UNITED STATES
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 FISCAL YEAR ENDED SEPTEMBER 30, 2006
- 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 23-2576479
(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:
Title of Each Class Name of exchange on which registered
COMMON STOCK (PAR VALUE $0.01 PER SHARE) THE NASDAQ STOCK MARKET
- ---------------------------------------- -----------------------
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark if the registrant is a well-known seasoned issuer, as
defined in Rule 405 of the Securities Act. YES [ ] NO [X]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. YES [ ] NO [X]
Indicate by check mark whether the Registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES [X] NO [ ]
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. [ ]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large Accelerated Filer [ ] Accelerated Filer [ ] Non-Accelerated Filer [X]
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). YES [ ] NO [X]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant based on the closing price of $19.55 on March 31, 2006, the last
business day of the Registrant's second quarter was $33.1 million (2,427,928
shares outstanding less 732,960 shares held by affiliates at $19.55 per share).
Although directors and executive officers of the Registrant and certain employee
benefit plans were assumed to be "affiliates" of the Registrant for purposes of
the calculation, the classification is not to be interpreted as an admission of
such status.
Number of shares of Common Stock outstanding as of December 15, 2006: 2,427,928
DOCUMENTS INCORPORATED BY REFERENCE
Listed hereunder are the documents incorporated by reference and the Part of the
Form 10-K into which the document is incorporated:
(1) Portions of the definitive proxy statement for the 2007 Annual Meeting of
Stockholders are incorporated into Part III.
FIRST KEYSTONE FINANCIAL, INC.
FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2006
INDEX
Page
----
PART I
Item 1. Business 1
Item 1A. Risk Factors 37
Item 1B. Unresolved Staff Comments 39
Item 2. Properties 40
Item 3. Legal Proceedings 41
Item 4. Submission of Matters to a Vote of Security Holders 41
PART II
Item 5. Market for Registrant's Common Stock, Related Stockholder
Matters and Issuer Purchases of Equity Securities 41
Item 6. Selected Financial Data 42
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations 44
Item 7A. Quantitative and Qualitative Disclosures about Market Risk 59
Item 8. Financial Statements and Supplementary Data 60
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 91
Item 9A. Controls and Procedures 91
Item 9B. Other Information 91
PART III
Item 10. Directors and Executive Officers of the Registrant 91
Item 11. Executive Compensation 91
Item 12. Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters 92
Item 13. Certain Relationships and Related Transactions 92
Item 14. Principal Accounting Fees and Services 92
PART IV
Item 15. Exhibits, Financial Statement Schedules 92
SIGNATURES 95
[This page left blank intentionally]
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995
relating to, without limitation, our future economic performance, plans and
objectives for future operations, and projections of revenues and other
financial items that are based on our beliefs, as well as assumptions made by
and information currently available to us. The words "may," "will,"
"anticipate," "should," "would," "believe," "contemplate," "could," "project,"
"predict," "expect," "estimate," "continue," and "intend," as well as other
similar words and expressions of the future, are intended to identify
forward-looking statements. Our actual results, performance, or achievements may
differ materially from the results expressed or implied by our forward-looking
statements.
The factors set forth under "Risk Factors" and other cautionary statements
made in this Annual Report should be read and understood as being applicable to
all related forward-looking statements wherever they appear in this Annual
Report on Form 10-K. In addition to the risks discussed in the "Risk Factors"
section of this Annual Report, factors that could have a material adverse effect
on our operations and future prospects include, but are not limited to, the
following: (1) changes in the interest rate environment; (2) changes in deposit
flows, loan demand or real estate values; (3) changes in accounting principles,
policies or guidelines; (4) legislation or regulatory changes; (5) changes in
loan delinquency rates or in our levels of non-performing assets; (6) changes in
the economic climate in the market areas in which we operate; (7) the economic
impact of any future terrorist threats and attacks, acts of war or threats
thereof and the response of the United States to any such threats and attacks;
(8) the effects of the supervisory agreements entered into by each of the
Company and the Bank with the Office of Thrift Supervision ("OTS"); and (9)
other factors, if any, referenced in this Annual Report or the documents
incorporated by reference.
These risks and uncertainties should be considered in evaluating
forward-looking statements and undue reliance should not be placed on such
statements. The forward-looking statements included in this Annual Report are
made only as of the date of this Annual Report. We disclaim any obligation to
update any such factors or to publicly announce the results of any revisions to
any of the forward-looking statements contained herein to reflect future events
or developments.
Any forward-looking earnings estimates included in this Annual Report have
not been examined or compiled by our independent registered public accounting
firm, nor has our independent registered public accounting firm applied any
procedures to our estimates. Accordingly, our accountants do not express an
opinion or any other form of assurance on them. Further information concerning
our business, including additional factors that could materially affect our
financial results, is included in our filings with the Securities and Exchange
Commission ("SEC").
PART I
ITEM 1. BUSINESS.
GENERAL
First Keystone Financial, Inc. (the "Company") is a Pennsylvania
corporation and the sole shareholder of First Keystone 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 loan to its employee stock ownership
plan, and various equity and other investments. See Note 17 of the Notes to
Consolidated Financial Statements for the fiscal year ended September 30, 2006
set forth in Item 8 hereof, "Financial Statements and Supplementary Data." The
primary business of the Company consists of operating the Bank.
The Bank is a community oriented bank emphasizing customer service and
convenience. The Bank's primary business is attracting deposits from the general
public and using those funds together with other available sources of funds,
primarily borrowings, to originate loans.
1
BUSINESS STRATEGY
Although the future growth of the Company and the Bank is restricted by the
supervisory agreements described below, the Company intends to continue
executing its strategy to transform itself from a traditional thrift into a
locally-based community bank. The principal components of the Company's strategy
include:
- Continuing expansion of product offerings. The Company intends to
continue expanding the origination of commercial business loans
and commercial and multi-family real estate loans while
de-emphasizing the origination for portfolio of single-family
residential loans. Commercial business and commercial and
multi-family loans grew to $94.9 million, or 28.0% of the
total loan portfolio, at September 30, 2006 compared to $72.3
million, or 23.9% of the total loan portfolio, at September 30,
2002. The Company has also expanded its presence in the land
acquisition and construction loan market, increasing such loans
to $38.2 million, or 11.3% of the total loan portfolio, at
September 30, 2006 from $28.3 million, or 9.3% of the total loan
portfolio, at September 30, 2002. The Bank in 2005 also
introduced Small Business Administration ("SBA") lending as an
additional product choice for its customers, allowing the Bank to
generate additional fee income. In 2006, the Bank was approved by
the SBA under their Preferred Lender Program, which will allow
the Bank to streamline the origination of SBA loans for its
customers. To assist its commercial customers and to attract new
business deposits, the Bank has created a Cash Management
Division which provides extensive support services, including ACH
activity, wire transfers, automated interest-earning clearing
accounts and other cash management products. The Bank has also
expanded its electronic delivery systems in recent years,
including both commercial and retail bill paying services.
- Expanding commercial and construction lending infrastructure. In
support of its expanded commercial business and commercial and
multi-family real estate lending activities, the Bank has hired
three additional employees with substantial commercial credit
administration experience, increasing the Bank's commercial
administration staff to five. The Bank plans to continue
improving the integration of its business development officers
and branch managers with the operations of its lending
department. In addition, the Bank plans to hire additional
experienced support personnel as well as commercial and
construction lenders to increase the Bank's market penetration.
The Bank's expanded commercial credit administration function is
instrumental in developing and implementing more rigorous and
extensive oversight of the Bank's commercial lending activities
to, among other things, reduce the likelihood of credit quality
issues.
- Increasing the amount of lower costing deposits. The Bank will
continue to emphasize the generation of core deposits, in
particular non-interest-bearing checking accounts, targeted to
commercial customers, as well as developing account relationships
with customers not traditionally focused on by the Bank, such as
large non-profit organizations, municipalities and school
districts. As of September 30, 2002, time deposits accounted for
53.3% of total deposits, while transaction, savings and MMDA
accounts constituted 19.4%, 12.6% and 14.7% of total deposits,
respectively. By contrast, as of September 30, 2006, the Company
had reduced time deposits to 51.8% of total deposits, with
low-cost transaction accounts increasing to 25.3% of total
deposits and savings and MMDA accounts comprising 11.6% and
11.3%, respectively, of total deposits. With the recent rise in
interest rates in 2006, the Bank, like many other financial
institutions, has found customers moving funds to time deposits
due to their generally higher rates. The Bank is currently
developing remote deposit capabilities, which will enhance its
ability to attract and retain commercial customers who are not
located in close proximity to the branch network. The Bank
expects to be able to commence offering its remote deposit
product by the end of the second quarter of fiscal 2007. In
tandem with the offering of the remote deposit product, the Bank
expects to introduce its relationship banking product, which will
reward customers for bundling services, allow more competitive
pricing and target non-profit institutions and their constituents
through affinity marketing programs.
2
- Establishing branches in desirable locations. The Company seeks
to open additional full-service branches in attractive suburban
communities with growing populations and significant numbers of
small and medium-sized businesses in Delaware and Chester
Counties. The Bank opened its last branch office in Aston,
Pennsylvania in October 2004, which, in less than 18 months,
generated deposits of $21.3 million as of September 30, 2006. The
Bank's goal is to open one new branch office approximately every
24 months, subject to the availability of attractive locations at
reasonable prices and termination of the supervisory agreements.
- Maintaining customer service focus within a sales culture. To
differentiate itself from its larger competitors, the Bank offers
a high level of knowledgeable, personalized service to its
customers. At the same time, the Bank emphasizes a sales culture
with a focus on cross-selling the many different types of
products it offers. In November 2005, the Bank completed an
18-month customer training program for all its employees designed
to improve and enhance the Bank's ability to meet its customers'
increasingly complex and diverse needs, especially those of its
business customers. The Bank has also hired two experienced
business development officers who are primarily responsible for
attracting new business and expanding current bank relationships.
These business development officers interface with the branch
network and commercial lenders to facilitate and expand banking
relationships and increase customer satisfaction and loyalty.
MARKET AREA AND COMPETITION
The Bank's primary market area is Delaware and Chester Counties, which are
located in the southeastern corner of Pennsylvania between two prominent
metropolitan areas - Philadelphia, Pennsylvania and Wilmington, Delaware. There
is easy access to I-95, the Philadelphia International Airport and the Delaware
River, and the Bank is fortunate to be located in such a desirable geographic
area. New York City is just 92 miles away from the Bank's headquarters in Media,
Pennsylvania, while Baltimore, Maryland and Washington, DC are only 80 miles and
127 miles away, respectively.
Through an extensive highway network, the economies of Delaware and Chester
Counties are knitted tightly into a regional economy of more than 2.5 million
workers. Delaware and Chester Counties have a large, well-educated, and skilled
labor force, with nearly one quarter of the counties' population having earned a
four-year college degree. The median household income of Delaware and Chester
Counties in 2005 was approximately $62,380 and $81,000, respectively, as
compared to approximately $48,500 for Pennsylvania as a whole. In addition,
Philadelphia's central location in the Northeast corridor, infrastructure, and
other factors have made the Bank's primary market area attractive to many large
corporate employers, including Comcast, Boeing, State Farm Insurance, United
Parcel Service, PECO Energy, SAP America, Inc. and Wawa.
The Philadelphia area economy is typical of many large northeastern cities
where the traditional manufacturing-based economy has declined and been replaced
by the service sector, including the health care market. Crozer/Keystone Health
System, Mercy Health Corp., and Astra-Zeneca are among the larger health care
employers within the Bank's market area. According to the Delaware County
Chamber of Commerce, there is more than 65 degree-granting institutions in the
Delaware Valley region, representing a higher density of colleges and
universities than any other area in the United States. Delaware County also has
one of the nation's lowest unemployment rates and one of the most active Chamber
of Commerce Offices in the Commonwealth. In fact, the Delaware County Chamber of
Commerce has been recognized by the U.S. Small Business Administration
(Philadelphia District Office) for its accomplishments several times within the
past few years.
The population of Delaware County is reported at over half a million
residents and is the fifth most populated county in the Commonwealth of
Pennsylvania. Much of the growth and development continues to be in the western
part of the county and adjacent Chester County. In the second calendar quarter
of 2006, unemployment in Chester County was extremely low - at 3.6% - compared
to the rest of the Commonwealth, which was at an average of 5.0%. The Bank
continues to benefit from this growth as its Chester Heights branch, situated in
a prime location in Western Delaware County, has exceeded the Company's deposit
and consumer loan projections year after year. Chester County's growth rate is
expected to increase even further in the next decade, and some of the
communities in Chester County that are experiencing the most rapid growth - East
Marlborough Township, New Garden Township and East Goshen - surround the Bank's
Chester County branch.
3
The Bank experiences strong competition for real estate loans, principally
from other savings associations, commercial banks, and mortgage-banking
companies. The Bank competes for these and other loans primarily 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.
The Bank faces strong competition both in attracting deposits and making
real estate and commercial loans. Its most direct competition for deposits has
historically come from other savings associations, credit unions, and commercial
banks located in its market area. This includes many large regional financial
institutions which have even greater financial and marketing resources available
to them. The ability of the Bank to attract and retain core deposits depends on
its ability to provide a competitive rate of return, liquidity, and service
convenience comparable to those offered by competing investment opportunities.
The Bank's management remains focused on attracting core deposits through its
branch network, business development efforts, and commercial business
relationships. The Business Development Team works closely with and strongly
supports the efforts of the branches, in addition to redesigning more
competitive business packages as well as provides SBA lending services to
enhance small business deposit products.
The Bank maintains seven branch offices in Delaware County with deposits
totaling $358.8 million at September 30, 2006 and one branch office in Chester
County with deposits totaling $19.9 million at September 30, 2006. Based on
deposits as of June 30, 2006 (the most recent data used by the FDIC), the Bank's
market share in Delaware and Chester Counties was 3.4% and 0.7%, respectively.
The Bank believes it has the opportunity to expand its deposit market share in
the future.
SUPERVISORY AGREEMENTS
On February 13, 2006, the Company and the Bank each entered into
supervisory agreements with the OTS. The Company and the Bank were required to
enter into these agreements primarily to address issues identified in the OTS'
report of examination issued in 2005 regarding the Company's and the Bank's
operations and financial condition.
Under the terms of the supervisory agreement between the Company and the
OTS, the Company agreed to, among other things, (i) develop and implement a
three-year capital plan designed to support the Company's efforts to maintain
prudent levels of capital and to reduce its debt-to-equity ratio below 50%; (ii)
not incur any additional debt without the prior written approval of the OTS; and
(iii) not repurchase any shares of or pay any cash dividends on its common stock
until the Company complied with certain conditions. Upon reducing its
debt-to-equity below 50%, the Company may resume the payment of quarterly cash
dividends at the lesser of the dividend rate in effect immediately prior to
entering into the supervisory agreement ($0.11 per share) or 35% of its
consolidated net income (on an annualized basis), provided that the OTS, upon
review of prior notice from the Company of the proposed dividend, does not
object to payment.
Under the terms of the supervisory agreement between the Bank and the OTS,
the Bank agreed to, among other things, (i) not grow in any quarter in excess of
the greater of 3% of total assets (on an annualized basis) or net interest
credited on deposit liabilities during such quarter; (ii) maintain its core
capital and total risk-based capital in excess of 7.5% and 12.5%, respectively;
(iii) adopt revised policies and procedures governing commercial lending; (iv)
conduct periodic reviews of its commercial loan department; (v) conduct periodic
internal loan reviews; (vi) adopt a revised asset classification policy; and
(vii) not amend compensatory arrangements with senior executive officers and
directors, subject to certain exceptions, without the prior approval of the OTS.
As a result of the growth restriction imposed on the Bank, the Company's growth
is currently and will continue to be substantially constrained unless and until
the supervisory agreements are terminated or modified. As of March 31, 2006 and
June 30, 2006, the Bank exceeded the growth limitation contained in the
supervisory agreement with the OTS described above. Subsequent to June 30, 2006,
the Bank reduced its assets sufficiently to be below the June 30, 2006
limitation. The OTS advised the Bank that it will not take any regulatory action
against the Bank provided it will be in compliance with the growth limitation as
of September 30, 2006. The Bank complied with the growth restriction at
September 30, 2006.
The Company recently underwent an examination by the OTS. In connection
with such examination, the OTS reviewed the Company's and the Bank's compliance
with the provisions of the supervisory agreements. Although the Company and the
Bank were determined to be in full or partial compliance with substantially all
of the provisions of the supervisory agreements, the examination did note a
number of areas for improvement with respect to the Bank's loan underwriting,
credit analysis and asset classification policies and procedures. In order to
strengthen these areas, the Bank intends to hire a Chief Credit Officer. The
Bank is aggressively addressing these areas for improvement in its lending
4
operations to be able to be in full compliance with the terms of the supervisory
agreements as soon as possible. Except as described above, the Company believes
it and the Bank are in material compliance with the supervisory agreements.
The Company has submitted to and received from the OTS approval of a
capital plan, which plan calls for an equity infusion in order to reduce the
Company's debt-to-equity ratio below 50%. As part of its capital plan, the
Company conducted a private placement of 400,000 shares of common stock, raising
gross proceeds of approximately $6.5 million. The net proceeds of approximately
$5.8 million will be used to reduce the amount of its outstanding trust
preferred securities. The Company intends to use all of the net proceeds to
redeem approximately $5.8 million of its trust preferred securities in June
2007. As a result of such redemption, the Company's debt-to-equity ratio will be
less than 50%. The Company believes it will be able to resume paying quarterly
cash dividends in the quarter ending September 30, 2007. However, no assurances
can be given that the Company will satisfy the conditions necessary to resume
paying dividends or that the OTS will not object to the resumption of dividends
or, if resumed, that the Company will be able to pay dividends at the same rate
that it has historically paid or be able to continue to pay dividends. The
Company and the Bank will make every effort to have both supervisory agreements
terminated or the operating restrictions substantially reduced by the end of
fiscal year 2007. However, no assurances can be given that either of such events
will occur.
Although the growth limitations imposed by the supervisory agreements
constrain the Bank's ability to implement certain aspects of its business
strategy, the Bank will continue to pursue its transition from a traditional
residential lender to a community bank. While the supervisory agreements are in
effect, the Bank intends to continue:
- emphasizing higher yielding assets, such as commercial business
and real estate loans, as well as further developing fee income
and other forms of non-interest income;
- developing relational deposits, in particular
non-interest-bearing checking accounts, with its commercial
customers;
- aggressively reviewing and managing its cost structure in order
to improve its financial performance; and
- enhancing its electronic delivery systems, in particular remote
banking, which will enable business customers to expedite check
processing, thereby allowing commercial customers faster access
to their funds as well as improved cash flow management.
Following the termination or substantive revision of the operating
restrictions in the supervisory agreements, the Company intends to expand its
commercial business and real estate loan portfolio and to continue expanding its
branch network and diversifying its funding sources.
5
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,
-----------------------------------------------------------------------------------------
2006 2005 2004 2003 2002
---------------- ---------------- ---------------- ---------------- ----------------
AMOUNT % AMOUNT % AMOUNT % AMOUNT % AMOUNT %
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Real estate loans:
Single-family $144,760 42.76% $149,237 46.64% $163,907 50.87% $166,042 55.51% $173,736 57.32%
Multi-family and commercial 70,439 20.81 69,704 21.78 64,509 20.02 59,022 19.73 60,379 19.92
Construction and land 38,158 11.27 36,828 11.51 38,078 11.82 28,975 9.69 28,292 9.33
Home equity loans and lines of
credit 59,319 17.52 46,748 14.61 43,621 13.54 33,459 11.19 27,595 9.10
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate loans 312,676 92.36 302,517 94.54 310,115 96.25 287,498 96.12 290,002 95.67
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Consumer:
Deposit 170 .05 112 .04 133 .04 112 .04 144 .05
Unsecured personal loans 538 .16 641 .20 629 .20 547 .18 322 .11
Other(1) 667 .20 623 .19 709 .21 779 .26 736 .24
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total consumer loans 1,375 .41 1,376 .43 1,471 .45 1,438 .48 1,202 .40
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Commercial business loans 24,474 7.23 16,085 5.03 10,624 3.30 10,161 3.40 11,919 3.93
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans receivable(2) 338,525 100.00% 319,978 100.00% 322,210 100.00% 299,097 100.00% 303,123 100.00%
-------- ====== -------- ====== -------- ====== -------- ====== -------- ======
Less:
Loans in process 12,081 14,614 15,807 10,655 11,384
Deferred loan origination fees
and discounts (143) (90) 116 35 605
Allowance for loan losses 3,367 3,475 2,039 1,986 2,358
-------- -------- -------- -------- --------
Total loans receivable, net $323,220 $301,979 $304,248 $286,421 $288,776
======== ======== ======== ======== ========
- ----------
(1) Consists primarily of credit card loans.
(2) Does not include $1.3 million, $41,000, $172,000, $4.5 million and $501,000
of loans held for sale at September 30, 2006, 2005, 2004, 2003 and 2002,
respectively.
6
Contractual Principal Repayments. The following table sets forth the
scheduled contractual maturities of the Bank's loans held to maturity at
September 30, 2006. 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
--------------------------------------------------- CONSUMER AND
MULTI-FAMILY COMMERCIAL
SINGLE- AND CONSTRUCTION BUSINESS
FAMILY (1) COMMERCIAL AND LAND TOTAL LOANS TOTAL
---------- ------------ ------------ -------- ------------ --------
(Dollars in thousands)
Amounts due in:
One year or less $ 12,506 $ 5,302 $38,158 $ 55,966 $12,371 $ 68,337
After one year through three years 26,992 12,212 -- 39,204 3,889 43,093
After three years through five years 32,456 14,193 -- 46,649 3,425 50,074
After five years through ten years 75,248 17,309 -- 92,557 3,625 96,182
After ten years through fifteen years 29,003 10,059 -- 39,062 1,213 40,275
Over fifteen years 27,874 11,364 -- 39,238 1,326 40,564
-------- ------- ------- -------- ------- --------
Total (2) $204,079 $70,439 $38,158 $312,676 $25,849 $338,525
======== ======= ======= ======== ======= ========
Interest rate terms on amounts due after
one year:
Fixed $174,415 $ 8,926 $183,341
Adjustable 82,295 4,552 86,847
-------- ------- --------
Total (2) $256,710 $13,478 $270,188
======== ======= ========
- ----------
(1) Includes home equity loans and lines of credit.
(2) Does not include adjustments relating to loans in process, allowances for
loan losses and deferred fee income and discounts.
7
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 current
mortgage loan rates are lower than rates on existing mortgage loans, 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 Sale Activity. The following table shows the
loan origination, purchase and sale activity of the Bank during the periods
indicated.
YEAR ENDED SEPTEMBER 30,
---------------------------------
2006 2005 2004
--------- --------- ---------
(Dollars in thousands)
Gross loans at beginning of period(1) $ 320,019 $ 322,382 $ 303,595
--------- --------- ---------
Loan originations for investment:
Real estate:
Residential 16,799 11,235 35,214
Commercial and multi-family 23,068 31,689 26,560
Construction 21,743 23,876 28,816
Home equity and lines of credit 41,592 33,033 29,133
--------- --------- ---------
Total real estate loans originated for investment 103,202 99,833 119,723
Consumer 3,265 3,458 2,695
Commercial business 32,424 26,281 13,734
--------- --------- ---------
Total loans originated for investment 138,891 129,572 136,152
Loans originated for resale 6,063 13,620 9,671
--------- --------- ---------
Total originations 144,954 143,192 145,823
--------- --------- ---------
Deduct:
Principal loan repayments and prepayments (116,316) (131,460) (116,748)
Transferred to real estate owned (2,700) -- (153)
Charge-offs (1,328) (344) (321)
Loans sold in secondary market (4,770) (13,751) (9,814)
--------- --------- ---------
Subtotal (125,114) (145,555) (127,036)
--------- --------- ---------
Net increase (decrease) in loans(1) 19,840 (2,363) 18,787
--------- --------- ---------
Gross loans at end of period(1) $ 339,859 $ 320,019 $ 322,382
========= ========= =========
- ----------
(1) Includes loans held for sale of $1.3 million, $41,000 and $172,000 at
September 30, 2006, 2005 and 2004, respectively.
The residential 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. Loan applications 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 are obtained predominately through loan originators who are employees
of the Bank. The Bank's residential 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 Residential Lending Department supervises the process
of obtaining credit reports, appraisals and other documentation involved with
the origination of 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 below $250,000
because alternative means of valuation are used (i.e., tax assessments, home
value estimators). Property appraisals generally are performed by an independent
appraiser selected 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.
8
Residential mortgage loan applications are primarily developed from
referrals from real estate brokers and builders, existing customers and walk-in
customers. 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 may be
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 Fannie Mae ("FNMA") or Freddie Mac ("FHLMC") limits are
approved by at least one of the following: the Bank's Director of Lending, the
Senior Mortgage Loan Underwriter or the Loan Committee (a committee comprised of
four directors and the Director of Lending). Residential mortgage loans in
excess of FNMA/FHLMC maximum amounts (currently $417,000 for single-family
properties) but less than $1.0 million must be approved by the Loan Committee.
Commercial and multi-family residential real estate mortgage loans in excess of
$250,000 and all construction loans 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 $250,000 can be approved by the Director of Lending, the Vice President of
Construction Loans, the Vice President of Residential Lending or the Senior
Mortgage Loan Underwriter. 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 nor 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 FHLMC or FNMA. During fiscal 2006, due to the inverted yield curve,
continuing interest rate margin compression, and the unappealing spreads on
mortgage-backed securities, the Bank decided to retain $13.8 million of its
newly originated 30-year term fixed-rate residential mortgage loans in its
portfolio. The Bank will continue to retain its 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 and balloon loans and
adjustable-rate loans. Fixed-rate loans generally have maturities ranging from
15 to 30 years and are fully amortized 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 or 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 interest rate for the remaining 25 or 23 years,
respectively, of the amortization period. At September 30, 2006, $127.7 million,
or 88.3% of the Bank's single-family residential mortgage loans held in
portfolio were fixed-rate loans, including $7.9 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 maximum adjustment
limit 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 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, loans
tied to the one-year CMT are underwritten using methods approved by FHLMC or
FNMA which require borrowers to be qualified at 2% above the discounted loan
rate under certain conditions. The Bank has taken steps to increase the amount
of such loans originated in recent years, but with limited interest by consumers
due to the
9
low interest rate environment that existed prior to fiscal 2006. At September
30, 2006, $16.9 million, or 11.7%, 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. 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 loans with a LTV ratio of over 80%, private mortgage
insurance may be required to be obtained or the Bank, on occasion, may lend the
excess as a home equity loan.
Commercial and Multi-Family Residential Real Estate Loans. During fiscal
2006, the Bank slightly increased its investment in commercial and multi-family
residential loans. Such loans are being made primarily to small- and
medium-sized businesses located in the Bank's primary market area, a segment of
the market that the Bank believes has continued to be underserved in recent
years. Loans secured by commercial and multi-family residential real estate
amounted to $70.4 million, or 20.8%, of the Bank's total loan portfolio, at
September 30, 2006. 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 up to 1% 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 20 years with
amortization of the 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 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
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. See "-Asset
Quality - Non-performing Assets" for further discussion of the Bank's
non-performing loans.
Construction Loans. Substantially all of the Bank's construction loans
consist of loans for acquisition and development of properties 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.
10
To a lesser extent, the Bank provides financing for construction to
permanent commercial real estate 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 of the project
upon completion. The loans convert to permanent commercial real estate 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 (including acquisition and
development loans) and revolving lines of credit to developers. The majority of
construction loans consists 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 36 months or less, generally
have a maximum LTV ratio of 75% of the appraised value of the property upon
completion and 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 0.5% to 3.0% of the amount 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 but usually not less than 25%. 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.
At September 30, 2006, residential construction loans totaled $18.5
million, or 5.5%, of the total loan portfolio, primarily consisting of
construction loans to developers. At September 30, 2006, commercial construction
loans totaled $967,000, or 0.29%, of the total loan portfolio.
The Bank also originates ground or land loans to individuals to purchase a
property on which they intend to build their primary residences, 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,
2006, land loans (including loans to acquire and develop land) totaled $18.7
million, or 5.5%, of the total loan portfolio.
Loans to developers include both secured and unsecured lines of credit
(which are classified as commercial business loans) with outstanding commitments
totaling $730,000. All have personal guarantees of the principals and are
cross-collateralized with existing loans. At September 30, 2006, loans
outstanding under builder lines of credit totaled $500,000, all of which was
unsecured. Such loans are only given 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 an 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.
11
Home Equity Loans and Lines of Credit. Home equity loans and home equity
lines of credit 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 with a maximum term of 15 years while
equity lines of credit have adjustable interest rates indexed to the Prime Rate
with a term of 10 years and interest-only payments. 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, 2006, home equity loans and lines of
credit amounted to $59.3 million, or 17.5%, of the Bank's total loan portfolio.
Commercial Business Loans. The Bank has also emphasized in recent periods
the growth of its commercial business loan portfolio by granting such 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 this product 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, 2006, commercial business loans
amounted to $24.5 million, or 7.2%, of the Bank's total loan portfolio. The
commercial business loans consist of a limited number of commercial lines of
credit secured by equipment and 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 certain other types of loans, management intends to
continue to offer commercial business loans to small- and medium-sized
businesses in an effort to better serve our community's needs, obtain core
non-interest-bearing deposits and increase the Bank's interest rate spread and
improve interest rate sensitivity. See " -Asset Quality" for discussion of the
Bank's non-performing and classified assets.
In the latter part of fiscal 2005, the Bank began to market loans
guaranteed by the Small Business Administration. During fiscal 2006, the Bank
was approved as an SBA Preferred Lender. As an SBA Preferred Lender, the Bank
has earned the privilege of approving SBA Loans without requesting the approval
of the SBA prior to closing the loan. All SBA policies and procedures must be
followed by the Bank to maintain its Preferred Lender Status. As part of the
Company's asset liability strategy, the Bank intends to sell the guaranteed
portion of the loan upon loan settlement. In fiscal 2006, the Bank recognized
$132,000 from the sale of SBA loans compared to $0 in 2005. Such experience will
continue to be leveraged to grow this business line.
Consumer Lending Activities. The Bank also offers a variety of consumer
loans in order to provide a full range of retail financial services to its
customers. At September 30, 2006, $1.4 million, or 0.41%, of the Bank's total
loan portfolio was comprised of consumer loans. The Bank originates
substantially all of such loans in its market area. At September 30, 2006, the
Bank's consumer loan portfolio was comprised of credit card, deposit,
automobile, unsecured personal loans and other consumer loans. The Bank's credit
card program is primarily offered to only the Bank's most creditworthy
customers. At September 30, 2006, these loans totaled $652,000, or 0.19%, of the
total loan portfolio. Another component of the consumer loan portfolio is
unsecured loans amounting to $538,000, or 0.16%, of the Bank's loan portfolio at
September 30, 2006.
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.
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. The Bank's net gain
on sales of single-family residential loans amounted to $24,000, $93,000 and
$54,000 during the fiscal years ended September 30, 2006, 2005 and 2004,
respectively. The decrease in net gain on sales for mortgage loans in fiscal
2006 was a result from the Bank's decision to retain 30-year single-family
residential loans into its loan portfolio as part of the Bank's asset/liability
strategy. Gains on sales of loans held for sale slightly increased in fiscal
2005; however, the Bank continued to experience a slowdown in 2006 in the
refinancing market in 30-year residential loans. The Bank did not have any
single-family residential loans held for sale at September 30, 2006 and 2005.
12
The Bank's conforming mortgage loans sold to others are sold, generally
with servicing retained, on a loan-by-loan basis primarily to FHLMC or 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
entered into at the same time of the commitment by the Bank of a loan rate to
the borrower. These commitments are mandatory delivery contracts with the
purchaser, generally FHLMC or 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 may be 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, net of costs, 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 non-interest-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.
SEPTEMBER 30,
---------------------------
2006 2005 2004
------- ------- -------
(Dollars in thousands)
Loans originated by the Bank and serviced for:
FNMA $ 544 $ 595 $ 673
FHLMC 50,290 54,457 49,849
Others 311 326 340
------- ------- -------
Total loans serviced for others $51,145 $55,378 $50,862
======= ======= =======
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. 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. For fiscal years ended September 30, 2006, 2005 and 2004, the Bank
earned gross fees of $139,000, $133,000 and $132,000, respectively, from loan
servicing.
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, 2006, the Bank's five largest loans or groups of loans-to-one
borrower, including related entities, ranged from an aggregate of $4.0 million
to $6.6 million. The Bank's loans-to-one borrower limit was $7.5 million at such
date.
13
ASSET QUALITY
General. As a part of the Bank's ongoing 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 Quality Review Committee. The Asset
Quality Review Committee is composed of the President and Chief Executive
Officer, the Chief Financial Officer, the Director of Lending, the Vice
President of Loan Administration, the Internal Auditor and the Vice President of
Construction Lending and meets at least monthly. All assets are placed into one
of the five following categories: pass, special mention, substandard, doubtful
and loss. During fiscal 2006, a rating system was created and implemented
grading assets as follows: 1-6 as pass, 7 as special mention and 8, 9 and 10 as
an adverse classification (substandard, doubtful and loss, respectively). Loans
classified as "pass" are then placed into one of the six grades based on
objective criteria of credit underwriting. 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.
When a borrower fails to make a required payment on a loan, the Bank
attempts to cure the deficiency by contacting the borrower and requesting
payment. Contact is generally made after the expiration of the grace period
(usually fifteen days) in the form of telephone calls and/or correspondence. In
most cases, deficiencies are cured promptly. If the delinquency increases, the
Bank will initiate foreclosure actions or legal collection actions if a borrower
fails to enter into satisfactory repayment arrangements. Such actions generally
commence at sixty to ninety days of delinquency.
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 generally does not accrue interest on loans past due 90 days or
more. See Note 2 of the Notes to Consolidated Financial Statements set forth in
Item 8 hereof.
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 expensed 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" under SFAS No. 15. 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.
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.
AT SEPTEMBER 30, 2006 AT SEPTEMBER 30, 2005
----------------------------- -----------------------------
30 TO 59 DAYS 60 TO 89 DAYS 30 TO 59 DAYS 60 TO 89 DAYS
------------- ------------- ------------- -------------
Real estate loans:
Single-family residential $ -- $ 3 $ -- $435
Construction loans -- -- 22 --
Home equity 362 29 189 5
Consumer loans 33 3 8 6
Commercial business loans 927 98 676 19
------ ---- ---- ----
Total $1,322 $133 $895 $465
====== ==== ==== ====
14
Non-performing Assets. The following table sets forth the amounts and
categories of the Bank's non-performing assets at the dates indicated.
SEPTEMBER 30,
--------------------------------------------
2006 2005 2004 2003 2002
------ ------ ------ ------ ------
(Dollars in thousands)
Non-performing loans:
Single-family residential $ 189 $ 378 $ 623 $ 688 $1,237
Commercial and multi-family(1) -- 3,337(2) -- 381 2,386
Construction(3) -- -- 770 -- --
Home equity and lines of credit 47 60 243 -- --
Consumer 4 5 6 16 19
Commercial business 26 500(2) -- 268 138
------ ------ ------ ------ ------
Total non-accrual loans 266 4,280 1,642 1,353 3,780
------ ------ ------ ------ ------
Accruing loans more than 90 days delinquent (4) 11 772 391 203 1,358
------ ------ ------ ------ ------
Total non-performing loans 277 5,052 2,033 1,556 5,138
------ ------ ------ ------ ------
Real estate owned 2,450 760 1,229 1,420 248
------ ------ ------ ------ ------
Total non-performing assets $2,727 $5,812 $3,262 $2,976 $5,386
====== ====== ====== ====== ======
Total non-performing loans
as a percentage of gross loans receivable(5) 0.08% 1.65% 0.66% 0.53% 1.76%
====== ====== ====== ====== ======
Total non-performing assets
as a percentage of total assets 0.52% 1.12% 0.57% 0.53% 1.04%
====== ====== ====== ====== ======
- ----------
(1) Consists of one loan at September 30, 2005 which became real estate owned
during fiscal 2006, one loan at September 30, 2003, and three loans at
September 30, 2002 (all of which became real estate owned during fiscal
2003).
(2) Loans extended to the same borrower. The commercial business loan to the
borrower was charged off in full in connection with the transfer to real
estate owned of the property in 2006.
(3) Consists of one single-family residential construction loan at September
30, 2004.
(4) Consists of three credit card accounts at September 30, 2006, four loans at
September 30, 2005 of which a $770,000 construction loan returned to
current status subsequent to September 30, 2005, six loans at September 30,
2004, two loans at September 30, 2003, and one commercial real estate loan
at September 30, 2002 which returned to current status subsequent to
September 30, 2002.
(5) Includes loans receivable and loans held for sale, less construction and
land loans in process and deferred loan origination fees and discounts.
The $189,000 of non-performing single-family residential loans at September
30, 2006 consisted of four loans with principal balances ranging from $4,000 to
$114,000, with an average balance of approximately $47,300. Included within the
four loans is one loan of $61,000 to a credit impaired borrower.
The $47,000 of non-performing home equity and lines of credit at September
30, 2006 consisted of one loan.
Loans 90 days or more past maturity which continued to make payments on a
basis consistent with the original repayment schedule amounted to $0 and
$770,000 at September 30, 2006 and 2005, respectively.
15
At September 30, 2006, the $2.4 million of real estate owned consisted of a
commercial real estate property. During the second quarter of fiscal 2006, the
Company transferred to real estate owned a restaurant located in Chesapeake
City, Maryland secured by a $3.3 million commercial real estate loan as a result
of the Company taking possession of the property. The Company also had a
$500,000 commercial business loan outstanding in connection with this loan
relationship. As a result of the transfer of the property to real estate owned
at its approximate fair value of $2.7 million and the charge-off of the
commercial business loan, the Company charged off $1.1 million against the
allowance for loan losses in the quarter ended March 31, 2006. The Company is
actively marketing the property for sale but believes that, due to the unique
nature of the property as a waterfront restaurant, it may take an extended
period to sell the property. In addition, the Company anticipates that certain
repairs and improvements will be necessary to improve the property's
marketability, a significant portion of which will be capitalized. Management
currently estimates the total of such costs to range between $500,000 and
$700,000, a portion of which will be charged in the period incurred.
The increase in real estate owned was offset, in part, by the sale of a
residential home residing on the commercial property which was carried at a
value of $250,000 and resulted in a pre-tax gain of $20,000. In addition, during
the second quarter of fiscal 2006, a commercial property in which the Company
held a 25% participation interest in a golf facility was sold with a carrying
value of $760,000 resulted in a pre-tax gain of $158,000.
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 four classifications for problem assets: "substandard," "doubtful," "loss"
and "special mention." 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.
In connection with the recent OTS examination, the Company reviewed its
asset classifications resulting in a substantial increase in its criticized and
classified assets. At September 30, 2006, the Bank had $11.7 million of assets
classified as substandard, no assets classified as either doubtful or loss, and
$8.2 million identified as special mention. A substantial majority of the assets
classified as substandard consists of commercial business and commercial real
estate loans.
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 by
management to cover all known and inherent losses in its loan portfolio.
Management's analysis of the adequacy of the allowance is based on an evaluation
of the loan 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. However, in fiscal 2006, the level of allowance for loan losses
increased due to the Bank's evaluation of its estimate including, among other
things, implementation of refinements to its rating system, an analysis of
delinquency trends, non-performing loan trends, the levels of charge-offs and
recoveries, the increased levels of classified and special mention assets, prior
loss experience, total loans outstanding, the volume of loan originations in
commercial real estate and business loans, the type, average size, terms and
geographic location and concentration of loans held by the Company, the value
and the nature of the collateral securing loans, the number of loans requiring
heightened management oversight, general economic conditions, particularly as
they relate to the Company's primary market area, trends in market rates of
interest as well as extensive discussions with the OTS examination staff in
connection with the examination. The Company's primary banking regulator
periodically reviews the Company's allowance for loan losses as an integral part
of the examination. As shown in the table below, at September 30, 2006, the
Bank's allowance for loan losses amounted to 1,215.6% and 1.0 % of the Bank's
non-performing loans and gross loans receivable, respectively.
16
Management of the Company presently believes that its allowance for loan
losses is adequate to cover all known and inherent losses that are both probable
and reasonably estimable in the Bank's loan portfolio. However, future
adjustments to this allowance may be necessary, and the Company'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. 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,
--------------------------------------------------
2006 2005 2004 2003 2002
--------- ------ ------- ------- ------
(Dollars in thousands)
Allowance for loan losses, beginning of period $ 3,475 $2,039 $ 1,986 $ 2,358 $2,181
Charged-off loans:
Single-family residential (50) (26) -- (50) (317)
Multi-family and commercial (637)(1) -- (62) (941) --
Consumer and commercial business (641)(1) (318) (259) (111) (56)
--------- ------ ------- ------- ------
Total charged-off loans (1,328) (344) (321) (1,102) (373)
--------- ------ ------- ------- ------
Recoveries on loans previously charged off:
Single-family residential -- -- 35 4 1
Multi-family and commercial 3 -- 32 -- --
Consumer and commercial business 11 -- 7 11 9
--------- ------ ------- ------- ------
Total recoveries 14 -- 74 15 10
--------- ------ ------- ------- ------
Net loans charged-off (1,314) (344) (247) (1,087) (363)
Provision for loan losses 1,206 1,780 300 715 540
--------- ------ ------- ------- ------
Allowance for loan losses, end of period $ 3,367 $3,475 $ 2,039 $ 1,986 $2,358
========= ====== ======= ======= ======
Net loans charged-off to average loans
outstanding(2) 0.42% 0.11% 0.08% 0.37% 0.13%
========= ====== ======= ======= ======
Allowance for loan losses to gross loans
receivable(2) 1.03% 1.14% 0.67% 0.68% 0.81%
========= ====== ======= ======= ======
Allowance for loan losses to total
non-performing loans 1,215.61% 68.79% 100.30% 127.63% 45.89%
========= ====== ======= ======= ======
Net loans charged-off to allowance for loan
losses 39.44% 9.90% 12.11% 54.73% 15.39%
========= ====== ======= ======= ======
Recoveries to charge-offs 1.05% 0.00% 23.05% 1.36% 2.68%
========= ====== ======= ======= ======
- ----------
(1) The charge-off in multi-family and commercial loans as well as a $500,000
charge-off in consumer and commercial business loans was related to the
commercial property transferred to real estate owned discussed above.
(2) Gross loans receivable and average loans outstanding include loans
receivable as well as loans held for sale, less construction and land loans
in process and deferred loan origination fees and discounts.
17
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,
-------------------------------------------------------------------------------------------------------
2006 2005 2004 2003 2002
------------------- ------------------- ------------------- ------------------- -------------------
% OF LOANS % OF LOANS % OF LOANS % OF LOANS % OF LOANS
IN EACH IN EACH IN EACH IN EACH IN EACH
CATEGORY TO CATEGORY TO CATEGORY TO CATEGORY TO CATEGORY TO
AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS AMOUNT TOTAL LOANS
------ ----------- ------ ----------- ------ ----------- ------ ----------- ------ -----------
(Dollars in thousands)
Single-family residential $ 326 42.76% $ 695 45.85% $ 700 50.87% $ 733 55.51% $ 815 57.32%
Commercial and multi-
family residential 1,346 20.81 1,888 22.61 446 20.02 317 19.73 767 19.92
Construction and land 129 11.27 383 11.50 467 11.82 329 9.69 304 9.33
Home equity 122 17.52 62 14.60 57 13.54 34 11.19 40 9.10
Consumer 85 .41 10 .42 11 .46 10 .48 10 .40
Commercial business 1,072 7.23 370 5.02 70 3.29 132 3.40 86 3.93
Unallocated 287 -- 67 -- 288 -- 431 -- 336 --
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total allowance for
loan losses $3,367 100.00% $3,475 100.00% $2,039 100.00% $1,986 100.00% $2,358 100.00%
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
18
MORTGAGE-RELATED 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
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 $417,000 (for single-family dwellings).
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 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.
19
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. However,
mortgage-related securities are more liquid than individual mortgage loans and
may be used to collateralize certain obligations of the Bank. At September 30,
2006, $22.2 million of the Bank's mortgage-related securities were pledged to
secure various obligations of the Bank, treasury tax and loan processing and as
collateral for certain municipal 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, 2006, the Bank had an aggregate of $108.4 million, or
13.4%, of total assets invested in mortgage-related securities, net, of which
$38.4 million was held to maturity and $70.0 million was available for sale. The
Company's investment strategy is to maintain the portfolio to complement the
asset-liability structure of the Company. The Company's strategy during fiscal
2006 was to reinvest its cash flows into the loan portfolio as well as to assist
the Bank in controlling its asset growth as required by the terms of the
supervisory agreement. See "- Supervisory Agreements". 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 level
yield method, 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 set forth in Item 8 hereof.
20
The following table sets forth the composition of the Bank's available for
sale (at fair value) and held to maturity (at amortized cost) mortgage-related
securities portfolios at the dates indicated.
SEPTEMBER 30,
-------------------------------
2006 2005 2004
------- ------- -------
(Dollars in thousands)
Available for sale:
Mortgage-backed securities:
FHLMC $ 7,224 $ 53 $ 5,811
FNMA 27,597 23,180 42,861
GNMA 2,906 3,920 1,270
------- ------- -------
Total mortgage-backed securities 37,727 27,153 49,942
------- ------- -------
Collateralized mortgage obligations:
FHLMC 5,582 3,514 15,649
FNMA 3,231 3,951 6,543
Other 23,490(1) 32,909(2) 25,486(3)
------- ------- -------
Total collateralized mortgage obligations 32,303 40,374 47,678
------- ------- -------
Total mortgage-related securities $70,030 $67,527 $97,620
======= ======= =======
Held to maturity:
Mortgage-backed securities:
FHLMC $14,376 $17,267 $16,226
FNMA 23,826 29,084 20,613
------- ------- -------
Total mortgage-backed securities 38,202 46,351 36,839
------- ------- -------
Collateralized mortgage obligations:
FNMA 153 303 524
------- ------- -------
Total collateralized mortgage obligations 153 303 524
------- ------- -------
Total mortgage-related securities, amortized cost $38,355 $46,654 $37,363
======= ======= =======
Total fair value(4) $37,163 $45,679 $37,312
======= ======= =======
- ----------
(1) Includes "AAA" rated securities of AMAC, Bank of America, Countrywide Home
Loans, Credit Suisse First Boston, GSR, MastrAsset, Structured Asset
Securities, Washington Mutual and Wells Fargo with book values of $3.6
million, $429,000, $2.6 million, $1.4 million, $1.2 million, $2.0 million,
$604,000, $4.7 million and $7.5 million, respectively, and fair values of
$3.5 million, $426,000, $2.5 million, $1.4 million, $1.2 million, $1.9
million, $602,000, $4.6 million and $7.3 million, respectively
(2) Includes "AAA" rated securities of AMAC, Credit Suisse First Boston,
Countrywide Home Loans, First Horizon, GSR, MastrAsset, Washington Mutual
and Wells Fargo with book values of $4.3 million, $1.7 million, $2.9
million, $4.4 million, $1.3 million, $3.1 million, $5.4 million, and $8.2
million, respectively, and fair values of $4.3 million, $1.6 million, $3.0
million, $4.3 million, $1.3 million, $3.1 million, $5.5 million, and $8.4
million, respectively.
(3) Includes "AAA" rated securities of Countrywide Home Loans, Washington
Mutual, AMAC, First Horizon and Mastr Asset with book values of $5.2
million, $4.7 million, $2.0 million, $ 4.9 million and $4.0 million,
respectively, and fair values of $5.2 million, $4.7 million, $1.9 million,
$4.9 million and $4.1 million, respectively.
(4) See Note 4 of the Notes to Consolidated Financial Statements set forth in
Item 8 hereof.
21
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,
------------------------------
2006 2005 2004
-------- -------- --------
(Dollars in thousands)
Mortgage-related securities, beginning of period(1)(2) $114,181 $134,983 $128,143
-------- -------- --------
Purchases:
Mortgage-backed securities - available for sale 18,353 23,532 11,106
Mortgage-backed securities - held to maturity -- 18,591 37,856
CMOs - available for sale -- 18,402 11,222
Sales:
Mortgage-backed securities - available for sale -- (31,758) (7,073)
CMOs - available for sale (1,708) (10,806) --
Repayments and prepayments:
Mortgage-backed securities (15,509) (22,802) (23,006)
CMOs (6,410) (14,314) (21,262)
Decrease in net premium (242) (643) (787)
Change in net unrealized loss on mortgage-related
securities available for sale (280) (1,004) (1,216)
-------- -------- --------
Net increase (decrease) in mortgage-related securities (5,796) (20,802) 6,840
-------- -------- --------
Mortgage-related securities, end of period(1) (2) $108,385 $114,181 $134,983
======== ======== ========
- ----------
(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, 2006, 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 generally 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,
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. During fiscal 2006 and 2005, the Company experienced lower
prepayment speeds and refinancing activity as interest rates offered for
mortgage loans in the marketplace increased during these time periods.
22
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,
------------------------------------------------------------
2006 2005 2004
------------------ ------------------ ------------------
CARRYING FAIR CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE VALUE VALUE
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
FHLB stock $ 6,233 $ 6,233 $ 9,499 $ 9,499 $ 9,827 $ 9,827
U.S. Government and agency
obligations
1 to 5 years 1,976 1,976 -- -- 14,495 14,495
5 to 10 years -- -- 1,979 1,979 -- --
Municipal obligations 13,365 13,376 16,502 16,530 15,641 15,691
Corporate bonds 10,769 10,769 12,036 12,032 16,101 16,134
Mutual funds 8,952 8,952 8,593 8,593 13,804 13,804
Asset-backed securities -- -- 593 593 1,197 1,197
Preferred stocks -- -- -- -- 3,900 3,900
Other equity investments 1,581 1,581 1,582 1,582 3,764 3,764
------- ------- ------- ------- ------- -------
Total $42,876 $42,887 $50,784 $50,808 $78,729 $78,812
======= ======= ======= ======= ======= =======
At September 30, 2006, the Company had an aggregate of $42.9 million, or
8.2 %, of its total assets invested in investment securities, of which $6.2
million consisted of FHLB stock, $33.4 million was investment securities
available for sale and $3.3 million investment securities held to maturity.
Included in U.S. Government and agency obligations is a callable bond with a
remaining term of approximately six years. The Bank's investment securities
(excluding mutual funds, equity securities and FHLB stock) had a weighted
average maturity to the call date of 3.8 years and a weighted average yield of
5.38%.
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 FHLBank 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, MMDAs, certificates of deposit ranging in terms from 30 days to
five years and non-interest-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.
23
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. During fiscal 2006 and 2005,
the Bank slightly increased deposits, primarily in certificate of deposits, due
to competitively pricing its jumbo certificates of deposit causing a decline in
its core deposits driven by the increases in short-term interest rates. Core
deposits amounted to $172.9 million or 48.2% of the Bank's total deposits at
September 30, 2006.
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,
------------------------------------------------------------
2006 2005 2004
------------------ ------------------ ------------------
AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Passbook $ 41,708 11.62% $ 47,139 13.48% $ 51,371 14.90%
MMDA 40,591 11.31 45,753 13.08 51,682 14.98
NOW 73,356 20.45 65,688 18.79 55,864 16.20
Certificates of deposit 185,929 51.82 173,113 49.50 164,917 47.82
Non-interest-bearing 17,232 4.80 18,001 5.15 21,046 6.10
-------- ------ -------- ------ -------- ------
Total deposits $358,816 100.00% $349,694 100.00% $344,880 100.00%
======== ====== ======== ====== ======== ======
The following table sets forth the net savings flows of the Bank during the
periods indicated
YEAR ENDED SEPTEMBER 30,
--------------------------
2006 2005 2004
------ ------ --------
(Dollars in thousands)
(Decrease) increase before interest credited $1,134 $ (650) $(22,744)
Interest credited 7,988 5,464 5,019
------ ------ --------
Net savings increase (decrease) $9,122 $4,814 $(17,725)
====== ====== ========
The following table sets forth maturities of the Bank's certificates of
deposit of $100,000 or more at September 30, 2006 and 2005 by time remaining to
maturity (amounts in thousands).
SEPTEMBER 30,
-----------------
2006 2005
------- -------
Three months or less $24,188 $13,484
Over three months through six months 6,089 7,916
Over six months through twelve months 12,424 9,748
Over twelve months 17,376 18,927
------- -------
$60,077 $50,075
======= =======
24
The following table presents, by various interest rate categories, the
amount of certificates of deposit at September 30, 2006 and 2005 and the amounts
at September 30, 2006 which mature during the periods indicated.
AMOUNTS AT SEPTEMBER 30, 2006
SEPTEMBER 30, MATURING WITHIN
------------------- -----------------------------------------------
2006 2005 ONE YEAR TWO YEARS THREE YEARS THEREAFTER
-------- -------- -------- --------- ----------- ----------
(Dollars in thousands)
Certificates of Deposit
2.0% or less $ 174 $ 18,651 $ 172 $ 2 $ -- $ --
2.01% to 3.0% 11,571 44,489 10,937 634 -- --
3.01% to 4.0% 62,755 91,595 39,643 14,400 4,805 3,907
4.01% to 5.0% 64,366 15,262 39,063 20,717 861 3,725
5.01% to 6.0% 47,063 3,116 28,964 18,099 -- --
-------- -------- -------- ------- ------ ------
Total certificate accounts $185,929 $173,113 $118,779 $53,852 $5,666 $7,632
======== ======== ======== ======= ====== ======
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,
------------------------------------------------------------
2006 2005 2004
------------------ ------------------ ------------------
AVERAGE AVERAGE AVERAGE
AVERAGE RATE AVERAGE RATE AVERAGE RATE
BALANCE PAID BALANCE PAID BALANCE PAID
-------- ------- -------- ------- -------- -------
(Dollars in thousands)
Passbook accounts $ 45,673 0.94% $ 50,574 0.94% $ 50,206 0.94%
MMDA accounts 42,966 2.13 51,284 1.49 53,054 1.14
Certificates of deposit 178,878 3.66 166,179 2.81 169,834 2.68
NOW accounts 67,254 1.03 61,051 0.65 55,115 0.52
Non-interest-bearing deposits 17,600 -- 19,988 -- 19,598 --
-------- ---- -------- ---- -------- ----
Total deposits $352,371 2.43% $349,076 1.81% $347,807 1.70%
======== ==== ======== ==== ======== ====
25
Borrowings. The Bank may obtain advances from the FHLBank 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. At September 30, 2006, the Bank had $107.2 million in
outstanding FHLB advances and overnight borrowings. The FHLB advances have
certain call features whereby the FHLBank Pittsburgh can call the borrowings
after the expiration of certain time frames. The time frames on the callable
borrowings are within 12 months. Note 9 of the Notes to Consolidated Financial
Statements set forth in Item 8 hereof.
The following table sets forth certain information regarding the Bank's
FHLB advances for the periods indicated.
SEPTEMBER 30,
----------------------
2006 2005
-------- --------
(Dollars in thousands)
FHLB advances
Average balance outstanding for the period $108,247 $160,265
Maximum outstanding at any month end 116,457 167,886
Balance outstanding at end of the period 107,153 113,170
Average interest rate for the period 5.46% 4.79%
Interest rate at the end of the period 5.46% 5.19%
In addition, the Company participated in junior subordinated debentures
aggregating $21.5 million at September 30, 2006 held by statutory trusts that
issued trust preferred securities comprising of $13.5 million in fixed-rate
preferred securities and $8.0 million in floating-rate preferred securities.
With the receipt of net proceeds from the private placement offering, the
Company intends to redeem a significant portion of the floating-rate preferred
securities. Due to the timing of this offering, the Company will not be able to
partially redeem these preferred securities before June 8, 2007. See Note 16 of
the Notes to Consolidated Financial Statements set forth in Item 8 hereof.
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, 2006, the Bank was authorized to invest up to approximately $10.5 million in
the stock of, or loans to, service corporations. As of September 30, 2006, the
net book value of the Bank's investment in stock, unsecured loans, and
conforming loans to its service corporations was $65,000.
At September 30, 2006, in addition to the Bank, the Company has four
indirect active subsidiaries: FKF Management Corp., Inc., State Street
Services Corp., First Chester Services, Inc., and First Pointe, Inc.
FKF Management Corp., Inc., a Delaware corporation, is a wholly owned
operating subsidiary of the Bank established in 1997 for the purpose of managing
certain assets of the Bank. Assets under management totaled $159.3 million at
September 30, 2006 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 ("First Keystone Insurance"). First Keystone Insurance's financial
data is consolidated into the Company's financial statements. Total assets for
First Keystone Insurance were $134,000 and $280,000 at September 30, 2006 and
2005, respectively. Total liabilities for First Keystone Insurance were $32,000
and $248,000 at September 30, 2006 and 2005, respectively. Net income for the
years ending September 30, 2006 and 2005 was $69,000 and $53,000, respectively.
First Chester Services, Inc. and First Pointe, Inc. are wholly owned
subsidiaries which were reactivated to manage a real estate owned parcel and
other assets related to the real estate owned parcel.
26
EMPLOYEES
The Bank had 104 full-time employees and 24 part-time employees as of
September 30, 2006. None of these employees is represented by a collective
bargaining agreement. The Bank believes that it enjoys excellent relations with
its personnel.
REGULATION
General. Set forth below is a brief description of certain laws and
regulations, which are applicable to the Company and the Bank. The description
of these laws and regulations, as well as descriptions of laws and regulations
contained elsewhere herein, do not purport to be complete and is qualified in
its entirety by reference to the applicable laws and regulations.
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, examination, 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 was a unitary saving and loan holding company prior to May 4, 1999 and its
non-savings institution subsidiaries. Under the Gramm-Leach-Bliley Act of 1999
(the "GLBA"), companies which apply to the OTS to become unitary savings and
loan holding companies are 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 regarding permissible business activities of
grandfathered unitary savings and loan holding companies under the GLBA (such as
the Company), if the savings association subsidiary of such a holding company
fails to meet the 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.
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 imposes 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.
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 capital distribution will be invalid. See "-
The Bank - 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
27
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 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 ("FRB") 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 of the assets thereof;
(ii) more than 5% of the voting shares of a savings association or holding
company thereof which is not a subsidiary; (iii) acquiring through a merger,
consolidation or purchase of assets of another savings institution (or holding
company thereof) or acquiring all or substantially all of the assets of another
savings institution (or holding company thereof) without prior OTS approval; or
(iv) acquiring control of an uninsured institution 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 of the Exchange Act.
Sarbanes-Oxley Act of 2002. On July 30, 2002, the President signed into law
the Sarbanes-Oxley Act of 2002 (the "Act") implementing legislative reforms
intended to address corporate and accounting fraud. In addition to the
establishment of a new accounting oversight board which will enforce auditing,
quality control and independence standards and will be funded by fees from all
publicly traded companies, the bill restricts provision of both auditing and
consulting services by accounting firms. To ensure auditor independence, any
non-audit services being provided to an audit client will require preapproval by
the company's audit committee members. In addition, the audit partners must be
rotated. The Act requires chief executive officers and chief financial officers,
or their equivalent, to certify to the accuracy of periodic reports filed with
the SEC, subject to civil and criminal penalties if they knowingly or willfully
violate this certification requirement. In addition, under the Act, counsel are
required to report evidence of a material violation of the securities laws or a
breach of fiduciary duty by a company to its chief executive officer or its
chief legal officer, and, if such officer does not appropriately respond, to
report such evidence to the audit committee or other similar committee of the
board of directors or the board itself.
Longer prison terms and increased penalties will also be applied to
corporate executives who violate federal securities laws, the period during
which certain types of suits can be brought against a company or its officers
has been extended, and bonuses issued to top executives prior to restatement of
a company's financial statements are now subject to disgorgement if such
restatement was due to corporate misconduct. Executives are also prohibited from
insider trading during retirement plan "blackout" periods, and loans to company
executives are restricted. In addition, a provision directs that civil penalties
levied by the SEC as a result of any judicial or administrative action under the
Act be deposited to a fund for the benefit of harmed investors. The Federal
Accounts for Investor Restitution ("FAIR") provision also requires the SEC to
develop methods of improving collection rates. The legislation accelerates the
time frame for disclosures by public companies, as they must immediately
disclose any material changes in their financial condition or operations.
Directors and executive officers must also provide information for most changes
in ownership in a company's securities within two business days of the change.
28
The Act also increases the oversight of, and codifies certain requirements
relating to audit committees of public companies and how they interact with the
company's "registered public accounting firm" ("RPAF"). Audit committee members
must be independent and are barred from accepting consulting, advisory or other
compensatory fees from the issuer. In addition, companies must disclose whether
at least one member of the committee is a "financial expert" (as such term is
defined by the SEC in regulations promulgated thereby) and if not, why not.
Under the Act, a RPAF is prohibited from performing statutorily mandated audit
services for a company if such company's chief executive officer, chief
financial officer, comptroller, chief accounting officer or any person serving
in equivalent positions has been employed by such firm and participated in the
audit of such company during the one-year period preceding the audit initiation
date. The Act also prohibits any officer or director of a company or any other
person acting under their direction from taking any action to fraudulently
influence, coerce, manipulate or mislead any independent public or certified
accountant engaged in the audit of the company's financial statements for the
purpose of rendering the financial statement's materially misleading. The Act
also requires the SEC to prescribe rules requiring inclusion of an internal
control report and assessment by management in the annual report to stockholders
which will become effective, due to a recent extension of the compliance period
by the SEC, for the fiscal year ending September 30, 2008. The Act requires the
RPAF that issues the audit report to attest to and report on management's
assessment of the company's internal controls. In addition, the Act requires
that each financial report required to be prepared in accordance with (or
reconciled to) accounting principles generally accepted in the United States of
America and filed with the SEC reflect all material correcting adjustments that
are identified by a RPAF in accordance with accounting principles generally
accepted in the United States of America and the rules and regulations of the
SEC.
The Bank. The OTS has extensive regulatory authority over the operations of
savings associations such as the Bank. 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 Deposit Insurance Fund, which is administered by the
Federal Deposit Insurance Corporation ("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.
Each FDIC insured institution is assigned to one of three capital groups
which are based solely on the level of an institution's capital - "well
capitalized," "adequately capitalized" and "undercapitalized" - which are
defined in the same manner as the regulations establishing the prompt corrective
action system discussed below. These three groups are then divided into three
subgroups which reflect varying levels of supervisory concern, from those which
are considered to be healthy to those which are considered to be of substantial
supervisory concern. The matrix so created results in nine assessment risk
classifications, with rates during the first six months of 2006 ranging from
zero for well capitalized, healthy institutions, to 27 basis points for
undercapitalized institutions with substantial supervisory concerns.
In addition, all institutions with deposits insured by the FDIC are
required to pay assessments to fund interest payments on bonds issued by the
Financing Corporation, a mixed-ownership government corporation established to
recapitalize the predecessor to the SAIF. The assessment rate for the third
quarter of 2006 was .0106% of insured deposits and is adjusted quarterly. These
assessments will continue until the Financing Corporation bonds mature in 2019.
29
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.
DEPOSIT INSURANCE REFORM. On February 8, 2006, President George W. Bush
signed into law legislation that merged the Bank Insurance Fund and the Savings
Association Insurance Fund to form the Deposit Insurance Fund, eliminated any
disparities in bank and thrift risk-based premium assessments, reduced the
administrative burden of maintaining and operating two separate funds and
established certain new insurance coverage limits and a mechanism for possible
periodic increases. The legislation also gave the FDIC greater discretion to
identify the relative risks all institutions present to the Deposit Insurance
Fund and set risk-based premiums.
Major provisions in the legislation include:
- merging the Savings Association Insurance Fund and Bank Insurance
Fund, which became effective March 31, 2006;
- maintaining basic deposit and municipal account insurance coverage at
$100,000 but providing for a new basic insurance coverage for
retirement accounts of $250,000. Insurance coverage for basic deposit
and retirement accounts could be increased for inflation every five
years in $10,000 increments beginning in 2011;
- providing the FDIC with the ability to set the designated reserve
ratio within a range of between 1.15% and 1.50%, rather than
maintaining 1.25% at all times regardless of prevailing economic
conditions;
- providing a one-time assessment credit of $4.7 billion to banks and
savings associations in existence on December 31, 1996, which may be
used to offset future premiums with certain limitations; and
- requiring the payment of dividends of 100% of the amount that the
insurance fund exceeds 1.5% of the estimated insured deposits and the
payment of 50% of the amount that the insurance fund exceeds 1.35% of
the estimated insured deposits (when the reserve is greater than 1.35%
but no more than 1.5%).
Pursuant to the Reform Act, the FDIC has determined to maintain the
designated reserve ratio at its current 1.25%, which will be reviewed annually.
The FDIC has also adopted a new risk-based premium system that provides for
quarterly assessments based on an insured institution's ranking in one of four
risk categories based upon supervisory and capital evaluations. Beginning in
2007, well-capitalized institutions (generally those with CAMELS composite
ratings of 1 or 2) will be grouped in Risk Category I and will be assessed for
deposit insurance at an annual rate of between five and seven basis points. The
assessment rate for an individual institution is determined according to a
formula based on a weighted average of the institution's individual CAMELS
component ratings plus either five financial ratios or, in the case of an
institution with assets of $10.0 billion or more, the average ratings of its
long-term debt. Institutions in Risk Categories II, III and IV will be assessed
at annual rates of 10, 28 and 43 basis points, respectively. The Bank
anticipates that it will be able to partially offset its deposit insurance
premium for 2007 with the special assessment credit.
Capital requirements. The OTS capital requirements consist of a "tangible
capital requirement," a "leverage capital requirement" and a "risk-based capital
requirement." The Office of Thrift Supervision is authorized to impose capital
requirements in excess of those standards on individual institutions on a
case-by-case basis. Under these requirements, 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's 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
30
("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, 2006, 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, 2006, the Bank did not have
any PMSRs.
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.
Certain exclusions from capital and assets are required for the purpose of
calculating total capital, in addition to the adjustments required for
calculating core capital. Such exclusions consist of equity investments (as
defined by regulation) and that portion of land loans and non-residential
construction loans in excess of an 80% loan-to-value ratio and reciprocal
holdings of qualifying capital instruments. However, in calculating regulatory
capital, institutions must exclude unrealized losses and gains on securities
available for sale, net of taxes, reported as a separate component of capital
calculated according to generally accepted accounting principles.
Under the terms of the supervisory agreement between the Bank and the OTS,
the Bank agreed to maintain its core capital and total risk-based capital in
excess of 7.5% and 12.5%, respectively. At September 30, 2006, the Bank exceeded
all of its regulatory capital requirements, with tangible, core and risk-based
capital ratios of 9.2%, 9.2% and 14.9%, respectively. See " Supervisory
Agreements" and Note 11 to the Notes to Consolidated Financial Statements
included set forth in Item 8 hereof.
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 making any capital distributions.
31
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, 2006, 2005 and 2004.
SEPTEMBER 30, 2006 SEPTEMBER 30, 2005 SEPTEMBER 30, 2004
------------------------------- ------------------------------- -------------------------------
TANGIBLE CORE RISK-BASED TANGIBLE CORE RISK-BASED TANGIBLE CORE RISK-BASED
CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL CAPITAL
-------- ------- ---------- -------- ------- ---------- -------- ------- ----------
(Dollars in thousands)
GAAP equity $47,771 $47,771 $47,771 $45,606 $45,606 $45,606 $46,535 $46,535 $46,535
General valuation allowances -- -- 3,367 -- -- 3,202 -- -- 1,765
------- ------- ------- ------- ------- ------- ------- ------- -------
Total regulatory capital 47,771 47,771 51,138 45,606 45,606 48,808 46,535 46,535 48,300
Minimum capital requirement 7,829 20,819 27,385 7,732 20,619 25,800 8,500 22,667 26,540
------- ------- ------- ------- ------- ------- ------- ------- -------
Excess $39,942 $26,952 $23,753 $37,874 $24,987 $23,008 $38,035 $23,868 $21,760
======= ======= ======= ======= ======= ======= ======= ======= =======
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. In February 2006, the OTS imposed minimum core capital and total
risk-based capital ratios of 7.5% and 12.5%, respectively. As of September 30,
2006, the Bank's regulatory capital was in excess of all regulatory capital
requirements, including those imposed by the supervisory agreement.
32
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).
In February 2006, the Bank entered into a Supervisory Agreement with the
OTS. As a result of the supervisory agreement, the Bank is not deemed to be
"well-capitalized" for purposes of the prompt corrective action regulations of
the OTS. At September 30, 2006, the Bank's regulatory capital is in excess of
all regulatory capital requirements, including those imposed by the supervisory
agreement.
The Bank is also required to observe certain requirements regarding limits
on asset growth, adoption of revised policies and procedures governing
commercial lending, conduct periodic internal loan reviews and its commercial
loan department, adoption of a revised asset classification policy and not
amend, renew or enter into compensatory arrangements with senior executive
officers and directors, subject to certain exceptions, without the prior
approval of the OTS.
In February 2006, the Company entered into a supervisory agreement with the
OTS. Under the terms of the supervisory agreement, the Company agreed to, among
other things, (i) develop and implement a three-year capital plan designed to
support the Company's efforts to maintain prudent levels of capital and to
reduce its debt-to-equity ratio below 50%; (ii) not incur any additional debt
without the prior written approval of the OTS; and (iii) not repurchase any
shares of or pay any cash dividends on its common stock until certain conditions
were complied with; provided, however, that upon reducing its debt-to-equity
below 50%, the Company may resume the payment of quarterly cash dividends at the
lesser of the dividend rate in effect immediately prior to entering into the
supervisory agreement or 35% of its consolidated net income (on an annualized
basis), provided that the OTS does not object to the payment of such dividend
pursuant to a required prior notice of the Company's intent to declare such
quarterly dividend. The Company has filed and received OTS approval of its
capital plan.
As part of its capital plan, the Company conducted a private placement of
400,000 shares of common stock, raising gross proceeds of approximately $6.5
million. The Company intends to use all of the net proceeds of $5.8 million to
redeem a significant portion of its floating-rate trust preferred securities in
June 2007. As a result of such redemption, the Company's debt-to-equity ratio
will be less than 50%.
Qualified Thrift Lender Test (the "QTL"). 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 FHLBank Pittsburgh, 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% loans for personal, family and household purposes (other then credit card
loans and education loans) (limited to 10% of total portfolio assets) and stock
issued by
33
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 the following restrictions on its
operations: (i) the institution may not engage in any new activity or make any
new investment, directly or indirectly, unless such activity or investment is
permissible for a national bank; (ii) the branching powers of the institution
shall be restricted to those of a national bank; (iii) the institution shall not
be eligible to obtain any new advances from its Federal Home Loan Bank, other
than special liquidity advances with the approval of the Office of Thrift
Supervision; and (iv) payment of dividends by the institution shall be subject
to the rules regarding payment of dividends by a national bank. 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, 2006, approximately 71.9% 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.
Capital Distribution. OTS regulations govern capital distributions by
savings institutions, which include cash dividends, stock repurchases and other
transactions charged to the capital account of a savings institution to make
capital distributions. A savings institution must file an application for OTS
approval of the capital distribution if any of the following occur or would
occur as a result of the capital distribution (1) the total capital
distributions for the applicable calendar year exceed the sum of the
institution's net income for that year to date plus the institution's retained
net income for the preceding two years, (2) the institution would not be at
least adequately capitalized following the distribution, (3) the distribution
would violate any applicable statute, regulation, agreement or OTS-imposed
condition, or (4) the institution is not eligible for expedited treatment of its
filings. If an application is not required to be filed, savings institutions
which are a subsidiary of a holding company (as well as certain other
institutions) must still file a notice with the OTS at least 30 days before the
Board of Directors declares a dividend or approves a capital distribution. 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. At September 30, 2006,
the Company is currently not permitted to pay dividends to its stockholders
under the terms of the supervisory agreement until certain conditions are
satisfied.
Community Reinvestment Act and the Fair Lending Laws. 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 CRA rating as a result
of its last OTS evaluation. In addition, the Equal Credit Opportunity Act and
the Fair Housing Act prohibit lenders from discriminating in their lending
practices on the basis of characteristics specified in those statutes. An
institution's failure to comply with the provisions of the CRA could, at a
minimum, result in regulatory restrictions on its activities, and failure to
comply with the fair lending laws could result in enforcement actions by the
OTS, as well as other federal regulatory agencies and the Department of Justice.
Branching by Federal Saving Institutions. OTS policy permits interstate
branching to the full extent permitted by statute (which is essentially
unlimited). Generally, federal law prohibits federal savings institutions from
establishing, retaining or operating a branch outside the state in which the
federal institution has its home office unless the institution meets the IRS'
domestic building and loan test (generally, 60% of a thrift's assets must be
housing-related) ("IRS Test"). The IRS Test requirement does not apply if: (a)
the branch(es) result(s) from an emergency acquisition of a troubled savings
institution (however, if the troubled savings institution acquired by a bank
holding company does not have its home office in the state of the bank holding
company bank subsidiary and does not qualify under the IRS Test, its branching
is limited to the branching laws for state-chartered banks in the state where
the savings institution is located); (b) the law of the state where the branch
would be located would permit the branch to be established if the federal
savings institution were chartered by the state in which its home office is
located; or (c) the branch was operated lawfully as a branch under state law
prior to the savings institution's reorganization to a federal charter.
34
Furthermore, the OTS will evaluate a branching applicant's record of CRA
compliance. An unsatisfactory CRA record may be the basis for denial of a
branching application.
Federal Home Loan Bank System. The Bank is a member of the FHLBank
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 of
September 30, 2006, the Bank has overnight borrowings and advances aggregating
$107.2 million from the FHLB or 21.7% of its total liabilities. The Bank
currently has the ability to obtain up to $164.9 million of additional advances
from FHLBank Pittsburgh.
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 FHLBank Pittsburgh,
whichever is greater. At September 30, 2006, the Bank had $6.2 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid and could continue to do so
in the future and could also result in the FHLBs imposing higher interest rates
on advances to members. These contributions also could have an adverse effect on
the value of FHLB stock in the future.
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, 2006,
the Bank was in compliance with applicable requirements. However, because
required reserves must be maintained in the form of vault cash or a
non-interest-bearing account at a FRB, the effect of this reserve requirement is
to reduce an institution's earning assets.
Savings institutions are authorized to borrow from a Federal Reserve Bank
"discount window," but FRB regulations require savings banks to exhaust other
reasonable alternative sources of funds, including FHLB advances, before
borrowing from a Federal Reserve Bank.
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. See "Supervisory
Agreements."
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 the Bank's 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.
35
Bad Debt Reserves. The Small Business Job Protection Act of 1996 eliminated
the use of the reserve method of accounting for bad debt reserves by savings
institutions, effective for taxable years beginning after 1995. Prior to that
time, the Company was permitted to establish a reserve for bad debts and to make
additions to the reserve. These additions could, within specified formula
limits, be deducted in arriving at taxable income. As a result of the Small
Business Job Protection Act, savings associations must use the specific
charge-off method in computing their bad debt deduction beginning with their
1996 federal tax return.
Prior to the Small Business Protection Act of 1996, bad debt reserves
created prior to January 1, 1988 were subject to recapture into taxable income
if the Bank failed to meet certain thrift asset and definitional tests. New
federal legislation eliminated these thrift-related recapture rules. However, to
the extent that the Bank makes "non-dividend distributions" that are considered
as made (i) from the reserve for losses on qualifying real property loans or
(ii) from the supplemental reserve for losses on loans, then an amount based on
the amount distributed will be included in its taxable income. Non-dividend
distributions include distributions in excess of the Bank's current and
accumulated earnings and profits, distributions in redemption of stock, and
distributions in partial or complete liquidation. Dividends paid out of the
Bank's current or accumulated earnings and profits, as calculated for federal
income tax purposes, will not be considered to result in a distribution from our
bad debt reserve. As a result, any dividends that would reduce amounts
appropriated to bad debt reserve and deducted for federal income tax purposes
would create a tax liability for the Bank.
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 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 2006 is 9.99% and is imposed on the Company's
unconsolidated taxable income for federal purposes with certain adjustments. In
general, the Capital Stock and Franchise Tax is a property tax imposed at the
rate of 0.60% 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 the 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 1A. RISK FACTORS.
OUR OPERATIONS ARE SUBJECT TO INTEREST RATE RISK AND VARIATIONS IN INTEREST
RATES MAY NEGATIVELY AFFECT FINANCIAL PERFORMANCE.
Our earnings and cash flows are largely dependent upon our net interest
income. Net interest income is the difference between interest income earned on
interest-earning assets such as loans and securities and interest expense paid
on interest-bearing liabilities such as deposits and borrowed money. Changes in
the general level of interest rates may have an adverse effect on our business,
financial condition and result of operations. Interest rates are highly
sensitive to many factors that are beyond our control, including general
economic conditions and policies of various governmental and regulatory agencies
and, in particular, the FRB. Changes in monetary policy, including changes in
interest rates, influence the amount of interest income that we receive on loans
and securities and the amount of interest that we pay on deposits and
borrowings. Changes in monetary policy and interest rates also can adversely
affect:
- our ability to originate loans and obtain deposits;
- the fair value of our financial assets and liabilities; and
- the average duration of our securities portfolio.
If the interest rates paid on deposits and other borrowings increase at a
faster rate than the interest rates received on loans and other investments, our
net interest income, and therefore earnings, could be adversely affected.
Earnings could also be adversely affected if the interest rates received on
loans and other investments fall more quickly than the interest rates paid on
deposits and other borrowings.
THE OPERATING RESTRICTIONS IMPOSED BY THE OTS IN THE SUPERVISORY AGREEMENTS
LIMIT OUR ABILITY TO GROW, WHICH MAY ADVERSELY AFFECT OUR ABILITY TO
SUCCESSFULLY IMPLEMENT OUR BUSINESS STRATEGY.
In February 2006, the Company and the Bank each entered into supervisory
agreements with the OTS. The supervisory agreements provide for a number of
restrictions on the operations of the Company and the Bank, including the
requirement for the Company to cease paying dividends and to not repurchase any
shares of its common stock and for the Bank to not grow in any quarter in excess
of the greater of its net interest credited or 3% (on an annualized basis). For
further information, see Item 1, "Business - Supervisory Agreements." If the
restrictions imposed by the supervisory agreements are not removed or reduced,
it may adversely affect our ability to successfully implement our business
strategy and thus may also adversely affect our financial condition and results
of operations. As a result of the supervisory agreements, the Company submitted
a capital plan to the OTS. The Company's capital plan, which has been approved
by the OTS, calls for, among other things, an equity infusion in order to reduce
the Company's debt-to-equity ratio below 50%. A private placement was undertaken
in order to comply with the Company's capital plan. The net proceeds from this
private placement both increased the Company's capital as well as reduced its
debt-to-equity ratio. In the event the Company is unable to reduce its
debt-to-equity ratio below 50%, it is unlikely that the Company will be able to
resume the payment of dividends or have the supervisory agreements terminated.
WE MAY BE UNABLE TO SUCCESSFULLY IMPLEMENT OUR BUSINESS STRATEGY.
Implementation of our business strategy is dependent on (i) the termination
of the supervisory agreements we entered into in February 2006 with the OTS or
the elimination of, or substantial reduction in, the operating restrictions
imposed by such agreements, in particular the restriction limiting our asset
growth, which likely will depend, in part, on our ability to comply with the
provisions of our capital plan which was recently approved by the OTS; (ii) our
ability to attract sufficient low cost retail and commercial deposits; (iii)
maintaining existing and attracting new business banking relationships; (iv)
expanding our commercial business and commercial real estate lending portfolios;
(v) attracting and retaining experienced commercial lenders and other key
managerial employees; and (vi) expanding our branch network in Delaware and
Chester Counties, Pennsylvania. The failure to achieve these strategic goals
could adversely affect our ability to successfully implement our business
strategy and thus our financial condition and results of operations.
37
WE ARE SUBJECT TO LENDING RISK AND COULD SUFFER LOSSES IN OUR LOAN PORTFOLIO
DESPITE OUR UNDERWRITING PRACTICES.
There are inherent risks associated with our lending activities. There are
risks inherent in making any loan, including those related to dealing with
individual borrowers, nonpayment, uncertainties as to the future value of
collateral and changes in economic and industry conditions. We attempt to
closely manage our credit risk through loan underwriting and application
approval procedures, monitoring of large loan relationship and periodic
independent reviews of outstanding loans by our lending department and third
party loan review specialists. We cannot assure that such approval and
monitoring procedures will reduce these credit risks.
OUR LOAN PORTFOLIO INCLUDES COMMERCIAL AND MULTI-FAMILY REAL ESTATE, COMMERCIAL
BUSINESS AND CONSTRUCTION LOANS WHICH HAVE A GENERALLY HIGHER RISK OF LOSS THAN
SINGLE-FAMILY RESIDENTIAL LOANS.
As of September 30, 2006, approximately 39.3% of our loan portfolio
consisted of commercial business, construction and land development and
commercial and multi-family real estate loans. We are focused on increasing
these types of loans in the future. These types of loans involve increased risks
because the borrower's ability to repay the loan typically depends on the
successful operation of the business or the property securing the loan.
Additionally, these loans are made to small or middle-market business customers
who may be more vulnerable to economic conditions and who may not have
experienced a complete business or economic cycle. These types of loans are also
typically larger than single-family residential mortgage loans or consumer
loans. Furthermore, since these types of loans frequently have relatively large
balances, the deterioration of one or more of these loans could cause a
significant increase in non-performing loans and or non-performing assets. An
increase in non-performing loans would result in a reduction in interest income
recognized on loans. An increase in non-performing loans also could require us
to increase the provision for losses on loans and increase loan charge-offs,
both of which would reduce our net income. All of these could have a material
adverse effect on our financial condition and results of operations.
ADVERSE ECONOMIC AND BUSINESS CONDITIONS IN OUR PRIMARY MARKET AREA COULD CAUSE
AN INCREASE IN LOAN DELINQUENCIES AND NON-PERFORMING ASSETS WHICH COULD
ADVERSELY AFFECT OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The substantial majority of our real estate loans are secured by properties
located in Delaware and Chester Counties, Pennsylvania, our primary market area.
Furthermore, at September 30, 2006, approximately 39.3% of our loan portfolio
consisted of commercial business, construction and land development and
commercial and multi-family real estate loans. The Company's results of
operations and financial condition may be adversely affected by changes in
prevailing economic conditions, particularly in the Philadelphia metropolitan
area, including decreases in real estate values, adverse local employment
conditions, and other significant local events. Any deterioration in the local
economy could result in borrowers not being able to repay their loans, the value
of the collateral securing the Company's loans to borrowers declining and the
quality of the loan portfolio deteriorating. This could result in an increase in
delinquencies and non-performing assets or require the Company to record loan
charge-offs and/or increase the Company's provisions for loan losses, which
would reduce the Company's earnings.
OUR ALLOWANCE FOR LOSSES ON LOANS MAY BE INSUFFICIENT TO COVER ACTUAL LOSSES ON
LOANS.
We maintain an allowance for losses on loans at a level believed adequate
by us to absorb credit losses inherent in the loan portfolio. The allowance for
losses on loans is a reserve established through a provision for losses on loans
charged to expense that represents our estimate of probable incurred losses
within the loan portfolio at each statement of condition date and is based on
the review of available and relevant information. The level of the allowance for
losses on loans reflects, among other things, our consideration of the Company's
historical experience, levels of and trends in delinquencies, the amount of
classified assets, the volume and type of lending, and current and anticipated
economic conditions, especially as they relate to the Company's primary market
area. The determination of the appropriate level of the allowance for losses on
loans inherently involves a high degree of subjectivity and requires us to make
significant estimates of current credit risks and future trends. Our allowance
for loan losses may be insufficient to cover actual losses experienced on loans.
Changes in economic conditions affecting borrowers, new information regarding
existing loans, identification of additional problem loans and other factors,
both within and outside of our control, may require an increase in the allowance
for losses on loans. In addition, bank regulatory agencies periodically review
our allowance for losses on loans and may require an increase in the provision
for losses on loans or the recognition of further loan charge offs, based on
judgments different from ours. Also, if charge offs in future periods exceed the
allowance for losses on loans, we will need additional provisions to increase
our allowance for losses on loans. Any increases in the allowance for losses on
loans will result in a decrease in net income and possibly capital, and may have
a material adverse effect on our financial condition and results of operations.
38
WE OPERATE IN A HIGHLY COMPETITIVE INDUSTRY AND MARKET AREA WITH OTHER FINANCIAL
INSTITUTIONS OFFERING PRODUCTS AND SERVICES SIMILAR TO THOSE WE OFFER.
We compete with savings associations, national banks, regional banks and
other community banks in making loans, attracting deposits and recruiting and
retaining talented employees, many of which have greater financial and technical
resources than us. Currently, there are more than 30 competing financial
institutions in Delaware and Chester Counties, our principal market area. We
also compete with securities and brokerage companies, mortgage companies,
insurance companies, finance companies, money market mutual funds, credit unions
and other non-bank financial service providers. Many of these competitors are
not subject to the same regulatory restrictions to which we are subject, yet are
able to provide customers with a feasible alternative to traditional banking
services. The competition in our market for making commercial and construction
loans has resulted in more competitive pricing as well as intense competition
for skilled commercial lending officers. These trends could have a material
adverse effect on our ability to grow (irrespective of the limitations imposed
by the supervisory agreements) and remain profitable. In addition, if we
experience an inability to recruit and retain skilled commercial lending
officers, including experienced construction lenders, it could pose a
significant barrier to retaining and growing our customer base. The competition
in our market for attracting deposits also has resulted in more competitive
pricing.
WE ARE SUBJECT TO EXTENSIVE GOVERNMENT REGULATION AND SUPERVISION WHICH COULD
ADVERSELY AFFECT OUR OPERATIONS.
We are subject to extensive federal and state regulations and supervision.
Banking regulations are primarily intended to protect depositors' funds, federal
deposit insurance funds and the banking system as a whole, not stockholders.
These regulations affect our lending practices, capital structure, investment
practices, dividend policy and growth, among other things. Congress and federal
agencies continually review banking laws, regulations and policies for possible
changes. Changes to statutes, regulations or regulatory policies, including
changes in interpretation or implementation of statutes, regulations or
policies, could affect us in substantial and unpredictable ways. Such changes
could subject us to additional costs, limit the types of financial services and
products we may offer and/or increase the ability of non-banks to offer
competing financial services and products, among other things. Failure to comply
with law, regulations or policies could result in sanctions by regulatory
agencies, civil money penalties and/or reputation damage, which could have a
material adverse effect on our business, financial condition and results of
operations.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
NOT APPLICABLE.
39
ITEM 2. PROPERTIES.
At September 30, 2006, the Bank conducted business from its executive
offices located in Media, Pennsylvania and seven full-service offices located in
Delaware and Chester Counties, Pennsylvania. See also Note 7 of the Notes to
Consolidated Financial Statements set forth in Item 8 hereof.
The following table sets forth certain information with respect to the
Bank's offices at September 30, 2006.
Net Book Value of Amount of
Description/Address Leased/Owned Property Deposits
------------------- ------------ ----------------- ---------
(Dollar in thousands)
Executive Offices:
22 West State Street
Media, Pennsylvania 19063 Owned(1) $1,389 $ 90,889
Branch Offices:
3218 Edgmont Avenue
Brookhaven, Pennsylvania 19015 Owned 233 70,708
Routes 1 and 100
Chadds Ford, Pennsylvania 19317 Leased(2) 29 27,608
23 East Fifth Street
Chester, Pennsylvania 19013 Leased(3) 24 27,199
31 Baltimore Pike
Chester Heights, Pennsylvania 19017 Leased(4) 481 42,983
106 East Street Road
Kennett Square, Pennsylvania 19348 Leased(5) 413 19,904
5000 Pennell Road
Aston, Pennsylvania 19014 Leased(6) 766 21,259
330 Dartmouth Avenue
Swarthmore, Pennsylvania 19081 Owned 97 58,266
------ --------
Total $3,432 $358,816
====== ========
- ----------
(1) Also a branch office.
(2) Lease expiration date is September 30, 2010. The Bank has one five-year
renewal option.
(3) Lease expiration date is December 31, 2015.
(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, 2034. The Bank has one six-year
followed by a five-year renewal option.
(6) Lease expiration date is December 31, 2033. The Bank has options to cancel
on the 15th, 20th and 25th year of the lease.
40
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 and operations of the Company.
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.
(a) On January 25, 1995 the conversion and reorganization of the Bank and
its holding company parent was completed. In connection with the consummation of
the Conversion, the Holding Company issued 2,720,000 shares of common stock. As
of September 30, 2006, there were 2,027,928 shares of common stock outstanding.
As of September 30, 2006, the Holding Company had 392 stockholders of record not
including the number of persons or entities holding stock in nominee or street
name through various brokers and banks.
The following table sets forth the quarterly high and low trading stock
prices of the Company's common stock as reported by the Nasdaq Stock Market
under the symbol "FKFS". Price information appears in a major newspaper under
the symbol "FstKeyst".
YEAR ENDED
---------------------------------------
SEPTEMBER 30, 2006 SEPTEMBER 30, 2005
------------------ ------------------
HIGH LOW HIGH LOW
------ ------ ------ ------
First Quarter $22.00 $19.27 $23.60 $21.64
Second Quarter $20.30 $19.01 $24.70 $21.10
Third Quarter $21.25 $18.01 $23.30 $16.37
Fourth Quarter $19.73 $16.47 $22.00 $17.98
The following schedule summarizes the cash dividends per share of common
stock paid by the Company during the periods indicated.
YEAR ENDED SEPTEMBER 30,
------------------------
2006 2005
----- -----
First Quarter $0.11 $0.11
Second Quarter 0.11 0.11
Third Quarter -- 0.11
Fourth Quarter -- 0.11
Pursuant to the terms of the supervisory agreement between the Company and
the OTS, the Company is not permitted to pay dividends until the Company meets
certain limitations. See Item 1, "Business -- Supervisory Agreements" and Notes
11 of the "Notes to Consolidated Financial Statements" set forth in Item 8
hereof for discussion of restrictions on the Company's and the Bank's ability to
pay dividends. Also see "Regulation-Capital Distributions" for a discussion of
restrictions on the Bank's ability to pay dividends to the Company.
The information for all equity based and individual compensation
arrangements is incorporated by reference from Item 12 hereof.
(b) The Registrant's completed a private placement of 400,000 shares of
Common Stock on December 11, 2006, resulting in gross proceeds of
approximately $6.5 million and net proceeds of approximately $5.8
million. Included in the expenses were placement agent fees paid to
Sandler O'Neill & Partners, LP totaling approximately $393,000. The
net proceeds of the offering will be used to redeem approximately the
same amount of trust preferred securities in June 2007. Pending such
use, the net proceeds will be invested in a deposit account at the
Bank or in other earning assets such as mortgage-backed securities or
U.S. Treasury Securities.
41
(c) As previously disclosed, the Company does not have a repurchase
program currently in effect. In addition, pursuant to the terms of the
supervisory agreement between the Company and the OTS, the Company is
not permitted to repurchase shares of common stock. See Item 1,
"Business -- Supervisory Agreements."
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial and other data of the Company set forth
below does not purport to be complete and should be read in conjunction with,
and is qualified in its entirety by, the more detailed information, including
the Consolidated Financial Statements and related Notes, set forth in Item 8
hereof.
AT OR FOR THE YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
(Dollars in thousands, except per share data) 2006 2005 2004 2003 2002
-------- -------- -------- -------- --------
SELECTED FINANCIAL DATA:
Total assets $522,960 $518,124 $571,919 $559,612 $519,259
Loans receivable, net 323,220 301,979 304,248 286,421 288,776
Mortgage-related securities held to maturity 38,355 46,654 37,363 3,487 8,855
Investment securities held to maturity 3,257 4,267 5,287 6,315 --
Assets held for sale:
Mortgage-related securities 70,030 67,527 97,620 124,656 85,674
Investment securities 33,386 37,019 63,615 77,700 80,624
Loans 1,334 41 172 4,498 501
Real estate owned 2,450 760 1,229 1,420 248
Deposits 358,816 349,694 344,880 362,605 330,765
Borrowings 107,241 113,303 171,149 136,272 126,237
Junior subordinated debentures 21,483 21,520 21,557 21,593 21,629
Stockholders' equity 28,659 28,193 29,698 32,388 32,795
Non-performing assets 2,727 5,812 3,262 2,976 5,386
SELECTED OPERATIONS DATA:
Interest income $ 27,493 $ 27,076 $ 26,143 $ 27,212 $ 30,121
Interest expense 16,415 15,768 14,712 16,012 18,250
-------- -------- -------- -------- --------
Net interest income 11,078 11,308 11,431 11,200 11,871
Provision for loan losses 1,206 1,780 300 715 540
-------- -------- -------- -------- --------
Net interest income
after provision for loan losses 9,872 9,528 11,131 10,485 11,331
Service charges and other fees 1,560 1,577 1,235 1,013 1,000
Net gain on sales of interest-earning assets 338 802 968 1,010 415
Other non-interest income 1,614 1,210 1,696 1,263 848
Non-interest expense 12,708 12,820 12,501 10,400 10,441
-------- -------- -------- -------- --------
Income before income taxes 676 297 2,529 3,371 3,153
Income tax (benefit) expense (359) (313) 326 632 427
-------- -------- -------- -------- --------
Net income $ 1,035 $ 610 $ 2,203 $ 2,739 $ 2,726
======== ======== ======== ======== ========
PER SHARE DATA:
Basic earnings per share $ 0.55 $ 0.33 $ 1.21 $ 1.44 $ 1.42
Diluted earnings per share 0.54 0.33 1.14 1.35 1.34
Cash dividends per share 0.11 0.44 0.44 0.40 0.36
42
AT OR FOR THE YEAR ENDED SEPTEMBER 30,
----------------------------------------------------
(Dollars in thousands, except per share data) 2006 2005 2004 2003 2002
-------- -------- -------- -------- --------
SELECTED OPERATING RATIOS:
Average yield earned on interest-earning assets (1) 5.78% 5.12% 5.01% 5.48% 6.42%
Average rate paid on interest-bearing liabilities 3.40 2.96 2.80 3.23 3.91
Average interest rate spread (1) 2.38 2.16 2.21 2.26 2.52
Net interest margin (1) 2.37 2.18 2.23 2.30 2.59
Ratio of interest-earning assets to interest-
bearing liabilities 99.67 100.52 100.69 101.44 101.83
Efficiency ratio (2) 87.10 86.06 81.55 64.50 66.07
Non-interest expense as a percent
of average assets 2.46 2.26 2.23 1.95 2.07
Return on average assets 0.20 0.11 0.39 0.51 0.54
Return on average equity 3.73 2.08 7.13 8.39 8.77
Ratio of average equity to average assets 5.37 5.18 5.50 6.12 6.17
Full-service offices at end of period 8 8 7 7 7
ASSET QUALITY RATIOS:(3)
Non-performing loans as a
percent of gross loans receivable 0.08% 1.65% 0.66% 0.53% 1.76%
Non-performing assets as a
percent of total assets 0.52 1.12 0.57 0.53 1.04
Allowance for loan losses as a
percent of gross loans receivable 1.03 1.14 0.67 0.68 0.81
Allowance for loan losses as a
percent of non-performing loans 1,215.61 68.79 100.29 127.63 45.89
Net loans charged-off to average
loans receivable 0.42 0.11 0.08 0.37 0.13
CAPITAL RATIOS:(3) (4)
Tangible capital ratio 9.15% 8.85% 8.21% 7.98% 8.07%
Core capital ratio 9.15 8.85 8.21 7.98 8.07
Risk-based capital ratio 14.94 15.13 14.56 14.97 16.17
(1) Adjusted for the effects of tax-free investments. See presentation of
reconciliation of tax-free investments in "Management's Discussion and
Analysis of Financial Condition and Results of Operation - Average
Balances, Net Interest Income and Yield Earned and Rates Paid" in Item 7
hereof.
(2) Reflects non-interest expense as a percent of the aggregate of net interest
income and non-interest income.
(3) Asset Quality Ratios and Capital Ratios are end of period ratios except for
the ratio of loan charge-offs to average loans. With the exception of end
of period ratios, all ratios are based on average daily balances during the
indicated periods. Gross loans receivable are net of loans in process.
(4) Reflects regulatory capital ratios of the Company's wholly owned
subsidiary, First Keystone Bank.
43
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
GENERAL
First Keystone Financial, Inc. (the "Company") is the holding company for
its wholly owned subsidiary, First Keystone Bank (the "Bank"). For purposes of
this discussion, references to the Company will include its wholly owned
subsidiaries, unless otherwise indicated. The Company is a community-oriented
banking organization that focuses on providing customer and business services
within its primary market area, consisting primarily of Delaware and Chester
Counties in southeastern Pennsylvania.
The following discussion should be read in conjunction with the Company's
consolidated financial statements presented in Item 8 of this Annual Report on
Form 10-K. The primary asset of the Company is its investment in the Bank and,
accordingly, the discussion below with respect to results of operations relates
primarily to the operations of the Bank.
The Company's results of operations depend primarily on its net interest
income which is the difference between interest income on interest-earning
assets, which principally consist of loans, mortgage-related securities and
investment securities, and interest expense on interest-bearing liabilities,
which principally consist of deposits and FHLB advances. The Company's results
of operations also are affected by the provision for loan losses (the amount of
which reflects management's assessment of the known and inherent losses in its
loan portfolio that are both probable and reasonably estimable), the level of
its non-interest income, including service charges and other fees as well as
gains and losses from the sale of certain assets, the level of its operating
expenses, and income tax expense.
CRITICAL ACCOUNTING POLICIES
Accounting policies involving significant judgments and assumptions by
management, which have, or could have, a material impact on the carrying value
of certain assets or comprehensive income, are considered critical accounting
policies. In management's opinion, the most critical accounting policy affecting
the Company's financial statements is the evaluation of the allowance for loan
losses. The Company maintains an allowance for loan losses at a level management
believes is sufficient to provide for known and inherent losses in the loan
portfolio that were both probable and reasonable to estimate. The allowance for
loan losses is considered a critical accounting estimate because there is a
large degree of judgment in (i) assigning individual loans to specific risk
levels (pass, substandard, doubtful and loss), (ii) valuing the underlying
collateral securing the loans, (iii) determining the appropriate reserve factor
to be applied to specific risk levels for criticized and classified loans
(special mention, substandard, doubtful and loss) and (iv) determining reserve
factors to be applied to pass loans based upon loan type. Accordingly, there is
a likelihood that materially different amounts would be reported under
different, but reasonably plausible conditions or assumptions.
The determination of the allowance for loan losses requires management to
make significant estimates with respect to the amounts and timing of losses and
market and economic conditions. Accordingly, a decline in the economy could
increase loan delinquencies, foreclosures or repossessions resulting in
increased charge-off amounts and the need for additional loan loss allowances in
future periods. The Bank will continue to monitor and adjust its allowance for
loan losses through the provision for loan losses as economic conditions and
other factors dictate. Management reviews the allowance for loan losses
generally on a monthly basis, but at a minimum at least quarterly. Although the
Bank maintains its allowance for loan losses at levels considered adequate to
provide for the inherent risk of loss in its loan portfolio, there can be no
assurance that future losses will not exceed estimated amounts or that
additional provisions for loan losses will not be required in future periods. In
addition, the Bank's determination as to the amount of its allowance for loan
losses is subject to review by its primary federal banking regulator, the OTS,
as part of its examination process, which may result in additional allowances
based upon the judgment and review of the OTS. See "- Provision for Loan
Losses."
44
SUPERVISORY AGREEMENTS
On February 13, 2006, the Company and the Bank each entered into a
supervisory agreement with the OTS which primarily addressed issues identified
in the OTS' most recent reports of examination of the Company's and the Bank's
operations and financial condition.
Under the terms of the supervisory agreement between the Company and the
OTS, the Company agreed to, among other things, (i) develop and implement a
three-year capital plan designed to support the Company's efforts to maintain
prudent levels of capital and to reduce its debt-to-equity ratio below 50%; (ii)
not incur any additional debt without the prior written approval of the OTS; and
(iii) not repurchase any shares of or pay any cash dividends on its common stock
until the Company complied with certain conditions. Upon reducing its
debt-to-equity below 50%, the Company may resume the payment of quarterly cash
dividends at the lesser of the dividend rate in effect immediately prior to
entering into the supervisory agreement ($0.11 per share) or 35% of its
consolidated net income (on an annualized basis), provided that the OTS, upon
review of prior notice from the Company of the proposed dividend, does not
object to payment.
Under the terms of the supervisory agreement between the Bank and the OTS,
the Bank agreed to, among other things, (i) not grow in any quarter in excess of
the greater of 3% of total assets (on an annualized basis) or net interest
credited on deposit liabilities during such quarter; (ii) maintain its core
capital and total risk-based capital in excess of 7.5% and 12.5%, respectively;
(iii) adopt revised policies and procedures governing commercial lending; (iv)
conduct periodic reviews of its commercial loan department; (v) conduct periodic
internal loan reviews; (vi) adopt a revised asset classification policy and
(vii) not amend, renew or enter compensatory arrangements with senior executive
officers and directors, subject to certain exceptions, without the prior
approval of the OTS. As a result of the growth restriction imposed on the Bank,
the Company's growth is currently and will continue to be substantially
constrained unless and until the supervisory agreements are terminated or
modified. As of March 31, 2006 and June 30, 2006, the Bank exceeded the growth
limitation contained in the supervisory agreement with the OTS described above.
Subsequent to June 30, 2006, the Bank reduced its assets sufficiently to be
below the June 30, 2006 limitation. The OTS advised the Bank that it will not
take any regulatory action against the Bank provided it will be in compliance
with the growth limitation as of September 30, 2006. The Bank complied with the
growth restriction at September 30, 2006.
The Company recently underwent an examination by the OTS. In connection
with such examination, the OTS reviewed the Company's and the Bank's compliance
with the provisions of the supervisory agreements. Although the Company and the
Bank were determined to be in full or partial compliance with substantially all
of the provisions of the supervisory agreements, the examination did note a
number of areas for improvement with respect to the Bank's loan underwriting,
credit analysis and asset classification policies and procedures. In order to
strengthen these areas, the Bank intends to hire a Chief Credit Officer. The
Bank is aggressively addressing these areas for improvement in its lending
operations to be able to be in full compliance with the terms of the supervisory
agreements as soon as possible. Except as described above, the Company believes
it and the Bank are in material compliance with the supervisory agreements.
The Company has submitted to and received from the OTS approval of a
capital plan, which plan calls for an equity infusion in order to reduce the
Company's debt-to-equity ratio below 50%. As part of its capital plan, the
Company conducted a private placement of 400,000 shares of common stock, raising
gross proceeds of approximately $6.5 million. The net proceeds of approximately
$5.8 million will be used to reduce the amount of its outstanding trust
preferred securities. The Company intends to use all of the net proceeds to
redeem approximately $5.8 million of its floating-rate trust preferred
securities in June 2007. As a result of such redemption, the Company's
debt-to-equity ratio will be less than 50%. The Company believes it will be able
to resume paying quarterly cash dividends in the quarter ending September 30,
2007. However, no assurances can be given that the Company will satisfy the
conditions necessary to resume paying dividends or that the OTS will not object
to the resumption of dividends or, if resumed, that the Company will be able to
pay dividends at the same rate that it has historically paid or be able to
continue to pay dividends. The Company and the Bank will make every effort to
have both supervisory agreements terminated or the operating restrictions
substantially reduced by the end of fiscal year 2007. However, no assurances can
be given that either of such events will occur.
45
ASSET AND LIABILITY MANAGEMENT
The principal objectives of the Company's asset and liability management
are to (i) evaluate the interest rate risk existing in certain assets and
liabilities, (ii) determine the appropriate level of risk given the Company's
business focus, operating environment, capital and liquidity requirements and
performance objectives, (iii) establish prudent asset and liability
compositions, and (iv) manage the assessed risk consistent with Board approved
guidelines. Through asset and liability management, the Company seeks to reduce
both the vulnerability and volatility of its operations to changes in interest
rates and to manage the ratio of interest-rate sensitive assets to interest-rate
sensitive liabilities within specified maturities or repricing periods. The
Company's actions in this regard are taken under the guidance of the
Asset/Liability Committee ("ALCO"), which is chaired by the Chief Financial
Officer and comprised of members of the Company's senior management. The ALCO
meets no less than quarterly to review, among other things, liquidity and cash
flow needs, current market conditions and the interest rate environment, the
sensitivity to changes in interest rates of the Company's assets and
liabilities, the historical and market values of assets and liabilities,
unrealized gains and losses, and the repricing and maturity characteristics of
loans, investment securities, deposits and borrowings. The ALCO reports to the
Company's Board of Directors no less than once a quarter. In addition,
management reviews at least weekly the pricing of the Company's commercial loans
and retail deposits. The pricing of residential loans, including those being
originated for sale in the secondary market, is reviewed daily.
The Company's primary asset/liability monitoring tools consist of various
asset/liability simulation models which are prepared on a quarterly basis. The
models are designed to capture the dynamics of the balance sheet as well as rate
and spread movements and to quantify variations in net interest income under
different interest rate scenarios.
One of the models consists of an analysis of the extent to which assets and
liabilities are interest rate sensitive and measures an institution's interest
rate sensitivity gap. An asset or liability is said to be interest rate
sensitive within a specific time period if it will mature or reprice within that
time period. An institution's interest rate sensitivity gap is defined as the
difference between interest-earning assets and interest-bearing liabilities
maturing or repricing within a given time period. A gap is considered positive
when the amount of interest rate sensitive assets exceeds the amount of interest
rate sensitive liabilities and is considered negative when the amount of
interest rate sensitive liabilities exceeds interest rate sensitive assets.
During a period of falling interest rates, a negative gap would tend to result
in an increase in net interest income, while a positive gap would tend to result
in a decline in net interest income. Conversely, during a period of rising
interest rates, a negative gap would tend to result in a decline in net interest
income, while a positive gap would tend to result in an increase in net interest
income.
The Bank's passbook, statement savings, MMDA and NOW accounts are generally
subject to immediate withdrawal. However, management considers a portion of
these deposits to be core deposits (which consists of passbook, statement
saving, MMDA and NOW accounts) having significantly longer effective maturities
based upon the Bank's experience in retaining such deposits in changing interest
rate environments. Borrowed funds are included in the period in which they can
be called or when they mature.
Management believes that the assumptions used to evaluate the vulnerability
of the Bank's operations to changes in interest rates are considered reasonable.
However, certain shortcomings are inherent in the method of analysis presented
in the table below. For example, although certain assets and liabilities may
have similar maturities or periods to repricing, they may react in different
degrees to changes in market interest rates, while interest rates on other types
may lag behind changes in market rates. Additionally, certain assets, such as
adjustable-rate loans, have features which restrict changes in market rates both
on a short-term and over the life of the asset. Further, in the event of a
material change in interest rates, prepayments and early withdrawal levels would
likely deviate significantly from those assumed in calculating the table.
46
The following table summarizes the Company's interest-earning assets and
interest-bearing liabilities as of September 30, 2006 based on certain
assumptions management has made that affect the rate at which loans will prepay
and the duration of core deposits.
More Than One More Than
Within Six Six to Year to Three Three Years to Over Five
Months Twelve Months Years Five Years Years Total
---------- ------------- ------------- -------------- --------- --------
(Dollars in thousands)
Interest-earning assets:
Loans receivable, net(1) $ 93,985 $ 29,196 $ 74,298 $ 67,722 $57,753 $322,954
Mortgage-related securities 11,804 12,977 39,248 25,819 18,537 108,385
Loans held for sale 1,334 -- -- -- -- 1,334
Investment securities(2) 20,203 1,130 9,790 -- 11,753 42,876
Interest-earning deposits 8,715 -- -- -- -- 8,715
-------- -------- -------- -------- ------- --------
Total interest-earning assets $136,041 $ 43,303 $123,336 $ 93,541 $88,043 $484,264
-------- -------- -------- -------- ------- --------
Interest-bearing liabilities:
Deposits $107,262 $ 59,527 $121,072 $ 58,963 $11,992 $358,816
Borrowed funds 20,818 18 10,729 75,531 145 107,241
Junior subordinated debentures 8,248 -- -- -- 13,235 21,483
-------- -------- -------- -------- ------- --------
Total interest-bearing liabilities $136,328 $ 59,545 $131,801 $134,494 $25,372 $487,540
-------- -------- -------- -------- ------- --------
Excess (deficiency) of interest-earning assets
over interest-bearing liabilities $ (287) $(16,242) $ (8,465) $(40,953) $62,671 $ (3,276)
======== ======== ======== ======== ======= ========
Cumulative deficiency of interest-earning
Assets over interest-bearing liabilities $ (287) $(16,529) $(24,994) $(65,947) $(3,276)
======== ======== ======== ======== =======
Cumulative deficiency of
interest-earning assets over
interest-bearing liabilities as a
percentage of total assets (0.05)% (3.16)% (4.78)% (12.61)% (0.63)%
======== ======== ======== ======== =======
- ----------
(1) Balances have been reduced for non-accruing loans, which amounted to
$266,000 at September 30, 2006.
(2) Balance includes FHLB stock.
Although an analysis of the interest rate sensitivity gap measure may be
useful, it is limited in its ability to predict trends in future earnings. It
makes no presumptions about changes in prepayment tendencies, deposit or loan
maturity preferences or repricing time lags that may occur in response to a
change in the interest rate environment. As a consequence, the Company also
utilizes an analysis of the market value of portfolio equity, which addresses
the estimated change in the value of the Bank's equity arising from movements in
interest rates. The market value of portfolio equity is estimated by valuing the
Bank's assets and liabilities under different interest rate scenarios. The
extent to which assets gain or lose value in relation to gains or losses of
liabilities as interest rates increase or decrease determines the appreciation
or depreciation in equity on a market value basis. Market value analysis is
intended to evaluate the impact of immediate and sustained shifts of the current
yield curve upon the market value of the Bank's current balance sheet.
The Company utilizes reports prepared by the OTS to measure interest rate
risk. Using data submitted by the Bank, the OTS performs scenario analysis to
estimate 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.
47
The table below sets forth the Bank's NPV assuming an immediate change in
interest rates of up to 300 basis points and a decline of 200 basis points. Due
to the prevailing interest rate environment, the OTS did not provide a
calculation for the minus 300 basis point change in rates. Dollar amounts are
expressed in thousands as of September 30, 2006.
NET PORTFOLIO VALUE
NET PORTFOLIO VALUE AS A % OF ASSETS
-------------------------------- ------------------
CHANGES IN RATES DOLLAR PERCENTAGE
IN BASIS POINTS AMOUNT CHANGE CHANGE NPV RATIO CHANGE
- ---------------- ------- --------- ---------- --------- -------
300 $42,466 $(22,943) (35)% 8.36% (383)bp
200 51,119 (14,290) (22) 9.88 (232)
100 59,226 (6,183) (9) 11.23 (96)
0 65,409 -- -- 12.20 --
(100) 69,407 3,999 6 12.76 56
(200) 71,139 5,730 9 12.93 74
(300) N/A N/A N/A N/A N/A
As is the case with interest rate sensitivity gap, 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 model 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. Although the NPV measurements and net interest
income models provide 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.
The Company is aware of its interest rate risk exposure in the event of
rapidly rising rates. During fiscal 2006, due to the inverted yield curve,
continuing interest rate margin compression, and the unappealing spreads on
mortgage-backed securities, the Bank decided to retain all of its newly
originated 30-year term fixed-rate residential mortgage loans in its portfolio.
In addition, in recent years, the Company has emphasized the origination of home
equity, construction and land, multi-family and commercial real estate and
business loans which generally have either adjustable interest rates and/or
shorter contractual terms than single-family residential loans. The Company
plans to continue these lending strategies.
Derivative financial instruments include futures, forwards, interest rate
swaps, option contracts, and other financial instruments with similar
characteristics. The Company currently does not enter into futures, forwards,
swaps or options. However, the Company is party to financial instruments with
off-balance sheet risk in the normal course of business to meet the financing
needs of our customers. These financial instruments include commitments to
extend credit. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the consolidated
statements of financial condition. Commitments generally have fixed expiration
dates and may require additional collateral from the borrower if deemed
necessary. Commitments to extend credit are not recorded as an asset or
liability until the instruments are exercised.
The Company is subject to certain market risks and interest rate risks from
the time a commitment is issued to originate new loans. In an effort to protect
the Company against adverse interest rate movements, at the time an application
is taken for a fixed-rate, single-family residential loan, the Company typically
enters into an agreement to sell such loan upon closing, or another loan which
bears an interest rate within the same interest-rate range, into the secondary
market. This is known as a "matched sale" approach and reduces interest-rate
risk with respect to these loans. There is still some portion of these loans
which may never close for various reasons. However, the agencies the Company
sells loans to permit some flexibility in delivering loan product to them. In
certain instances, if the loans delivered for sale do not match the
characteristics outlined in the forward sale commitments, the gain on sale may
be reduced.
48
CHANGES IN FINANCIAL CONDITION
GENERAL. Total assets of the Company increased $4.8 million from $518.1
million at September 30, 2005 to $523.0 million at September 30, 2006. The
increase was largely the result of the growth of the loan portfolio partially
offset by the decrease in the mortgage-related and investment securities
portfolios. The asset growth was primarily funded by increases in customer
deposits. However, the Company's growth was constrained by the growth limitation
contained in the supervisory agreement entered into with the OTS. See Item I,
"Business - Supervisory Agreements."
CASH AND CASH EQUIVALENTS. Cash and cash equivalents, which consists of
cash on hand and deposited in other banks in interest-earning and
non-interest-earning accounts, amounted to $12.8 million and $16.2 million at
September 30, 2006 and 2005, respectively. The $3.4 million, or 20.9%, decrease
in cash and cash equivalents was primarily due to the utilization of cash to
repay FHLB overnight borrowings.
INVESTMENT SECURITIES HELD TO MATURITY AND INVESTMENT SECURITIES AVAILABLE
FOR SALE. Total investment securities decreased in the aggregate by $4.6
million, or 11.3%, from $41.3 million at September 30, 2005 to $36.6 million at
September 30, 2006. As part of the Company's strategy to control its asset
growth as required by the terms of the supervisory agreement, the decrease in
the investment portfolios resulted from the sale of $2.8 million in investment
securities available for sale and from asset backed and municipal bonds maturing
or being called.
MORTGAGE-RELATED SECURITIES HELD TO MATURITY AND MORTGAGE-RELATED
SECURITIES AVAILABLE FOR SALE. Mortgage-related securities held to maturity and
mortgage-related securities available for sale decreased in the aggregate by
$5.8 million, or 5.1%, to $108.4 million at September 30, 2006 compared to
$114.2 million at September 30, 2005. The decrease is consistent with the
Company's overall strategy to reduce the mortgage-related securities portfolios
in connection with the Company's continued expansion of its loan portfolio and
to assist in controlling its asset growth in order to be in compliance with the
terms of the supervisory agreement.
LOANS HELD FOR SALE. At September 30, 2006, $1.3 million of commercial
business loans were classified as held for sale compared to $41,000 at September
30, 2005. The increase reflected the Company's strategy to originate commercial
business loans held for sale through the Small Business Administration Program.
In addition, during fiscal year 2006, the Company elected not to sell 30-year
fixed-rate single-family residential loans into the secondary market due to the
inverted yield curve, continuing interest rate margin compression, and the
unappealing spreads on mortgage-backed securities.
LOANS RECEIVABLE, NET. Total loans receivable, net, increased $21.2
million, or 7.1%, to $323.2 million at September 30, 2006 compared to $302.0
million at September 30, 2005. The increase was primarily due to a $12.8
million, or 26.9%, increase in home equity loans and lines of credit, an $8.4
million, or 52.2%, increase in commercial business loans and $1.3 million, or
3.6%, increase in construction loans partially offset by a decrease of $4.7
million, or 3.0%, in single-family residential loans.
NON-PERFORMING ASSETS. The Company's total non-performing loans and real
estate owned decreased to $2.7 million, or 0.5% of total assets, at September
30, 2006 compared to $5.8 million, or 0.6% of total assets, at the end of the
prior fiscal year. The decrease in non-performing assets in fiscal 2006 was
attributable to a $4.8 million decrease to $277,000 in non-performing loans
partially offset by a $1.7 million increase to $2.5 million in real estate
owned. The decrease in non-performing loans was primarily due to the transfer of
a $3.3 million commercial real estate loan to real estate owned and the
charge-off in full of a related $500,000 commercial business loan combined with
the repayment in full of a $770,000 residential construction loan. In connection
with the transfer of the property located in Chesapeake City, Maryland securing
the commercial real estate loan to real estate owned, the Company recorded the
property at its approximate fair value of $2.7 million resulting in the Company
charging off $1.1 million against the allowance for loan losses in the quarter
ended March 31, 2006. Offsetting, in part, the increase in real estate owned was
the sale of a residential property which was located on the property in
Chesapeake City as well as a commercial property in which the Company held a 25%
participation interest. The sale of the properties, which were carried at an
aggregate value of $1.0 million, resulted in a pre-tax gain of $178,000 during
fiscal 2006. See Item 1 Business "-Asset Quality."
49
DEPOSITS. Deposits increased by $9.1 million, or 2.6%, from $349.7 million
at September 30, 2005 to $358.8 million at September 30, 2006. Certificates of
deposit increased by $12.8 million, or 7.4%, to $185.9 million representing
51.8% of total deposits at September 30, 2006 from $173.1 million, or 49.5%, of
total deposits at September 30, 2005. The increase was partially offset by a
$3.7 million, or 2.1%, decrease in the Company's core accounts
(non-interest-bearing, NOW, passbook, and MMDA accounts). The increase in
certificates of deposit was due to the competitive pricing of the Company's
certificates, in particular jumbo certificates, compared to those paid by the
competition.
BORROWINGS. The Company's total borrowings, which primarily consist of
advances from the FHLB, decreased to $107.2 million at September 30, 2006 from
$113.3 million at September 30, 2005 primarily as the result of the
de-leveraging strategy of the remaining proceeds from the sale of
mortgage-related securities the Company used to repay overnight borrowings along
with repayments from excess cash. Borrowings had a weighted average interest
rate of 5.5% at September 30, 2006 as compared to 5.2% at September 30, 2005.
See Note 9 to the Consolidated Financial Statements set forth in Item 8 hereof
for further information.
EQUITY. At September 30, 2006, total stockholders' equity was $28.7
million, or 5.5% of total assets, compared to $28.2 million, or 5.4% of total
assets, at September 30, 2005. The increase was due to net income of $1.0
million for the fiscal year ended September 30, 2006 partially offset by a
decline in other comprehensive income of $578,000 primarily due to increases in
market rates of interest combined with dividend payments in the first quarter of
fiscal 2006 totaling $209,000. As a result of entering into the supervisory
agreement in February 2006, the Company was required to cease paying dividends.
50
AVERAGE BALANCES, NET INTEREST INCOME AND YIELDS EARNED AND RATES PAID. The
following table sets forth, for the periods indicated, information regarding (i)
the total dollar amount of interest income of the Company from interest-earning
assets and the resultant average yields; (ii) the total dollar amount of
interest expense on interest-bearing liabilities and the resultant average rate;
(iii) net interest income; (iv) interest rate spread; and (v) net interest
margin. Information is based on average daily balances during the indicated
periods; yields were adjusted for the effects of tax-free investments using the
statutory tax rate.
The adjustment of tax exempt securities to a tax equivalent yield in the
table below may be considered to include non-GAAP financial information.
Management believes that it is a common practice in the banking industry to
present net interest margin, net interest rate spread and net interest income on
a fully tax equivalent basis when a significant proportion of interest-earning
assets are tax-free. Therefore, management believes these measures provide
useful information to investors by allowing them to make peer comparisons. A
GAAP reconciliation also is included below.
YEAR ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------------------------
2006 2005 2004
YIELD/COST --------------------------- --------------------------- ---------------------------
AT AVERAGE AVERAGE AVERAGE
SEPT. 30, AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
2006 BALANCE INTEREST COST BALANCE INTEREST COST BALANCE INTEREST COST
---------- -------- -------- ------- -------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest-earning assets:
Loans receivable(1)(2)(3) 6.51% $312,778 $19,956 6.38% $304,367 $17,926 5.89% $295,701 $17,529 5.93%
Mortgage-related securities(3) 4.57 113,995 5,054 4.43 155,292 6,223 4.01 137,256 5,298 3.86
Investment securities(3) 5.69 45,478 2,613 5.75 63,505 3,099 4.88 83,911 3,597 4.29
Other interest-earning assets 5.33 8,632 197 2.28 11,602 167 1.44 12,056 76 0.63
-------- ------- -------- ------- -------- -------
Total interest-earning
assets 5.99 480,883 27,820 5.78 534,766 27,415 5.12 528,924 26,500 5.01
---- -------- ----- -------- ------ -------- ------- ------
Non-interest-earning assets 35,885 32,543 32,847
-------- -------- --------
Total assets $516,768 $567,309 $561,771
======== ======== ========
Interest-bearing liabilities:
Deposits 2.93 $352,371 8,547 2.43 $349,076 6,280 1.80 $347,807 5,910 1.70
FHLB advances and other
borrowings 5.47 108,603 5,914 5.45 161,382 7,694 4.77 155,932 7,126 4.57
Junior subordinated debentures 9.50 21,503 1,954 9.09 21,540 1,794 8.33 21,576 1,676 7.77
---- -------- ------- -------- ------- -------- -------
Total interest-bearing
liabilities 3.77 482,477 16,415 3.40 531,998 15,768 2.96 525,315 14,712 2.80
-------- ------- ----- -------- ------- ------ -------- ------- ------
Interest rate spread 2.22% 2.38% 2.16% 2.21%
==== ===== ====== ======
Non-interest-bearing liabilities 6,517 5,918 5,565
-------- -------- --------
Total liabilities 488,994 537,916 530,880
Stockholders' equity 27,774 29,393 30,891
-------- -------- --------
Total liabilities and
stockholders' equity $516,768 $567,309 $561,771
======== ======== ========
Net interest-earning (liabilities)
assets $(1,594) $ 2,768 $ 3,609
======== ======== ========
Net interest income $11,405 $11,647 $11,788
======= ======= =======
Net interest margin(4) 2.37% 2.18% 2.23%
===== ====== ======
Ratio of average interest-earning
assets to average interest-
bearing liabilities 99.67% 100.52% 100.69%
===== ====== ======
- ----------
(1) Includes non-accrual loans.
(2) Loan fees are included in interest income and the amount is not material
for this analysis.
(3) Includes assets classified as either available for sale or held for sale.
(4) Net interest income divided by interest-earning assets.
51
Although management believes that the above mentioned non-GAAP financial
measures enhance an investor's understanding of the Company's business and
performance, these non-GAAP financials measures should not be considered an
alternative to GAAP. The reconciliation of these non-GAAP financials measures
from GAAP to non-GAAP is presented below.
FOR THE YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------------------
2006 2005 2004
--------------------- --------------------- ---------------------
AVERAGE AVERAGE AVERAGE
INTEREST YIELD/COST INTEREST YIELD/COST INTEREST YIELD/COST
-------- ---------- -------- ---------- -------- ----------
(Dollars in thousands)
Investment securities - nontaxable $ 2,286 5.03% $ 2,760 4.35% $ 3,240 3.86%
Tax equivalent adjustments 327 339 357
------- ------- -------
Investment securities - nontaxable to
a taxable equivalent yield $ 2,613 5.75% $ 3,099 4.88% $ 3,597 4.29%
======= ======= =======
Net interest income $11,078 $11,308 $11,431
Tax equivalent adjustment 327 339 357
------- ------- -------
Net interest income, tax equivalent $11,405 $11,647 $11,788
======= ======= =======
Net interest rate spread, no tax
adjustment 2.32% 2.10% 2.14%
Net interest margin, no tax adjustment 2.30% 2.11% 2.16%
RATE/VOLUME ANALYSIS. The following table describes the extent to which
changes in interest rates and changes in the volume of interest-related assets
and liabilities have affected the Company's interest income and expense during
the periods indicated. For each category of interest-earning asset and
interest-bearing liability, information is provided on changes attributable to
(i) changes in volume (change in volume multiplied by prior year rate), (ii)
changes in rate (change in rate multiplied by prior year volume), and (iii)
total change in rate and volume. The combined effect of changes in both rate and
volume has been allocated proportionately to the change due to rate and the
change due to volume. The table below has been prepared on a tax-equivalent
basis. See footnote 1 to the table for a reconciliation.
YEAR ENDED SEPTEMBER 30,
------------------------------------------------------------
2006 VS. 2005 2005 VS. 2004
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
----------------------------- ----------------------------
TOTAL TOTAL
INCREASE INCREASE
RATE VOLUME (DECREASE) RATE VOLUME (DECREASE)
------ ------- ---------- ----- ------- ----------
Interest-earnings assets:
Loans receivable(1) $1,525 $ 505 $ 2,030 $(112) $ 509 $ 397
Mortgage-related securities(1) 779 (1,948) (1,169) 208 717 925
Investment securities(1) (2) 810 (1,296) (486) 658 (1,156) (498)
Other interest-earning assets 53 (23) 30 94 (3) 91
------ ------- ------- ----- ------- -------
Total interest-earning assets 3,167 (2,762) 405 848 67 915
------ ------- ------- ----- ------- -------
Interest-bearing liabilities:
Deposits 2,207 60 2,267 348 22 370
FHLB advances and other borrowings 1,369 (3,149) (1,780) 121 (3) 118
Junior subordinated debentures 163 (3) 160 314 254 568
------ ------- ------- ----- ------- -------
Total interest-bearing liabilities 3,739 (3,092) 647 783 273 1,056
------ ------- ------- ----- ------- -------
Decrease in net interest income $ (572) $ 330 $ (242) $ 65 $ (206) $ (141)
====== ======= ======= ===== ======= =======
- ----------
(1) Includes assets classified as either available for sale or held for sale.
(2) Total decrease in investment securities on a nontaxable equivalent basis
would be $(474) and $(480) for the 2006 and the 2005 comparisons,
respectively, resulting in a decrease in net interest income of $(230) and
$(123), respectively.
52
RESULTS OF OPERATIONS
GENERAL. The Company reported net income of $1.0 million, $610,000, and
$2.2 million for the years ended September 30, 2006, 2005 and 2004,
respectively.
The $425,000 increase in net income for the year ended September 30, 2006
compared to the year ended September 30, 2005 was primarily due to a $574,000,
or 32.3%, decrease in the provision for loan losses combined with a $132,000, or
1.0%, decrease in non-interest expense and an increase of $46,000, or 14.7%, in
income tax benefit partially offset by a $230,000, or 2.0%, decrease in net
interest income and a $97,000, or 2.7%, decrease in non-interest income.
The $1.6 million decrease in net income for the year ended September 30,
2005 compared to the year ended September 30, 2004 was primarily due to a $1.5
million increase in the provision for loan losses partially offset by a decrease
of $639,000 in income tax expense. In addition, the decrease also reflected the
effects of a $123,000, or 1.1%, decrease in net interest income combined with a
$319,000, or 2.6%, increase in non-interest expense combined with a $310,000, or
8.0%, decrease in non-interest income.
NET INTEREST INCOME. Net interest income is determined by the interest rate
spread (the difference between the yields earned on interest-earning assets and
the rates paid on interest-bearing liabilities) and the relative amounts of
interest-earning assets and interest-bearing liabilities. All yields are
reported on a fully tax-equivalent basis (see the table on the prior page for a
recalculation of such percentages in accordance with accounting principles
generally accepted in the United States of America ("GAAP") and the rationale
for the use of such non-GAAP information). The Company's average interest-rate
spread was 2.38%, 2.16 % and 2.21% for the years ended September 30, 2006,
2005, and 2004, respectively. The Company's interest-rate spread was 2.22% at
September 30, 2006. The Company's net interest margin (net interest income as
a percentage of average interest-earning assets) was 2.37%, 2.18% and 2.23% for
the years ended September 30, 2006, 2005 and 2004, respectively. The
improvement in the Company's net interest margin during fiscal 2006 was a
result of the implementation in the fourth quarter of fiscal 2005 of a
de-leveraging strategy involving the sale of $47.5 million of various
low-yielding securities, using the proceeds to repay $46.0 million in FHLB
convertible advances and overnight borrowings. During fiscal 2005, the interest
rate compression experienced by the Company reflected the impact on the rates
paid on the Company's interest-bearing liabilities as a result of the increases
in short-term interest rates. However, during fiscal 2004, the Company's margin
compression primarily reflected the effects of the accelerated rate of
repayments and prepayments of loans and mortgage-related securities experienced
by the Company requiring it to reinvest the resulting proceeds at then current
lower market rates of interest without a corresponding decrease in the rates
paid on deposits and borrowings. Market rates of interest did not start to
increase until the summer of 2004. Thus the full effect of the rise in interest
rates was not experienced until fiscal 2005.
For the year ended September 30, 2006, net interest income decreased to
$11.1 million as compared to $11.3 million in fiscal 2005. The $230,000, or
2.0%, decrease came as a result of a $647,000, or 4.1%, decrease in interest
expense partially offset by a $417,000, or 1.5%, increase in interest income.
The decrease in net interest income was primarily due to the increase in the
cost of funds due to the continued increase of market rates of interest on the
short-term end of the yield curve which outpaced the increases in the yield on
interest-earning assets.
Net interest income decreased to $11.3 million in fiscal 2005 as compared
to $11.4 million in fiscal 2004. The $123,000, or 1.1%, decrease came as a
result of a $1.1 million, or 7.2%, increase in interest expense partially offset
by a $933,000, or 3.6%, increase in interest income. The decrease in net
interest income was primarily due to the increase in short-term interest rates
impacting the rates paid on the Company's interest-bearing core deposits,
certificates of deposit and floating-rate borrowings more rapidly than its
interest-earning assets.
INTEREST INCOME. The $417,000, or 1.5%, increase in total interest income
during the year ended September 30, 2006 as compared to fiscal 2005 was
primarily due to a $2.0 million, or 11.3%, increase in interest income on loans
due to an $8.4 million, or 2.8%, increase in the average balance of the loan
portfolio combined with a 49 basis point increase in the average yield earned.
The increase in interest income was offset, in part, by a $1.2 million, or
18.8%, decrease in interest income from mortgage-related securities as a result
of a $41.3 million, or 26.6%, decrease in the average balance of the
mortgage-related securities portfolio offset, in part, by a 42 basis point
increase in the yield earned. Additionally, the increase in interest income was
offset, in part, by a $474,000, or 17.2%, decrease in interest income on
investment securities as a result of an 18.0 million, or 28.4%, decrease in the
average balance offset, in part, by an 87 basis point increase in the yield
earned on such assets. The increase in interest income was primarily the result
of the de-leveraging strategy implemented in the fourth quarter of fiscal 2005
combined with the cash flows from the mortgage-related and investment portfolios
being reinvested at higher market interest rates.
53
The $933,000, or 3.6%, increase in total interest income during the year
ended September 30, 2005 as compared to fiscal 2004 was primarily due to a
$925,000, or 17.5%, increase in interest income from mortgage-related securities
as a result of a $18.0 million, or 13.1%, increase in the average balance of the
mortgage-related securities portfolio combined with a 15 basis point increase in
the yield earned. Additionally, interest income on loans increased $397,000, or
2.3%, due to an $8.7 million, or 2.9%, increase in the average balance of the
loan portfolio offset partially by a 4 basis point decrease in the average yield
earned. The increase in interest income was offset, in part, by a $480,000, or
14.8%, decrease in interest income on investment securities as a result of a
$20.4 million, or 24.3%, increase in the average balance offset, in part, by a
59 basis point increase in the yield earned on such assets. The increase in
interest income was primarily due to the increase in the overall yield earned on
investment and mortgage-related securities resulting from the slowdown of
prepayments and the reinvestment of proceeds being reinvested at higher market
interest rates.
INTEREST EXPENSE. Total interest expense amounted to $16.4 million for the
year ended September 30, 2006 as compared to $15.8 million for fiscal 2005. The
$647,000, or 4.1%, increase in fiscal 2006 compared to fiscal 2005 reflected a
$2.3 million, or 36.1%, increase in interest expense on deposits combined with a
$160,000, or 8.9%, increase in interest expense on junior subordinated
debentures. The increase in interest expense on deposits was due primarily to a
63 basis point increase in the average rate paid thereon and, to a lesser
degree, a $3.3 million increase in the average balance of deposits. The increase
in interest expense on junior subordinated debentures was due to a 76 basis
point increase in the average rate paid due to the repricing of $8.0 million of
junior subordinated debentures to 9.2%. Offsetting the increase in interest
expense was a $1.8 million, or 23.1%, decrease in interest expense on borrowings
primarily due to a $52.8 million, or 32.7%, decrease in the average balance
reflecting the effects of the de-leveraging strategy. However, the decrease in
interest expense on borrowings was partially offset by a 68 basis point increase
in the average rate paid reflecting higher current market rates of interest. The
increase in the overall cost of funds was primarily a result of the upwards
repricing of deposits and floating-rate debt due to increases in market rates of
interest.
Total interest expense amounted to $15.8 million for the year ended
September 30, 2005 as compared to $14.7 million for fiscal 2004. The $1.1
million, or 7.2%, increase in fiscal 2005 compared to fiscal 2004 reflected a
$568,000, or 8.0%, increase in interest expense on borrowings combined with a
$370,000, or 6.3%, and $118,000, or 7.0% increase in interest expense on
deposits and junior subordinated debentures, respectively. The increase in
interest expense on borrowings was due to a $5.5 million increase in the average
balance of borrowings along with a 20 basis point increase in the average rate
paid. The increase in interest expense on deposits was due primarily to a 10
basis point increase in the average rate paid thereon and, to a lesser degree, a
$1.3 million increase in the average balance of deposits. The increase in
interest expense on junior subordinated debentures was due to a 56 basis point
increase in the average rate paid. The increase in the overall cost of funds was
primarily a result of the upwards repricing of certificates of deposit, money
market accounts and floating-rate debt due to increases in market rates of
interest.
PROVISIONS FOR LOAN LOSSES. The Company establishes provisions for loan
losses, which are charges to its operating results, in order to maintain a level
of total allowance for losses that management believes covers all known and
inherent losses that are both probable and reasonably estimable at each
reporting date. Management performs reviews generally on a monthly basis, but at
a minimum at least quarterly, in order to identify these known and inherent
losses and to assess the overall collection probability for the loan portfolio.
Management's reviews consist of a quantitative analysis by loan category, using
historical loss experience, and consideration of a series of qualitative loss
factors. For each primary type of loan, management establishes a loss factor
reflecting our estimate of the known and inherent losses in each loan type using
both the quantitative analysis as well as consideration of the qualitative
factors. Management's evaluation process includes, among other things, an
analysis of delinquency trends, non-performing loan trends, the levels of
charge-offs and recoveries, the levels of classified and special mention assets,
prior loss experience, total loans outstanding, the volume of loan originations,
the type, average size, terms and geographic location and concentration of loans
held by the Company, the value and the nature of the collateral securing loans,
the number of loans requiring heightened management oversight, general economic
conditions, particularly as they relate to the Company's primary market area,
and trends in market rates of interest. The amount of the allowance for loan
losses is an estimate and actual losses may vary from these estimates.
Furthermore, the Company's primary banking regulator periodically reviews the
Company's allowance for loan losses as an integral part of the examination
process. Such agency may require the Company to make additional provisions for
estimated loan losses based upon judgments different from those of management.
54
For the years ended September 30, 2006, 2005 and 2004, the provisions for
loan losses were $1.2 million, $1.8 million and $300,000, respectively. For the
year ended September 30, 2006, the provision for loan losses decreased $574,000,
or 32.2%, to $1.2 million compared to fiscal 2005. The $1.2 million provision
reflected management's assessment of a number of factors including the
implementation of refinements to its rating system, the increased level of
classified and criticized assets, continued growth of the commercial and
multi-family real estate and commercial business loan portfolio as well as
extensive discussions with the OTS examination staff in connection with their
recent examination. At September 30, 2006, the Bank had $19.9 million of
criticized and classified assets of which $11.7 million was classified as
substandard. No assets were classified as doubtful or loss. The Company charged
off $1.3 million during fiscal 2006 primarily related to the write down to fair
value of a property securing a $3.3 million commercial real estate loan and a
related $500,000 commercial business loan compared to $344,000 in the prior
fiscal year. See Item 1, "Business - Asset Quality." At September 30, 2006, the
Company's allowance for loan losses totaled $3.4 million which amounted to
1215.6% of total non-performing loans and 1.03% of gross loans receivable.
During fiscal 2005, the Company significantly increased its provision for
loan losses which reflected management's assessment of a number of factors,
including, among other things, the significant increase in the level of the
Company's non-performing loans including migration in the Company's
classification of such assets in substandard, doubtful and special mention
categories in the fiscal 2005 period, the increased level of charge-offs, the
changing composition of the commercial and multi-family real estate and
commercial business loan portfolios as well as discussions with the examination
staff in connection with the examination of the Company by the OTS in 2005. At
September 30, 2005, the Bank had $2.8 million of assets classified as
substandard, $3.8 million classified as doubtful, and no assets classified as
loss as well as $5.9 million identified as special mention. The Company charged
off $344,000 in fiscal 2005 compared to $321,000 in the prior fiscal year. At
September 30, 2005, the Company's allowance for loan losses totaled $3.5 million
which amounted to 68.8% of total non-performing loans and 1.14% of gross loans
receivable. During fiscal 2004, the Company lowered its provision for loan
losses primarily due to its assessment of the amount of losses and charge-offs
it would incur with respect to non-performing commercial real estate loans.
NON-INTEREST INCOME. Non-interest income decreased $97,000, or 2.7% for the
year ended September 30, 2006, compared to the year ended September 30, 2005.
The decrease in non-interest income was primarily due to the Company
experiencing only a $3,000 gain on sales of investment and mortgage-related
securities in the 2006 period as compared to $709,000 for fiscal 2005. In
addition, the increase in cash surrender value of the bank owned insurance
experienced a slower rate of appreciation, decreasing $229,000 in fiscal 2006.
The decrease in non-interest income was partially offset by the receipt of
death-benefit proceeds of $567,000 from the bank owned life insurance. In
addition, the Company recognized an increase of $158,000 on the sale of real
estate owned properties referenced above.
For the year ended September 30, 2005, the Company reported non-interest
income of $3.6 million compared to $3.9 million for the year ended September 30,
2004, a $290,000, or 7.4%, decrease. Non-interest income in fiscal 2004 included
a one-time recognition of $550,000 related to a non-recurring real estate fee.
In addition, during fiscal 2005, realized gains on sale of securities declined
due to market opportunities which existed in fiscal 2004 but not in fiscal 2005
partially offset by an increase in service charges and other fees. For fiscal
2005, the net gains on sale of investment and mortgage-related securities
decreased $205,000 resulting from the reduction in gains due primarily to the
rising interest rate environment existing throughout fiscal 2005 which reduced
the values of the securities. This was partially offset by a $342,000, or 27.7%,
increase in service charges due to the implementation of additional fee-based
deposit services in fiscal 2004. The full effect was not experienced until
fiscal 2005.
NON-INTEREST EXPENSE. Non-interest expense include salaries and employee
benefits, occupancy and equipment expense, Federal Deposit Insurance Corporation
(FDIC) deposit insurance premiums, professional fees, data processing expense,
advertising, deposit processing and other items.
Non-interest expense decreased $132,000, or 1.0%, for the year ended
September 30, 2006 compared to the year ended September 30, 2005. Non-interest
expense decreased in fiscal 2006 primarily due to the non-recurring pre-tax
charge of $486,000 experienced in fiscal 2005 incurred as a result of the
retirement of FHLB advances as part of the de-leveraging strategy. In addition,
the Company experienced decreases of $131,000, or 2.2%, and $269,000, or 14.1%,
in salaries and employee benefits and other non-interest expense, respectively.
The decrease in other non-interest expense was primarily due to the completion
of a bank-wide customer service training program during the fourth quarter of
fiscal 2005. The decrease in non-interest expense was partially offset by a
$457,000, or 39.4%, increase in professional fees due to professional costs
incurred relating to the foreclosure proceedings of a non-performing commercial
loan (See Item 1, "Business - Asset Quality") as well as additional auditing and
legal fees incurred as a result of the supervisory
55
agreement. During fiscal 2006, expenses incurred in connection with real estate
operations increased $156,000 as a result of maintenance of the real estate
property. In addition, the Company incurred increases of $77,000, and $62,000 in
federal deposit insurance premiums and occupancy and equipment, respectively.
Non-interest expense increased $339,000, or 2.7%, for the year ended
September 30, 2005 compared to the year ended September 30, 2004 and was
primarily due to a $486,000 prepayment penalty charge resulting from the
retirement of certain FHLB convertible advances as part of the Company's
de-leveraging strategy. The Company also experienced increases of $309,000, or
24.7%, $292,000, or 33.7%, and $105,000, or 5.8%, in occupancy and equipment,
professional fees and other non-interest expense, respectively. The increase in
occupancy and equipment expense was related to implementation of the Company's
branch expansion plans in fiscal 2005. The increase in professional fees was due
to the additional auditing and legal fees incurred as a result of complying with
additional regulatory requirements combined with professional costs incurred in
connection with a non-performing loan. Other non-interest expense increased due
to the implementation of a training program as well as increased general
administrative expenses. The increase in non-interest expense was partially
offset by a $716,000, or 10.5%, decrease in compensation and employee benefit
expense. During fiscal 2004, the Company funded a non-qualified supplemental
retirement plan for certain executive officers and the original ESOP loan
through the prepayment of the last installment due on such loan. In addition,
during fiscal 2005, expenses incurred in connection real estate operations
decreased $180,000. In fiscal 2004, the Company was required to fund a portion
of the operations related to a non-performing loan which was sold during fiscal
2006.
INCOME TAXES. The Company recognized income tax benefits of $359,000 and
$313,000, for the years ended September 30, 2006 and 2005, respectively,
compared to recognition of income tax expense of $326,000, or 12.9%, of pre-tax
income, for the year ended September 30, 2004. The primary reason for the
recognition of income tax benefits for fiscal 2006 and 2005 was the reduction in
income before income taxes combined with the effects of non-taxable earning
assets.
LIQUIDITY AND CAPITAL RESOURCES
The Company's liquidity, represented by cash and cash equivalents, is a
product of its operating, investing and financing activities. The Company's
primary sources of funds are deposits, amortization, prepayments and maturities
of outstanding loans and mortgage-related securities, sales of loans, maturities
of investment securities and other short-term investments, borrowings and funds
provided from operations. While scheduled payments from the amortization of
loans and mortgage-related securities and maturing investment securities and
short-term investments are relatively predictable sources of funds, deposit
flows and loan and mortgage-related securities prepayments are greatly
influenced by general interest rates, economic conditions and competition. In
addition, the Company invests excess funds in overnight deposits and other
short-term interest-earning assets which provide liquidity to meet lending
requirements. The Company has the ability to obtain advances from the FHLBank
Pittsburgh through several credit programs with the FHLB in amounts not to
exceed the Bank's maximum borrowing capacity and subject to certain conditions,
including holding a predetermined amount of FHLB stock as collateral. As an
additional source of funds, the Company has access to the FRB discount window,
but only after it has exhausted its access to the FHLB. At September 30, 2006,
the Company had $86.4 million of outstanding advances and $20.8 million of
overnight borrowings from the FHLBank Pittsburgh.
Liquidity management is both a daily and long-term function of business
management. Excess liquidity is generally invested in short-term investments
such as overnight deposits. On a longer term basis, the Company maintains a
strategy of investing in various lending products and mortgage-related
securities. The Company uses its sources of funds primarily to meet its ongoing
commitments, to pay maturing savings certificates and savings withdrawals, fund
loan commitments and maintain a portfolio of mortgage related and investment
securities. At September 30, 2006, the total of approved loan commitments
outstanding amounted to $8.3 million. At the same date, commitments under unused
lines of credit and loans in process on construction loans amounted to an
aggregate of $51.3 million. Certificates of deposit scheduled to mature in one
year or less at September 30, 2006 totaled $118.8 million. Based upon its
historical experience, management believes that a significant portion of
maturing deposits will remain with the Company.
56
The OTS requires that the Bank meet minimum regulatory tangible, core,
tier-1 risk-based and total risk-based capital requirements. At September 30,
2006, as a result of the supervisory agreement, the Bank is not deemed to be
"well-capitalized" for purposes of the prompt corrective action regulations of
the OTS even though the Bank exceeded all regulatory capital requirements and
met the capital requirements for regulatory purposes. See Note 11 to the
Consolidated Financial Statements set forth in Item 8 hereof.
The Company's assets consist primarily of its investment in the Bank and
investments in various corporate debt and equity instruments. Its only material
source of income consists of earnings from its investment in the Bank and
interest and dividends earned on other investments. The Company, as a separately
incorporated holding company, has no significant operations other than serving
as the sole stockholder of the Bank and paying interest to its subsidiaries,
First Keystone Capital Trust I and II, for junior subordinated debt issued in
conjunction with the issuance of trust preferred securities. See Note 16 to the
Consolidated Financial Statements set forth in Item 8 hereof. On an
unconsolidated basis, the Company has no paid employees. The expenses primarily
incurred by the Company relate to its reporting obligations under the Securities
Exchange Act of 1934, related expenses incurred as a publicly traded company,
and expenses relating to the issuance of the trust preferred securities and the
junior subordinated debentures issued in connection therewith. Management
believes that the Company has adequate liquidity available to respond to its
liquidity demands. Under applicable federal regulations, the Bank may pay
dividends to the Company (its sole stockholder) within certain limits after
obtaining the approval of the OTS. See Note 11 of the Consolidated Financial
Statements set forth in Item 8 hereof.
Under the terms of the supervisory agreement, the Company submitted a
capital plan to the OTS. As part of the capital plan, which was approved by the
OTS, the Company conducted a private placement of 400,000 shares of common
stock, raising gross proceeds of approximately $6.5 million. The net proceeds of
approximately $5.8 million will be used to reduce the amount of its outstanding
trust preferred securities. The Company intends to use all of the net proceeds
to redeem approximately $5.8 million of its trust preferred securities in June
2007.
DERIVATIVE FINANCIAL INSTRUMENTS, CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS
The Company has not used, and has no intention to use, any significant
off-balance sheet financing arrangements for liquidity purposes. The Company's
primary financial instruments with off-balance sheet risk are limited to loan
servicing for others, its obligations to fund loans to customers pursuant to
existing commitments and commitments to purchase and sell mortgage loans. In
addition, the Company has not had, and has no intention to have, any significant
transactions, arrangements or other relationships with any unconsolidated,
limited purpose entities that could materially affect its liquidity or capital
resources. The Company has not, and does not intend to, trade in commodity
contracts.
We anticipate that we will continue to have sufficient funds and
alternative funding sources to meet our current commitments.
The Company's contractual cash obligations as of September 30, 2006 are as
follows:
PAYMENTS DUE BY PERIOD:
--------------------------------------------------------
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
-------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
FHLB borrowings $107,647 $21,314 $10,690 $75,532 $ 111
Junior subordinated debentures 22,365 882 -- -- 21,483
Operating leases 3,633 322 681 391 2,239
Purchased letters of credit 4,136 4,136 -- -- --
-------- ------- ------- ------- -------
Total obligations $137,781 $26,654 $11,371 $75,923 $23,833
======== ======= ======= ======= =======
57
OFF-BALANCE-SHEET OBLIGATIONS
The Company is a party to financial instruments with off-balance-sheet risk
in the normal course of business to meet the financing needs of its customers.
These financial instruments include commitments to extend credit and letters of
credit. Those instruments involve, to varying degrees, elements of credit risk
in excess of the amount recognized in the balance sheet. The Company's exposure
to credit loss in the event of non-performance by the other party to the
financial instrument for commitments to extend credit and letters of credit is
represented by the contractual notional amount of those instruments. The Company
uses the same credit policies in making commitments and conditional obligations
as it does for on-balance-sheet instruments (see Note 1 of the Consolidated
Financial Statements set forth in Item 8 hereof).
The Company's outstanding commitments to originate loans and to advance
additional amounts pursuant to outstanding letters of credit, lines of credit
and undisbursed portions of construction loans as of September 30, 2006 are as
follows:
LESS THAN MORE THAN
TOTAL 1 YEAR 1-3 YEARS 3-5 YEARS 5 YEARS
------- --------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Lines of credit(1) $39,866 $ 12,004 $ 387 $1,278 $26,197
Letters of credit 367 329 38 -- --
Other commitments to originate loans 4,637 4,637 -- -- --
Undisbursed portions of construction loans 11,850 2,686 9,130 34 --
------- ------- ------ ------ -------
Total $56,720 $19,656 $9,555 $1,312 $26,197
======= ======= ====== ====== =======
- ----------
(1) Includes lines of credit for commercial real estate, commercial loans and
home equity loans.
INVESTMENT AND MORTGAGE-RELATED SECURITIES
Securities are evaluated on at least a quarterly basis and more frequently
when economic or market conditions warrant such an evaluation to determine
whether a decline in their value is other than temporary. Management utilizes
criteria such as the magnitude and duration of the decline and the intent and
ability of the Company to retain its investment in the issues for a period of
time sufficient to allow for an anticipated recovery in fair value, in addition
to the reasons underlying the decline, to determine whether the loss in value is
other than temporary. Once a decline in value is determined to be other than
temporary, the value of the security is reduced and a corresponding charge to
earnings is recognized.
On November 3, 2005, the FASB issued FASB Staff Position ("FSP") Nos. FAS
115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments." This FSP addresses the determination as to
when an investment is considered impaired, whether that impairment is other than
temporary, and the measurement of an impairment loss. This FSP also includes
accounting considerations subsequent to the recognition of an
other-than-temporary impairment and requires certain disclosures about
unrealized losses that have not been recognized as other-than-temporary
impairments. This FSP nullifies certain requirements of EITF Issue 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments", and supersedes EITF Topic No. D-44, "Recognition of
Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost
Exceeds Fair Value." The guidance in this FSP amends SFAS Statement No. 115,
"Accounting for Certain Investments in Debt and Equity Securities." The FSP is
effective for reporting periods beginning after December 15, 2005. The Company
adopted this guidance on January 1, 2006 and it did not have a significant
impact on the Company's consolidated financial statements.
RECENT ACCOUNTING PRONOUNCEMENTS
For discussion of recent accounting pronouncements, see Note 2 of the
Consolidated Financial Statements set forth in Item 8 hereof.
58
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements of the Company and related notes
presented herein have been prepared in accordance with accounting principles
generally accepted in the United States of America which require the measurement
of financial position and operating results in terms of historical dollars,
without considering changes in the relative purchasing power of money over time
due to inflation.
Unlike most industrial companies, substantially all of the assets and
liabilities of a financial institution are monetary in nature. As a result,
interest rates have a more significant impact on a financial institution's
performance than the effects of general levels of inflation. Interest rates do
not necessarily move in the same direction or in the same magnitude as the
prices of goods and services, since such prices are affected by inflation to a
larger extent than interest rates. In the current interest rate environment,
liquidity and the maturity structure and repricing characteristics of the
Company's assets and liabilities are critical to the maintenance of acceptable
performance levels.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information required herein is incorporated by reference to "Asset and
Liability Management" set forth in Item 7 above.
59
(DELOITTE(R) LOGO) Deloitte Touche LLP
1700 Market Street
Philadelphia, PA 19103-3984
Tel: 215-246-2300
Fax: 215-569-2441
www.deloitte.com
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF FIRST KEYSTONE FINANCIAL, INC. AND
SUBSIDIARIES - MEDIA, PENNSYLVANIA:
We have audited the accompanying consolidated statements of financial condition
of First Keystone Financial, Inc. and Subsidiaries (the "Company") as of
September 30, 2006 and 2005, and the related consolidated statements of
operations, changes in stockholders' equity, and cash flows for each of the
three years in the period ended September 30, 2006. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of their internal control over
financial reporting. Our audits included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of First Keystone Financial, Inc. and
Subsidiaries as of September 30, 2006 and 2005, and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 2006, in conformity with accounting principles generally accepted
in the United States of America.
As discussed in Note 2, in 2004, the Company applied the provisions of Financial
Accounting Standards Board Interpretation No. 46(R).
(DELOITTE & TOUCHE LLP)
December 28, 2006
Member of
DELOITTE TOUCHE TOHMATSU
60
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
SEPTEMBER 30,
-------------------
2006 2005
-------- --------
ASSETS
Cash and amounts due from depository institutions $ 4,072 $ 8,321
Interest-bearing deposits with depository institutions 8,715 7,834
-------- --------
Total cash and cash equivalents 12,787 16,155
Investment securities available for sale 33,386 37,019
Mortgage-related securities available for sale 70,030 67,527
Loans held for sale 1,334 41
Investment securities held to maturity - at amortized
cost (approximate fair value of $3,268 and $4,290
September 30, 2006 and 2005, respectively) 3,257 4,267
Mortgage-related securities held to maturity - at
amortized cost (approximate fair value of $37,163
and $45,679 at September 30, 2006 and 2005,
respectively) 38,355 46,654
Loans receivable (net of allowance for loan losses of
$3,367 and $3,475 at September 30, 2006 and 2005,
respectively) 323,220 301,979
Accrued interest receivable 2,667 2,435
Real estate owned 2,450 760
FHLBank stock, at cost 6,233 9,499
Office properties and equipment, net 4,643 4,782
Deferred income taxes 2,281 2,008
Cash surrender value of life insurance 16,624 16,835
Prepaid expenses and other assets 5,693 8,163
-------- --------
Total Assets $522,960 $518,124
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Deposits
Non-interest-bearing $ 17,232 $ 18,001
Interest-bearing 341,584 331,693
-------- --------
Total deposits 358,816 349,694
Advances from FHLBank and other borrowings 107,241 113,303
Junior subordinated debentures 21,483 21,520
Accrued interest payable 2,164 1,870
Advances from borrowers for taxes and insurance 866 839
Accounts payable and accrued expenses 3,731 2,705
-------- --------
Total liabilities 494,301 489,931
-------- --------
Commitments and contingencies (see Note 13)
Stockholders' Equity:
Preferred stock, $.01 par value, 10,000,000 shares
authorized; none issued
Common stock, $.01 par value, 20,000,000 shares
authorized; issued 2,712,556 shares;
outstanding at September 30, 2006 and 2005,
2,027,928 and 2,023,534 shares, respectively 27 27
Additional paid-in capital 12,974 12,920
Employee stock ownership plan (3,089) (3,185)
Treasury stock at cost: 684,628 and 689,022 shares at
September 30, 2006 and 2005, respectively (10,522) (10,590)
Accumulated other comprehensive loss (787) (209)
Retained earnings-partially restricted 30,056 29,230
-------- --------
Total stockholders' equity 28,659 28,193
-------- --------
Total Liabilities and Stockholders' Equity $522,960 $518,124
======== ========
See notes to consolidated financial statements.
61
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED SEPTEMBER 30,
------------------------------------
2006 2005 2004
---------- ---------- ----------
INTEREST INCOME:
Interest and fees on loans $ 19,956 $ 17,926 $ 17,529
Interest and dividends on:
Mortgage-related securities 5,054 6,223 5,298
Investment securities:
Taxable 1,196 1,491 2,127
Tax-exempt 711 755 842
Dividends 379 514 271
Interest-bearing deposits 197 167 76
---------- ---------- ----------
Total interest income 27,493 27,076 26,143
---------- ---------- ----------
INTEREST EXPENSE:
Interest on:
Deposits 8,547 6,280 5,910
FHLBank advances and other borrowings 5,914 7,694 7,126
Junior subordinated debentures 1,954 1,794 1,676
---------- ---------- ----------
Total interest expense 16,415 15,768 14,712
---------- ---------- ----------
Net interest income 11,078 11,308 11,431
Provision for loan losses 1,206 1,780 300
---------- ---------- ----------
Net interest income after provision for loan losses 9,872 9,528 11,131
---------- ---------- ----------
NON-INTEREST INCOME:
Service charges and other fees 1,560 1,577 1,235
Net gain on sale of:
Investments and mortgage-related securities 3 709 914
Loans held for sale 157 93 54
Real estate owned 178 20 --
Proceeds from life insurance 567 -- --
Increase in cash surrender value of life insurance 600 725 731
Other real estate fees -- -- 550
Other income 447 485 415
---------- ---------- ----------
Total non-interest income 3,512 3,609 3,899
---------- ---------- ----------
NON-INTEREST EXPENSE:
Salaries and employee benefits 5,960 6,091 6,807
Occupancy and equipment 1,624 1,562 1,253
Professional fees 1,616 1,159 867
Federal deposit insurance premium 125 48 53
Operations of real estate owned 162 6 186
Data processing 533 526 478
Advertising 444 413 423
Deposit processing 602 638 628
Prepayment penalty on FHLB advances -- 486 --
Other 1,642 1,911 1,806
---------- ---------- ----------
Total non-interest expense 12,708 12,840 12,501
---------- ---------- ----------
Income before income tax (benefit) expense 676 297 2,529
Income tax (benefit) expense (359) (313) 326
---------- ---------- ----------
Net income $ 1,035 $ 610 $ 2,203
========== ========== ==========
Earnings per common share:
Basic $ 0.55 $ 0.33 $ 1.21
Diluted $ 0.54 $ 0.33 $ 1.14
Weighted average shares - basic 1,892,510 1,842,434 1,820,137
Weighted average shares - diluted 1,912,282 1,871,401 1,937,612
See notes to consolidated financial statements.
62
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY
(DOLLARS IN THOUSANDS)
ACCUMULATED
EMPLOYEE OTHER RETAINED
ADDITIONAL STOCK COMPREHENSIVE EARNINGS- TOTAL
COMMON PAID-IN OWNERSHIP TREASURY INCOME PARTIALLY STOCKHOLDERS'
STOCK CAPITAL PLAN STOCK (LOSS) RESTRICTED EQUITY
------ ---------- --------- -------- ------------- ---------- -------------
Balance at October 1, 2003 $27 $13,430 $ (830) $(11,378) $ 3,069 $28,070 $ 32,388
--- ------- ------- -------- ------- ------- --------
Comprehensive income:
Net income -- -- -- -- -- 2,203 2,203
Other comprehensive income, net of tax:
Net unrealized loss on securities
Net of reclassification adjustment(1) -- -- -- -- (1,335) -- (1,335)
--- ------- ------- -------- ------- ------- --------
Comprehensive income -- -- -- -- -- -- 868
--- ------- ------- -------- ------- ------- --------
ESOP stock committed to be released -- -- 220 -- -- -- 220
Common stock acquired by stock benefit plan -- -- (2,579) -- -- -- (2,579)
Excess of fair value above cost of ESOP
shares committed to be released -- 417 -- -- -- -- 417
Exercise of stock options -- (238) -- 804 -- -- 566
Purchase of treasury stock -- -- -- (1,339) -- -- (1,339)
Dividends paid -- -- -- -- -- (843) (843)
--- ------- ------- -------- ------- ------- --------
Balance at September 30, 2004 $27 $13,609 $(3,189) $(11,913) $ 1,734 $29,430 $ 29,698
=== ======= ======= ======== ======= ======= ========
Comprehensive income:
Net income -- -- -- -- -- 610 610
Other comprehensive income, net of tax:
Net unrealized loss on securities
Net of reclassification adjustment(1) -- -- -- -- (1,943) -- (1,943)
--- ------- ------- -------- ------- ------- --------
Comprehensive loss -- -- -- -- -- -- (1,333)
--- ------- ------- -------- ------- ------- --------
ESOP stock committed to be released -- -- 76 -- -- -- 76
Common stock acquired by stock benefit plan -- -- (72) -- -- -- (72)
Excess of fair value above cost of ESOP
shares committed to be released -- 88 -- -- -- -- 88
Exercise of stock options -- (777) -- 1,433 -- -- 656
Purchase of treasury stock -- -- -- (110) -- -- (110)
Dividends paid -- -- -- -- -- (810) (810)
--- ------- ------- -------- ------- ------- --------
Balance at September 30, 2005 $27 $12,920 $(3,185) $(10,590) $ (209) $29,230 $ 28,193
=== ======= ======= ======== ======= ======= ========
Comprehensive income:
Net income -- -- -- -- -- 1,035 1,035
Other comprehensive income, net of tax:
Net unrealized loss on securities
Net of reclassification adjustment(1) -- -- -- -- (578) -- (578)
--- ------- ------- -------- ------- ------- --------
Comprehensive income -- -- -- -- -- -- 457
--- ------- ------- -------- ------- ------- --------
ESOP stock committed to be released -- -- 96 -- -- -- 96
Excess of fair value above cost of ESOP
shares committed to be released -- 50 -- -- -- -- 50
Exercise of stock options -- (21) -- 68 -- -- 47
Share-based compensation -- 25 -- -- -- -- 25
Dividends paid -- -- -- -- -- (209) (209)
--- ------- ------- -------- ------- ------- --------
Balance at September 30, 2006 $27 $12,974 $(3,089) $(10,522) $ (787) $30,056 $ 28,659
=== ======= ======= ======== ======= ======= ========
(1) Disclosure of reclassification amount, net of tax for the years ended:
2006 2005 2004
----- ------- -------
Net unrealized depreciation arising during the year $(580) $(2,411) $(1,938)
Less: reclassification adjustment for net gains included in net income
(net of tax $1, $241 and $311, respectively) 2 468 603
----- ------- -------
Net unrealized loss on securities $(578) $(1,943) $(1,335)
===== ======= =======
See notes to consolidated financial statements.
63
FIRST KEYSTONE FINANCIAL, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEAR ENDED SEPTEMBER 30,
---------------------------------
2006 2005 2004
--------- --------- ---------
OPERATING ACTIVITIES:
Net income $ 1,035 $ 610 $ 2,203
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Provision for depreciation and amortization 535 534 473
Amortization of premiums and discounts 310 582 540
Decrease (increase) in cash surrender value of life insurance (600) (725) (745)
(Gain) loss on sales of:
Loans held for sale (157) (93) (54)
Investment securities available for sale (46) (1,499) (619)
Mortgage-related securities available for sale 43 790 (295)
Real estate owned (178) (20) --
Provision for loan losses 1,206 1,780 300
Amortization of ESOP 146 164 637
Deferred income taxes 25 (81) (550)
Share-based compensation 25 -- --
Insurance proceeds on real estate owned -- 29 --
Changes in assets and liabilities which provided (used) cash:
Origination of loans held for sale (6,063) (13,620) (9,671)
Loans sold in the secondary market 4,770 13,751 9,814
Accrued interest receivable (232) 142 77
Prepaid expenses and other assets 2,470 2,532 (6,779)
Accrued interest payable 294 87 (16)
Accrued expenses 1,026 668 (1,379)
--------- --------- ---------
Net cash provided by (used in) operating activities 4,609 5,631 (6,064)
--------- --------- ---------
INVESTING ACTIVITIES:
Loans originated (141,352) (130,133) (130,824)
Purchases of:
Investment securities available for sale (444) (9,700) (8,579)
Mortgage-related securities available for sale (18,353) (41,934) (22,329)
Mortgage-related securities held to maturity -- (18,591) (37,856)
Redemption (purchase) of FHLB stock 3,266 328 (1,533)
Proceeds from life insurance 811 -- --
Proceeds from sales of investment and mortgage-related
securities available for sale 4,559 74,056 16,485
Proceeds from sales of real estate owned 1,188 435 376
Principal collected on loans 116,309 130,830 116,894
Proceeds from maturities, calls or repayments of:
Investment securities available for sale 590 3,527 13,454
Investment securities held to maturity 1,000 1,000 1,000
Mortgage-related securities available for sale 13,760 28,006 40,344
Mortgage-related securities held to maturity 8,160 9,110 3,924
Purchase of property and equipment (396) (1,041) (1,321)
--------- --------- ---------
Net cash (used in) provided by investing activities (10,902) 45,893 (9,965)
--------- --------- ---------
FINANCING ACTIVITIES:
Net increase (decrease) in deposit accounts 9,122 4,814 (17,725)
Net (decrease) increase in FHLB advances and other borrowings (6,062) (57,846) 34,877
Net increase (decrease) in advances from borrowers for taxes and
insurance 27 24 (143)
Common stock acquired by ESOP -- (72) (2,579)
Proceeds from exercise of stock options 47 656 566
Purchase of treasury stock -- (110) (1,339)
Cash dividends (209) (810) (843)
--------- --------- ---------
Net cash (used in) provided by financing activities 2,925 (53,344) 12,814
--------- --------- ---------
Decrease in cash and cash equivalents (3,368) (1,820) (3,215)
Cash and cash equivalents at beginning of year 16,155 17,975 21,190
--------- --------- ---------
Cash and cash equivalents at end of year $ 12,787 $ 16,155 $ 17,975
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW AND NON-CASH INFORMATION:
Cash payments for interest on deposits and borrowings $ 16,121 $ 15,681 $ 14,362
Cash (refunds) payments of income taxes (374) 654 959
Fair value adjustment to investments available for sale -- -- 1,074
Transfer of loans held for sale to loan portfolio -- -- 4,186
Transfers of loans receivable into real estate owned 2,700 -- 153
See notes to consolidated financial statements.
64
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
1. NATURE OF OPERATIONS AND ORGANIZATION STRUCTURE
The primary business of First Keystone Financial, Inc. (the "Company") is
to act as the holding company for its principal wholly owned subsidiary, First
Keystone Bank (the "Bank"), a federally chartered stock savings association
founded in 1934. The Bank has the following four wholly owned subsidiaries: FKF
Management Corp., Inc. which manages investment securities, First Chester
Services, Inc. and First Pointe, Inc. which acquire certain loans, real estate
and other assets in satisfaction of debts previously contracted by the Bank, and
State Street Services Corporation, which holds a 51% interest in First Keystone
Insurance Services ("First Keystone Insurance"), an insurance agency, which is
consolidated into the Company's financial statements. The Company's capital
trusts, First Keystone Capital Trust I and First Keystone Capital Trust II,
collectively, the ("Issuing Trusts") are not consolidated with the accounts of
the Company as discussed in Note 2. The Issuer Trusts were formed in connection
with the issuance of trust preferred securities.
The primary business of the Bank is to offer a wide variety of commercial
and retail products through its branch system located in Delaware and Chester
counties in Pennsylvania. The Bank is primarily supervised and regulated by the
Office of Thrift Supervision ("OTS").
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of
the Company, the Bank and the Company's and the Bank's wholly owned
subsidiaries. In addition, the Company consolidates First Keystone Insurance in
which one of the Bank's subsidiaries holds a 51% ownership interest.
In 2004, upon adoption of Financial Accounting Standards Board ("FASB")
Interpretation ("FIN") No. 46 and FIN 46(R), the "Issuing Trusts" are not
consolidated with the accounts of the Company.
Intercompany accounts and transactions have been eliminated in
consolidation.
SEGMENT ACCOUNTING
The Company evaluated Statement of Financial Accounting Standards ("SFAS")
No. 131, "Disclosure about Segments of an Enterprise and Related Information,"
and determined the Company operates in two segments: Banking and Insurance
Services.
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of income and expense during the reporting periods. Actual
results could differ from those estimates.
SECURITIES HELD TO MATURITY AND SECURITIES AVAILABLE FOR SALE
Securities held to maturity are carried at amortized cost. Securities are
designated as held to maturity only if the Company has the positive intent and
ability to hold these securities to maturity. Securities available for sale are
carried at fair value with the resulting unrealized gains or losses recorded in
equity, net of tax. Premiums are amortized and discounts are accreted using the
interest method over the estimated remaining term of the underlying security.
For the years ended September 30, 2006 and 2005, the Company did not maintain a
trading portfolio.
OTHER-THAN-TEMPORARY IMPAIRMENT OF SECURITIES
Securities are evaluated on at least a quarterly basis and more frequently
when economic or market conditions warrant such an evaluation to determine
whether a decline in their value is other than temporary. Management utilizes
criteria such as the magnitude and duration of the decline and the intent and
ability of the Company to retain its
65
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
investment in the issues for a period of time sufficient to allow for an
anticipated recovery in fair value, in addition to the reasons underlying the
decline, to determine whether the loss in value is other than temporary. Once a
decline in value is determined to be other than temporary, the value of the
security is reduced and a corresponding charge to earnings is recognized.
On November 3, 2005, the FASB issued FASB Staff Position ("FSP") Nos. FAS
115-1 and FAS 124-1, "The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments." This FSP addresses the determination as to
when an investment is considered impaired, whether that impairment is other than
temporary, and the measurement of an impairment loss. This FSP also includes
accounting considerations subsequent to the recognition of an
other-than-temporary impairment and requires certain disclosures about
unrealized losses that have not been recognized as other-than-temporary
impairments. This FSP nullifies certain requirements of EITF Issue 03-1, "The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments", and supersedes EITF Topic No. D-44, "Recognition of
Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost
Exceeds Fair Value." The guidance in this FSP amends SFAS Statement No. 115,
"Accounting for Certain Investments in Debt and Equity Securities." The FSP is
effective for reporting periods beginning after December 15, 2005. The Company
adopted this guidance on January 1, 2006 and it did not have a significant
impact on the Company's consolidated financial statements.
ALLOWANCE FOR LOAN LOSSES
An allowance for loan losses is maintained at a level that management
considers adequate to provide for probable losses based upon an evaluation of
known and inherent losses in the loan portfolio that are both probable and
reasonably estimated. The Company is constantly reviewing the methodology,
conducting assessments and redefining the process to determine the appropriate
level of allowance for loan losses. In establishing the allowance for loan
losses, management must use a large degree of judgment in (i) assigning
individual loans to specific risk levels (pass, special mention, substandard,
doubtful and loss), (ii) valuing the underlying collateral securing the loans,
(iii) determining the appropriate reserve factor to be applied to specific risk
levels for criticized and classified loans (special mention, substandard,
doubtful and loss) and (iv) determining reserve factors to be applied to pass
loans based upon loan type. Management reviews the allowance for loan losses
generally on a monthly basis, but at a minimum at least quarterly. To the extent
that loans change risk levels, collateral values change or reserve factors
change, the Company may need to adjust its provision for loan losses which would
impact earnings. In this framework, a series of qualitative factors are used in
a methodology as a measurement of how current circumstances are affecting the
loan portfolio. Included, among other things, in these qualitative factors are
past loss experience, the type and volume of loans, changes in lending policies
and procedures, underwriting standards, collections, charge-offs and recoveries,
national and local economic conditions, concentrations of credit, and the effect
of external factors on the level of estimated credit losses in the current
portfolio. While management uses the best information available to make such
evaluation, future adjustments to the allowance may be necessary if conditions
differ substantially from the assumptions used in making the evaluations.
Impaired loans are predominantly measured based on the fair value of the
collateral. The provision for loan losses charged to expense is based upon past
loan loss experience and an evaluation of probable losses and impairment
existing in the current loan portfolio. A loan is considered to be impaired
when, based upon current information and events, it is probable that the Company
will be unable to collect all amounts due in accordance with the original
contractual terms of the loan. An insignificant delay or insignificant shortfall
in amounts of payments does not necessarily result in the loan being identified
as impaired. For this purpose, delays of less than 90 days are considered to be
insignificant. Large groups of smaller balance homogeneous loans, including
residential real estate and consumer loans, are collectively evaluated for
impairment, except for loans restructured pursuant to a troubled debt
restructuring.
Loans secured by residential real estate, including home equity and home
equity lines of credit, are classified as nonaccrual at 90 days past due. Loans
other than consumer loans are charged-off based on the facts and circumstances
of the individual loan. Consumer loans are generally charged-off in the month
they become 180 days past due.
66
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
MORTGAGE BANKING ACTIVITIES
The Company originates mortgage loans held for investment and for sale. At
origination, the mortgage loan is identified as either held for sale or for
investment. Mortgage loans held for sale are carried at the lower of cost or
forward committed contracts (which approximates market).
At September 30, 2006, 2005 and 2004, loans serviced for others totaled
approximately $51,145, $55,378 and $50,862, respectively. Servicing loans for
others consists of collecting mortgage payments, maintaining escrow accounts,
disbursing payments to investors, and processing foreclosures. Loan servicing
income is recorded when earned and includes servicing fees from investors and
certain charges collected from borrowers, such as late payment fees. The Company
has fiduciary responsibility for related escrow and custodial funds aggregating
approximately $345 and $451 at September 30, 2006 and 2005, respectively.
The Company assesses the retained interest in the servicing asset or
liability associated with the sold loans based on the relative fair values. The
servicing asset or liability is amortized in proportion to and over the period
during which estimated net servicing income or net servicing loss, as
appropriate, will be received. Assessment of the fair value of the retained
interest is performed on a quarterly basis. At September 30, 2006 and 2005,
mortgage servicing rights totaling $314 and $288, respectively, were included in
other assets.
TRANSFERS OF FINANCIAL ASSETS
Transfers of financial assets are accounted for as sales when control over
the assets has been surrendered. Control is surrendered when (1) the assets have
been isolated from the Company, (2) the transferee obtains the right (free of
conditions that constrain it from taking advantage of that right) to pledge or
exchange the transferred assets, and (3) the Company does not maintain effective
control over the transferred assets through an agreement to repurchase them
before their maturity.
INCOME RECOGNITION ON LOANS
Interest on loans is credited to income when earned. Accrual of loan
interest is discontinued and a reserve established through a charge to interest
income on existing accruals if management believes after considering, among
other things, economic and business conditions and collection efforts, that the
borrowers' financial condition is such that collection of interest is doubtful.
Such interest ultimately collected is credited to income when collection of
principal and interest is no longer in doubt.
REAL ESTATE OWNED
Real estate owned consists of properties acquired by foreclosure or deed
in-lieu of foreclosure. These assets are initially recorded at the lower of
carrying value of the loan or estimated fair value less selling costs at the
time of foreclosure and at the lower of the new cost basis or net realizable
value thereafter. The amounts recoverable from real estate owned could differ
materially from the amounts used in arriving at the net carrying value of the
assets at the time of foreclosure because of future market factors beyond the
control of the Company. Costs relating to the development and improvement of
real estate owned properties are capitalized and those relating to holding the
property are charged to expense.
OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are recorded at cost. Depreciation is
computed using the straight-line method over the expected useful lives of the
assets which range from two to 40 years. The costs of maintenance and repairs
are expensed as they are incurred, and renewals and betterments are capitalized.
67
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
CASH SURRENDER VALUE OF LIFE INSURANCE
The Bank funded the purchase of insurance policies on the lives of certain
officers and employees of the Bank. The Bank has recognized any increase in cash
surrender value of life insurance, net of insurance costs, in the consolidated
statements of income. The cash surrender value of the insurance policies is
recorded as an asset in the statements of financial condition. For the year
ended September 30, 2006, the Company recognized the receipt of death-benefit
proceeds of $567 from the Company's bank owned life insurance policies.
INTEREST RATE RISK
At September 30, 2006 and 2005, the Company's assets consisted primarily of
assets that earned interest at either adjustable or fixed interest rates and the
average life of which is longer term. At September 30, 2006, the Bank had
interest-earning assets of approximately $487.5 million having a weighted
average effective yield of 5.99% and interest-bearing liabilities of
approximately $487.5 million with a weighted average cost of 3.77%. These assets
were funded primarily with shorter term liabilities that have interest rates
which vary over time with market rates and, in some cases, certain call features
that are affected by changes in market rates of interest. The shorter duration
of the interest-sensitive liabilities indicates that the Company is exposed to
interest rate risk because, in a rising rate environment, liabilities will be
repricing faster at higher interest rates, thereby reducing the market value of
long-term assets and net interest income.
EARNINGS PER SHARE
Basic earnings per share ("EPS") is computed based on the weighted average
number of shares of common stock outstanding. Diluted earnings per common share
is computed based on the weighted average number of shares of common stock
outstanding increased by the number of common shares that are assumed to have
been purchased with the proceeds from the exercise of stock options. Weighted
average shares used in the computation of earnings per share were as follows:
YEAR ENDED SEPTEMBER 30,
---------------------------------
2006 2005 2004
--------- --------- ---------
Average common shares outstanding 1,892,510 1,842,434 1,820,137
Increase in shares due to options 19,772 28,967 117,475
--------- --------- ---------
Adjusted shares outstanding - diluted 1,912,282 1,871,401 1,937,612
========= ========= =========
For the year ended September 30, 2006, 2,221 outstanding options were
anti-dilutive. For the years ended September 30, 2005 and 2004, there were no
outstanding options that were anti-dilutive.
INCOME TAXES
Deferred income taxes are recognized for the tax consequences of temporary
differences by applying enacted statutory tax rates applicable to future years
to differences between the financial statement carrying amounts and the tax
bases of existing assets and liabilities. The effect on deferred taxes of a
change in tax rates is recognized in income in the period that includes the
enactment date.
ACCOUNTING FOR STOCK OPTIONS
On October 1, 2005, the Company adopted SFAS No. 123 (Revised 2004),
"Share-Based Payment" (SFAS No. 123(R)) using the modified prospective
application transition method. This Statement requires an entity to recognize
the cost of employee services received in exchange for an award of equity
investment based on grant-date fair value of the award. That cost will be
recognized over the period during which an employee is required to provide
service in exchange for the award. Upon adoption of SFAS No. 123R, the Company
was required to recognize compensation expense for the fair value of stock
options that are granted or vested after that date. The revised Statement
generally requires that an entity account for those transactions using the
fair-value based method and eliminates an entity's ability to account for
share-based compensation transactions using the intrinsic value method of
accounting provided in Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," which was permitted under SFAS No.
123, as originally issued. Prior to October 1, 2005, the Company did not
recognize employee equity-based compensation costs in net income. The remaining
unrecognized compensation cost relating to non-vested stock based compensation
68
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
awards at September 30, 2006 was $55. The weighted average remaining life for
these awards is 4.7 years.
The adoption of SFAS No. 123R had the following impact on reported amounts
compared with amounts that would have been reported using the intrinsic value
method under previous accounting:
YEAR ENDED SEPTEMBER 30,
---------------------------------
2006 2005 2004
--------- --------- ---------
Net income, as reported $1,035 $ 610 $2,203
Add: Total stock-based employee
compensation expense included in
reported net income (net of tax) 17 -- --
Deduct: Total stock-based employee
compensation expense determined
under fair value method (net of
tax) (17) (17) (20)
------ ----- ------
Pro forma net income $1,035 $ 593 $2,183
====== ===== ======
Net income per common and common
equivalent share:
Earnings per common share - diluted
- As reported $ 0.54 $0.33 $ 1.14
- Pro forma 0.54 0.33 1.13
Weighted average fair value of
options granted during the period N/A $7.30 N/A
The binomial option-pricing model was used to determine the fair value of
options at the grant date. No grants were made in fiscal 2004 and 2006.
Significant assumptions used to calculate the above fair value of the awards are
as follows:
SEPTEMBER 30,
--------------------
2006 2005 2004
---- ----- -----
Risk-free interest rate of return N/A 4.04% N/A
Expected option life (months) N/A 120 N/A
Expected volatility N/A 34% N/A
Expected dividends N/A 2.2% N/A
OTHER COMPREHENSIVE INCOME
The Company presents as a component of comprehensive income the amounts
from transactions and other events which currently are excluded from the
statement of income and are recorded directly as an adjustment to stockholders'
equity.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS
In April 2004, the FASB issued SFAS Statement No.149, "Amendment of
Statement No.133 on Derivative Instruments and Hedging Activities," which
establishes accounting and reporting standards for derivative instruments,
including derivatives embedded in other contracts and hedging activities. SFAS
No. 133 "Accounting for Derivative Instruments and Hedging Activities," as
amended by SFAS Nos. 137 and 138 and interpreted by the FASB and the Derivative
Implementation Group through Statement 133 Implementation Issues, requires that
an entity recognize all derivatives as either assets or liabilities in the
statement of financial condition and measure those instruments at fair value. In
accordance with SFAS No. 149 and SFAS No. 133, the accounting for changes in the
fair value of a derivative depends on the intended use of the derivative and the
resulting designation. The Company's derivative instruments outstanding during
fiscal year ended September 30, 2006 included commitments to fund loans
held-for-sale and forward loan sale agreements. At September 30, 2006, the
Company did not have any embedded derivatives and did not employ hedging
activities.
69
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
STATEMENT OF CASH FLOWS
For purposes of reporting cash flows, cash and cash equivalents include
cash and amounts due from depository institutions and interest-bearing deposits
with depository institutions. The Company is required to maintain certain
balances at the Federal Reserve Bank of Philadelphia which amounted to $520.
RECENT ACCOUNTING PRONOUNCEMENTS
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain
Hybrid Financial Instruments-an amendment of FASB Statements No. 133 and 140"
("SFAS No. 155.") SFAS No. 155 amends SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," to permit fair value remeasurement for any
hybrid financial instrument with an embedded derivative that otherwise would
require bifurcation, provided that the whole instrument is accounted for on a
fair value basis. SFAS No. 155 amends SFAS No. 140, "Accounting for the
Impairment or Disposal of Long-Lived Assets", to allow a qualifying
special-purpose entity to hold a derivative financial instrument that pertains
to a beneficial interest other than another derivative financial instrument.
SFAS No. 155 is effective for all financial instruments acquired or issued after
the beginning of an entity's first fiscal year beginning after September 15,
2006 (October 1, 2007 for the Company) and is not expected to have a material
impact on the Company's consolidated financial statements.
In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing of
Financial Assets-an amendment of FASB Statement No. 140," ("SFAS No. 156"). SFAS
No. 156 amends SFAS No. 140, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities," with respect to the
accounting for separately recognized servicing assets and servicing liabilities.
SFAS No. 156 requires an entity to recognize a servicing asset or servicing
liability each time it undertakes an obligation to service a financial asset by
entering into a servicing contract in certain situations prescribed by SFAS No.
156. All separately recognized servicing assets and servicing liabilities are to
be initially measured at fair value, if practicable, and SFAS No. 156 permits an
entity to choose either the amortization method or fair value measurement method
for subsequent measurement methods for each class of separately recognized
servicing assets and servicing liabilities. SFAS No. 156 is effective as of the
beginning of an entity's first fiscal year that begins after September 15, 2006.
The requirements for recognition and initial measurement of servicing assets and
servicing liabilities should be applied prospectively to all transactions after
the effective date of this statement. The Company adopted SFAS No. 156 for the
fiscal year which began on October 1, 2006 and the Company believes it will not
have a material effect on the Company's financial position or results of
operations.
In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements".
SFAS No. 157 defines fair value, establishes a framework for measuring fair
value in GAAP, and expands disclosures about fair value measurements. SFAS No.
157 does not require any new fair value measurements. The definition of fair
value retains the exchange price notion in earlier definitions of fair value.
SFAS No. 157 clarifies that the exchange price is the price in an orderly
transaction between market participants to sell the asset or transfer the
liability in the market in which the reporting entity would transact for the
asset or liability. The definition focuses on the price that would be received
to sell the asset or paid to transfer the liability (an exit price), not the
price that would be paid to acquire the asset or received to assume the
liability (an entry price). SFAS No. 157 emphasizes that fair value is a
market-based measurement, not an entity-specific measurement. This Statement is
effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. The Company is
evaluating the impact of this pronouncement but does not expect that the
guidance will have a material effect on the Company's financial position or
results of operations.
70
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for
Defined Benefit Pension and Other Post-retirement Plans, an amendment of FASB
Statements No. 87, 88, 106 and 132(R)." For defined benefit post-retirement
plans, SFAS 158 requires that the funded status be recognized in the statement
of financial position, that assets and obligations that determine funded status
be measured as of the end of the employer's fiscal year, and that changes in
funded status be recognized in comprehensive income in the year the changes
occur. SFAS 158 does not change the amount of net periodic benefit cost included
in net income or address measurement issues related to defined benefit
post-retirement plans. The requirement to recognize funded status is effective
for fiscal years ending after December 15, 2006. The requirement to measure
assets and obligations as of the end of the employer's fiscal year is effective
for fiscal years ending after December 15, 2008. The Company is assessing SFAS
No. 158 and its impact on shareholders' equity, if any, and on the Company's
financial position or results of operations.
In June 2006, the FASB issued Interpretation No. 48 ("FIN 48"), "FASB
Interpretation No. 48 - Accounting for Uncertainty in Income Taxes - an
interpretation of FASB Statement No. 109". This Interpretation clarifies the
accounting for uncertainty in income taxes recognized in an enterprise's
financial statements in accordance with SFAS No. 109, "Accounting for Income
Taxes". This Interpretation prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. This Interpretation also
provides guidance on recognition, classification, interest and penalties,
accounting in interim periods, disclosure, and transition. FIN 48 is effective
for fiscal years beginning after December 15, 2006 or October 1, 2008 for the
Company. The Company is currently evaluating the impact of this pronouncement.
In September 2006, the SEC Staff issued Staff Accounting Bulletin No.108,
"Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in the Current Year Financial Statements" ("SAB No. 108"). SAB No.
108 requires the use of two alternative approaches in quantitatively evaluating
materiality of misstatements. If the misstatement as quantified under either
approach is material to the current year financial statements, the misstatement
must be corrected. If the effect of correcting the prior year misstatements, if
any, in the current year income statement is material, the prior year financial
statements should be corrected. This guidance is effective for the calendar year
ending 2006. In the year of adoption, the misstatements may be corrected as an
accounting change by adjusting opening retained earnings rather than being
included in the current year income statement. The Company is currently
evaluating the impact of SAB No. 108.
RECLASSIFICATIONS
Certain reclassifications have been made to the September 30, 2005 and 2004
consolidated financial statements to conform to the September 30, 2006
presentation. Such reclassifications had no impact on the reported net income.
71
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
3. INVESTMENT SECURITIES
The amortized cost and approximate fair value of investment securities
available for sale and held to maturity, by contractual maturities, are as
follows:
SEPTEMBER 30, 2006
-----------------------------------------------------------------------
GROSS UNREALIZED GROSS APPROXIMATE FAIR
AMORTIZED COST GAIN UNREALIZED LOSS VALUE
-------------- ---------------- --------------- -----------------
Available for Sale:
U.S. Government bonds
1 to 5 years $ 2,000 $ -- $ (24) $ 1,976
Municipal obligations
5 to 10 years 1,010 21 -- 1,031
Over 10 years 8,910 181 (15) 9,076
Corporate bonds
1 to 5 years 1,000 39 -- 1,039
5 to 10 years 2,000 -- (183) 1,817
Over 10 years 7,941 11 (39) 7,913
Mutual funds 9,229 -- (276) 8,953
Other equity investments 1,040 547 (6) 1,581
------- ---- ----- -------
Total $33,130 $799 $(543) $33,386
======= ==== ===== =======
Held to Maturity:
Municipal obligations
5 to 10 years $ 3,257 $ 11 $ -- $ 3,268
======= ==== ===== =======
Provided below is a summary of investment securities available for sale and
held to maturity which were in an unrealized loss position at September 30,
2006.
LOSS POSITION LOSS POSITION
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ----------
U.S. Government and agency
bonds $ -- $ -- $ 1,976 $ (24) $ 1,976 $ (24)
Corporate bonds 5,201 (18) 3,439 (204) 8,640 (222)
Municipal bonds 348 -- 985 (15) 1,333 (15)
Mutual funds 8,952 (276) 8,952 (276)
Equity 56 (6) -- -- 56 (6)
------ ---- ------- ----- ------- -----
Total $5,605 $(24) $15,352 $(519) $20,957 $(543)
====== ==== ======= ===== ======= =====
72
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
At September 30, 2006, investment securities in a gross unrealized loss
position for twelve months or longer consist of seven securities having an
aggregate depreciation of 3.3% from the Company's amortized cost basis.
Management believes that the estimated fair value of the securities disclosed
above is primarily dependent upon the movement in market interest rates
particularly given the negligible inherent credit risk associated with these
securities. These investment securities are comprised of securities that are
rated investment grade by at least one bond credit rating service. Although the
fair value will fluctuate as the market interest rates move, management believes
that these fair values will recover as the underlying portfolios mature and are
reinvested in market rate yielding investments. Mutual funds in an unrealized
loss position for 12 months or longer consist of two funds primarily invested in
asset-backed securities and have an aggregate depreciation of 3.0%. The Company
has the ability and intent to hold these securities until such time as the value
recovers. Management does not believe any individual unrealized loss as of
September 30, 2006 represents an other-than-temporary impairment.
The amortized cost and approximate fair value of investment securities
available for sale and held to maturity, by contractual maturities, are as
follows:
SEPTEMBER 30, 2005
-----------------------------------------------------------------------
GROSS UNREALIZED GROSS APPROXIMATE FAIR
AMORTIZED COST GAIN UNREALIZED LOSS VALUE
-------------- ---------------- --------------- -----------------
Available for Sale:
U.S. Government bonds
5 to 10 years $ 1,997 $ -- $ (18) $ 1,979
Municipal obligations
5 to 10 years 130 4 -- 134
Over 10 years 12,633 494 (18) 13,109
Corporate bonds
1 to 5 years 1,000 71 -- 1,071
5 to 10 years 2,000 -- (47) 1,953
Over 10 years 7,990 34 (19) 8,005
Asset-backed securities
1 to 5 years 590 3 -- 593
Mutual funds 8,846 -- (253) 8,593
Other equity investments 978 604 -- 1,582
------- ------ ----- -------
Total $36,164 $1,210 $(355) $37,019
======= ====== ===== =======
Held to Maturity:
Municipal obligations
5 to 10 years $ 3,259 $ 28 $ -- $ 3,287
Corporate bonds
Less than 1 year 1,008 -- (5) 1,003
------- ------ ----- -------
Total $ 4,267 $ 28 $ (5) $ 4,290
======= ====== ===== =======
73
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Provided below is a summary of investment securities available for sale and
held to maturity which were in an unrealized loss position at September 30,
2005.
LOSS POSITION LOSS POSITION
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ----------
U.S. Government and agency
bonds $1,979 $(18) $ -- $ -- $ 1,979 $ (18)
Corporate bonds 2,642 (24) 1,953 (47) 4,595 (71)
Municipal bonds 983 (18) -- -- 983 (18)
Mutual funds -- -- 8,593 (253) 8,593 (253)
------ ---- ------- ----- ------- -----
Total $5,604 $(60) $10,546 $(300) $16,150 $(360)
====== ==== ======= ===== ======= =====
For the years ended September 30, 2006, 2005 and 2004, proceeds from sales
of investment securities available for sale amounted to $2,893, $32,282 and
$9,986, respectively. For such periods, gross realized gains on sales amounted
to $46, $1,957 and, $1,754, respectively, while gross realized losses amounted
to $0, $458 and $61, respectively. The tax provision applicable to these net
realized gains amounted to $16, $510 and $576, respectively. Gains are realized
and recorded on the specific identification method.
4. MORTGAGE-RELATED SECURITIES
Mortgage-related securities available for sale and held to maturity are
summarized as follows:
SEPTEMBER 30, 2006
-------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- -----------
Available for Sale:
FHLMC pass-through certificates $ 7,290 $ 1 $ (67) $ 7,224
FNMA pass-through certificates 28,037 34 (474) 27,597
GNMA pass-through certificates 2,966 4 (63) 2,907
Collateralized mortgage obligations 33,188 24 (910) 32,302
------- --- ------- -------
Total $71,481 $63 $(1,514) $70,030
======= === ======= =======
Held to Maturity:
FHLMC pass-through certificates $14,376 $ 6 $ (450) $13,932
FNMA pass-through certificates 23,826 3 (751) 23,078
Collateralized mortgage obligations 153 -- -- 153
------- --- ------- -------
Total $38,355 $ 9 $(1,201) $37,163
======= === ======= =======
74
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Provided below is a summary of mortgage-related securities available for
sale and held to maturity which were in an unrealized loss position at September
30, 2006.
LOSS POSITION LOSS POSITION
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ----------
Pass-through
certificates $14,955 $(104) $55,887 $(1,701) $ 70,842 $(1,805)
Collateralized
mortgage obligations -- -- 31,965 (910) 31,965 (910)
------- ----- ------- ------- -------- -------
Total $14,955 $(104) $87,852 $(2,611) $102,807 $(2,715)
======= ===== ======= ======= ======== =======
At September 30, 2006, mortgage-related securities in a gross unrealized
loss position for twelve months or longer consist of fifty-four securities
having an aggregate depreciation of 2.9% from the Company's amortized cost
basis. Management does not believe any individual unrealized loss as of
September 30, 2006 represents an other-than-temporary impairment. The unrealized
losses reported for mortgage-related securities relate primarily to securities
issued by the Federal National Mortgage Association, the Federal Home Loan
Mortgage Corporation and private institutions. Management believes that market
value fluctuations in these securities are dependent upon the movement in market
interest rates, particularly given the negligible inherent credit risk
associated with these securities, rather than from the deterioration of the
creditworthiness of the issuer. Accordingly, management does not believe that
any individual unrealized loss as of September 30, 2006 represents an
other-than-temporary impairment. The Company has the ability and intent to hold
these securities until the anticipated recovery of fair value occurs or until
the securities mature.
Mortgage-related securities available for sale and held to maturity are
summarized as follows:
SEPTEMBER 30, 2006
-------------------------------------------------
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED APPROXIMATE
COST GAIN LOSS FAIR VALUE
--------- ---------- ---------- -----------
Available for Sale:
FHLMC pass-through certificates $ 50 $ 3 $ -- $ 53
FNMA pass-through certificates 23,493 51 (364) 23,180
GNMA pass-through certificates 3,947 12 (39) 3,920
Collateralized mortgage obligations 41,207 23 (856) 40,374
------- --- ------- -------
Total $68,697 $89 $(1,259) $67,527
======= === ======= =======
Held to Maturity:
FHLMC pass-through certificates $17,267 $ 9 $ (371) $16,905
FNMA pass-through certificates 29,084 9 (619) 28,474
Collateralized mortgage obligations 303 -- (3) 300
------- --- ------- -------
Total $46,654 $18 $ (993) $45,679
======= === ======= =======
75
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Provided below is a summary of mortgage-related securities available for
sale and held to maturity which were in an unrealized loss position at September
30, 2005.
LOSS POSITION LOSS POSITION
LESS THAN 12 MONTHS 12 MONTHS OR LONGER TOTAL
----------------------- ----------------------- -----------------------
UNREALIZED UNREALIZED UNREALIZED
FAIR VALUE LOSSES FAIR VALUE LOSSES FAIR VALUE LOSSES
---------- ---------- ---------- ---------- ---------- ----------
Pass-through
certificates $54,321 $ (916) $14,893 $(477) $ 69,214 $(1,393)
Collateralized
mortgage obligations 30,206 (485) 9,873 (374) 40,079 (859)
------- ------- ------- ----- -------- -------
Total $84,527 $(1,401) $24,766 $(851) $109,293 $(2,252)
======= ======= ======= ===== ======== =======
The collateralized mortgage obligations contain both fixed and
adjustable-rate classes of securities which are repaid in accordance with a
predetermined priority. The underlying collateral of the securities consisted of
loans which are primarily guaranteed by FHLMC, FNMA and GNMA.
For the years ended September 30, 2006, 2005 and 2004, proceeds from sales
of mortgage-related securities available for sale amounted to $1,666, $41,774
and $7,174, respectively. Gross realized gains amounted to $0, $0 and $299 for
the years ended September 30, 2006, 2005 and 2004, respectively. Gross realized
losses amounted to $43, $790 and $4 for the years ended September 30, 2006, 2005
and 2004 respectively. The tax provision (benefit) applicable to these net
realized gains and losses amounted to $(15), $(269) and $100 for the years ended
September 30, 2006, 2005 and 2004, respectively. Gains and losses are realized
and recorded on the specific identification method.
Mortgage-related securities with aggregate carrying values of $22,224 and
$18,783 were pledged as collateral at September 30, 2006 and 2005, respectively,
for municipal deposits, treasury tax, loan processing and financings (see Note
8).
5. ACCRUED INTEREST RECEIVABLE
The following is a summary of accrued interest receivable by category:
SEPTEMBER 30,
---------------
2006 2005
------ ------
Loans $1,816 $1,456
Mortgage-related securities 426 448
Investment securities 425 531
------ ------
Total $2,667 $2,435
====== ======
76
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
6. LOANS RECEIVABLE
Loans receivable consist of the following:
SEPTEMBER 30,
-------------------
2006 2005
-------- --------
Single-family $144,760 $149,237
Construction and land 38,158 36,828
Multi-family and commercial 70,439 69,704
Home equity and lines of credit 59,319 46,748
Consumer loans 1,375 1,376
Commercial loans 24,474 16,085
-------- --------
Total loans 338,525 319,978
Loans in process (12,081) (14,614)
Allowance for loan losses (3,367) (3,475)
Deferred loan costs 143 90
-------- --------
Loans receivable net $323,220 $301,979
======== ========
The Company originates loans primarily in its local market area of Delaware
and Chester Counties, Pennsylvania to borrowers that share similar attributes.
This geographic concentration of credit exposes the Company to a higher degree
of risk associated with this economic region.
The Company participates in the origination and sale of fixed-rate
single-family residential loans and Small Business Administration-guaranteed
loans in the secondary market. The Company recognized gains on sale of loans
held for sale of $157, $93 and $54 for fiscal years ended September 30, 2006,
2005 and 2004, respectively.
The Company offers loans to its directors and senior officers on terms
permitted by Regulation O promulgated by the Board of Governors of the Federal
Reserve System. There were approximately $4,267, $4,374 and $3,812 of loans
outstanding to senior officers and directors as of September 30, 2006, 2005 and
2004, respectively. The amount of repayments during the years ended September
30, 2006, 2005 and 2004, totaled $$112, $737 and $400, respectively. There were
$5, $1,300 and $1,614 of new loans granted during fiscal years 2006, 2005 and
2004, respectively.
The Company had undisbursed portions under consumer and commercial lines of
credit as of September 30, 2006 of $28,973 and $8,293, respectively.
77
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company originates both adjustable and fixed interest rate loans and
purchases mortgage-related securities in the secondary market. The originated
adjustable-rate loans have annual and lifetime interest rate adjustment
limitations and are generally indexed to U.S. Treasury securities plus a fixed
margin. Future market factors may affect the correlation of the interest rate
adjustment with rates the Company pays on the short-term deposits that have been
the primary funding source for these loans. The adjustable-rate mortgage-related
securities adjust to various national indices plus a fixed margin. At September
30, 2006, the composition of these loans and mortgage-related securities was as
follows:
FIXED-RATE
TERM TO MATURITY BOOK VALUE
- ---------------- ----------
1 month to 1 year $ 4,118
1 year to 3 years 8,411
3 years to 5 years 28,446
5 years to 10 years 59,027
Over 10 years 189,984
--------
Total $289,986
========
ADJUSTABLE-RATE
TERM TO RATE ADJUSTMENT BOOK VALUE
- ----------------------- ----------
1 month to 1 year $ 81,406
1 year to 3 years 25,866
3 years to 5 years 33,772
5 years to 10 years 3,799
--------
Total $144,843
========
The following is an analysis of the allowance for loan losses:
YEAR ENDED
SEPTEMBER 30,
-------------------------
2006 2005 2004
------- ------ ------
Beginning balance $ 3,475 $2,039 $1,986
Provisions charged to income 1,206 1,780 300
Charge-offs (1,328) (344) (321)
Recoveries 14 -- 74
------- ------ ------
Total $ 3,367 $3,475 $2,039
======= ====== ======
At September 30, 2006 and 2005, non-performing loans (which include loans
in excess of 90 days delinquent) amounted to approximately $277 and $5,052,
respectively. At September 30, 2006, non-performing loans consisted of loans
that were both individually and collectively evaluated for impairment.
Loans collectively evaluated for impairment include residential real
estate, home equity (including lines of credit) and consumer loans and are not
included in the data that follow:
SEPTEMBER 30,
-------------
2006 2005
---- ------
Impaired loans with related allowance for loan losses
under SFAS No. 114 $-- $3,837
Impaired loans with no related allowance for loan losses
under SFAS No. 114 25 --
--- ------
Total impaired loans $25 $3,837
=== ======
Valuation allowance related to impaired loans $-- $ 959
=== ======
78
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
At September 30, 2006 and 2005, the Company had impaired loans with a total
recorded investment of $25 and $3,837, respectively, and an average recorded
investment of $1,727 and $1,279, respectively. There was $1, $39 and $0 of
interest income recognized on these impaired loans during the years ended
September 30, 2006, 2005 and 2004, respectively. Interest income of
approximately $1, $338 and $8, respectively, was not recognized as interest
income due to the non-accrual status of loans during fiscal 2006, 2005 and 2004.
7. OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment are summarized by major classification as
follows:
SEPTEMBER 30,
-----------------
2006 2005
------- -------
Land and buildings $ 7,423 $ 7,372
Furniture, fixtures and equipment 3,797 3,529
------- -------
Total 11,220 10,901
Accumulated depreciation and amortization (6,577) (6,119)
------- -------
Net $ 4,643 $ 4,782
======= =======
The future minimum rental payments required under operating leases that
have initial or remaining non-cancelable lease terms in excess of one year as of
September 30, 2006 are as follows:
September 30,
2007 $ 322
2008 338
2009 343
2010 248
2011 143
Thereafter 2,239
------
Total minimum future rental payments $3,633
======
Leasehold expense was approximately $532, $502 and $356 for the years ended
September 30, 2006, 2005 and 2004, respectively.
Depreciation expense amounted to $535, $534 and $473 for the years ended
September 30, 2006, 2005 and 2004, respectively.
8. DEPOSITS
Deposits consist of the following major classifications:
SEPTEMBER 30,
---------------------------------------
2006 2005
------------------ ------------------
AMOUNT PERCENT AMOUNT PERCENT
-------- ------- -------- -------
Non-interest-bearing $ 17,232 4.8% $ 18,001 5.1%
NOW 73,356 20.5 65,688 18.8
Passbook 41,708 11.6 47,139 13.5
Money market 40,591 11.3 45,753 13.1
Certificates of deposit 185,929 51.8 173,113 49.5
-------- ----- -------- -----
Total $358,816 100.0% $349,694 100.0%
======== ===== ======== =====
The weighted average interest rates paid on deposits were 2.43% and 1.81%
at September 30, 2006 and 2005, respectively.
79
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Included in deposits as of September 30, 2006 and 2005 were deposits
greater than $100 totaling approximately $123,651 and $112,950, respectively.
Deposits in excess of $100 are generally not federally insured.
At September 30, 2006 and 2005, the Company had pledged certain
mortgage-related securities aggregating $19,259 and $15,145, respectively, as
collateral for municipal deposits.
A summary of scheduled maturities of certificates is as follows:
SEPTEMBER 30,
-------------------
2006 2005
-------- --------
Within one year $118,779 $ 94,653
One to two years 53,852 50,465
Two to three years 5,666 13,584
Thereafter 7,632 14,411
-------- --------
Total $185,929 $173,113
======== ========
A summary of interest expense on deposits is as follows:
YEAR ENDED SEPTEMBER 30,
------------------------
2006 2005 2004
------ ------ ------
NOW $ 693 $ 399 $ 287
Passbook 429 475 473
Money market 914 762 606
Certificates of deposit 6,511 4,644 4,544
------ ------ ------
Total $8,547 $6,280 $5,910
====== ====== ======
9. BORROWINGS
A summary of borrowings is as follows:
SEPTEMBER 30,
-------------------
2006 2005
-------- --------
FHLB advances $ 86,353 $ 96,371
FHLB overnight borrowings 20,800 16,800
Other 88 132
-------- --------
Total borrowings $107,241 $113,303
======== ========
Advances from the FHLB bear fixed interest rates with remaining periods
until maturity, summarized as follows:
SEPTEMBER 30,
-----------------
2006 2005
------- -------
Over one year through five years $86,175 $40,685
Over five years through ten years 178 55,500
Over 10 years -- 186
------- -------
$86,353 $96,371
======= =======
Included in the table above at September 30, 2006 and 2005 are $86,353 and
$96,371, respectively, of FHLB advances whereby the FHLB has the option at
predetermined times to convert the fixed interest rate to an adjustable rate
tied to the London Interbank Offered Rate (LIBOR). At September 30, 2006,
substantially all the FHLB advances with the convertible feature are subject to
conversion in fiscal 2007. The Company then has the option to prepay these
advances if the FHLB converts the interest rate. These advances are included in
the periods in which they mature rather than the period in which they can be
converted. The average balance of FHLB advances and overnight borrowings was
$108,247 with an average cost of 5.46% for the year ended September 30, 2006.
80
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Advances from the FHLB are collateralized by all FHLB stock, which is
carried at cost, owned by the Bank in addition to a blanket pledge of eligible
assets in an amount required to be maintained so that the estimated fair value
of such eligible assets exceeds, at all times, 110% of the outstanding advances.
10. INCOME TAXES
The Company and its subsidiaries file a consolidated federal income tax
return. The Company uses the specific charge-off method for computing reserves
for bad debts. The bad debt deduction allowable under this method is available
to large banks with assets of greater than $500 million. Generally, this method
allows the Company to deduct an annual addition to the reserve for bad debts
equal to its net charge-offs.
Retained earnings at September 30, 2005 and 2004 included approximately
$2,500 representing bad debt deductions for which no income tax has been
provided.
Income tax (benefit) expense is comprised of the following:
YEAR ENDED SEPTEMBER 30,
------------------------
2006 2005 2004
----- ----- -----
Federal:
Current $(384) $(232) $ 876
Deferred 25 (81) (550)
State -- -- --
----- ----- -----
Total $(359) $(313) $ 326
===== ===== =====
The tax effect of temporary differences that give rise to significant
portions of the deferred tax accounts, calculated at 34%, is as follows:
SEPTEMBER 30,
---------------
2006 2005
------ ------
Deferred tax assets:
Accelerated depreciation $ 475 $ 471
Allowance for loan losses 1,145 1,182
Unrealized loss on available for sale securities 406 108
Accrued expenses 608 569
------ ------
Total deferred tax assets $2,634 $2,330
====== ======
Deferred tax liabilities:
Deferred loan fees (274) (253)
Other (79) (69)
------ ------
Total deferred tax liabilities (353) (322)
------ ------
Net deferred income taxes $2,281 $2,008
====== ======
From time to time, the Company may be subject to examination by various tax
authorities in jurisdictions in which the Company has its business operations.
The Company regularly assesses the likelihood of additional assessments in each
of the tax jurisdictions resulting from these examinations. Tax reserves have
been established, which the Company believes to be adequate in relation to the
potential for additional assessments. Once established, reserves are adjusted as
information becomes available or when an event requiring a change to the reserve
occurs. The resolution of tax matters could have an impact on the Company's
effective tax rate.
81
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company's effective tax rate is less than the statutory federal income
tax rate for the following reasons:
YEAR ENDED SEPTEMBER 30,
---------------------------------------------------------------
2006 2005 2004
------------------- ------------------- -------------------
PERCENTAGE PERCENTAGE PERCENTAGE
OF PRETAX OF PRETAX OF PRETAX
AMOUNT INCOME AMOUNT INCOME AMOUNT INCOME
------ ---------- ------ ---------- ------ ----------
Tax at statutory rate $ 238 34.0% $ 101 34.0% $ 860 34.0%
Decrease (increase) in taxes resulting from:
Tax exempt interest, net (222) (31.7) (231) (77.8) (246) (9.7)
Increase in cash surrender value (383) (54.8) (194) (65.3) (206) (8.2)
Dividend received deduction (19) (2.7) (50) (16.8) (49) (1.9)
Other 27 3.9 61 20.5 (33) (1.3)
----- ------ ----- ------ ----- ----
Total $(359) (51.30)% $(313) (105.4)% $ 326 12.9%
===== ====== ===== ====== ===== ====
11. REGULATORY CAPITAL REQUIREMENTS
The Bank is subject to various regulatory capital requirements administered
by the federal banking agencies. Failure to meet minimum regulatory capital
requirements can result in certain mandatory, and possibly additional
discretionary, actions by regulators that, if undertaken, could have a direct
material effect on the Company's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities, and certain off-balance sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by regulators about
components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth below) of
tangible and core capital (as defined in the regulations) to adjusted assets (as
defined), and of Tier I and total capital (as defined) to average assets (as
defined). Management believes, as of September 30, 2006, that the Bank meets all
regulatory capital adequacy requirements to which it is subject.
The Bank's actual capital amounts and ratios are presented in the following
table.
WELL CAPITALIZED
REQUIRED FOR CAPITAL UNDER PROMPT
ACTUAL ADEQUACY PURPOSE CORRECTIVE ACTION
-------------------- -------------------- --------------------
AMOUNT PERCENTAGE AMOUNT PERCENTAGE AMOUNT PERCENTAGE
------- ---------- ------- ---------- ------- ----------
At September 30, 2006:
Core Capital (to Adjusted Tangible Assets) $47,771 9.15% $20,819 4.0% $26,096 5.0%
Tier I Capital (to Risk-Weighted Assets) 47,771 13.96 N/A N/A 20,539 6.0
Total Capital (to Risk-Weighted Assets) 51,138 14.94 27,385 8.0 34,231 10.0
Tangible Capital (to Tangible Assets) 47,771 9.15 7,829 1.5 N/A N/A
At September 30, 2005:
Core Capital (to Adjusted Tangible Assets) $45,606 8.85% $20,619 4.0% $25,774 5.0%
Tier I Capital (to Risk-Weighted Assets) 45,606 14.14 N/A N/A 19,350 6.0
Total Capital (to Risk-Weighted Assets) 48,808 15.13 25,800 8.0 32,250 10.0
Tangible Capital (to Tangible Assets) 45,606 8.85 7,732 1.5 N/A N/A
82
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
On February 13, 2006, the Bank entered into a supervisory agreement with
the OTS. The supervisory agreement requires the Bank, among other things, to
maintain a minimum core capital and total risk-based capital ratios of 7.5% and
12.5%, respectively. At September 30, 2006, the Bank was in compliance with such
requirement. As a result of the supervisory agreement, the Bank is not deemed to
be "well-capitalized" for purposes of the prompt corrective action regulations
of the OTS even though the Bank's regulatory capital is in excess of all
regulatory capital requirements.
The Company's capital at September 30, 2006 and 2005 for financial
statement purposes differs from tangible, core (leverage), and Tier-1 risk-based
capital amounts by $18,150 and $16,973, respectively, representing the inclusion
for regulatory capital purposes of unrealized losses on securities available for
sale and a portion of capital securities (see Note 16) that qualifies as
regulatory capital as well as adjustments to the Bank's capital that do not
affect the parent company.
At September 30, 2006 and 2005, total risk-based capital, for regulatory
requirements, was increased by $3,367 and $3,202, respectively, of general loan
loss reserves, for a total of $51,138 and $48,800, respectively.
At the date of the Bank's conversion from the mutual to stock form in
January 1995 (the "Conversion"), the Bank established a liquidation account in
an amount equal to its retained income as of August 31, 1994. The liquidation
account is maintained for the benefit of eligible account holders and
supplemental eligible account holders (as such terms are defined in the Bank's
plan of conversion) who continue to maintain their accounts at the Bank after
the Conversion. The liquidation account is reduced annually to the extent that
eligible account holders and supplemental eligible account holders have reduced
their qualifying deposits as of each anniversary date. Subsequent increases in
such balances will not restore an eligible account holder's or supplemental
eligible account holder's interest in the liquidation account. In the event of a
complete liquidation of the Bank, each eligible account holder and supplemental
eligible account holder will be entitled to receive a distribution from the
liquidation account in an amount proportionate to the current adjusted
qualifying balances for accounts then held.
The principal source of cash flow for the Company is dividends from the
Bank. Various federal banking regulations and capital guidelines limit the
amount of dividends that may be paid to the Company by the Bank. Future payment
of dividends by the Bank is dependent on individual regulatory capital
requirements, levels of profitability, and safety and soundness concerns. Under
current regulatory requirements of the OTS, the Bank is required to apply for
approval to dividend funds to the Company. No assurances can be given that such
approval, if requested, would be granted. In addition, loans or advances made by
the Bank to the Company are generally limited to 10 percent of the Bank's
capital stock and surplus on a secured basis, subject to compliance with various
collateral and other requirements. Accordingly, at September 30, 2006, funds
potentially available for loans or advances by the Bank to the Company amounted
to $4,681.
12. EMPLOYEE BENEFITS
401(K) PROFIT SHARING PLAN
The Bank's 401(k) profit sharing plan covers substantially all full-time
employees of the Company and provides for pre-tax contributions by the employees
with matching contributions at the discretion of the Board of Directors
determined at the beginning of the calendar year. All amounts are fully vested.
For calendar years 2006, 2005 and 2004, the Company matched twenty-five cents
for every dollar contributed up to 5% of a participant's salary. The profit
sharing expense for the plan was $36, $38 and $37 for the years ended September
30, 2006, 2005 and 2004, respectively.
83
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
EMPLOYEE STOCK OWNERSHIP PLAN
In connection with the Conversion, the Company established an employee
stock ownership plan ("ESOP") for the benefit of eligible employees. The Company
accounts for its ESOP in accordance with AICPA Statement of Position 93-6,
"Employers Accounting for Employee Stock Ownership Plans," which requires the
Company to recognize compensation expense equal to the fair value of the ESOP
shares during the periods in which they become committed to be released. To the
extent that the fair value of the ESOP shares released differs from the cost of
such shares, this difference is charged or credited to equity as additional
paid-in capital. Management expects the recorded amount of expense in any given
period to fluctuate from period to period as continuing adjustments are made to
reflect changes in the fair value of the ESOP shares. The Company's ESOP, which
is internally leveraged, does not report the loans receivable extended to the
ESOP as assets and does not report the ESOP debt due the Company. At September
30, 2006, 263,826 shares were committed to be released, of which 6,516 shares
have not yet been allocated to participant accounts. The Company recorded
compensation and employee benefit expense related to the ESOP of $183, $219 and
$850 for the years ended September 30, 2006, 2005 and 2004, respectively.
RECOGNITION AND RETENTION PLAN
Under the 1995 Recognition and Retention Plan and Trust (the "RRP"), there
are 81,600 shares authorized under the RRP. At September 30, 2006, the Company
had awarded 81,600 shares to the Company's non-employee directors and executive
officers subject to vesting and other provisions of the RRP. At September 30,
2006, 79,799 shares granted to the plan participants had vested and been
distributed.
STOCK OPTION PLANS
Under the 1995 Stock Option Plan (the "Option Plan"), common stock totaling
272,000 shares was reserved for issuance pursuant to the exercise of options.
The Option Plan expired by its terms in July 2005. Options granted pursuant to
the Option Plan, prior to its expiration, remain exercisable according to the
terms of their issuance. During fiscal year 1999, stockholders approved the
adoption of the 1998 Stock Option Plan ("1998 Option Plan") (collectively with
the Option Plan, the "Plans") pursuant to which an additional 111,200 shares of
common stock were reserved for issuance of which 29,623 were available for
future grant at September 30, 2006. Options covering an aggregate of 353,577
shares have been granted to the Company's executive officers, nonemployee
directors and other key employees, subject to vesting and other provisions of
the Plans. At September 30, 2006, 2005 and 2004, the number of shares covered by
options exercisable at such dates was 55,810, 56,836 and 181,023, respectively,
and the weighted average exercise price of those options was $12.76, $12.38 and
$9.84, respectively.
The following table summarizes transactions regarding the stock option
plans:
WEIGHTED
NUMBER AVERAGE
OF OPTION EXERCISE EXERCISE PRICE
SHARES PRICE RANGE PER SHARE
--------- -------------- --------------
Outstanding at October 1, 2003 240,538 $ 7.50 - 16.15 $ 9.83
Granted -- -- --
Exercised (54,436) 7.50 - 14.25 8.39
-------- -------------- ------
Outstanding at September 30, 2004 186,102 $ 7.50 - 16.15 $10.26
Granted 2,221 19.75 - 21.89 20.14
Exercised (116,396) 7.50 - 16.15 8.69
Cancelled (5,750) 12.13 - 14.25 14.17
-------- -------------- ------
Outstanding at September 30, 2005 66,177 $ 7.50 - 21.89 $13.01
-------- -------------- ------
Granted -- -- --
Exercised (4,730) 8.50 - 12.38 10.95
Cancelled -- -- --
-------- -------------- ------
Outstanding at September 30, 2006 61,447 $10.13 - 21.89 $13.17
-------- -------------- ------
84
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
A summary of the exercise price range at September 30, 2006 is as follows:
WEIGHTED AVERAGE WEIGHTED
NUMBER OF EXERCISE PRICE REMAINING AVERAGE EXERCISE
OPTION SHARES RANGE CONTRACTUAL LIFE PRICE PER SHARE
- ------------- -------------- ---------------- ----------------
3,860 $10.13 - 10.13 4.00 $10.13
55,366 12.13 - 16.15 3.46 13.10
2,221 19.75 - 21.89 8.66 20.14
------
61,447 $10.13 - 21.89 3.68 $13.17
====== ============== ==== ======
SUPPLEMENTAL RETIREMENT BENEFITS
During fiscal 2004, the Bank implemented a defined contribution
supplemental executive retirement plan (the "SERP") covering certain senior
executive officers of the Bank. For the initial year of the SERP, the crediting
rate on the amounts contributed was established at 5.0% and will remain in
effect until such time that the Company's Compensation Committee administering
the SERP determines to change it. Upon retirement of a participant, he or she
will receive his or her account balance paid out in equal annual payments for a
period not to exceed 15 years provided that a participant did not make a prior
election to receive his or her distribution in a lump sum. The SERP also
provides for the payment of benefits in the event of the death of the
participant or the termination of the employment of the participant subsequent
to a change in control of the Company.
In addition, the Bank previously maintained split dollar insurance
arrangements with certain senior executive officers. Such arrangements were
terminated in December 2003. In March 2005, the Company entered into a
Transition, Consulting, Noncompetition and Retirement Agreement with the
Company's previous President (the "Agreement"). The Agreement provides for a
consulting fee for five years and for payments for a period of ten years
beginning upon the commencement of the retirement phase of the agreement. The
Agreement provides for full payments in the event of a change in control of the
Company. For the fiscal years ended September 30, 2006, 2005 and 2004, the
pension expense relating to supplemental retirement benefits was approximately
$254, $261 and $837, respectively.
The Bank also provides supplemental retirement benefits to certain
directors and Advisory Board members. The expense relating to these arrangements
was approximately $114, $119 and $88 for the years ended September 30, 2006,
2005 and 2004, respectively.
13. COMMITMENTS AND CONTINGENCIES
The Bank has outstanding commitments to originate loans, excluding
undisbursed portion of loans in process and equity lines of credit, of
approximately $4,637 and $12,742 as of September 30, 2006 and 2005,
respectively, all of which are expected to be funded within four months. Of
these commitments outstanding, the breakdown between fixed and adjustable-rate
loans is as follows:
SEPTEMBER 30,
----------------
2006 2005
------ -------
Fixed-rate (ranging from 4.65% to 9.05%) $3,662 $ 2,721
Adjustable-rate 975 10,021
------ -------
Total $4,637 $12,742
====== =======
Depending on cash flow, interest rate, risk management and other
considerations, longer term fixed-rate residential loans originated prior to
February 2006 were sold in the secondary market. Currently, the Bank sells
participations in SBA loans to the secondary market. There were an aggregate of
approximately $1,099 and $315 in outstanding commitments to sell SBA
participations and residential loans at September 30, 2006 and 2005,
respectively.
85
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Bank issues letters of credit to its commercial customers, which are
commitments to guarantee the performance of the customer to a third party. There
were $367 and $1,539 outstanding letters of credit at September 30, 2006 and
2005, respectively. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loan facilities to customers.
The Bank currently has the ability to obtain up to $164.9 million in
additional advances from the FHLBank Pittsburgh.
The Bank also purchased letters of credit from the FHLBank Pittsburgh,
which totaled $4,136 and $0 at September 30, 2006 and 2005, respectively.
There may be various claims and pending actions against the Company and its
subsidiaries arising out of the conduct of its business. In the opinion of the
Company's management and based upon advice of legal counsel, the resolution of
these matters is not expected to have a material adverse impact on the
consolidated financial position or the results of operations of the Company and
its subsidiaries.
14. RELATED PARTY TRANSACTIONS
The Company retains the services of a law firm in which one of the
Company's directors is a member. In addition to providing general legal counsel
to the Company, the firm also prepares mortgage documents and attends loan
closings for which it is paid directly by the borrower.
The Company utilizes two of the Company's directors as consultants on
various real estate and general business matters. In addition, one of the
Company's board members has an interest in an insurance agency, First Keystone
Insurance, in which one of the Bank's subsidiaries has a 51% ownership interest.
15. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by the Company using
available market information and appropriate valuation methodologies. However,
considerable judgment is required to interpret market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
SEPTEMBER 30,
---------------------------------------------
2006 2005
--------------------- ---------------------
CARRYING/ ESTIMATED CARRYING/ ESTIMATED
NOTIONAL FAIR NOTIONAL FAIR
AMOUNT VALUE AMOUNT VALUE
--------- --------- --------- ---------
Assets:
Cash and cash equivalents $ 12,787 $ 12,787 $ 16,155 $ 16,155
Investment securities 36,643 36,654 41,286 41,309
Loans 323,220 321,939 301,979 298,228
Loans held for sale 1,334 1,334 41 41
Mortgage-related securities 108,385 107,193 114,181 113,206
FHLB stock 6,233 6,233 9,499 9,499
Liabilities:
Passbook deposits 41,708 41,708 47,139 47,139
NOW and money market deposits 131,179 131,179 111,441 111,441
Certificates of deposit 185,929 183,629 173,113 169,801
Borrowings 107,241 106,127 113,303 112,827
86
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The fair value of cash and cash equivalents is their carrying value due to
their short-term nature. The fair value of investment and mortgage-related
securities is based on quoted market prices, dealer quotes, and prices obtained
from independent pricing services. The fair value of loans is estimated, based
on present values using approximate current entry value interest rates,
applicable to each category of such financial instruments. The fair value of
FHLB stock approximates its carrying amount.
The fair value of NOW deposits, money market deposits and passbook deposits
is the amount reported in the financial statements. The fair value of
certificates of deposit and FHLB advances is based on a present value estimate,
using rates currently offered for deposits and borrowings of similar remaining
maturity.
Fair values for off-balance sheet commitments are based on fees currently
charged to enter into similar agreements, taking into account the remaining
terms of the agreements and the counterparties credit standings.
No adjustment was made to the entry-value interest rates for changes in
credit performing commercial real estate and business loans, construction loans,
and land loans for which there are no known credit concerns. Management believes
that the risk factor embedded in the entry-value interest rates, along with the
general reserves applicable to the performing commercial, construction, and land
loan portfolios for which there are no known credit concerns, result in a fair
valuation of such loans on an entry-value basis. The fair value of
non-performing loans, with a recorded book value of approximately $277 and
$5,052 (which are collateralized by real estate properties with property values
in excess of carrying amounts) as of September 30, 2006 and 2005, respectively,
was not estimated because it is not practicable to reasonably assess the credit
adjustment that would be applied in the marketplace for such loans. The fair
value estimates presented herein are based on pertinent information available to
management as of September 30, 2006 and 2005. Although management is not aware
of any factors that would significantly affect the estimated fair value amounts,
such amounts have not been comprehensively revalued for purposes of these
financial statements since September 30, 2006 and 2005 and, therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
16. CAPITAL SECURITIES
On August 21, 1997, First Keystone Capital Trust I (the "Trust"), a trust
formed under Delaware law, that is a subsidiary of the Company, issued $16.2
million of preferred securities (the "Preferred Securities") at an interest rate
of 9.7%, with a scheduled maturity of August 15, 2027. The Company owns all the
common stock of the Trust. The proceeds from the issue were invested in Junior
Subordinated Debentures (the "Debentures") issued by the Company. The Debentures
are unsecured and rank subordinate and junior in right of payment to all
indebtedness, liabilities and obligations of the Company. On November 15, 2001,
the Company purchased $3.5 million of the Preferred Securities. Debentures
represent the sole assets of the Trust. Interest on the Preferred Securities is
cumulative and payable semiannually in arrears. The Company has the option,
subject to required regulatory approval, if any, to prepay the securities
beginning August 15, 2007. The Company has, under the terms of the Debentures
and the related Indenture as well as the other operative corporate documents,
agreed to irrevocably and unconditionally guarantee the Trust's obligations
under the Debentures. In 1997, the Company made a capital contribution of
approximately $6.0 million of the net proceeds to the Bank to support the Bank's
lending activities.
On November 28, 2001, First Keystone Capital Trust II (the "Trust II"), a
trust formed under Delaware law, that is a subsidiary of the Company, issued
$8.0 million of securities ("Preferred Securities II") in a pooled securities
offering at a floating rate of 375 basis over the six month LIBOR with a
maturity date of December 8, 2031. The Company owns all the common stock of
Trust II. The proceeds from the issue were invested in Junior Subordinated
Debentures (the "Debentures II") issued by the Company. The Debentures II are
unsecured and rank subordinate and junior in right of payment to all
indebtedness, liabilities and obligations of the Company. The Debentures II
represent the sole assets of the Trust II. Interest on the Preferred Securities
II is cumulative and payable semi-annually in arrears. The Company has the
option, subject to required regulatory approval, if any, to redeem, in whole or
in part, the securities beginning December 8, 2006 and every six months
thereafter. With the receipt of net proceeds from the private placement
offering, the Company intends to use the proceeds to redeem $5.8 million of
Preferred Securities II. Due to the timing of the offering, the Company will not
be able to redeem these securities before June 8, 2007.
87
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
The Company had previously established Issuer Trusts that issued guaranteed
preferred beneficial interests in the Company's junior subordinated debentures.
Prior to FIN 46 and FIN 46 (R), the Company classified its Issuer Trusts after
total liabilities and before shareholders' equity on its consolidated statements
of financial condition under the caption "Guaranteed Preferred Beneficial
Interest in Company's Subordinated Debt" and the retained common capital
securities of the Issuer Trusts were eliminated against the Company's investment
in the Issuer Trusts. Distributions on the preferred securities were recorded as
non-interest expense on the consolidated statements of operations.
As a result of the adoption of FIN 46 and FIN 46 (R), the Company
deconsolidated all the Issuer Trusts. As a result, the junior subordinated
debentures issued by the Company to the Issuer Trusts, totaling $21.5 million,
are reflected in the Company's consolidated statements of financial condition in
the liabilities section at September 30, 2006 and 2005, under the caption
"Junior Subordinated Debentures." The Company records interest expense on the
corresponding debentures in its consolidated statements of operations. The
Company also recorded the common capital securities issued by the Issuer Trusts
in "Prepaid expenses and other assets" in its consolidated statements of
financial condition at September 30, 2006 and 2005.
17. PARENT COMPANY ONLY FINANCIAL INFORMATION
Condensed financial statements of First Keystone Financial, Inc. are as
follows:
CONDENSED STATEMENTS OF FINANCIAL CONDITION
SEPTEMBER 30,
-----------------
2006 2005
------- -------
Assets:
Interest-bearing deposits $ 1,802 $ 2,098
Investment securities available for sale 1,581 1,582
Investment in subsidiaries 47,853 46,177
Other assets 277 1,311
------- -------
Total assets $51,513 $51,168
======= =======
Liabilities and Stockholders' Equity:
Junior subordinated debentures $21,483 $21,520
Other liabilities 1,371 1,455
------- -------
Total liabilities 22,854 22,975
Stockholders' equity 28,659 28,193
------- -------
Total liabilities and stockholders' equity $51,513 $51,168
======= =======
CONDENSED STATEMENTS OF OPERATIONS
YEAR ENDED SEPTEMBER 30,
------------------------
2006 2005 2004
------ ------ ------
Interest and dividend income:
Dividends from subsidiary $ 14 $ 11 $ 9
Loans to ESOP 233 192 59
Interest and dividends on investments 125 280 173
Interest on deposits 25 13 17
------ ------ ------
Total interest and dividend income 397 496 258
Interest on debt and other borrowed money 1,954 1,794 1,676
Other income -- 1,256 1,393
Operating expenses 211 183 210
Equity in earnings of subsidiaries 2,213 770 2,369
------ ------ ------
Income before income taxes 445 545 2,134
Income tax benefit (590) (65) (69)
------ ------ ------
Net income $1,035 $ 610 $2,203
====== ====== ======
88
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
CONDENSED STATEMENTS OF CASH FLOWS
YEAR ENDED SEPTEMBER 30,
---------------------------
2006 2005 2004
------- ------- -------
Cash flows from operating activities:
Net income $ 1,035 $ 610 $ 2,203
Adjustment to reconcile net income to
cash provided by (used in) operations:
Equity in earnings of subsidiaries (2,213) (770) (2,369)
Shared-based compensation 25 -- --
Amortization of common stock acquired by stock benefit plans 146 164 637
Gain on sales of investment securities available for sale -- (1,133) (1,390)
Amortization of premium (37) (37) (37)
Decrease (increase) in other assets 1,034 (897) 675
(Decrease) increase in other liabilities (62) 660 (159)
------- ------- -------
Net cash used in operating activities (72) (1,403) (440)
------- ------- -------
Cash flows from investing activities:
Purchase of investments available for sale (62) -- (578)
Dividend from subsidiary -- 1,500 --
Proceeds from calls or repayments of investment securities -- -- 500
Proceeds from sale of investments available for sale -- 1,911 3,339
------- ------- -------
Net cash (used in) provided by investing activities (62) 3,411 3,261
------- ------- -------
Cash flows from financing activities:
Purchase of treasury stock -- (110) (1,339)
Common stock acquired by ESOP -- (72) (2,579)
Dividends paid (209) (810) (843)
Proceeds from exercise of stock options 47 656 566
------- ------- -------
Net cash used in financing activities (162) (336) (4,195)
------- ------- -------
Increase (decrease) in cash (296) 1,672 (1,374)
Cash at beginning of year 2,098 426 1,800
------- ------- -------
Cash at end of year $ 1,802 $ 2,098 $ 426
======= ======= =======
89
FIRST KEYSTONE FINANCIAL, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
18. QUARTERLY FINANCIAL DATA (UNAUDITED)
Unaudited quarterly financial data for the years ended September 30, 2006
and 2005 is as follows:
2006 2005
--------------------------------- ----------------------------------
1ST 2ND 3RD 4TH 1ST 2ND 3RD 4TH
QTR QTR QTR QTR QTR QTR QTR QTR
------ ------ ------ ------ ------ ------ ------- ------
Interest income $6,550 $6,696 $7,064 $7,183 $6,635 $6,779 $ 6,788 $6,875
Interest expense 3,770 3,868 4,222 4,555 3,815 3,818 3,963 4,173
------ ------ ------ ------ ------ ------ ------- ------
Net interest income 2,780 2,828 2,842 2,628 2,820 2,961 2,825 2,702
Provision for loan losses 45 525 81 555 45 45 1,645 45
------ ------ ------ ------ ------ ------ ------- ------
Net income after
provision for loan losses 2,735 2,303 2,761 2,073 2,775 2,916 1,180 2,657
Non-interest income 775 800 668 1,269 899 1,101 683 929
Non-interest expense 2,993 3,226 3,181 3,308 3,046 3,204 2,946 3,647(1)
------ ------ ------ ------ ------ ------ ------- ------
Income (loss) before income taxes 517 (123) 248 34 628 813 (1,083) (61)
Income tax expense (benefit) 72 (142) (19) (270) 105 175 (470) (123)
------ ------ ------ ------ ------ ------ ------- ------
Net income (loss) $ 445 $ 19 $ 267 $ 304 $ 523 $ 638 $ (613) $ 62
====== ====== ====== ====== ====== ====== ======= ======
Per Share:
Earnings per share - basic $ 0.24 $ 0.01 $ 0.14 $ 0.16 $ 0.29 $ 0.35 $ (0.33) $ 0.03
Earnings per share - diluted $ 0.23 $ 0.01 $ 0.14 $ 0.16 $ 0.28 $ 0.34 $ (0.32) $ 0.03
Dividend per share $ 0.11 -- -- -- $ 0.11 $ 0.11 $ 0.11 $ 0.11
- ----------
(1) As part of the deleveraging strategy, the Company repaid certain FHLB
advances resulting in a pre-tax prepayment penalty of $468.
Earnings per share are computed independently for each period presented.
Consequently, the sum of the quarters may not equal the total earnings per share
for the year.
Certain reclassifications have been made to the quarters presented to
conform to the presentation. Such reclassifications had no impact on the
reported net income.
19. SUBSEQUENT EVENT
The Company conducted a private placement of 400,000 shares of common stock
resulting in gross proceeds of approximately $6.5 million. The offering was
undertaken by the Company to strengthen its capital position in accordance with
a capital plan designed to maintain the Company's capital at prudent levels as
well as reduce its debt-to-equity ratio below 50%. The Company intends to use
all of the net proceeds, estimated to be $5.8 million, to redeem a portion of
its outstanding trust preferred securities in June 2007. The capital plan was
adopted by the Company in April 2006 pursuant to the supervisory agreement
between the Company and the OTS.
****
90
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES.
Not applicable.
ITEM 9-A. CONTROLS AND PROCEDURES.
Under the supervision and with the participation of the Company's
management, including its chief executive officer and chief financial officer,
the Company has evaluated the effectiveness of the design and operation of its
disclosure controls and procedures (as defined in Rule 13a-15(e) or 15d-15(e)
under the Exchange Act) as of September 30, 2006. Based on such evaluation, the
Company's chief executive officer and chief financial officer have concluded
that these controls and procedures are designed to ensure that the information
required to be disclosed by the Company in reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported within
the time periods specified in the SEC's rules and regulations and are operating
in an effective manner.
No change in the Company's internal control over financial reporting (as
defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during
the fourth fiscal quarter of fiscal 2006 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
ITEM 9-B. OTHER INFORMATION.
There is no information to be reported on Form 8-K during the fourth
quarter of fiscal 2006 that has not already been reported pursuant thereto.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein with respect to directors and executive
officers of the Company is incorporated by reference from the information
contained in the sections captioned "Information with Respect to Nominees for
Director, Continuing Directors and Executive Officers" and "Section 16(a)
Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy
Statement for the Annual Meeting of Stockholders currently expected (as of the
date hereof) to be held on February 7, 2007 (the "Proxy Statement"), a copy of
which will be filed with the SEC within 120 days of the end of the Company's
fiscal year.
The Company has adopted a Code of Conduct and Ethics that applies to its
principal executive officer and principal financial officer, principal
accounting officer as well as other officers and employees of the Company and
the Bank. A copy of the Code of Ethics was included as Exhibit 99.1 to the
Annual Report on Form 10-K for the year ended September 30, 2003 filed with the
SEC.
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from the
information contained in the sections captioned "Executive Compensation",
"Report of the Compensation Committee of the Bank" and "Performance Graph" in
the Registrant's Proxy Statement. The reports of the Audit Committee and the
Compensation Committee included in the Registrant's Proxy Statement should not
be deemed filed or incorporated into this filing or any other filing by the
Company under the Exchange Act or the Securities Act of 1933 except to the
extent the Company specifically incorporates said reports herein or therein by
reference thereto.
91
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The
information required herein is incorporated by reference from the information
contained in the section captioned "Beneficial Ownership of Common Stock by
Certain Beneficial Owners and Management" in the Registrant's Proxy Statement.
EQUITY COMPENSATION PLAN INFORMATION. The following table sets forth
certain information for all equity compensation plans and individual
compensation arrangements (whether with employees or non-employees, such as
directors) in effect as of September 30, 2006.
Number of Number of Shares
Shares to be Issued Remaining Available
Upon the Exercise of Weighted Average for Future Issuance
Outstanding Options, Exercise Price (Excluding Shares Reflected
Plan Category Warrants and Rights of Outstanding Options in the First Column)
------------- -------------------- ---------------------- ---------------------------
Equity Compensation Plans
Approved by Security Holders 61,447 $13.17 29,623
Equity Compensation Plans Not
Approved by Security Holders -- -- --
------ ------ ------
Total 61,447 $13.17 29,623
====== ====== ======
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from the
information contained in the section captioned "Indebtness of Management and
Related Party Transactions" in the Registrant's Proxy Statement.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES.
The information required herein is incorporated by reference from the
information contained in the section captioned "Ratification of Appointment of
Auditors" in the Registrant's Proxy Statement.
PART IV.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
(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 Item 8 hereof.
Report of Independent Registered Public Accounting Firm.
Consolidated Statements of Financial Condition at September 30,
2006 and 2005.
Consolidated Statements of Operations for the Years Ended
September 30, 2006, 2005 and 2004.
Consolidated Statements of Changes in Stockholders' Equity for
the Years Ended September 30, 2006, 2005 and 2004.
Consolidated Statements of Cash Flows for the Years Ended
September 30, 2006, 2005 and 2004.
Notes to the Consolidated Financial Statements.
92
(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.
No Description
- ----- -----------
3.1 Amended and Restated Articles of Incorporation of First Keystone
Financial, Inc. 1
3.2 Amended and Restated Bylaws of First Keystone Financial, Inc.
4.1 Specimen Stock Certificate of First Keystone Financial, Inc. 1
4.2 Instrument defining the rights of security holders **
10.1 Employment Agreement between First Keystone Financial, Inc. and Thomas
M. Kelly dated December 1, 2004 2,*
10.2 Severance Agreement between First Keystone Financial, Inc. and Elizabeth
M. Mulcahy dated December 1, 2004 2,*
10.3 Severance Agreement between First Keystone Financial, Inc. and Carol
Walsh dated December 1, 2004 2,*
10.4 1995 Stock Option Plan 3, *
10.5 1995 Recognition and Retention Plan and Trust Agreement 4,*
10.6 1998 Stock Option Plan 4, *
10.7 Employment Agreement between First Keystone Bank and Thomas M. Kelly
dated December 1, 2004 2, *
10.8 Severance Agreement between First Keystone Bank and Elizabeth M. Mulcahy
dated December 1, 2004 2, *
10.9 Severance Agreement between First Keystone Bank and Carol Walsh dated
December 1, 2004 2, *
10.10 First Keystone Bank Supplemental Executive Retirement Plan 5,*
10.11 Consulting Agreement between First Keystone Bank and Edmund Jones 6,*
10.12 Amendment No. 1 to the Employment Agreement between First Keystone
Financial, Inc. and Thomas M. Kelly 7,*
10.13 Amendment No. 1 to the Employment Agreement between First Keystone Bank
and Thomas M. Kelly 7,*
10.14 Transition, Consulting, Noncompetition and Retirement Agreement by and
between First Keystone Financial, Inc., First Keystone Bank and Donald
S. Guthrie 8,*
10.15 Confidentiality Agreement between First Keystone Bank and Marshall Soss
and KarMar Realty Group*
10.16 Letter dated December 11, 2006 with respect to appointment to Board 9
10.17 Form of Registration Rights Agreement
11 Statement re: computation of per share earnings. See Note 2 to the
Consolidated Financial Statements included in Item 8 hereof
23 Consent of independent registered accounting firm
31.1 Section 302 Certification of Chief Executive Officer
31.2 Section 302 Certification of Chief Financial Officer
32.1 Certification of Chief Executive Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
99.1 Codes of Ethics 10
99.2 Supervisory Agreement between First Keystone Financial, Inc. and the
Office of Thrift Supervision dated February 13, 2006. 11
99.3 Supervisory Agreement between First Keystone Bank and the Office of
Thrift Supervision dated February 13, 2006. 11
93
- ----------
(1) Incorporated by reference from the Registration Statement on Form S-1
(Registration No. 33-84824) filed by the Registrant with the SEC on October
6, 1994, as amended.
(2) Incorporated by reference from Exhibits 10.5, 10.6, 10.8, 10.14, 10.15 and
10.16, respectively, in the Form 8-K filed by the Registrant with the SEC
on December 7, 2004 (File No. 000-25328).
(3) Incorporated by reference from Exhibit 10.9 in the Form 10-K filed by the
Registrant with SEC on December 29, 1995 (File No. 000-25328).
(4) Incorporated from Appendix A of the Registrant's definitive proxy statement
dated December 24, 1998 (File No. 000-25328).
(5) Incorporated by reference from Exhibit 10.17 in the Form 10-Q filed by the
Registrant with the SEC on May 17, 2004.
(6) Incorporated by reference from Exhibit 10.18 in the Form 10-K filed by the
Registrant with the SEC on December 29, 2004.
(7) Incorporated by reference from Exhibits 10.19 and 10.20, respectively, in
the Form 8-K filed by the Registrant with the SEC on March 29, 2005.
(8) Incorporated by reference from Exhibit 10.21 in the Form 8-K filed by the
Registrant with the SEC on March 29, 2005.
(9) Incorporated by reference from Exhibit 10.1 in the Form 8-K filed by the
Registrant with the SEC on December 20, 2006.
(10) Incorporated by reference from the Form 10-K filed by the Registrant with
the SEC on December 23, 2003.
(11) Incorporated by reference from the Form 10-Q for the quarter ended December
31, 2005 filed by the Registrant with the SEC on February 14, 2006.
(*) Consists of a management contract or compensatory plan
(**) The Company has no instruments defining the rights of holders of long-term
debt where the amount of securities authorized under such instrument
exceeds 10% of the total assets of the Company and its subsidiaries on a
consolidated basis. The Company hereby agrees to furnish a copy of any such
instrument to the SEC upon request.
(b) Exhibits
The exhibits listed under (a)(3) of this Item 15 are filed herewith.
(c) Reference is made to (a)(2) of this Item 15.
94
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/ Thomas M. Kelly
------------------------------------
Thomas M. Kelly
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 28, 2006
- ----------------------------------------
Donald S. Guthrie
Chairman of the Board
/s/ Thomas M. Kelly December 28, 2006
- ----------------------------------------
Thomas M. Kelly
President and Chief Executive Officer
(Principal Executive Officer)
/s/ Edmund Jones December 28, 2006
- ----------------------------------------
Edmund Jones
Director
/s/ Donald G. Hosier, Jr. December 28, 2006
- ----------------------------------------
Donald G. Hosier, Jr.
Director
/s/ Marshall J. Soss December 28, 2006
- ----------------------------------------
Marshall J. Soss
Director
/s/ William J. O'Donnell December 28, 2006
- ----------------------------------------
William J. O'Donnell
Director
/s/ Bruce C. Hendrixson December 28, 2006
- ----------------------------------------
Bruce C. Hendrixson
Director
/s/ Jerry A. Naessens December 28, 2006
- ----------------------------------------
Jerry A. Naessens
Director
/s/ Rose M. DiMarco December 28, 2006
- ----------------------------------------
Rose M. DiMarco
Senior Vice President and Chief
Financial Officer (Principal Financial
and Accounting Officer)
95