK's allowance for loan losses totaled $2,506,000 representing 317% of non-accrual loans compared to $2,425,000 representing 172% of non-accrual loans at the end of the third quarter 1998. Non-Interest Income Non-interest income consists of deposit account service fees, net gains on securities and other non-interest income. Non-interest income increased to $1,089,000 for the quarter ended September 30, 1999, from $796,000 for the comparable quarter of the prior year. This improvement is due to an increase in securities gains in 1999. Net gains on securities totaled $752,000 in the third quarter of this year compared to $430,000 in the third quarter of the prior year. The Bank's equity securities portfolio continues to provide the Bank with favorable returns. Realized gains on the sale of equity securities totaled $867,000 for the three months ended September 30, 1999. These gains, however, were partially offset by net losses realized on the sale of debt securities of $109,000. The Bank also recorded a mark-to-market loss of $6,000 on its trading account during this same period. The Bank's deposit account service fees and other non-interest income totaled $187,000 and $150,000, respectively, in the third quarter of 1999 compared to $194,000 and $172,000, respectively, in the third quarter of 1998. Non-Interest Expense Non-interest expense increased $195,000 to $3,066,000 in the third quarter of 1999, from $2,871,000 in the same quarter of the prior year. This increase is due largely to an increase in salaries and employee benefits expenses. Salaries and employee benefits, the largest component of non-interest expense, increased by $225,000 or 14.1% in the third quarter of 1999 to $1,823,000. The primary reasons for this increase are twofold: an increase of $105,000 in the expense amount provided for payments to employees under the Company's profit sharing and incentive compensation bonus plans and an increase of $91,000 in the Company's directors' deferred compensation plan expense. The expense related to the directors' deferred compensation plan is tied closely to the market value of the Company's common stock. A decrease in the market value of the Company's common stock during the third quarter of last year, from $49.00 per share at June 30, 1998 to $38.75 per share at September 30, 1998, significantly decreased the expense for the plan for the 1998 third quarter. In the 1999 third quarter, the price of MASSBANK Corp. stock declined from $37.50 per share at June 30, 1999 to $35.69 per share at September 30, 1999 also reducing the expense for the plan but by a much smaller amount than in the prior year. This produced an increase in expense of $91,000 when comparing the third quarter of 1999 to the third quarter of 1998. All other expenses combined, consisting of occupancy and equipment, data processing, professional services, advertising and marketing, amortization of intangibles and other expenses, decreased by $30,000 from $1,273,000 for the three months ended September 30, 1998 to $1,243,000 for the three months ended September 30, 1999. This was due largely to a reduction in the amortization of the costs of computer software. Income Tax Expense The Company, the Bank and its subsidiaries file a consolidated federal income tax return. The Parent Company is subject to a State of Delaware Franchise Tax and a State of Massachusetts Bank Excise Tax and the Bank's subsidiaries are subject to a State of Massachusetts Corporate Excise Tax. The provision for federal and state income taxes increased to $1,564,000 for the three months ended September 30, 1999 from $1,507,000 for the same period in 1998. This increase in income taxes is due to higher income before income taxes in the recent quarter combined with a modest increase in effective income tax rate. The Company's combined effective income tax rate for the third quarter of 1999 is 36.0% compared to 35.9% for the same quarter a year ago. Results of Operations for the nine months ended September 30, 1999 GENERAL For the nine months ended September 30, 1999, the Company reported consolidated net income of $8,562,000 or $2.52 in basic earnings per share ($2.44 per share on a diluted basis) compared to net income of $8,235,000 or $2.32 in basic earnings per share ($2.23 per share on a diluted basis) earned in the first nine months of 1998. The Company's positive financial performance in the first nine months of 1999 reflects an increase in net securities gains of $1,403,000 due to the favorable performance of the Bank's equity securities portfolio, partially offset by a decrease in net interest income of $718,000. The lower net interest income results from a decline in net interest margin, partially offset by modest growth in the Company's average earning assets. Average earning assets for the first nine months of 1999 increased to $925.6 million, up $15.7 million from the corresponding period in 1998. The Company's earnings results for the nine months ended September 30, 1999 were also impacted by increases in the provision for loan losses, non-interest expense and income tax expense, and modest reductions in deposit account service fees and other non-interest income. AVERAGE BALANCE SHEETS Nine Months Ended September 30, 1999 1998 ______________ ______________ Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (In thousands) Balance Expense Rate Balance Expense Rate (4) (4) (4) (4) __________________________________________________________________________________________ Assets: Earning assets: Federal funds sold $133,167 $ 4,778 4.80% $132,048 $ 5,404 5.47% Short-term investments (2) 26,609 966 4.85 26,796 1,096 5.47 Investment securities 163,415 6,628 5.40 148,366 6,521 5.86 Mortgage-backed securities 270,268 13,759 6.79 307,553 15,812 6.85 Trading securities 12,345 420 4.54 12,356 506 5.44 Mortgage loans (1) 292,545 15,421 7.03 260,245 14,351 7.35 Other loans (1) 27,212 1,573 7.71 22,509 1,529 9.08 __________________________________________________ ________________ Total earning assets 925,561 $43,545 6.27% 909,873 $45,219 6.62% Allowance for loan losses (2,493) (2,373) __________________________________________________________________________________________ Total earning assets less allowance for loan losses 923,068 907,500 Other assets 19,957 19,491 __________________________________________________________________________________________ Total assets $943,025 $926,991 __________________________________________________________________________________________ AVERAGE BALANCE SHEETS - (continued) Nine Months Ended September 30, 1999 1998 ______________ ______________ Interest Average Interest Average Average Income/ Yield/ Average Income/ Yield/ (In thousands) Balance Expense Rate Balance Expense Rate (4) (4) (4) (4) __________________________________________________________________________________________ Liabilities: Deposits: Demand and NOW $ 74,965 $ 382 0.68% $ 69,042 $ 411 0.80% Savings 352,955 8,987 3.40 351,020 8,998 3.43 Time certificates of deposit 400,018 15,470 5.17 389,139 16,377 5.63 __________________________________________________ ________________ Total deposits 827,938 24,839 4.01 809,201 25,786 4.26 Other liabilities 8,105 9,730 __________________________________________________________________________________________ Total liabilities 836,043 818,931 Stockholders' equity 106,982 108,060 __________________________________________________________________________________________ Total liabilities and stockholders' equity $943,025 $926,991 __________________________________________________________________________________________ Net interest income (tax-equivalent basis) 18,706 19,433 Less adjustment of tax-exempt interest income 97 106 __________________________________________________________________________________________ Net interest income $18,609 $19,327 __________________________________________________________________________________________ Interest rate spread 2.26% 2.36% __________________________________________________________________________________________ Net interest margin (3) 2.69% 2.85% __________________________________________________________________________________________ (1) Loans on non-accrual status are included in the average balance. (2) Short-term investments consist of interest-bearing deposits in banks and investments in money market funds. (3) Net interest income (tax equivalent basis) before provision for loan losses divided by average interest-earning assets. (4) Includes the effects of SFAS No. 115. Net Interest Income Net interest income was $18,609,000 for the nine months ended September 30, 1999, reflecting a decrease of $718,000 from the same period a year ago. This decrease is the result of a lower net interest margin, partially offset by modest growth in the Company's average earning assets. The Company's net interest margin for the first nine months of 1999 was 2.69%, down from 2.85% for the comparable period in 1998. Average earning assets for the nine months ended September 30, 1999 increased $15.7 million or 1.7% to $925.6 million from $909.9 million for the corresponding period in 1998. The Company's interest rate spread decreased to 2.26% for the first nine months of 1999, from 2.36% in the first nine months of last year. The yield on the Company's average earning assets in the first nine months of 1999 decreased by 35 basis points to 6.27% from 6.62% in the corresponding period of 1998. This decrease was partially offset by a decrease of 25 basis points in the Company's average cost of funds, from 4.26% for the nine months ended September 30, 1998 to 4.01% for the same period this year. Provision for Loan Losses The provision for loan losses for the first nine months of 1999 was $125,000 versus $105,000 for the comparable period in 1998. This increase is essentially due to the growth in the Bank's loan portfolio during the last twelve months and a modest increase in loan charge-offs. Loan charge-offs net of recoveries for the nine months ended September 30, 1999 increased to $69,000 from $14,000 for the same period last year. Non-Interest Income Non-interest income consists of deposit account service fees, net gains on securities and other non-interest income. Non-interest income for the first nine months of 1999 totaled $4,408,000, up $1,265,000 or approximately 40% from $3,143,000 reported in the corresponding period last year. This increase is due to net gains on securities of $3,261,000 reported for the nine months ended September 30, 1999 versus $1,858,000 reported for the same period last year. The Company continues to benefit from the strong performance of its stock portfolio. Deposit account service fees and other non- interest income combined decreased $138,000 to $1,147,000 in the first nine months of 1999 from $1,285,000 in the first nine months of 1998. Non-Interest Expense Non-interest expense increased by $110,000, or 1.2% to $9,356,000 in the first nine months of 1999 from $9,246,000 in the first nine months of 1998. This was due primarily to an increase in salaries and employee benefits expenses. Salaries and employee benefits, the largest component of non-interest expense, increased by $140,000 or 2.6% from $5,445,000 in the first nine months of 1998 to $5,585,000 in the first nine months of this year. This increase is due primarily to an increase of $155,000 in the expense amount provided for payments to employees under the Company's profit sharing and incentive compensation bonus plans. The increase in salaries and employee benefits expenses also reflects an increase in expense of $98,000 related to the Bank's deferred compensation plans which was partially offset by a reduction of $82,000 in the Bank's Employee Stock Ownership Plan ("ESOP") expense. All other expenses combined, consisting of occupancy and equipment, data processing, professional services, advertising and marketing, amortization of intangibles and other expenses, decreased by $30,000 from $3,801,000 for the nine months ended September 30, 1998 to $3,771,000 for the same period in 1998. Income Tax Expense The provision for federal and state income taxes increased to $4,974,000 for the nine months ended September 30, 1999 from $4,884,000 for the same period in 1998. This increase is due primarily to an increase in income before taxes in the first nine months of 1999, partly offset by a reduction in the Company's effective income tax rate. The Company's combined effective income tax rate for the first nine months of 1999 is 36.7% compared to 37.2% for the same period a year ago. The Company's income tax expense for the first nine months of 1998 includes a state income tax refund, net of federal tax, of approximately $44,000 which the Company received in 1998, representing the financial settlement of a state income tax issue for prior years. Financial Condition Total assets at September 30, 1999 were $935.1 million, down $11.5 million or 1.2% from $946.6 million at December 31, 1998. The decrease in total assets was driven by a decline of $37.1 million in the investment portfolio, partially offset by $25.0 million growth in the loan portfolio, net of allowance for loan losses. Other assets increased by $0.6 million in 1999. Total investments consisting of investment securities and other short-term investments, including term federal funds sold and interest-bearing bank deposits, decreased from $624.1 million at December 31, 1998 to $587.0 million at September 30, 1999. The decrease is mainly attributable to the Bank's trading securities portfolio, term federal funds sold and short-term investments which declined $24.8 million, $25.0 million and $26.8 million, respectively, during the first nine months of 1999. These reductions were partially offset by a net increase in the Bank's investment in debt and equity securities available for sale and held to maturity, and interest-bearing bank deposits, which grew by $37.7 million and $1.8 million, respectively, during this same period. MASSBANK's net loan portfolio increased to $327.5 million at September 30, 1999 reflecting a net increase in loans of $25.0 million in the first nine months of 1999. This improvement results essentially from loan originations of $74.6 million which exceeded loan principal payments, including prepayments, received from borrowers during the first nine months of 1999. Total deposits were $826.0 million at September 30, 1999 reflecting an increase of approximately $2.0 million from $824.0 million at year-end 1998. Total stockholders' equity declined to $102.9 million at September 30, 1999 from $110.5 million at December 31, 1998. The decrease results primarily from a reduction in net unrealized gains, net of tax effect, on the Company's available for sale securities in the amount of $8.2 million, and the cost of the 147,285 shares of (MASSBANK Corp.) treasury stock that the Company repurchased during the first nine months of 1999 for a total amount of $5.5 million. These decreases were partially offset by an increase of $5.8 million in the Company's retained earnings in the nine months ended September 30, 1999. As a result, the Company's book value per share decreased to $30.62 per share, from $31.58 per share at year-end 1998. Investments As previously noted, total investments consisting of investment securities, short-term investments, term federal funds sold and interest-bearing bank deposits equalled $587.0 million at September 30, 1999, down $37.1 million from $624.1 million at year end 1998. These investments are principally in federal funds sold, short-term U.S. Treasury and government agency obligations and government agency fifteen year mortgage-backed securities. The Bank also maintains an equity securities portfolio, valued at $21.8 million as of September 30, 1999, that has yielded substantial realized and unrealized gains. Nearly all of the Bank's investment securities are classified as available for sale or trading securities. Management evaluates its investment alternatives in order to properly manage the mix of assets on its balance sheet. Investment securities available for sale and trading securities provide liquidity, facilitate interest rate sensitivity management and enhance the Bank's ability to respond to customers' needs should loan demand increase and/or deposits decline. The Bank continues to maintain a large proportion of its securities portfolio in government agency mortgage-backed securities. These represent an attractive investment with minimal credit risk, no servicing responsibilities, and no delinquencies. The Bank's investment in mortgage-backed securities totaled $297.3 million at September 30, 1999 versus $272.6 million at year end 1998. The Bank also maintains a portfolio of trading securities which consisted of the following as of the dates shown: September 30, December 31, (In thousands) 1999 1998 _____________ ____________ U.S. Treasury bills $ 4,898 $29,707 Investment in mutual funds 1,093 1,086 Equity securities 42 -- _______ _______ Total $ 6,033 $30,793 FINANCIAL CONDITION INVESTMENT SECURITIES The amortized cost and estimated market value of investment securities at September 30, 1999 with gross unrealized gains and losses, follows: __________________________________________________________________________________________ Gross Gross Amortized Unrealized Unrealized Market (In thousands) At September 30, 1999 Cost Gains Losses Value __________________________________________________________________________________________ Securities held to maturity: Other bonds and obligations $ 230 $ -- $ -- $ 230 __________________________________________________________________________________________ Total securities held to maturity $ 230 $ -- $ -- $ 230 __________________________________________________________________________________________ Securities available for sale: Debt securities: U.S. Treasury obligations $120,660 $ 515 $ (376) $120,799 U.S. Government agency obligations 16,139 -- (103) 16,036 __________________________________________________________________________________________ Total 136,799 515 (479) 136,835 __________________________________________________________________________________________ Mortgage-backed securities: Government National Mortgage Association 39,838 438 (383) 39,893 Federal Home Loan Mortgage Corporation 249,041 1,110 (2,266) 247,885 Federal National Mortgage Association 4,535 102 (40) 4,597 Collateralized mortgage obligations 4,888 28 (8) 4,908 __________________________________________________________________________________________ Total mortgage-backed securities 298,302 1,678 (2,697) 297,283 __________________________________________________________________________________________ Total debt securities 435,101 2,193 (3,176) 434,118 __________________________________________________________________________________________ Equity securities 14,717 7,796 (690) 21,823 __________________________________________________________________________________________ Total securities available for sale 449,818 $ 9,989 $ (3,866) $455,941 __________________________________________________________________________________________ Net unrealized gains on securities available for sale 6,123 __________________________________________________________________________________________ Total securities available for sale, net $455,941 __________________________________________________________________________________________ Total investment securities, net $456,171 __________________________________________________________________________________________ Trading securities $ 6,052 $ 6,033 __________________________________________________________________________________________ FINANCIAL CONDITION INVESTMENT SECURITIES (continued) The amortized cost and estimated market value of investment securities at December 31, 1998 with gross unrealized gains and losses, follows: __________________________________________________________________________________________ Gross Gross Amortized Unrealized Unrealized Market (In thousands) At December 31, 1998 Cost Gains Losses Value __________________________________________________________________________________________ Securities held to maturity: Other bonds and obligations $ 354 $ -- $ -- $ 354 __________________________________________________________________________________________ Total securities held to maturity $ 354 $ -- $ -- $ 354 __________________________________________________________________________________________ Securities available for sale: Debt securities: U.S. Treasury obligations $112,627 $ 2,354 $ -- $114,981 U.S. Government agency obligations 8,966 26 -- 8,992 __________________________________________________________________________________________ Total 121,593 2,380 -- 123,973 __________________________________________________________________________________________ Mortgage-backed securities: Government National Mortgage Association 48,347 1,517 -- 49,864 Federal Home Loan Mortgage Corporation 205,949 5,116 (6) 211,059 Federal National Mortgage Association 4,984 181 -- 5,165 Collateralized mortgage obligations 6,193 60 (3) 6,250 Other 223 12 -- 235 __________________________________________________________________________________________ Total mortgage-backed securities 265,696 6,886 (9) 272,573 __________________________________________________________________________________________ Total debt securities 387,289 9,266 (9) 396,546 __________________________________________________________________________________________ Equity securities 11,054 10,579 (53) 21,580 __________________________________________________________________________________________ Total securities available for sale 398,343 $ 19,845 $ (62) $418,126 __________________________________________________________________________________________ Net unrealized gains on securities available for sale 19,783 __________________________________________________________________________________________ Total securities available for sale, net $418,126 __________________________________________________________________________________________ Total investment securities, net $418,480 __________________________________________________________________________________________ Trading securities $ 30,802 $ 30,793 __________________________________________________________________________________________ Investments (continued) The amortized cost and estimated market value of debt securities held to maturity and debt securities available for sale by contractual maturity at September 30, 1999 and December 31, 1998 are as follows: September 30, 1999 ____________________________________________ Available for Sale Held to Maturity Amortized Market Amortized Market Maturing: Cost Value Cost Value (In thousands) Within 1 year $ 44,891 $ 45,049 $ -- $ -- After 1 year but within 5 years 88,791 88,700 230 230 After 5 years but within 10 years 2,965 2,938 -- -- After 15 years 152 148 -- -- ________ _______ ______ ______ 136,799 136,835 230 230 Mortgage-backed securities 298,302 297,283 -- -- ________ _______ ______ ______ $435,101 $434,118 $ 230 $ 230 December 31, 1998 ____________________________________________ Available for Sale Held to Maturity Amortized Market Amortized Market Maturing: Cost Value Cost Value (In thousands) Within 1 year $ 52,876 $ 53,266 $ -- $ -- After 1 year but within 5 years 65,561 67,345 230 230 After 5 years but within 10 years 2,961 3,164 82 82 After 15 years 195 198 42 42 ________ _______ ______ ______ 121,593 123,973 354 354 Mortgage-backed securities 265,696 272,573 -- -- ________ _______ ______ ______ $387,289 $396,546 $ 354 $ 354 LOANS The composition of the Bank's loan portfolio is summarized as follows: _______________________________________________________________________________________ At At (In thousands) September 30, 1999 December 31, 1998 _______________________________________________________________________________________ Mortgage loans: Residential $292,107 $281,862 Commercial 2,519 2,257 Construction 390 730 _______________________________________________________________________________________ 295,016 284,849 Add: Premium on loans 209 259 Less: Deferred mortgage loan origination fees (1,481) (1,454) _______________________________________________________________________________________ Total mortgage loans 293,744 283,654 Other loans: Consumer: Installment 1,320 1,547 Guaranteed education 7,207 7,967 Other secured 1,290 1,366 Home equity lines of credit 11,207 10,159 Unsecured 224 235 _______________________________________________________________________________________ Total consumer loans 21,248 21,274 Commercial 15,030 61 _______________________________________________________________________________________ Total other loans 36,278 21,335 _______________________________________________________________________________________ Total loans $330,022 $304,989 _______________________________________________________________________________________ The Bank's loan portfolio increased $25.0 million during the first nine months of 1999, from $305.0 million at December 31, 1998 to $330.0 million at September 30, 1999. The increase was primarily in the commercial loan and residential 1-4 family mortgage loan categories. Loan originations decreased by $0.8 million to $74.6 million in the first nine months of 1999 compared to $75.4 million in the first nine months of last year. NON-PERFORMING ASSETS The following table shows the composition of the Bank's non-performing assets at September 30, 1999 and 1998, and December 31, 1998: At At At September 30, December 31, September 30, (In thousands) 1999 1998 1998 ____________________________________________________________________________________ Non-Performing Assets: Non-accrual loans $ 790 $ 1,004 $ 1,406 Real estate acquired through foreclosure 58 86 53 ____________________________________________________________________________________ Total non-performing assets $ 848 $ 1,090 $ 1,459 ____________________________________________________________________________________ Allowance for loan losses $ 2,506 $ 2,450 $ 2,425 Allowance as a percent of non-accrual loans 317.2 % 244.0 % 172.5 % Allowance as a percent of non-performing assets 295.5 % 224.8 % 166.2 % Non-accrual loans as a percent of total loans 0.24% 0.33% 0.47% Non-performing assets as a percent of total assets 0.09% 0.12% 0.16% ____________________________________________________________________________________ The Bank generally does not accrue interest on loans which are 90 days or more past due. It is the Bank's policy to place such loans on non-accrual status and to reverse from income all interest previously accrued but not collected and to discontinue all amortization of deferred loan fees. Non-performing assets decreased from December 31, 1998 to September 30, 1999 as noted in the table above. The principal balance of non-accrual loans was down to $790,000, or approximately one-quarter of 1% of total loans at September 30, 1999. The Bank did not have any impaired loans as of September 30, 1999. ALLOWANCE FOR LOAN LOSSES An analysis of the activity in the allowance for loan losses is as follows: Nine Months Ended September 30, 1999 1998 _______________________________________________________________________________ (In thousands) Balance at beginning of period $ 2,450 $ 2,334 Provision for loan losses 125 105 Recoveries of loans previously charged-off 4 18 Less: Charge-offs (73) (32) _________________________________________________________________________________ Balance at end of period $ 2,506 $ 2,425 _________________________________________________________________________________ The allowance for loan losses is established through a provision for loan losses charged to operations based on management's assessment of many factors including the risk characteristics of the portfolio, underlying collateral, current and anticipated economic conditions that may effect the borrowers ability to pay, and trends in loan delinquencies and charge-offs. Realized losses, net of recoveries, are charged directly to the allowance. While management uses the information available in establishing the allowance for losses, future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the evaluation. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management. At September 30, 1999 the balance of the allowance for loan losses was $2,506,000 representing 317.2% of non-accrual loans. Management believes that the allowance for loan losses is adequate to cover the risks inherent in the portfolio under current conditions. DEPOSITS Deposit accounts of all types have traditionally been the primary source of funds for the Bank's lending and investment activities. The Bank's deposit flows are influenced by prevailing interest rates, competition and other market conditions. The Bank's management attempts to manage its deposits through selective pricing and marketing. The Bank's total deposits increased by approximately $2.0 million to $826.0 million at September 30, 1999 from $824.0 million at December 31, 1998. The composition of the Bank's total deposits as of the dates shown are summarized as follows: September 30, December 31, 1999 1998 ______________________________________________________________________________ (In thousands) Demand and NOW $ 72,602 $ 76,173 Savings and money market accounts 358,969 348,049 Time certificates of deposit 394,934 400,524 Deposit acquisition premium, net of amortization (545) (715) ______________________________________________________________________________ Total deposits $825,960 $824,031 ______________________________________________________________________________ Recent Accounting Developments "Accounting for Derivative Instruments and Hedging Activities" In June 1998, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities." This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in its balance sheet and measure those instruments at fair market value. Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. In June 1999, FASB issued Statement No. 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of Statement No. 133" which defers the effective date of Statement No. 133. Statement No. 133 is now effective for all fiscal quarters of fiscal years beginning after June 15, 2000. This Statement is not expected to have a material effect on the Company's consolidated financial statements. Liquidity and Capital Resources The Bank must maintain a sufficient amount of cash and assets which can readily be converted into cash in order to meet cash outflows from normal depositor requirements and loan demands. The Bank's primary sources of funds are deposits, loan amortization and prepayments, sales or maturities of investment securities and income on earning assets. In addition to loan payments and maturing investment securities, which are relatively predictable sources of funds, the Bank maintains a high percentage of its assets invested in overnight federal funds sold, which can be immediately converted into cash and United States Treasury and Government agency securities, which can be sold or pledged to raise funds. At September 30, 1999 the Bank had $111.1 million or 11.9% of total assets and $141.7 million or 15.2% of total assets invested, respectively, in overnight federal funds sold and United States obligations. The Bank is a Federal Deposit Insurance Corporation ("FDIC") insured institution subject to the FDIC regulatory capital requirements. The FDIC regulations require all FDIC insured institutions to maintain minimum levels of Tier 1 capital. Highly rated banks (i.e., those with a composite rating of 1 under the CAMEL rating system) are required to maintain a minimum leverage ratio of Tier 1 capital to total assets of at least 3.00%. An additional 100 to 200 basis points are required for all but these most highly rated institutions. The Bank is also required to maintain a minimum level of risk-based capital. Under the new risk-based capital standards, FDIC insured institutions must maintain a Tier 1 capital to risk-weighted assets ratio of 4.00% and are generally expected to meet a minimum total qualifying capital to risk-weighted assets ratio of 8.00%. The new risk-based capital guidelines take into consideration risk factors, as defined by the regulators, associated with various categories of assets, both on and off the balance sheet. Under the guidelines, capital strength is measured in two tiers which are used in conjunction with risk adjusted assets to determine the risk-based capital ratios. Tier II components include supplemental capital components such as qualifying allowance for loan losses and qualifying subordinated debt and up to 45 percent of the pre-tax net unrealized holding gains on certain available for sale equity securities. Tier I plus the Tier II capital components is referred to as total qualifying capital. The capital ratios of the Bank and the Company currently exceed the minimum regulatory requirements. At September 30, 1999, the Bank had a leverage Tier I capital to total assets ratio of 10.48%, a Tier I capital to risk- weighted assets ratio of 31.38% and a total capital to risk-weighted assets ratio of 33.22%. The Company, on a consolidated basis, had ratios of leverage Tier I capital to total assets of 10.50%, Tier I capital to risk-weighted assets of 31.42% and total capital to risk-weighted assets of 33.26% at September 30, 1999. Impact of the Year 2000 Issue As we near the 21st century, MASSBANK is taking important steps to tackle the computer glitch dubbed the Year 2000 Problem, Y2K, or Millennium Bug. The problem originated from software designers' attempt to save memory by recording years in a two-digit format - "98" instead of "1998" for example - but didn't take into account that the year 2000, or "00" could also be interpreted, by any system that has time sensitive software, as the year 1900 rather than the year 2000. This could result in a system failure or in miscalculations. In May 1997, the Company organized a Year 2000 project team to address the Y2K critical issues in order to resolve its Year 2000 computer problems. The Company's Year 2000 project continues to be directed by the project team which provides direct oversight of the Year 2000 initiative. The team's project manager continues to update the Bank's Board of Directors monthly on the project's progress and the Company's Board of Directors continues to receive formal project updates on a quarterly basis. The project team has completed its assessment of the Company's technology and non-information technology systems, such as vault doors, elevators, and security systems, to identify the systems that could be affected by the Year 2000 issue and has developed a plan to address this issue. The project plan, which incorporates the Federal Financial Institutions Examination Council ("FFIEC") recommended guidelines, encompasses a service bureau for systems that are outsourced, in-house systems, vendors, customers and suppliers (including correspondent banks). In addition to addressing the Company's technology issues, the project plan includes a customer awareness program designed to keep the Bank's customers informed about the Year 2000 issue and the Company's state of readiness. The Company has incurred and will continue to incur expenses in connection with its Year 2000 readiness efforts. Year 2000 project expenditures to-date, excluding personnel costs, approximate $262,000. Expenditures for the first nine months of 1999 totaled $209,000. Approximately $45,000 of the current year's expenditures were expensed as incurred, while the costs of new hardware and software of approximately $164,000 was capitalized and will be amortized over the hardware and software's useful life in accordance with the Company's standard accounting practices. The capitalized expenditures represent the payment on new check processing equipment and the replacement of some personal computers and VCRs that were not Year 2000 ready. Expenses for the remainder of the Year 2000 project are not expected to exceed $75,000. The expenditures of the project are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. The Company relies on a third party service bureau for its primary business processes (e.g., loans and deposits applications). It has worked closely with the service bureau to monitor the progress of their Year 2000 efforts. The service bureau's Y2K remediation efforts are also being monitored by the federal banking regulators. The service bureau has successfully completed the remediation and testing of all its applications and the Company has successfully completed testing with the service bureau. Year 2000 (continued) The Company has also successfully completed the testing of all its computer hardware and mission critical internal information systems. However, the Company will continue to re-test some of its computer hardware and internal information systems throughout 1999. Most of the Company's other date sensitive systems operate on software supported by outside vendors. The Company continues to monitor the progress of their Year 2000 efforts and is seeking to receive written verification from these vendors as to their Year 2000 readiness. A majority of these vendors have represented themselves to the Company as being Year 2000 compliant. Testing of the Company's non-mission critical internal information systems and interfaces has also been substantially completed. Examination of the Company's non-information technology systems indicated that no significant replacements are required for Year 2000 readiness. While the Company continues to receive written verification from its service bureau and vendors as to their Year 2000 compliance, and has tested a number of their systems, there is no guarantee that these systems will not fail in the Year 2000. Also, there can be no assurance that the systems of other companies, banks, government agencies, utilities, etc. that interface with the Company will be timely remediated. If they are not successful, the Year 2000 problem could have a material effect on the Company's operations. In the unlikely event that a disruption does occur, the Company has developed business resumption contingency plans that will provide the Company with alternative methods of operation for its primary lines of business. These plans, which were completed in the second quarter 1999, continue to be enhanced to address potential Year 2000 failure scenarios. In addition, the Company has developed a Year 2000 event plan to govern its activities prior to, during and after the calendar rollover to 2000. The Company will continue to focus on the Year 2000 preparedness of its vendors, enhance its contingency and event plans, and communicate with its customers and employees throughout 1999. Management presently does not believe that the Year 2000 issue will result in significant operational problems for the Company. Management believes that the Company is now ready for the year 2000. The Company expects to conduct business as usual in the Year 2000 and beyond. Impact Of Inflation And Changing Prices MASSBANK Corp.'s financial statements presented herein have been prepared in accordance with generally accepted accounting principles which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in the relative purchasing power of money over time, due to the fact that substantially all of the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates have a more significant impact on a financial institution's performance than the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or in the same magnitude as the prices of goods and services. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Sensitivity and Liquidity See discussion and analysis of interest rate sensitivity and liquidity provided in the Corporation's Annual Report on Form 10-K for the year ended December 31, 1998. There have been no material changes in reported market risks faced by the Corporation since the filing of the Corporation's 1998 Annual Report on Form 10-K. PART II - OTHER INFORMATION Item 1. Legal Proceedings From time to time, MASSBANK Corp. and/or the Bank are involved as a plaintiff or defendant in various legal actions incident to their business. As of September 30, 1999, none of these actions individually or in the aggregate is believed by management to be material to the financial condition of MASSBANK Corp. or the Bank. Item 2. Changes in Securities Not Applicable. Item 3. Defaults Upon Senior Securities Not Applicable. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K a. Exhibits Exhibit No. 11.1: Statement regarding computation of per share earnings. b. Reports on Form 8-K None. SIGNATURES Pursuant to the requirements 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. MASSBANK Corp. & Subsidiaries _____________________________ (Registrant) Date: November 12, 1999 /s/Gerard H. Brandi ___________________________ (Signature) Gerard H. Brandi President and CEO Date: November 12, 1999 /s/Reginald E. Cormier ___________________________ (Signature) Reginald E. Cormier V.P., Treasurer and CFO