SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED SEPTEMBER 30, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-25328 FIRST KEYSTONE FINANCIAL, INC. -------------------------------- (Exact name of registrant as specified in its charter) Pennsylvania 23-0469351 --------------------------------- ---------------------- (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 22 West State Street Media, Pennsylvania 19063 --------------------------------------- ---------------------- (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (610) 565-6210 Securities registered pursuant to Section 12(b) of the Act: NOT APPLICABLE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK (PAR VALUE $.01 PER SHARE) Indicate by check mark whether the Registrant (1) has filed all reports required 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 ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. -------- As of December 21, 2001 the aggregate value of the 1,668,912 shares of Common Stock of the Registrant issued and outstanding on such date, which excludes 368,603 shares held by all directors and officers of the Registrant as a group, was approximately $23.2 million. This figure is based on the closing price of $13.81 per share of the Registrant's Common stock on December 21, 2001. Number of shares of Common Stock outstanding as of December 21, 2001: 2,037,515 DOCUMENTS INCORPORATED BY REFERENCE List hereunder the following documents incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) Portions of the Annual Report to Stockholders for the fiscal year ended September 30, 2001 are incorporated into Parts II and III. (2) Portions of the definitive proxy statement for the 2002 Annual Meeting of Stockholders are incorporated into Part III. PART I. Item 1. BUSINESS GENERAL First Keystone Financial, Inc. (the "Company") is a Pennsylvania corporation and sole shareholder of First Keystone Federal Savings Bank, a federally chartered stock savings bank (the "Bank") which, converted to the stock form of organization in January 1995. The only significant assets of the Company are the capital stock of the Bank, the Company's loans to its employee stock ownership plan, and various equity and other investments. See Note 18 of the Notes to Consolidated Financial Statements in the Annual Report to Stockholders for the fiscal year ended September 30, 2001 set forth as Exhibit 13 hereto ("Annual Report"). The business of the Company primarily consists of the business of the Bank. The Bank is a traditional, community oriented bank emphasizing customer service and convenience. The Bank's primary business is to attract deposits from the general public and invest those funds together with other available sources of funds, primarily borrowings, to originate loans. A substantial portion of the Bank's deposits are comprised of core deposits consisting of passbook, money market ("MMDA"), NOW and non-interest-bearing accounts. Core deposits amounted to $129.4 million or 41.5% of the Bank's total deposits at September 30, 2001. The Bank's primary lending emphasis is the origination of loans secured by first and second liens on single-family (one-to-four units) residences located in Delaware and Chester Counties, Pennsylvania and to a lesser degree, Montgomery County, Pennsylvania and New Castle County, Delaware. The Bank originates residential first mortgage loans with either fixed and/or adjustable rates. Adjustable rate loans are retained for the Bank's portfolio while fixed-rate loans may be sold in the secondary market depending on the Bank's asset/liability strategy, cash flow needs and current market conditions. The Bank also originates for portfolio, due to their generally shorter terms, adjustable or variable interest rates and generally higher yields, loans secured by commercial and multi-family residential real estate properties as well as residential and commercial construction loans secured by properties located in the Bank's market area. The level of the Bank's originations of commercial, construction and multi-family residential loans has remained strong as a direct result of the Bank's continued emphasis on developing business loan products. Multi-family residential and commercial real estate loans amounted to $43.5 million or 16.2% of the total loan portfolio at September 30, 2001 as compared to $37.9 million or 15.5% at September 30, 2000. In addition, the Bank originates for sale in the secondary market, servicing released, non-conforming loans in excess of Fannie Mae ("FNMA") and Freddie Mac ("FHLMC") limits. The Bank has on occasions purchased loan participation interests in both residential and commercial loans depending on market conditions and portfolio needs. To a lesser extent, the Bank also originates consumer loans (consisting almost entirely of home equity loans and lines of credit) and other mortgage loans. In addition to its deposit gathering and lending activities, the Bank invests in mortgage-related securities, which are issued or guaranteed by U.S. Government agencies and government sponsored or private enterprises, as well as U.S. Treasury and federal government agency obligations, corporate bonds and municipal obligations. At September 30, 2001, the Bank's mortgage-related securities (including mortgage-related securities available for sale) amounted to $129.1 million, or 26.4% of the Company's total assets, and investment securities available for sale amounted to $62.6 million, or 12.8% of total assets. MARKET AREA AND COMPETITION The Bank's primary market area consists of Delaware and Southern Chester Counties and to a lesser extent the contiguous counties of Montgomery and Northern Chester Counties, Pennsylvania and New Castle County, Delaware. Delaware County is part of the Philadelphia Primary Metropolitan Statistical Area ("PMSA") which includes besides Delaware County, Bucks, Chester, Montgomery and Philadelphia Counties (as well as four counties in New Jersey). The Philadelphia area economy is typical of many large Northeastern and Midwestern cities where the traditional manufacturing based economy has declined to a certain degree and has been replaced by growth of the service sector. As a result of such growth, the Philadelphia PMSA's economic diversity has broadened and employment in the area is derived from a number of different employment sectors. In particular, Delaware County has experienced the development of companies providing products and services for the health care market such as Crozer/Keystone Health System, Wyeth-Ayerst Labs, Inc. and Mercy Health Corp. Philadelphia's central location in the Northeast corridor, its well-educated and skilled population base, infrastructure and other factors has made the Bank's market area attractive to many large corporate employers. Such employers include Comcast Corp., Boeing, State Farm Insurance, Unisys Corp., PECO Energy, SAP America, Inc., and many others. There are over seventy-five Fortune 1,000 companies maintaining a presence in this area and approximately twenty Fortune 500 companies headquartered in the region surrounding the Philadelphia PMSA including CIGNA Corp., E.I. duPont de Nemours, Bethlehem Steel, Ikon Office Solutions, Sun Company, Crown Cork & Seal and others. Delaware County has experienced slower population growth than the Philadelphia PMSA, although the growth rates in the outlying areas of Delaware County have exceeded that of the Philadelphia PMSA. Since 1990, there has been minimal population growth in Delaware County and it is expected to decrease slightly over the next 20 years. Chester County, on the other hand, has grown over 15% since 1990 and expected to increase further in the next decade. The Bank faces strong competition both in attracting deposits and making real estate loans. Its most direct competition for deposits has historically come from other savings associations, credit unions and commercial banks located in its market area including many large financial institutions which have greater financial and marketing resources available to them. In addition, during times of high interest rates, the Bank has faced additional significant competition for investors' funds from short-term money market securities, mutual funds and other corporate and government securities. The ability of the Bank to attract and retain savings deposits depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. The Bank experiences strong competition for real estate loans principally from other savings associations, commercial banks and mortgage-banking companies. The Bank competes for loans principally through the interest rates and loan fees it charges, the efficiency and quality of the services it provides borrowers and the convenient locations of its branch office network. Competition may increase as a result of the continuing reduction of restrictions on the interstate operations of financial institutions. 2 Lending Activities Loan Portfolio Composition. The following table sets forth the composition of the Bank's loan portfolio by type of loan at the dates indicated (excluding loans held for sale). September 30, --------------------------------------------------------------------------------------------------- 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- Amount % Amount % Amount % Amount % Amount % ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ (Dollars in thousands) Real estate loans: Single-family $160,289 59.81% $160,143 65.54% $166,802 69.82% $148,088 71.34% $135,168 68.53% Multi-family and commercial 43,472 16.22 37,870 15.50 31,188 13.05 20,563 9.91 18,305 9.28 Construction and land 29,117 10.86 17,905 7.33 18,426 7.71 15,858 7.64 16,400 8.31 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total real estate loans 232,878 86.89 215,918 88.37 216,416 90.58 184,509 88.89 169,873 86.12 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Consumer: Home equity loans and lines of credit 25,847 9.65 22,597 9.25 18,624 7.80 19,609 9.45 22,964 11.64 Deposit 232 .09 251 .10 243 .10 181 .09 348 .18 Education 285 .12 365 .15 449 .21 365 .19 Other(1) 893 .33 807 .33 1,080 .45 1,429 .69 1,690 .86 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total consumer loans 26,972 10.07 23,940 9.80 20,312 8.50 21,668 10.44 25,367 12.87 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Commercial business loans 8,158 3.04 4,475 1.83 2,190 .92 1,390 .67 2,000 1.01 -------- ------ -------- ------ -------- ------ -------- ------ -------- ------ Total loans receivable(2) 268,008 100.00% 244,333 100.00% 238,918 100.00% 207,567 100.00% 197,240 100.00% -------- ====== -------- ====== -------- ====== -------- ====== -------- ====== Less: Loans in process (construction and land) 17,016 10,330 9,005 5,781 5,670 Deferred loan origination fees and discounts 1,147 1,298 1,610 1,705 1,653 Allowance for loan losses 2,181 2,019 1,928 1,738 1,628 -------- -------- -------- -------- -------- 20,344 13,647 12,543 9,224 8,951 -------- -------- -------- -------- -------- Total loans receivable, net $247,664 $230,686 $226,375 $198,343 $188,289 ======== ======== ======== ======== ======== - ---------- (1) Consists primarily of credit card loans. (2) Does not include $225,000, $3.1 million, $1.8 million, $2.8 million, and $4.6 million of loans held for sale at September 30, 2001, 2000, 1999, 1998 and 1997, respectively. 3 Contractual Principal Repayments. The following table sets forth the scheduled contractual maturities of the Bank's loans held to maturity at September 30, 2001. Demand loans, loans having no stated schedule of repayments and no stated maturity and overdraft loans are reported as due in one year or less. The amounts shown for each period do not take into account loan prepayments and normal amortization of the Bank's loan portfolio held to maturity. Real Estate Loans ---------------------------------------------------- Multi-family Consumer and and Construction Commercial Single-family Commercial and Land Total Business Loans Total ------------- ---------- -------- ----- -------------- ----- (Dollars in thousands) Amounts due in: One year or less $ 5,923 $ 993 $29,117 $ 36,033 $11,509 $ 47,542 After one year through three years 12,243 14,696 26,939 5,189 32,128 After three years through five years 14,725 7,525 22,250 4,304 26,554 After five years through ten years 35,513 9,818 45,331 9,613 54,944 After ten years through fifteen years 32,395 5,120 37,515 3,640 41,155 Over fifteen years 59,490 5,320 64,810 875 65,685 -------- ------- ------- -------- -------- -------- Total(1) $160,289 $43,472 $29,117 $232,878 $35,130 $268,008 ======== ======= ======= ======== ======== ======== Interest rate terms on amounts due after one year: Fixed $122,431 $19,061 $141,492 Adjustable 74,414 4,560 78,974 -------- ------- -------- Total(1) $196,845 $23,621 $220,466 ======== ======= ======== - ---------- (1) Does not include adjustments relating to loans in process, allowances for loan losses and deferred fee income. 4 Scheduled contractual amortization of loans does not reflect the expected term of the Bank's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates (due to refinancings of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates. Loan Origination, Purchase and Sales Activity. The following table shows the loan origination, purchase and sale activity of the Bank during the periods indicated. Year Ended September 30, --------------------------------------------- 2001 2000 1999 (In thousands) Gross loans at beginning of period(1) $ 247,532 $ 240,710 $ 210,366 --------- --------- --------- Loan originations for investment: Real estate: Residential 25,889 20,002 49,970 Commercial and multi-family 11,265 10,704 16,070 Construction 18,503 15,470 22,313 --------- --------- --------- Total real estate loans originated for investment 55,657 46,176 88,353 Consumer 11,650 10,045 7,309 Commercial business 12,102 4,443 3,594 --------- --------- --------- Total loans originated for investment 80,533 61,017 101,217 Participations purchased(2) 1,124 353 1,961 Loans originated for resale 20,685 39,531 46,199 --------- --------- --------- Total originations 101,218 100,548 147,416 --------- --------- --------- Deduct: Principal loan repayments and prepayments (56,086) (54,325) (68,549) Transferred to real estate owned (872) (1,177) (1,317) Loans sold in secondary market (23,559) (38,224) (47,206) --------- --------- --------- Subtotal (80,517) 93,726 117,072 --------- --------- --------- Net increase in loans(1) 20,701 6,822 30,344 --------- --------- --------- Gross loans at end of period(1) $ 268,233 $ 247,532 $ 240,710 ========= ========= ========= - ---------- (1) Includes loans held for sale of $225,000, $3.1 million, and $1.8 million at September 30, 2001, 2000 and 1999, respectively. (2) Consist of commercial real estate loans. 5 The lending activities of the Bank are subject to written underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. Applications for all types of loans may be taken at all of the Bank's branch offices by the branch manager or other designated loan officers. Applications for single-family residential mortgage loans for portfolio retention also are obtained through loan originators who are employees of the Bank. The Bank's loan originators will take loan applications outside of the Bank's offices at the customer's convenience and are compensated on a commission basis. The Mortgage Lending Department supervises the process of obtaining credit reports, appraisals and other documentation involved with a loan. In most cases, the Bank requires that a property appraisal be obtained in connection with all new first mortgage loans. Generally, appraisals are not required on home equity loans because alternative means of valuation are used (i.e. tax assessments). Property appraisals generally are performed by an independent appraiser from a list approved by the Bank's Board of Directors. The Bank requires that title insurance (other than with respect to home equity loans) and hazard insurance be maintained on all security properties and that flood insurance be maintained if the property is within a designated flood plain. Residential mortgage loan applications are primarily developed from referrals from real estate brokers and builders, existing customers and walk-in customers. Residential mortgage loans also are originated through correspondents. Commercial and multi-family real estate loan applications are obtained primarily from previous borrowers, direct solicitations by Bank personnel, as well as referrals. Consumer loans originated by the Bank are obtained primarily through existing and walk-in customers who have been made aware of the Bank's programs by advertising and other means. Applications for single-family residential mortgage loans which are originated for resale in the secondary market or loans designated for portfolio retention that conform to the requirements for resale into the secondary market and do not exceed FNMA/FHLMC limits are approved by the Bank's Chief Lending Officer or in his absence, by the Vice President of Mortgage Lending or the Loan Committee (a committee comprised of four directors and the Bank's Chief Lending Officer). All other mortgage loans (commercial and multi-family residential real estate and construction loans) and residential mortgage loans in excess of FNMA/FHLMC maximum amounts (currently $300,700) but less than $1.0 million must be approved by the Loan Committee. All mortgage loans in excess of $1.0 million must be approved by the Bank's Board of Directors or the Executive Committee thereof. All mortgage loans which do not require approval by the Board of Directors are submitted to the Board at its next meeting for review and ratification. Home equity loans and lines of credit up to $100,000 can be approved by the Chief Lending Officer, the Vice President of Construction Loans or the Vice President of Mortgage Lending. Loans in excess of such amount must be approved by the Loan Committee. Single-Family Residential Loans. Substantially all of the Bank's single-family residential mortgage loans consist of conventional loans. Conventional loans are loans that are neither insured by the Federal Housing Administration or partially guaranteed by the Department of Veterans Affairs. The vast majority of the Bank's single-family residential mortgage loans are secured by properties located in Pennsylvania, primarily in Delaware and Chester Counties, and are originated under terms and documentation which permit their sale to the FHLMC or FNMA. The Bank, consistent with its asset/liability management strategies, sells some of its newly originated longer term fixed-rate residential mortgage loans and to a limited degree, existing longer term fixed-rate residential mortgage loans while retaining adjustable-rate mortgage loans and shorter term fixed-rate residential mortgage loans. See "-Mortgage-Banking Activities." The single-family residential mortgage loans offered by the Bank currently consist of fixed-rate loans, including bi-weekly, balloon and adjustable-rate loans. Fixed-rate loans generally have maturities ranging from 15 to 30 years and are fully amortizing with monthly loan payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank's fixed-rate loans are originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies, such as FHLMC and FNMA, and other purchasers in the secondary mortgage market. The Bank also offers bi-weekly loans under the terms of which the borrower makes payments every two weeks. Although such loans have a 30 year amortization schedule, due to the bi-weekly payment schedule, such loans repay substantially more rapidly than a standard monthly amortizing 30-year fixed-rate loan. The Bank also offers five and seven year balloon loans which provide that the borrower can conditionally renew the loan at the fifth or seventh year at a then to-be-determined rate for the remaining 25 or 23 years, respectively, of the amortization period. At September 30, 2001, $125.0 million, or 78.0%, of the Bank's single-family residential mortgage 6 loans held in portfolio were fixed-rate loans, including $25.3 million of bi-weekly fixed-rate residential mortgage loans. The adjustable-rate loans currently offered by the Bank have interest rates which adjust every one, three or five years in accordance with a designated index, such as U.S. Treasury obligations, adjusted to a constant maturity ("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family residential real estate loans generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date, and a cap and floor of 6% on any such increase or decrease over the life of the loan. In order to increase the originations of adjustable-rate loans, the Bank recently has been originating loans which bear a fixed interest rate for a period of three to five years after which they convert to one-year adjustable-rate loans. The Bank's adjustable-rate loans require that any payment adjustment resulting from a change in the interest rate of an adjustable-rate loan be sufficient to result in full amortization of the loan by the end of the loan term and, thus, do not permit any of the increased payment to be added to the principal amount of the loan, creating negative amortization. Although the Bank does offer adjustable-rate loans with initial rates below the fully indexed rate, such loans are underwritten using methods approved by FHLMC and FNMA which require borrowers to be qualified at 2% above the discounted loan rate under certain conditions. At September 30, 2001, $35.3 million, or 22.0%, of the Bank's single-family residential mortgage loans held for portfolio were adjustable-rate loans. Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because in the event interest rates increase, the loan payment by the borrower also increases to the extent permitted by the terms of the loan, thereby increasing the potential for default. In addition, adjustable rate loans tend to prepay and convert to fixed rates when the overall interest rate environment is low. Moreover, as with fixed-rate loans, as interest rates increase, the marketability of the underlying collateral property may be adversely affected by higher interest rates. The Bank believes that these risks, which have not had a material adverse effect on the Bank to date, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment. For conventional residential mortgage loans held in portfolio and also for those loans originated for sale in the secondary market, the Bank's maximum loan-to-value ("LTV") ratio is 97%, and is based on the lesser of sales price or appraised value. On most loans with a LTV ratio of over 80%, private mortgage insurance is required to be obtained. Commercial and Multi-Family Residential Real Estate Loans. The Bank has moderately increased its investment in commercial and multi-family residential lending. Such loans are being made primarily to small- and medium-sized businesses located in the Bank's primary market area, a portion of the market that the Bank believes has been underserved in recent years. Loans secured by commercial and multi-family residential real estate amounted to $43.5 million, or 16.2%, of the Bank's total loan portfolio, at September 30, 2001. The Bank's commercial and multi-family residential real estate loans are secured primarily by professional office buildings, small retail establishments, warehouses and apartment buildings (with 36 units or less) located in the Bank's primary market area. The Bank's adjustable-rate multi-family residential and commercial real estate loans generally are either three or five-year adjustable-rate loans indexed to the CMT plus a margin. In addition, depending on collateral value and strength of the borrower, fixed-rate balloon loans and longer term fixed-rate loans may be originated. Generally, fees of 1% to 3% of the principal loan balance are charged to the borrower upon closing. Although terms for multi-family residential and commercial real estate loans may vary, the Bank's underwriting standards generally provide for terms of up to 25 years with amortization of principal over the term of the loan and LTV ratios of not more than 75%. Generally, the Bank obtains personal guarantees of the principals of the borrower as additional security for any commercial real estate and multi-family residential loans and requires that the borrower have at least a 25% equity investment in any such property. The Bank evaluates various aspects of commercial and multi-family residential real estate loan transactions in an effort to mitigate risk to the extent possible. In underwriting these loans, consideration is given to the stability of the property's cash flow history, future operating projections, current and projected occupancy, position in the market, location and physical condition. In recent periods, the Bank has generally imposed a debt coverage ratio (the ratio of net cash from operations before payment of debt service to debt service) of not less than 110%. The underwriting analysis also includes credit checks and a review of the financial condition of the borrower and guarantor, if applicable. An appraisal report is prepared by a state-licensed and certified appraiser (generally an appraiser who is qualified as a Member of the Appraisal Institute ("MAI")) commissioned by the Bank to substantiate property values for every 7 commercial real estate and multi-family loan transaction. All appraisal reports are reviewed by the commercial loan underwriter prior to the closing of the loan. Multi-family residential and commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans often involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. These risks also can be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. The Bank attempts to minimize its risk exposure by limiting such lending to proven developers/owners, only considering properties with existing operating performance which can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral. Construction Loans. Substantially all of the Bank's construction loans consist of loans to construct single-family properties extended either to individuals or to selected developers with whom the Bank is familiar to build such properties on a pre-sold or limited speculative basis. To a lesser extent, the Bank provides financing for construction to permanent commercial loan properties. Commercial construction loans have a maximum term of 24 months during the construction period with interest based upon the prime rate published in the Wall Street Journal ("Prime Rate") plus a margin and have LTV ratios of 80% or less of the appraised value upon completion. The loans convert to permanent commercial term loans upon completion of construction. With respect to construction loans to individuals, such loans have a maximum term of 12 months, have variable rates of interest based upon the Prime Rate plus a margin and have LTV ratios of 80% or less of the appraised value of the property upon completion and generally do not require the amortization of principal during the term. Upon completion of construction, the borrower is required to refinance the loan although the Bank may be the lender of the permanent loan secured by the property. The Bank also provides construction loans and lines of credit to developers. The majority of construction loans consist of loans to selected local developers with whom the Bank is familiar and who build single-family dwellings on a pre-sold or, to a significantly lesser extent, on a speculative basis. The Bank generally limits to two the number of unsold units that a developer may have under construction in a project. Such loans generally have terms of 24 to 36 months or less, have maximum LTV ratios of 75% of the appraised value of the property upon completion and generally do not require the amortization of the principal during the term. The loans are made with variable rates of interest based on the Prime Rate plus a margin adjusted on a monthly basis. The Bank also receives origination fees that generally range from .5% to 3.0% of the loan commitment. The borrower is required to fund a portion of the project's costs, the exact amount being determined on a case-by-case basis. Loan proceeds are disbursed by percentage of completion of the cost of the project after inspections indicate that such disbursements are for costs already incurred and which have added to the value of the project. Only interest payments are due during the construction phase and the Bank may provide the borrower with an interest reserve from which it can pay the stated interest due thereon. The Bank's construction loans include a small number of loans to developers to acquire the land, develop the site and construct the residential units ("ADC loans"). At September 30, 2001, residential construction loans totaled $21.0 million, or 7.8%, of the total loan portfolio, primarily consisting of construction loans to developers. At September 30, 2001, commercial construction loans totaled $1.6 million, or .60%, of the total loan portfolio. The Bank also originates ground or land loans to individuals to purchase a property on which he intends to build his primary residence, as well as to developers to purchase lots to build speculative homes at a later date. Such loans have terms of 36 months or less with a maximum LTV ratio of 75% of the lower of appraised value or sale price. The loans are made with variable rates based on the Prime Rate plus a margin. The Bank also receives origination fees, which generally range between 1.0% and 3.0% of the loan amount. At September 30, 2001, land loans (including loans to acquire and develop land) totaled $6.5 million, or 2.4%, of the total loan portfolio. Loans to developers include both secured and unsecured lines of credit (which are classified as a commercial loans) with outstanding commitments totaling $1.7 million. All have personal guaranties of the principals and are cross- collateralized with existing loans. At September 30, 2001, loans outstanding under builder lines of credit totaled $1.4 8 million, or .52%, of the total loan portfolio, of which $683,800 were unsecured and given only to the Bank's most creditworthy long standing customers. Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property by a MAI appraiser approved by the Board of Directors. In addition, during the term of the construction loan, the project is inspected by an independent inspector. Construction financing generally is considered to involve a higher degree of risk of loss than long-term financing on improved, owner-occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with a project, when completed, having a value which is insufficient to assure full repayment. Loans on lots may run the risk of adverse zoning changes as well as environmental or other restrictions on future use. Consumer Lending Activities. The Bank offers consumer loans in order to provide a full range of retail financial services to its customers. At September 30, 2001, $27.0 million, or 10.1 %, of the Bank's total loan portfolio was comprised of consumer loans. The Bank originates substantially all of such loans in its primary market area. The largest component of the Bank's consumer loan portfolio consists of home equity loans and home equity lines of credit, both of which are secured by the underlying equity in the borrower's primary residence or, occasionally, other types of real estate. Home equity loans are amortizing loans with fixed interest rates and maximum terms of 15 years while equity lines of credit have adjustable interest rates indexed to the Prime Rate. Generally home equity loans or home equity lines of credit do not exceed $100,000. The Bank's home equity loans and lines of credit generally require combined LTV ratios of 80% or less. Loans with higher LTV ratios are available but with higher interest rates and stricter credit standards. At September 30, 2001, home equity loans and lines of credit amounted to $25.8 million, or 9.7%, of the Bank's total loan portfolio. At September 30, 2001, the remaining portion of the Bank's consumer loan portfolio was comprised of credit card, deposit and other consumer loans. Credit cards, deposit loans and other consumer loans totaled $1.1 million, or .4%, of the Bank's total loan portfolio at September 30, 2001. The Bank's credit card program is primarily offered to only the Bank's most creditworthy customers. At September 30, 2001, these loans totaled $618,000, or .2%, of the total loan portfolio. Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral. These risks are not as prevalent in the Bank's consumer loan portfolio, however, because a high percentage of the portfolio is comprised of home equity loans and lines of credit that are secured by real estate and underwritten in a manner such that they result in a lending risk that is substantially similar to single-family residential loans. Commercial Business Loans. The Bank grants commercial business loans directly to business enterprises that are located in its market area. The majority of such loans are for less than $1.0 million. The Bank actively targets and markets to small- and medium-sized businesses. Applications for commercial business loans are obtained from existing commercial customers, branch and customer referrals, direct inquiry and those that are obtained by our commercial lending officers. As of September 30, 2001, commercial business loans amounted to $8.2 million, or 3.0%, of the Bank's total loan portfolio. 9 The commercial business loans consist of a limited number of commercial lines of credit secured by real estate, securities, some working capital financings secured by accounts receivable and inventory and, to a limited extent, unsecured lines of credit. Commercial business loans originated by the Bank ordinarily have terms of five years or less and fixed rates or adjustable rates tied to the Prime Rate plus a margin. Although commercial business loans generally are considered to involve greater credit risk than other certain types of loans, management intends to offer commercial business loans to small- and medium-sized businesses in an effort to better serve our community's needs, obtain core noninterest-bearing deposits and increase the Bank's interest rate spread. Mortgage-Banking Activities. Due to customer preference for fixed-rate loans, the Bank has continued to originate fixed-rate loans. Long-term (generally 30 years) fixed-rate loans not taken into portfolio for asset/liability purposes are sold into the secondary market. In addition, the Bank has developed for sale in the secondary market non-conforming loans (loans not conforming to FHLMC/FNMA underwriting guidelines). The Bank's net gain on sales of mortgage loans amounted to $122,000, $206,000, and $325,000 during the fiscal years ended September 30, 2001, 2000 and 1999, respectively. Profits from sales of loans held for sale have declined due to declining profitability on subprime lending and the Bank's decision in fiscal 2001 to exit the subprime line of business. The Bank had $225,000 and $3.1 million of mortgage loans held for sale at September 30, 2001 and 2000, respectively. The Bank's conforming mortgage loans sold to others are sold, generally with servicing retained, on a loan-by-loan basis primarily to FHLMC and FNMA. A period of less than five days generally elapses between the closing of the loan by the Bank and its purchase by the investor. Mortgages with established interest rates generally will decrease in value during periods of increasing interest rates. Accordingly, fluctuations in prevailing interest rates may result in a gain or loss to the Bank as a result of adjustments to the carrying value of loans held for sale or upon sale of loans. The Bank attempts to protect itself from these market fluctuations through the use of forward commitments at the time of the commitment by the Bank of a loan rate to the borrower. These commitments are mandatory delivery contracts with FHLMC and FNMA within a certain time frame and within certain dollar amounts by a price determined at the commitment date. Market risk does exist as non-refundable points paid by the borrower may not be sufficient to offset fees associated with closing the forward commitment contract. Loan Origination Fees and Servicing. Borrowers are generally charged an origination fee, which is a percentage of the principal balance of the loan. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," the various fees received by the Bank in connection with the origination of loans are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. However, when such loans are sold, the remaining unamortized fees (which is all or substantially all of such fees due to the relatively short period during which such loans are held) are recognized as income on the sale of loans held for sale. The Bank, for conforming loan products, generally retains the servicing on all loans sold to others. In addition, the Bank services substantially all of the loans that it retains in its portfolio. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, making advances to cover delinquent payments, making inspections as required of mortgaged premises, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults and generally administering the loans. Funds that have been escrowed by borrowers for the payment of mortgage-related expenses, such as property taxes and hazard and mortgage insurance premiums, are maintained in noninterest-bearing accounts at the Bank. The following table presents information regarding the loans serviced by the Bank for others at the dates indicated. Substantially all the loans were secured by properties in Pennsylvania. A small percentage of the loans are secured by properties located in Delaware, Maryland or New Jersey. 10 September 30, ------------------------------------- 2001 2000 1999 ---- ---- ---- (In thousands) Loans originated by the Bank and serviced for: FNMA $ 1,726 $ 2,140 $ 2,752 FHLMC 64,195 67,858 74,031 Others 380 392 403 ------- ------- ------- Total loans serviced for others $66,301 $70,390 $77,186 ======= ======= ======= The Bank receives fees for servicing mortgage loans, which generally amount to 0.25% per annum on the declining principal balance of mortgage loans. Such fees serve to compensate the Bank for the costs of performing the servicing function. Other sources of loan servicing revenues include late charges. For fiscal years ended September 30, 2001, 2000 and 1999, the Bank earned gross fees of $148,000, $150,000 and $205,000, respectively, from loan servicing. The Bank retains a portion of funds received from borrowers on the loans it services for others in payment of its servicing fees received on loans serviced for others. Loans-to-One Borrower Limitations. Regulations impose limitations on the aggregate amount of loans that a savings institution could make to any one borrower, including related entities. Under such regulations, the permissible amount of loans-to-one borrower follows the national bank standard for all loans made by savings institutions, which generally does not permit loans-to-one borrower to exceed 15% of unimpaired capital and surplus. Loans in an amount equal to an additional 10% of unimpaired capital and surplus also may be made to a borrower if the loans are fully secured by readily marketable securities. At September 30, 2001, the Bank's five largest loans or groups of loans-to-one borrower, including related entities, ranged from an aggregate of $3.7 million to $5.4 million. The Bank's loans-to-one borrower limit was $5.9 million at such date. ASSET QUALITY General. As a part of the Bank's efforts to improve its asset quality, it has developed and implemented an asset classification system. All of the Bank's assets are subject to review under the classification system, but particular emphasis is placed on the review of multi-family residential and commercial real estate loans, construction loans and commercial business loans. All assets of the Bank are periodically reviewed and the classification recommendations submitted to the Asset Classification Committee at least monthly. The Asset Classification Committee is composed of the President and Chief Executive Officer, the Chief Financial Officer, the Vice President of Loan Administration, the Internal Auditor and the Vice President of Construction Lending. All assets are placed into one of the four following categories: Pass, Substandard, Doubtful and Loss. The criteria used to review and establish each asset's classification are substantially identical to the asset classification system used by the Office of Thrift Supervision (the "OTS") in connection with the examination process. As of September 30, 2001, the Bank did not have any assets which it had classified as doubtful or loss. See "- Non-Performing Assets" and "- Other Classified Assets" for a discussion of certain of the Bank's assets which have been classified as substandard and regulatory classification standards generally. 11 When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made 30 days after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency continues, late charges are assessed and additional efforts are made to collect the loan. While the Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 90 days delinquent, the Bank institutes foreclosure or other proceedings, as necessary, to minimize any potential loss. Loans are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more. See Note 2 of the Notes to Consolidated Financial Statements included in the Company's Annual Report. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. Real estate owned is initially recorded at the lower of fair value less estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition). After the date of acquisition, all costs incurred in maintaining the property are expenses and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value. Under accounting principles generally accepted in the United States of America ("GAAP"), the Bank is required to account for certain loan modifications or restructurings as "troubled debt restructurings." In general, the modification or restructuring of a debt constitutes a troubled debt restructuring if the Bank, for economic or legal reasons related to the borrower's financial difficulties, grants a concession to the borrower that the Bank would not otherwise consider under current market conditions. Debt restructuring or loan modifications for a borrower do not necessarily always constitute troubled debt restructuring, however, and troubled debt restructuring does not necessarily result in non-accrual loans. 12 Delinquent Loans. The following table sets forth information concerning delinquent loans at the dates indicated, in dollar amounts and as a percentage of each category of the Bank's loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due. September 30, 2001 September 30, 2000 ------------------------------------------- ------------------------------------------- 30-59 Days 60-89 Days 30-59 Days 60-89 Days -------------------- ------------------- ------------------- ------------------- Percent Percent Percent Percent of of of of Loan Loan Loan Loan Amount Category Amount Category Amount Category Amount Category ------ -------- ------ -------- ------ -------- ------ -------- (Dollars in thousands) Real estate loans: Single-family residential $526 .33% $ 80 .05% $752 .46% $148 .09% Construction Consumer loans 204 .76 46 .17 13 .05 24 .10 Commercial business loans ---- ---- ---- ---- Total $730 .27% $126 .05% $765 .31% $172 .07% ==== === ==== === ==== === ==== === 13 Non-Performing Assets. The following table sets forth the amounts and categories of the Bank's non-performing assets and troubled debt restructurings at the dates indicated. September 30, -------------------------------------------------------- 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- (Dollars in thousands) Non-performing loans: Single-family residential $1,924 $2,109 $2,312 $2,341 $1,661 Commercial and multi- family(1) 33 289 323 22 Construction(2) 556 895 275 Consumer 314 48 16 43 14 Commercial business 3 6 83 100 ------ ------ ------ ------ ------ Total non-performing loans 2,271 2,160 3,179 3,685 2,072 ------ ------ ------ ------ ------ Accruing loans more than 90 days delinquent 31 355 1 19 5 ------ ------ ------ ------ ------ Total non-performing loans 2,302 2,515 3,180 3,704 2,077 ------ ------ ------ ------ ------ Real estate owned 887 947 297 1,663 1,672 ------ ------ ------ ------ ------ Total non-performing assets $3,189 $3,462 $3,477 $5,367 $3,749 ====== ====== ====== ====== ====== Troubled debt restructurings(3) $ $ $ 24 $ 46 $ 384 ====== ====== ====== ====== ====== Total non-performing loans and troubled debt restructurings as a percentage of gross loans receivable(4) .92% 1.07% 1.39% 1.85% 1.29% ====== ====== ====== ====== ====== Total non-performing assets as a percentage of total assets .65% .75% .77% 1.29% 1.00% ====== ====== ====== ====== ====== Total non-performing assets and troubled debt restructurings as percentage of total assets .65% .75% .78% 1.30% 1.11% ====== ====== ====== ====== ====== - ---------- (1) Consists of two loans at September 30, 1999, 1998 and 1996 and one loan at September 30, 2001 and 1997. (2) Consists of three loans made to two borrowers at September 30, 1999, six loans made to three borrowers at September 30, 1998 and two loans at September 30, 1997. (3) Consists of lease financing receivables at September 30, 1999, 1998 and 1997 from the Bennett Funding Group of Syracuse, New York ("Bennett Funding"). The troubled debt restructurings entered into in 1997 performed in accordance with the terms of the agreements since the restructurings. (4) Includes loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 14 The $1.9 million of single-family residential loans at September 30, 2001 consisted of 32 loans with principal balances ranging from $1,000 to $219,000, with an average balance of approximately $60,200. Included within the 32 loans, are 9 loans aggregating $1.0 million to credit impaired borrowers. At September 30, 2001, the $887,000 of real estate owned consisted of 12 single-family residential properties, with an average carrying value of $74,000 with the largest having a carrying value of $270,000. Other Classified Assets. Federal banking regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. At September 30, 2001, the Bank had $3.5 million of assets classified as substandard, and no assets classified as doubtful or loss. Substantially all classified assets consist of non-performing assets. Allowance for Loan Losses. The Bank's policy is to establish reserves for estimated losses on delinquent loans when it determines that losses are probable. The allowance for losses on loans is maintained at a level believed adequate by management to absorb probable losses in its portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income. The level of provisions increased in fiscal 2001 and 2000 due to the Bank's increasing originations of commercial and consumer loans which have a greater inherent degree of credit risk. As shown in the table below, at September 30, 2001, the Bank's allowance for loan losses amounted to 94.74% and .87% of the Bank's non-performing loans and gross loans receivable, respectively. On July 6, 2001, the Securities and Exchange Commission (the "SEC") issued Staff Accounting Bulletin ("SAB") No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues. The guidance contained in the SAB was effective immediately. This SAB expresses the views of the SEC staff regarding a registrant's development, documentation, and application of a systematic methodology for determining the allowance for loan and lease losses, as required by SEC Financial Reporting Release No. 28. The guidance in SAB No. 102 focuses on the documentation the SEC staff normally expects registrants to prepare and maintain in support of the allowance for loans and lease losses. Concurrent with the SEC's issuance of SAB No. 102, the federal banking agencies (the Federal Deposit Insurance Corporation (the "FDIC"), the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency and the Office of Thrift Supervision (the "OTS")) represented by the Federal Financial Institutions Examination Council issued an interagency policy statement entitled Allowance for Loan and Lease Losses Methodologies and Documentation for Banks and Savings Institutions (the "Policy Statement"). SAB No. 102 and the Policy Statement were the result of an agreement between the SEC and the federal banking agencies in March 1999 to provide guidance on allowance for loan and lease methodologies and supporting documentation. The guidance contained in SAB No. 102 does not prescribe specific allowance estimation methodologies registrants should employ in estimating their allowance for loan and lease losses, but rather emphasizes the need for a systematic methodology that is properly designed and implemented by registrants. Management of the Bank presently believes that its allowance for loan losses is adequate to cover any probable losses in the Bank's loan portfolio. However, future adjustments to this allowance may be necessary, and the Bank's results of operations could be adversely affected if circumstances differ substantially from the assumptions used by management in making its determinations in this regard. 15 The following table provides information regarding the changes in the allowance for loan losses and other selected statistics for the periods presented. Year Ending September 30, ------------------------------------------------------------------------ 2001 2000 1999 1998 1997 ---- ---- ---- ---- ---- (Dollars in thousands) Allowance for loan losses, beginning of period $ 2,019 $ 1,928 $ 1,738 $ 1,628 $ 2,624 Charged-off loans: Single-family residential (492) (182) (12) (86) (119) Construction (117) Commercial leases(1) (956) Consumer and commercial business (40) (64) (60) (28) (177) ------- ------- ------- ------- ------- Total charged-off loans (532) (363) (72) (114) (1,252) ------- ------- ------- ------- ------- Recoveries on loans previously charged off: Single-family residential 11 2 22 7 Construction 14 10 Commercial leases(1) 134 33 Consumer and commercial business 9 1 1 2 ------- ------- ------- ------- ------- Total recoveries 154 34 3 38 17 ------- ------- ------- ------- ------- Net loans charged-off (378) (329) (69) (76) (1,235) Provision for loan losses 540 420 259 186 239 ------- ------- ------- ------- ------- Allowance for loan losses, end of period $ 2,181 $ 2,019 $ 1,928 $ 1,738 $ 1,628 ======= ======= ======= ======= ======= Net loans charged-off to average loans outstanding(2) .16% .14% .03% .04% .68% ======= ======= ======= ======= ======= Allowance for loan losses to gross loans receivable(2) .87% .86% .84% .86% .86% ======= ======= ======= ======= ======= Allowance for loan losses to total non-performing loans 94.74% 80.28% 60.63% 46.92% 78.38% ======= ======= ======= ======= ======= Net loans charged-off to allowance for loan losses 17.33% 16.30% 3.58% 4.37% 75.86% ======= ======= ======= ======= ======= Recoveries to charge-offs 28.95% 9.37% 4.17% 33.33% 1.36% ======= ======= ======= ======= ======= - ---------- (1) Relate to commercial lease purchases in prior years. (2) Gross loans receivable and average loans outstanding include loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 16 The following table presents the Bank's allocation of the allowance for loan losses to the total amount of loans in each category listed at the dates indicated. September 30, ------------------------------------------------------------------------------------------------------ 2001 2000 1999 1998 1997 ----------------- ------------------ ------------------ ------------------ ------------------ % % % % % of Loans of Loans of Loans of Loans of Loans in Each in Each in Each in Each in Each Category Category Category Category Category to Total to Total to Total to Total to Total Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans ------ ----- ------ ----- ------ ----- ------ ----- ------ ----- (Dollars in thousands) Single-family residential $ 615 59.81% $1,098 65.54% $ 572 69.82% $ 446 71.34% $ 439 68.53% Commercial and multi- family residential 566 16.22 198 15.50 166 13.05 109 9.91 77 9.28 Construction 249 10.86 171 7.33 320 7.71 382 7.64 300 8.31 Consumer 70 10.07 49 9.80 42 8.50 63 10.44 67 12.87 Commercial business 87 3.04 60 1.83 14 .92 20 .67 31 1.01 Unallocated 594 443 814 718 714 ------ ------ ------ ------ ------ ------ ------ ------ ------ ------ Total allowance for loan losses $2,181 100.00% $2,019 100.00% $1,928 100.00% $1,738 100.00% $1,628 100.00% ====== ====== ====== ====== ====== ====== ====== ====== ====== ====== 17 MORTGAGE-RELATED SECURITIES AND INVESTMENT SECURITIES Mortgage-Related Securities. Federally chartered savings institutions have authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and of state and municipal governments, certificates of deposit at federally insured banks and savings and loan associations, certain bankers' acceptances and federal funds. Subject to various restrictions, federally chartered savings institutions also may invest a portion of their assets in commercial paper, corporate debt securities and mutual funds, the assets of which conform to the investments that federally chartered savings institutions are otherwise authorized to make directly. The Bank maintains a significant portfolio of mortgage-related securities (including mortgage-backed securities and collateralized mortgage obligations ("CMOs")) as a means of investing in housing-related mortgage instruments without the costs associated with originating mortgage loans for portfolio retention and with limited credit risk of default which arises in holding a portfolio of loans to maturity. Mortgage-backed securities (which also are known as mortgage participation certificates or pass-through certificates) represent a participation interest in a pool of single-family or multi-family residential mortgages. The principal and interest payments on mortgage-backed securities are passed from the mortgage originators, as servicer, through intermediaries (generally U.S. Government agencies and government-sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as the Bank. Such U.S. Government agencies and government sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include FHLMC, FNMA and the Government National Mortgage Association ("GNMA"). The Bank also invests in certain privately issued, credit enhanced mortgage-related securities rated AAA by national securities rating agencies. FHLMC is a public corporation chartered by the U.S. Government. FHLMC issues participation certificates backed principally by conventional mortgage loans. FHLMC guarantees the timely payment of interest and the ultimate return of principal on participation certificates. FNMA is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for mortgage loans. FNMA guarantees the timely payment of principal and interest on FNMA securities. FHLMC and FNMA securities are not backed by the full faith and credit of the United States, but because FHLMC and FNMA are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks. GNMA is a government agency within the Department of Housing and Urban Development which is intended to help finance government-assisted housing programs. GNMA securities are backed by Federal Housing Administration ("FHA") insured and the Department of Veterans Affairs ("VA") guaranteed loans, and the timely payment of principal and interest on GNMA securities are guaranteed by the GNMA and backed by the full faith and credit of the U.S. Government. Because FHLMC, FNMA and GNMA were established to provide support for low- and middle-income housing, there are limits to the maximum size of loans that qualify for these programs which is currently $300,700. Mortgage-related securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The underlying pool of mortgages can be composed of either fixed-rate or adjustable-rate loans. As a result, the risk characteristics of the underlying pool of mortgages (i.e., fixed-rate or adjustable rate) as well as prepayment risk, are passed on to the certificate holder. Thus, the life of a mortgage-backed pass-through security thus approximates the life of the underlying mortgages. The Bank's mortgage-related securities include regular interests in CMOs. CMOs were developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by governmental agencies, governmental sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. A CMO can be (but is not required to be) collateralized by loans or securities which are insured or guaranteed by FNMA, FHLMC or the GNMA. In contrast to pass-through mortgage-related securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics. 18 The short-term classes of a CMO usually carry a lower coupon rate than the longer term classes and, therefore, the interest differential cash flow on a residual interest is greatest in the early years of the CMO. As the early coupon classes are extinguished, the residual income declines. Thus, the longer the lower coupon classes remain outstanding, the greater the cash flow accruing to CMO residuals. As interest rates decline, prepayments accelerate, the interest differential narrows, and the cash flow from the CMO declines. Conversely, as interest rates increase, prepayments decrease, generating a larger cash flow to residuals. A senior-subordinated structure often is used with CMOs to provide credit enhancement for securities which are backed by collateral which is not guaranteed by FNMA, FHLMC or the GNMA. These structures divide mortgage pools into various risk classes: a senior class and one or more subordinated classes. The subordinated classes provide protection to the senior class. When cash flow is impaired, debt service goes first to the holders of senior classes. In addition, incoming cash flows also may go into a reserve fund to meet any future shortfalls of cash flow to holders of senior classes. The holders of subordinated classes may not receive any funds until the holders of senior classes have been paid and, when appropriate, until a specified level of funds has been contributed to the reserve fund. Mortgage-related securities generally bear yields which are less than those of the loans which underlie such securities because of their payment guarantees or credit enhancements which reduce credit risk to nominal levels. In addition, mortgage-related securities are more liquid than individual mortgage loans and may be used to collateralize certain obligations of the Bank. At September 30, 2001, $19.9 million of the Bank's mortgage-related securities were pledged to secure various obligations of the Bank, including reverse repurchase agreements, treasury tax and loan processing, and as collateral for certain government deposits. The Bank's mortgage-related securities are classified as either "held to maturity" or "available for sale" based upon the Bank's intent and ability to hold such securities to maturity at the time of purchase, in accordance with GAAP. As of September 30, 2001, the Bank had an aggregate of $129.1 million, or 26.4%, of total assets invested in mortgage-related securities, net, of which $11.5 million was held to maturity and $117.6 million was available for sale. The mortgage-related securities of the Bank which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield, while mortgage-related securities available for sale are carried at the current fair value. See Notes 2 and 4 of the Notes to Consolidated Financial Statements in the Annual Report. 19 The following table sets forth the composition of the Bank's available for sale (at fair value) and held to maturity (at amortized cost) of the mortgage-related securities portfolios at the dates indicated. September 30, ------------------------------------------ 2001 2000 1999 ---- ---- ---- Available for sale: (In thousands) Mortgage-backed securities: FHLMC $ 9,175 $ 5,771 $ 11,834 FNMA 15,056 23,546 31,955 GNMA 43,907 38,421 33,959 -------- ------- -------- Total mortgage-backed securities 68,138 67,738 77,748 -------- ------- -------- Collateralized mortgage obligations: FHLMC 10,994 9,117 6,283 FNMA 6,215 6,905 9,115 GNMA 17 309 549 Other 32,244(1) 12,188 19,351 -------- ------- -------- Total collateralized mortgage obligations 49,470 28,519 35,298 -------- ------- -------- Total mortgage-related securities $117,608 $96,257 $113,046 ======== ======= ======== Held to maturity: Mortgage-backed securities: FHLMC $ 2,285 $ 2,898 $ 3,156 FNMA 4,684 5,674 6,832 -------- ------- -------- Total mortgage-backed securities 6,969 8,572 9,988 -------- ------- -------- Collateralized mortgage obligations: FHLMC 25 FNMA 4,485 4,484 4,484 -------- ------- -------- Total collateralized mortgage obligations 4,485 4,484 4,509 -------- ------- -------- Total mortgage-related securities, amortized cost $ 11,454 $13,056 $ 14,497 ======== ======= ======== Total fair value(2) $ 11,550 $12,580 $ 14,100 ======== ======= ======== - ---------- (1) Includes "AAA" rated securities of Northwest Asset Securities Corporation, Chase Mortgage Services, Washington Mutual and Countrywide Home Loans with book values of $5.5 million, $3.1 million, $4.2 million and $5.0 million, respectively, and fair values of $5.7 million, $3.1 million, $4.3 million and $5.0 million, respectively. (2) See Note 4 of the Notes to Consolidated Financial Statements in the Annual Report. 20 The following table sets forth the purchases, sales and principal repayments of the Bank's mortgage-related securities for the periods indicated. Year Ended September 30, --------------------------------------------- 2001 2000 1999 ---- ---- ---- (In thousands) Mortgage-related securities, beginning of period(1)(2) $ 109,313 $ 127,543 $ 134,255 --------- --------- --------- Purchases: Mortgage-backed securities - available for sale 24,501 11,873 21,210 CMOs - available for sale 34,162 3,965 24,685 Sales: Mortgage-backed securities - available for sale (6,888) (13,407) CMOs - available for sale (5,132) Repayments and prepayments: Mortgage-backed securities (21,568) (10,410) (22,759) CMOs (14,808) (5,675) (25,493) Decrease in net premium (145) (62) (469) Change in net unrealized gain (loss) on mortgage-related securities available for sale 4,495 618 (3,886) --------- --------- --------- Net increase (decrease) in mortgage-related securities 19,749 (18,230) (6,712) --------- --------- --------- Mortgage-related securities, end of period(1) $ 129,062 $ 109,313 $ 127,543 ========= ========= ========= - ---------- (1) Includes both mortgage-related securities available for sale and held to maturity. (2) Calculated at amortized cost for securities held to maturity and at fair value for securities available for sale. At September 30, 2001, the estimated weighted average maturity of the Bank's fixed-rate mortgage-related securities was approximately 3.6 years. The actual maturity of a mortgage-backed security is less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and adversely affect its yield to maturity. The yield is based upon the interest income and the amortization of any premium or discount related to the mortgage-backed security. In accordance with GAAP, premiums and discounts are amortized over the estimated lives of the securities, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of declining mortgage interest rates, such as the Bank experienced during most of fiscal 2001, if the coupon rates of the underlying mortgages exceed the prevailing market interest rates offered for mortgage loans, refinancings generally increase and accelerate the prepayment rate of the underlying mortgages and the related securities. Conversely, during periods of increasing mortgage interest rates, if the coupon rates of the underlying mortgages are less than the prevailing market interest rates offered for mortgage loans, refinancings generally decrease and decrease the prepayment rate of the underlying mortgages and the related securities. As a result, in a declining interest rate environment, the Bank may be subject to reinvestment risk because to the extent that the Bank's mortgage-related securities amortize or prepay faster than anticipated, the Bank may not be able to reinvest the proceeds of such repayments and prepayments at a comparable yield. 21 Investment Securities. The following table sets forth information regarding the carrying and fair value of the Company's investment securities, both held to maturity and available for sale, at the dates indicated. At September 30, ----------------------------------------------------------------------------------- 2001 2000 1999 ----------------------- ---------------------- ----------------------- Carrying Fair Carrying Fair Carrying Fair Value Value Value Value Value Value ----- ----- ----- ----- ----- ----- (In thousands) FHLB stock $ 6,917 $ 6,917 $ 6,672 $ 6,672 $ 6,157 $ 6,157 U.S. Government and agency obligations 1 to 5 years 2,961 3,133 2,936 2,970 5,746 5,652 5 to 10 years 1,843 2,050 6,997 6,745 6,994 6,780 Municipal securities 21,890 22,626 18,930 18,153 18,924 17,873 Corporate bonds 14,333 14,087 4,910 4,596 4,909 4,639 Mutual funds 5,009 5,004 2,000 1,970 2,000 1,972 Asset backed securities 2,986 2,970 Preferred stocks 9,474 9,197 5,528 4,732 5,534 5,248 Other equity investments 2,778 3,497 2,778 3,049 2,390 2,151 ------- ------- ------- ------- ------- ------- Total $68,191 $69,481 $50,751 $48,887 $52,654 $50,472 ======= ======= ======= ======= ======= ======= At September 30, 2001, the Company had an aggregate of $69.5 million, or 14.2%, of its total assets invested in investment securities, of which $6.9 million consisted of FHLB stock and $62.6 million was investment securities available for sale. Included in U.S. Government and agency obligations is a callable bond with a remaining term of approximately two years. The Bank's investment securities (excluding equity securities and FHLB stock) had a weighted average maturity to the call date of 6.1 years and a weighted average yield of 6.57% (adjusted to a fully taxable equivalent yield). SOURCES OF FUNDS General. The Bank's principal source of funds for use in lending and for other general business purposes has traditionally come from deposits obtained through the Bank's branch offices. The Bank also derives funds from contractual payments and prepayments of outstanding loans and mortgage-related securities, from sales of loans, from maturing investment securities and from advances from the FHLB of Pittsburgh and other borrowings. Loan repayments are a relatively stable source of funds, while deposits inflows and outflows are significantly influenced by general interest rates and money market conditions. The Bank uses borrowings to supplement its deposits as a source of funds. Deposits. The Bank's current deposit products include passbook accounts, NOW accounts, MMDA, certificates of deposit ranging in terms from 30 days to five years and noninterest-bearing personal and business checking accounts. The Bank's deposit products also include Individual Retirement Account ("IRA") certificates and Keogh accounts. The Bank's deposits are obtained primarily from residents in Delaware and Chester Counties in southeastern Pennsylvania. The Bank attracts local deposit accounts by offering a wide variety of accounts, competitive interest rates, and convenient branch office locations and service hours. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including print media, radio advertising and direct mailings. However, the Bank does not solicit funds through deposit brokers nor does it pay any brokerage fees if it accepts such deposits. 22 The Bank has been competitive in the types of accounts and interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. Even with the significant decline in interest rates paid on deposit products in fiscal 2001, due to generally declining returns on competing investment opportunities as well as the effects of the stock market decline, the Bank did not experience disintermediation of deposits into competing investment products in fiscal 2001. The following table shows the distribution of, and certain information relating to, the Bank's deposits by type of deposit as of the dates indicated. September 30, -------------------------------------------------------------------------------------- 2001 2000 1999 ------------------------ ------------------------ ------------------------ Amount Percent Amount Percent Amount Percent ------ ------- ------ ------- ------ ------- (Dollars in thousands) Passbook $ 37,806 12.13% $ 37,861 13.89% $ 40,324 15.46% MMDA 40,781 13.09 23,583 8.65 19,417 7.45 NOW 45,161 14.49 38,898 14.27 33,412 12.81 Certificates of deposit 182,155 58.46 165,456 60.71 159,761 61.25 Noninterest-bearing 5,698 1.83 6,764 2.48 7,912 3.03 -------- -------- -------- -------- -------- -------- Total deposits $311,601 100.00% $272,562 100.00% $260,826 100.00% ======== ======== ======== ======== ======== ======== The following table sets forth the net savings flows of the Bank during the periods indicated. Year Ended September 30, ------------------------------------- 2001 2000 1999 ---- ---- ---- (In thousands) Increase before interest credited $27,876 $ 1,894 $ 4,336 Interest credited 11,163 9,842 9,179 ------- ------- ------- Net savings increase $39,039 $11,736 $13,515 ======= ======= ======= The following table sets forth maturities of the Bank's certificates of deposit of $100,000 or more at September 30, 2001 by time remaining to maturity. Amounts in Thousands --------- Three months or less $12,688 Over three months through six months 7,624 Over six months through twelve months 5,782 Over twelve months 4,685 ------- $30,779 ======= 23 The following table presents, by various interest rate categories, the amount of certificates of deposit at September 30, 2001 and 2000 and the amounts at September 30, 2001 which mature during the periods indicated. Amounts at September 30, 2001 September 30, Maturing Within ------------------------ ------------------------------------------------------ Certificates of Deposit 2001 2000 One Year Two Years Three Years Thereafter ------- ---- ---- -------- --------- ----------- ---------- (Dollars in thousands) 3.0% or less $ 3,694 $ 1,886 $ 1,808 3.01% to 4.0% 23,209 $ 386 19,250 1,496 $ 803 $1,660 4.01% to 5.0% 45,287 24,013 38,240 3,826 1,799 1,422 5.01% to 6.0% 26,107 39,929 16,270 3,511 717 5,609 6.01% to 7.0% 83,858 101,128 74,262 106 9,267 223 -------- -------- -------- ------- ------- ------ Total certificate accounts $182,155 $165,456 $149,908 $10,747 $12,586 $8,914 ======== ======== ======== ======= ======= ====== The following table presents the average balance of each deposit type and the average rate paid on each deposit type for the periods indicated. September 30, ------------------------------------------------------------------------------------------- 2001 2000 1999 ------------------------- -------------------------- -------------------------- Average Average Average Average Rate Average Rate Average Rate Balance Paid Balance Paid Balance Paid ------- ---- ------- ---- ------- ---- (Dollars in thousands) Passbook accounts $ 37,661 2.41% $ 39,498 2.41% $ 39,625 2.41% MMDA accounts 31,645 3.86 17,345 3.44 17,833 2.82 Certificates of deposit 177,086 5.87 164,783 5.61 157,134 5.33 NOW accounts 40,681 1.32 39,918 1.40 34,581 1.27 Noninterest-bearing deposits 7,658 6,613 6,360 -------- -------- -------- Total deposits $294,731 4.43% $268,157 4.23% $255,533 4.02% ======== ==== ======== ==== ======== ==== 24 Borrowings. The Bank may obtain advances from the FHLB of Pittsburgh upon the security of the common stock it owns in the FHLB and certain of its residential mortgage loans and securities held to maturity, provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. During fiscal 2001, deposit increases exceeded asset growth which allowed the Bank to repay some of the existing FHLB advances. The Bank, during fiscal 2000 and 1999, increased its FHLB borrowings to fund asset growth. At September 30, 2001, the Bank had $126.1 million in outstanding FHLB advances. See Note 9 of the Notes to Consolidated Financial Statements in the Annual Report for additional information. The Bank has entered into agreements to sell securities under terms which require it to repurchase the same or substantially similar securities by a specified date. Repurchase agreements are considered borrowings which are secured by the sold securities. At September 30, 2000, the Bank had $10.0 million of repurchase agreements outstanding callable within one year. There were no outstanding repurchase agreements during the year ended September 30, 2001. See Note 10 of the Notes to Consolidated Financial Statements in the Annual Report. Both the FHLB advances and the repurchase agreements have certain call features whereby the issuer can call the borrowings after the expiration of certain time frames. The time frames on the callable borrowings range from three months to seven years. SUBSIDIARIES The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, service corporations, with an additional investment of 1% of assets when such additional investment is utilized primarily for community development purposes. It may invest essentially unlimited amounts in subsidiaries deemed operating subsidiaries that can only engage in activities that the Bank is permitted to engage in. Under such limitations, as of September 30, 2001, the Bank was authorized to invest up to approximately $9.6 million in the stock of, or loans to, service corporations. As of September 30, 2001, the net book value of the Bank's investment in stock, unsecured loans, and conforming loans to its service corporations was $39,600. At September 30, 2001, in addition to the Bank, the Company has five direct or indirect subsidiaries: First Keystone Capital Trust I, FKF Management Corp., Inc., State Street Services Corp., First Pointe, Inc., and First Chester Services, Inc. First Keystone Capital Trust I (the "Trust") is a Delaware statutory business trust wholly owned by the Company formed in 1997 for the purpose of issuing trust preferred securities and investing the proceeds therefrom in Junior Subordinated Debentures issued by the Company. See Note 17 of the Notes to Consolidated Financial Statements in the Annual Report for further discussion regarding the issuance of trust preferred securities. 25 FKF Management Corp., Inc., a Delaware corporation, is a wholly owned operating subsidiary of the Bank established in 1997 for the purpose of managing assets of the Bank. Assets under management totaled $145.6 million at September 30, 2001 and were comprised principally of investment and mortgage-related securities. State Street Services Corp. is a wholly owned subsidiary of the Bank established in 1999 for the purpose of offering a full array of insurance products through its ownership of a 51% interest in First Keystone Insurance Services, LLC. In addition, it holds a 10% equity position in a title company which offers title services. First Pointe, Inc. is a wholly owned subsidiary of the Bank which was formed for the purpose of developing a real estate parcel received in a deed-in-lieu of foreclosure action. At September 30, 2000, all of the townhouses had been completed and sold. The Bank has one remaining subsidiary, First Chester Services, Inc., which was involved in real estate management but is now inactive. EMPLOYEES The Bank had 78 full-time employees and 8 part-time employees as of September 30, 2001. None of these employees is represented by a collective bargaining agreement. The Bank believes that it enjoys excellent relations with its personnel. 26 REGULATION The Company. The Company as a savings and loan holding company within the meaning of the Home Owners' Loan Act, as amended ("HOLA"), is registered as such with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof. Federal Activities Restrictions. The Company operates as a unitary savings and loan holding company. Generally, there are only limited restrictions on the activities of a unitary savings and loan holding company which applied to become or were a unitary saving and loan holding company prior to May 4, 1999 and its non-savings institution subsidiaries. Under the enacted Gramm-Leach-Bliley Act of 1999 (the "GLBA"), companies which apply to the OTS to become unitary savings and loan holding companies will be restricted to only engaging in those activities traditionally permitted to multiple saving and loan holding companies. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the Director may impose such restrictions as deemed necessary to address such risk, including limiting (i) payment of dividends by the savings association; (ii) transactions between the savings association and its affiliates; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the above rules as to permissible business activities of grandfathered unitary savings and loan holding companies under the GBLA (such as the Company), if the savings association subsidiary of such a holding company fails to meet a Qualified Thrift Lender ("QTL") test, then such unitary holding company also shall become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the savings association qualifies as a QTL within one year thereafter, shall register as, and become subject to the restrictions applicable to, a bank holding company. See "- The Bank - Qualified Thrift Lender Test." If the Company were to acquire control of another savings association, other than through merger or other business combination with the Bank, the Company would thereupon become a multiple savings and loan holding company and would thereafter be subject to further restrictions on its activities. The GLBA also imposed new financial privacy obligations and reporting requirements on all financial institutions. The privacy regulations require, among other things, that financial institutions establish privacy policies and disclose such policies to its customers at the commencement of a customer relationship and annually thereafter. In addition, financial institutions are required to permit customers to opt out of the financial institution's disclosure of the customer's financial information to non-affiliated third parties. Such regulations become mandatory as of July 1, 2001. The HOLA requires every savings institution subsidiary of a savings and loan holding company to give the OTS at least 30 days' advance notice of any proposed dividends to be made on its guarantee, permanent or other nonwithdrawable stock, or else such dividend will be invalid. See "- The Bank - Restrictions on Capital Distributions." Limitations on Transactions with Affiliates. Transactions between savings associations and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act ("FRA") and OTS regulations issued in connection therewith. Affiliates of a savings institution include, among other entities, the savings institution's holding company and companies that are controlled by or under common control with the savings institution. Generally, Sections 23A and 23B (i) limit the extent to which the savings association or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such association's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes, among other things, the making of loans or extension of credit to an affiliate, purchase of assets, issuance of a guarantee and similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, under OTS regulations no savings association may (i) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, (ii) a savings association may not purchase or invest in securities of an affiliate other than shares of a subsidiary; (iii) a savings association and its subsidiaries may not purchase a low-quality asset 27 from an affiliate; (iv) and covered transactions and certain other transactions between a savings association or its subsidiaries and an affiliate must be on terms and conditions that are consistent with safe and sound banking practices. With certain exceptions, each extension of credit by a savings association to an affiliate must be secured by collateral with a market value ranging from 100% to 130% (depending on the type of collateral) of the amount of the loan or extension of credit. OTS regulations generally exclude all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except to the extent that the OTS or the Federal Reserve Board decides to treat such subsidiaries as affiliates. The regulations also require savings associations to make and retain records that reflect affiliate transactions in reasonable detail, and provide that certain classes of savings associations may be required to give the OTS prior notice of affiliate transactions. Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the Director of the OTS, (i) control of any other savings association or savings and loan holding company or substantially all the assets thereof or (ii) more than 5% of the voting shares of a savings association or holding company thereof which is not a subsidiary. Except with the prior approval of the Director of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company's stock, may acquire control of any savings association, other than a subsidiary savings association, or of any other savings and loan holding company. Federal Securities Laws. The Company's Common Stock is registered with the SEC under the Securities Exchange Act of 1934, as amended ("Exchange Act"). The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act. Shares of Common Stock owned by an affiliate of the Company are subject to the resale restrictions of Rule 144 under the Securities Act of 1933, as amended ("Securities Act"). If the Company meets the current public information requirements of Rule 144 under the Securities Act, each affiliate of the Company who complies with the other conditions of Rule 144 (including those that require the affiliate's sale to be aggregated with those of certain other persons) generally is able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of (i) 1% of the outstanding shares of the Company or (ii) the average weekly volume of trading in such shares during the preceding four calendar weeks. The Bank. The OTS has extensive regulatory authority over the operations of savings associations. As part of this authority, savings associations are required to file periodic reports with the OTS and are subject to periodic examinations by the OTS. The investment and lending authority of savings associations are prescribed by federal laws and regulations and they are prohibited from engaging in any activities not permitted by such laws and regulations. Those laws and regulations generally are applicable to all federally chartered savings associations and may also apply to state-chartered savings associations. Such regulation and supervision is primarily intended for the protection of depositors. Insurance of Accounts. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the U. S. Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances which could result in termination of the Bank's deposit insurance. 28 Capital requirements. Current OTS capital standards require savings associations to satisfy three different capital requirements. Under these standards, savings associations must maintain "tangible" capital equal to 1.5% of adjusted total assets, "core" capital equal to 4% (3% if the association receives the OTS' highest rating) of adjusted total assets and "total" capital (a combination of core and "supplementary" capital) equal to 8.0% of "risk-weighted" assets. For purposes of the regulation, core capital generally consists of common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, minority interests in the equity accounts of fully consolidated subsidiaries, certain nonwithdrawable accounts and pledged deposits and "qualifying supervisory goodwill." Tangible capital is given the same definition as core capital but does not include qualifying supervisory goodwill and is reduced by the amount of all the savings association's intangible assets, with only a limited exception for purchased mortgage servicing rights ("PMSRs"). Both core and tangible capital are further reduced by an amount equal to a savings association's debt and equity investments in subsidiaries engaged in activities not permissible for national banks (other than subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities and subsidiary depository institutions or their holding companies). In addition, under the Prompt Corrective Action provisions of the OTS regulations, all but the most highly rated institutions must maintain a minimum leverage ratio of 4% in order to be adequately capitalized. See "- Prompt Corrective Action." At September 30, 2001, the Bank did not have any investment in subsidiaries engaged in impermissible activities and required to be deducted from its capital calculation. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") granted the OTS the authority to prescribe rules for the amount of PMSRs that may be included in a savings association's regulatory capital and required that the value of readily marketable PMSRs included in the calculation of a savings association's regulatory capital not exceed 90% of fair market value and that such value be determined at least quarterly. Under OTS regulations, (i) PMSRs do not have to be deducted from tangible and core regulatory capital, provided that they do not exceed 50% of core capital, (ii) savings associations are required to determine the fair market value and to review the book value of their PMSRs at least quarterly and to obtain an independent valuation of PMSRs annually, (iii) savings associations that desire to include PMSRs in regulatory capital may not carry them at a book value under GAAP that exceeds the discounted value of their future net income stream and (iv) for purposes of calculating regulatory capital, the amount of PMSRs reported as balance sheet assets should amount to the lesser of 90% of their fair market value, 90% of their original purchase price or 100% of their remaining unamortized book value. At September 30, 2001, the Bank had PMSRs totalling $45,500. A savings association is allowed to include both core capital and supplementary capital in the calculation of its total capital for purposes of the risk-based capital requirements, provided that the amount of supplementary capital does not exceed the savings association's core capital. Supplementary capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as core capital; subordinated debt and intermediate-term preferred stock; and, subject to limitations, general allowances for loan losses. Assets are adjusted under the risk-based guidelines to take into account different risk characteristics, with the categories ranging from 0% (requiring no additional capital) for assets such as cash to 100% for repossessed assets or loans more than 90 days past due. Single-family residential real estate loans which are not past-due or non-performing and which have been made in accordance with prudent underwriting standards are assigned a 50% level in the risk-weighing system, as are certain privately-issued mortgage-backed securities representing indirect ownership of such loans. Off-balance sheet items also are adjusted to take into account certain risk characteristics. The OTS amended its risk-based capital requirements that would require institutions with an "above normal" level of interest rate risk to maintain additional capital. A savings association is considered to have a "normal" level of interest rate risk if the decline in the market value of its portfolio equity after an immediate 200 basis point increase or decrease in market interest rates (whichever leads to the greater decline) is less than two percent of the current estimated market value of its assets. The market value of portfolio equity is defined as the net present value of expected cash inflows and outflows from an association's assets, liabilities, and off-balance sheet items. The amount of additional capital, that an institution with an above normal interest rate risk is required to maintain (the "interest rate risk component") equals one-half of the dollar amount by which its measured interest rate risk exceeds the normal level of interest rate risk. The interest rate risk component is in addition to the capital otherwise required to satisfy the risk-based capital requirement. Implementation of this component has been postponed by the OTS. The final rule was to be effective as of January 1, 29 1994, subject however to a three quarter lag time in implementation. However, because of continuing delays by the OTS, the interest rate risk component has never been operative. At September 30, 2001, the Bank exceeded all of its regulatory capital requirements, with tangible, core and risk-based capital ratios of 7.8%, 7.8%, and 16.8%, respectively. See Note 12 to the Notes to Consolidated Financial Statements included in the Annual Report. The OTS and the FDIC generally are authorized to take enforcement action against a savings association that fails to meet its capital requirements, which action may include restrictions on operations and banking activities, the imposition of a capital directive, a cease-and-desist order, civil money penalties or harsher measures such as the appointment of a receiver or conservator or a forced merger into another institution. In addition, under current regulatory policy, an association that fails to meet its capital requirements is prohibited from paying any dividends. 30 The following is a reconciliation of the Bank's equity determined in accordance with GAAP to regulatory tangible, core and risk-based capital at September 30, 2001, 2000 and 1999. September 30, 2001 September 30, 2000 September 30, 1999 -------------------------------- ----------------------------- ------------------------------ Tangible Core Risk-based Tangible Core Risk-based Tangible Core Risk-based Capital Capital Capital Capital Capital Capital Capital Capital Capital ------- ------- ------- ------- ------- ------- ------- ------- ------- (In thousands) GAAP equity $ 37,211 $37,211 $37,211 $38,127 $38,127 $38,127 $36,467 $36,467 $36,467 Assets required to be deducted(1) (511) General valuation allowances 1,883 1,667 1,813 -------- ------- ------- ------- ------- ------- ------- ------- ------- Total regulatory capital 37,211 37,211 39,094 38,127 38,127 39,283 36,467 36,467 38,280 Minimum capital requirement per FIRREA published guidelines 7,189 19,172 18,602 6,874 18,332 17,782 6,696 17,586 16,294 -------- ------- ------- ------- ------- ------- ------- ------- ------- Excess $ 30,022 $18,039 $20,492 $31,253 $19,795 $21,501 $29,771 $18,881 $21,986 ======== ======= ======= ======= ======= ======= ======= ======= ======= - ---------- (1) Consists of equity investment non-includable in regulatory capital. These capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. In addition, the OTS regulations provide that minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings association's capital, upon a determination that circumstances exist that higher individual minimum capital requirements may be appropriate. 31 Prompt Corrective Action. Under the prompt corrective action regulations of the OTS, an institution shall be deemed to be (i) "well capitalized" if it has total risk-based capital of 10% or more, has a Tier I risk-based capital ratio of 6% or more, has a Tier I leverage capital ratio of 5% or more and is not subject to any order or final capital directive to meet and maintain a specific capital level for any capital measure, (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8% or more, a Tier I risk-based capital ratio of 4% or more and a Tier I leverage capital ratio of 4% or more (3% under certain circumstances) and does not meet the definition of "well capitalized," (iii) "undercapitalized" if it has a total risk-based capital ratio that is less than 8%, a Tier I risk-based capital ratio that is less than 4% or a Tier I leverage capital ratio that is less than 4% (3% under certain circumstances), (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6%, a Tier I risk-based capital ratio that is less than 3% or a Tier I leverage capital ratio that is less than 3%, and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2%. Under specified circumstances, the OTS may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At September 30, 2001, the Bank met the requirements of a "well capitalized" institution under OTS regulations. Liquidity Requirements. All savings institutions were previously required to maintain an average daily balance of liquid assets equal to a certain percentage of the sum of its average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. The liquidity requirement varied from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings institutions. During 2000, the required minimum liquid asset ratio was 4%. This regulation was discontinued by the OTS effective in 2001. Qualified Thrift Lender Test. A savings association can comply with the QTL test by either meeting the QTL test set forth in the HOLA and the implementing regulations or qualifying as a domestic building and loan association as defined in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended ("Code"). Currently, the portion of the QTL test that is based on the HOLA rather than the Code requires that 65% of an institution's "portfolio assets" (as defined) consist of certain housing and consumer-related assets on a monthly average basis in nine out of every 12 months. Assets that qualify without limit for inclusion as part of the 65% requirement are loans made to purchase, refinance, construct, improve or repair domestic residential housing and manufactured housing, home equity loans, mortgage-backed securities (where the mortgages are secured by domestic residential housing or manufactured housing), stock issued by the FHLB, and direct or indirect obligations of the FDIC. In addition, small business loans, credit card loans, student loans and loans for personal, family and household purposes are allowed to be included without limitation as qualified investments. The following assets, among others, also may be included in meeting the test subject to an overall limit of 20% of the savings institution's portfolio assets: 50% of residential mortgage loans originated and sold within 90 days of origination, 100% of consumer and educational loans (limited to 10% of total portfolio assets) and stock issued by FHLMC or FNMA. Portfolio assets consist of total assets minus the sum of (i) goodwill and other intangible assets, (ii) property used by the savings institution to conduct its business, and (iii) liquid assets up to 20% of the institution's total assets. A savings institution that does not comply with the QTL test must either convert to a bank charter or comply with certain restrictions on its operations. Upon the expiration of three years from the date the association ceases to be a QTL, it must cease any activity and not retain any investment not permissible for a national bank and immediately repay any outstanding FHLB advances (subject to safety and soundness considerations). At September 30, 2001, approximately 78.08% of the Bank's assets were invested in qualified thrift investments, which was in excess of the percentage required to qualify the Bank under the QTL test in effect at that time. 32 Restrictions on Capital Distributions. OTS regulations govern capital distributions by savings associations, which include cash dividends, stock redemptions or repurchases, cash-out mergers, interest payments on certain convertible debt and other transactions charged to the capital account of a savings association to make capital distributions. Generally, the regulation creates a safe harbor for specified levels of capital distributions (as a percentage of income) from associations meeting at least their minimum capital requirements, so long as such associations notify the OTS and receive no objection to the distribution from the OTS. Savings institutions and distributions that do not qualify for the safe harbor are required to obtain prior OTS approval before making any capital distributions. Generally, savings associations such as the Bank can, upon 30 days prior notice, distribute during each calendar year an amount equal to or less than its net income for the year to date plus retained net income (which takes into account distributions in such periods) for the preceding two years. Amounts in excess of this must be approved by the OTS. OTS regulations also prohibit the Bank from declaring or paying any dividends or from repurchasing any of its stock if, as a result, the regulatory (or total) capital of the Bank would be reduced below the amount required to be maintained for the liquidation account established by it for certain depositors in connection with its conversion from mutual to stock form. Community Reinvestment. Under the Community Reinvestment Act of 1977, as amended ("CRA"), as implemented by OTS regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The Bank received a satisfactory rating as a result of its last OTS evaluation. Policy Statement on Nationwide Branching. OTS policy on branching by federally chartered savings associations permits nationwide branching to the extent allowed by federal statute. Current OTS policy generally permits a federally chartered savings association to establish branch offices outside of its home state if the association meets the domestic building and loan test in Section 7701(a)(19) of the Code or the asset composition test of subparagraph (c) of that section, and if, with respect to each state outside of its home state where the association has established branches, the branches, taken alone, also satisfy one of the two tax tests. An association seeking to take advantage of this authority would have to have a branching application approved by the OTS, which would consider the regulatory capital of the association and its record under the CRA, as amended, among other things. Federal Home Loan Bank System. The Bank is a member of the FHLB of Pittsburgh, which is one of 12 regional FHLBs that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank is required to purchase and maintain stock in the FHLB of Pittsburgh in an amount equal to at least 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of its advances from the FHLB of Pittsburgh, whichever is greater. At September 30, 2001, the Bank had $6.9 million in FHLB stock, which was in compliance with this requirement. The FHLBs are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members. For the years ended September 30, 2001, 2000 and 1999, dividends from the FHLB to the Bank amounted to approximately $471,000, $428,000 and $375,000, respectively. If dividends were reduced, the Bank's net interest income would likely also be 33 reduced. Further, there can be no assurance that the impact of recent or future legislation on the FHLBs will not also cause a decrease in the value of FHLB stock held by the Bank, if any. Federal Reserve System. The Board of Governors of The Federal Reserve System ("FRB") requires all depository institutions to maintain reserves against their transaction accounts (primarily NOW and Super NOW checking accounts) and non-personal time deposits. At September 30, 2001, the Bank was in compliance with applicable requirements. However, because required reserves must be maintained in the form of vault cash or a noninterest-bearing account at a FRB, the effect of this reserve requirement is to reduce an institution's earning assets. Safety and Soundness Guidelines. The OTS and the other federal banking agencies have established guidelines for safety and soundness, addressing operational and managerial, as well as compensation matters for insured financial institutions. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal regulators. The OTS and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions. 34 FEDERAL AND STATE TAXATION General. The Company and the Bank are subject to the corporate tax provisions of the Code, as well as certain additional provisions of the Code which apply to thrift and other types of financial institutions. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company and the Bank. Fiscal Year. The Company and the Bank and its subsidiaries file a consolidated federal income tax return on a fiscal year basis ending September 30. Method of Accounting. The Bank maintains its books and records for federal income tax purposes using the accrual method of accounting. The accrual method of accounting generally requires that items of income be recognized when all events have occurred that establish the right to receive the income and the amount of income can be determined with reasonable accuracy, and that items of expense be deducted at the later of (i) the time when all events have occurred that establish the liability to pay the expense and the amount of such liability can be determined with reasonable accuracy or (ii) the time when economic performance with respect to the item of expense has occurred. Bad Debt Reserves. The Bank is permitted to establish reserves for bad debts and to make annual additions thereto which qualify as deductions from taxable income. The Company, as of October 1, 1996, changed its method of computing reserves for bad debts to the experience method (the "Experience Method"). The bad debt deduction allowable under this method is available to small banks with assets less than $500 million. Generally, this method will allow the Company to deduct an annual addition to the reserve for bad debts equal to the increase in the balance of the Company's reserve for bad debts at the end of the year to an amount equal to the percentage of total loans at the end of the year, computed using the ratio of the previous six years net charge offs divided by the sum of the previous six years total outstanding loans at year end. The Bank treated such change as a change in a method of accounting determined solely with respect to the "applicable excess reserves" of the institution. The amount of the applicable excess reserves will be taken into account ratably over a six-taxable year period, beginning with the first taxable year beginning after December 31, 1995. The timing of the recapture may be delayed for a two-year period provided certain residential lending requirements are met. For financial reporting purposes, the Company will not incur any additional tax expense. At September 30, 1997, under SFAS No. 109, deferred taxes were provided on the difference between the book reserve at September 30, 1997 and the applicable excess reserve in an amount equal to the Bank's increase in the tax reserve from December 31, 1987 to September 30, 1997. Distributions. While the Bank maintains a bad debt reserve, if it were to distribute cash or property to its sole stockholder having a total fair market value in excess of its accumulated tax-paid earnings and profits, or were to distribute cash or property to its stockholder in redemption of its stock, the Bank would generally be required to recognize as income an amount which, when reduced by the amount of federal income tax that would be attributable to the inclusion of such amount in income, is equal to the lesser of: (i) the amount of the distribution or (ii) the sum of (a) the amount of the accumulated bad debt reserve of the Bank with respect to qualifying real property loans (to the extent that additions to such reserve exceed the additions that would be permitted under the experience method) and (b) the amount of the Bank's supplemental bad debt reserve. Minimum Tax. The Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The alternative minimum tax is payable to the extent such AMTI is in excess of an exemption amount. The Code provides that an item of tax preference is the excess of the bad debt deduction allowable for a taxable year pursuant to the percentage of taxable income method over the amount allowable under the experience method. The other items of tax preference that constitute AMTI include (a) tax-exempt interest on newly-issued (generally, issued on or after August 8, 1986) private activity bonds other than certain qualified bonds and (b) for taxable years beginning after 1989, 75% of the excess (if any) of (i) adjusted current 35 earnings as defined in the Code, over (ii) AMTI (determined without regard to this preference and prior to reduction by net operating losses). Net operating losses can offset no more than 90% of AMTI. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. Audit by IRS. The Bank's consolidated federal income tax returns for taxable years through September 30, 1998 have been closed for the purpose of examination by the IRS. STATE TAXATION The Company and the Bank's subsidiaries are subject to the Pennsylvania Corporate Net Income Tax and Capital Stock and Franchise Tax. The Corporate Net Income Tax rate for fiscal 2001 is 9.99% and is imposed on the Company's unconsolidated taxable income for federal purposes with certain adjustments. In general, the Capital Stock Tax is a property tax imposed at the rate of 1.1% of a corporation's capital stock value, which is determined in accordance with a fixed formula. The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax Act (the ("MTIT"), as amended to include thrift institutions having capital stock. Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the Bank from all other taxes imposed by the Commonwealth of Pennsylvania for state income tax purposes and from all local taxation imposed by political subdivisions, except taxes on real estate and real estate transfers. The MTIT is a tax upon net earnings, determined in accordance with GAAP with certain adjustments. The MTIT, in computing GAAP income, allows for the deduction of interest earned on state and federal securities, while disallowing a percentage of a thrift's interest expense deduction in the proportion of interest income on those securities to the overall interest income of the Bank. Net operating losses, if any, thereafter can be carried forward three years for MTIT purposes. 36 ITEM 2. PROPERTIES At September 30, 2001, the Bank conducted business from its executive offices located in Media, Pennsylvania and six full-service offices located in Delaware and Chester Counties, Pennsylvania. See also Note 7 of the Notes to Consolidated Financial Statements in the Annual Report. The following table sets forth certain information with respect to the Bank's offices at September 30, 2001. Net Book Value Amount of Description/Address Leased/Owned of Property Deposits ------------------- ------------ ----------- -------- (In thousands) Executive Offices: 22 West State Street Media, Pennsylvania 19063 Owned(1) $1,252 $ 90,735 Branch Offices: 3218 Edgmont Avenue Brookhaven, Pennsylvania 19015 Owned 451 85,766 Routes 1 and 100 Chadds Ford, Pennsylvania 19318 Leased(2) 92 24,536 23 East Fifth Street Chester, Pennsylvania 19013 Leased(3) 152 24,297 31 Baltimore Pike Chester Heights, Pennsylvania 19017 Leased(4) 668 21,229 Route 82 and 926 Kennett Square, Pennsylvania 19348 Leased(5) 43 9,558 330 Dartmouth Avenue Swarthmore, Pennsylvania 19081 Owned 111 55,480 ------ -------- $2,769 $311,601 ====== ======== - ---------- (1) Also a branch office. (2) Lease expiration date is September 30, 2005. The Bank has one five-year renewal option. (3) Lease expiration date is December 31, 2005. The Bank has one ten-year renewal option. (4) Lease expiration date is December 31, 2028. The Bank has options to cancel on the 15th, 20th and 25th year of the lease. (5) Lease expiration date is September 30, 2006. The Bank has three five-year renewal options. 37 ITEM 3. LEGAL PROCEEDINGS. The Company is involved in routine legal proceedings occurring in the ordinary course of business which, in the aggregate, are believed by management to be immaterial to the financial condition of the Company. In late September 2001, the Company was served in the following action: Aurora Loan Services, Inc. v. First Keystone Federal Savings Bank, Civil Action No. 01-CV-4774 (United States District Court for the Eastern District of Pennsylvania). This is a civil action arising out of five residential mortgage loans that Aurora holds in its portfolio. Aurora alleges that it suffered losses in connection with these loans (all of which were purchased by Aurora from the Bank more than 18 months prior hereto) and that the Bank is required to purchase the loans or compensate Aurora for its alleged losses. The Complaint asserts claims for breach of contract (Count One), violation of the New York Consumer Protection Law (Count Two) and Unjust Enrichment (Count Three). The Bank denies that any of its actions breached any contract between it and Aurora. Moreover, the Bank denies that Aurora can, as a matter of law, assert claims under the New York Consumer Protection Law or for unjust enrichment. The Bank has filed a motion to dismiss Counts Two and Three of the Complaint because they fail to state a claim as a matter of law. The Bank plans to assert all other available defenses to Aurora's claims. No discovery has been taken in this civil action and no trial date has been set. In the opinion of the Company's management and based upon advice of legal counsel, the resolution of this action will not have a material adverse impact on the consolidated financial position or the results of operations of the Company and its subsidiaries. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not applicable. PART II. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The information required herein is incorporated by reference on page 39 of the Registrant's Annual Report. ITEM 6. SELECTED FINANCIAL DATA. The information required herein is incorporated by reference from pages 7 to 8 of the Registrant's Annual Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information required herein is incorporated by reference from pages 9 to 17 of the Registrant's Annual Report. ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company's balance sheet consists of interest-earning assets and interest-bearing liabilities, and thus, the Company is therefore exposed to interest rate risk. The following additional information is being provided regarding the exposure to this interest rate risk. The Company utilizes reports prepared by the OTS to measure interest rate risk. Using data from the Bank's quarterly thrift financial reports, the OTS models the net portfolio value ("NPV") of the Bank over a variety of interest rate scenarios. The NPV is defined as the present value of expected cash flows from existing assets less the present value of expected cash flows from existing liabilities plus the present value of net expected cash inflows from existing off-balance sheet contracts. The model assumes instantaneous, parallel shifts in the U.S. Treasury Securities yield curve of 100 to 300 basis points, where applicable, either up or down, and in 100 basis point increments. 38 The interest rate risk measures used by the OTS include an "Exposure Measure" or "Post-Shock" NPV ratio and a "Sensitivity Measure". The "Post-Shock" NPV ratio is the net present value as a percentage of assets over the various yield curve shifts. A low "Post-Shock" NPV ratio indicates greater exposure to interest rate risk and can result from a low initial NPV ratio or high sensitivity to changes in interest rates. The "Sensitivity Measure" is the decline in the NPV ratio, in basis points, caused by a 2% increase or decrease in rates, whichever produces a larger decline. The following sets forth the Bank's NPV as of September 30, 2001. Net Portfolio Value ------------------------------------------------------------------------------------------------------ Changes in Rates in Dollar Percentage Net Portfolio Value As Change in Basis Points Amount Change Change a % of Assets Percentage(1) ------------ ------ ------ ------ ------------- -------------- (Dollars in thousands) 300 $16,868 $(15,598) (48.04)% 3.69% (43.58)% 200 25,613 (6,853) (21.11) 5.46 (16.51) 100 34,002 1,536 4.73 7.05 7.80 0 32,466 6.54 (100) 41,805 9,339 28.77 8.30 26.91 (200) 40,078 7,612 73.44 7.84 19.88 (1) Based on the portfolio value of the Bank's assets in the base case scenario. Certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in NPV require the making of certain assumptions which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV table presented assumes that the composition of the Bank's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Also, the model does not take into account the Bank's business or strategic plans. Accordingly, although the NPV table provides an indication of the Bank's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Bank's net interest income and may differ from actual results. See also the discussion on pages 9 to 10 of the Annual Report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements and supplementary data required herein are incorporated by reference from pages 19 to 38 of the Annual Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. 39 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT. The information required herein is incorporated by reference from pages 2 to 6 and page 15 of the Registrant's Proxy Statement dated December 26, 2001 ("Proxy Statement"). ITEM 11. EXECUTIVE COMPENSATION. The information required herein is incorporated by reference from pages 9 to 14 of the Registrant's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required herein is incorporated by reference from pages 7 to 9 of the Registrant's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required herein is incorporated by reference from page 15 of the Registrant's Proxy Statement. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Report. (1) The following documents are filed as part of this report and are incorporated herein by reference from the Registrant's Annual Report. Report of Independent Auditors. Consolidated Statements of Financial Condition at September 30, 2001 and 2000. Consolidated Statements of Income for the Years Ended September 30, 2001, 2000 and 1999. Consolidated Statements of Changes in Stockholders' Equity for the Years Ended September 30, 2001, 2000 and 1999. Consolidated Statements of Cash Flows for the Years Ended September 30, 2001, 2000 and 1999. Notes to the Consolidated Financial Statements. (2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto. (3) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index. 40 No Description - -- ----------- 3.1 Amended and Restated Articles of Incorporation of First Keystone Financial, Inc. * 3.2 Amended and Restated Bylaws of First Keystone Financial, Inc. * 4 Specimen Stock Certificate of First Keystone Financial, Inc. * 10.1 Employee Stock Ownership Plan and Trust of First Keystone Financial, Inc. * 10.2 401(K)/Profit-sharing Plan of First Keystone Federal Savings Bank. * 10.3 Employment Agreement between First Keystone Financial, Inc. and Donald S. Guthrie dated May 26, 1999. ** 10.4 Employment Agreement between First Keystone Financial, Inc. and Stephen J. Henderson dated May 26, 1999. ** 10.5 Employment Agreement between First Keystone Financial, Inc. and Thomas M. Kelly dated May 26, 1999. ** 10.6 Form of Severance Agreement between First Keystone Financial, Inc. and Elizabeth M. Mulcahy dated May 26, 1999. ** 10.8 Form of Severance Agreement between First Keystone Financial, Inc. and Carol Walsh dated May 26, 1999. ** 10.9 1995 Stock Option Plan.*** 41 10.10 1995 Recognition and Retention Plan and Trust Agreement. *** 10.11 1998 Stock Option Plan. **** 10.12 Employment Agreement between First Keystone Federal Savings Bank and Donald S. Guthrie dated May 26, 1999. ** 10.13 Employment Agreement between First Keystone Federal Savings Bank and Stephen J. Henderson dated May 26, 1999. ** 10.14 Employment Agreement between First Keystone Federal Savings Bank and Thomas M. Kelly dated May 26, 1999. ** 10.15 Form of Severance Agreement between First Keystone Federal Savings Bank and Elizabeth M. Mulcahy dated May 26, 1999. ** 10.16 Form of Severance Agreement between First Keystone Federal Savings Bank and Carol Walsh dated May 26, 1999. ** 11 Statement re: computation of per share earnings. See Note 2 to the Consolidated Financial Statements included in the Annual Report set forth as Exhibit 13 hereto. 13 Annual Report to Stockholders. 21 Subsidiaries of the Registrant - Reference is made to Item 1 "Business," for the required information. 23 Consent of Deloitte & Touche LLP. - ---------- (*) Incorporated by reference from the Registration Statement Form S-1 (Registration No. 33-84824) filed by the Registrant with the SEC on October 6, 1994, as amended. (**) Incorporated by reference from the Form 10-K filed by the Registrant with the SEC on December 29, 1999. (***) Incorporated by reference from the 10-K filed by the Registrant with SEC on December 29, 1995. (****) Incorporated from Appendix A of the Registrant's definitive proxy statement dated December 24, 1998. (b) Reports filed on Form 8-K. None. 42 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST KEYSTONE FINANCIAL, INC. By: /s/ Donald S. Guthrie -------------------------------- Donald S. Guthrie President and Chief Executive Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this report had been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Donald S. Guthrie December 21, 2001 - ----------------------------------------------- Donald S. Guthrie President and Chief Executive Officer (Principal Executive Officer) /s/ Thomas M. Kelly December 21, 2001 - ----------------------------------------------- Thomas M. Kelly Executive Vice-President and Chief Financial Officer (Principal Financial and Accounting Officer) /s/ Donald A. Purdy December 21, 2001 - ----------------------------------------------- Donald A. Purdy Chairman of the Board /s/ Edward Calderoni December 21, 2001 - ----------------------------------------------- Edward Calderoni Director /s/ Edmund Jones December 21, 2001 - ----------------------------------------------- Edmund Jones Director /s/ Donald G. Hosier, Jr. December 21, 2001 - ---------------------------------------------- Donald G. Hosier, Jr. Director /s/ Marshall J. Soss December 21, 2001 - ----------------------------------------------- Marshall J. Soss Director 43