1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED SEPTEMBER 30, 1999 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 0-25328 FIRST KEYSTONE FINANCIAL, INC. (Exact name of registrant as specified in its charter) Pennsylvania 23-0469351 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 22 West State Street Media, Pennsylvania 19063 (Address of principal executive office) (Zip Code) Registrant's telephone number, including area code: (610) 565-6210 Securities registered pursuant to Section 12(b) of the Act: NOT APPLICABLE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK (PAR VALUE $.01 PER SHARE) Indicate by check mark whether the Registrant (1) has filed all reports required by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. X --- As of December 15, 1999 the aggregate value of the 1,897,005 shares of Common Stock of the Registrant issued and outstanding on such date, which excludes 354,711 shares held by all directors and officers of the Registrant as a group, was approximately $17.5 million. This figure is based on the last known trade price of $9.25 per share of the Registrant's Common stock on December 15, 1999. Number of shares of Common Stock outstanding as of December 15, 1999: 2,251,716 DOCUMENTS INCORPORATED BY REFERENCE List hereunder the following documents incorporated by reference and the Part of the Form 10-K into which the document is incorporated: (1) Portions of the Annual Report to Stockholders for the fiscal year ended September 30, 1999 are incorporated into Parts II and III. (2) Portions of the definitive proxy statement for the Annual Meeting of Stockholders are incorporated into Part III. 2 PART I. Item 1. BUSINESS GENERAL First Keystone Financial, Inc. (the "Company") is a Pennsylvania corporation and sole shareholder of First Keystone Federal Savings Bank (the "Bank") which converted to the stock form of organization in January 1995. The only significant assets of the Company are the capital stock of the Bank, the Company's loans to its employee stock ownership plan, and various equity and other investments. See Note 19 of the Notes to Consolidated Financial Statements in the Annual Report to Stockholders for the year ended September 30, 1999 set forth as Exhibit 13 hereto ("Annual Report"). The business of the Company primarily consists of the business of the Bank. The Bank is a traditional, community oriented federal savings bank emphasizing customer service and convenience. The Bank's primary business is to attract deposits from the general public and invest those funds together with other available sources of funds, primarily borrowings, to originate loans. A substantial portion of the Bank's deposits are comprised of core deposits consisting of passbook, money market("MMDA"), NOW and noninterest-bearing accounts which amounted to $101.1 million or 38.7% of the Bank's total deposits at September 30, 1999. The Bank's primary lending emphasis has been loans secured by first and second liens on single-family (one-to-four units) residences located in Delaware and Chester Counties, Pennsylvania and to a lesser degree, Montgomery County, Pennsylvania and New Castle County, Delaware. The Bank originates these first mortgage loans for resale into the secondary market while retaining for its portfolio adjustable-rate mortgage loans and fixed-rate loans that complement the Bank's asset/liability strategies. The Bank also originates, due to their shorter terms, adjustable or variable interest rates, higher yields, and as a result of the Bank's analysis that the markets have become more stable, loans secured by commercial and residential multi-family real estate properties as well as residential and commercial construction loans secured by properties located in the Bank's market area. The Bank's originations of commercial, construction and multi-family loans has continued to increase as a direct result of the Bank's emphasis on developing business loan products. Multi-family and commercial real estate loans amounted to $31.2 million or 13.1% of the total loan portfolio at September 30, 1999 as compared to $20.6 million or 9.9% at September 30, 1998. The Bank also originates for sale, servicing released, in the secondary market, single-family residences secured by first and second mortgages with respect to non-conforming jumbo loans and sub-prime loans to credit impaired borrowers. The Bank also purchases loan participation interests depending on market conditions and portfolio needs. To a lesser extent, the Bank also originates consumer loans (consisting almost entirely of home equity loans and lines of credit) and other mortgage loans. In addition to its deposit gathering and lending activities, the Bank invests in mortgage-related securities, substantially all of which are issued or guaranteed by U.S. Government agencies and government sponsored enterprises, as well as U.S. Treasury and federal government agency obligations and municipal obligations. At September 30, 1999, the Bank's mortgage-related securities (including mortgage-related securities available for sale) amounted to $127.5 million, or 28.3% of the Company's total assets, and investment securities available for sale amounted to $44.3 million, or 9. 8% of total assets. 3 MARKET AREA The Bank's primary market area consists of Delaware and Southern Chester Counties and to a lesser extent the contiguous counties of Montgomery and Northern Chester Counties, Pennsylvania and New Castle County, Delaware. Delaware County is part of the Philadelphia Primary Metropolitan Statistical Area ("PMSA") which includes besides Delaware County, Bucks, Chester, Montgomery and Philadelphia Counties (as well as four counties in New Jersey). The Philadelphia area economy is typical of many large northeast and midwest cities where the traditional manufacturing based economy has declined to a certain degree and has been replaced with service sector and specialty area growth. As a result of such growth, the Philadelphia PMSA's economic diversity has broadened and employment in the area is derived from a number of different employment sectors. In particular, Delaware County has experienced the development of companies providing products and services for the health care market such as Crozer/Keystone Health System, Wyeth-Ayerst Labs, Inc. and Mercy Health Corp. Philadelphia's central location in the northeast corridor, its well-educated and skilled population base, infrastructure and other factors has made the Bank's market area attractive to many large corporate employers. Such employers include Comcast Corp., Boeing, State Farm Insurance, Unisys Corp., ARCO Chemical Company, PECO Energy, SAP America, Inc., and many others. There are over seventy-five Fortune 1,000 companies maintaining a presence in this area and approximately twenty Fortune 500 companies headquartered in the region surrounding the Philadelphia PMSA including CIGNA Corp., E.I. duPont de Nemours, Bethlehem Steel, Ikon Office Solutions, Sun Company, Crown Cork & Seal and others. Delaware County has experienced slower population growth than the Philadelphia PMSA, although the growth rates in the outlying areas of Delaware County have exceeded that of the Philadelphia PMSA. Since 1990, there has been no population growth in Delaware County and it is expected to increase by less than 1 percent over the next 20 years. Chester County, on the other hand, has grown over 11% since 1990 and expected to increase further through the millennium. By comparison, median household income in Delaware County and Chester County is approximately $42,300 and $55,100, respectively, both of which are near or more than the Philadelphia PMSA median of approximately $26,900 (1996 estimates). Likewise, median home values in Delaware and Chester Counties were approximately $113,200 and $155,900, respectively, as compared to approximately $112,000 for the Philadelphia PMSA in 1990. Unemployment rates in Delaware County have been below those experienced by the Philadelphia PMSA but higher than some of the other counties comprising the PMSA. The average annual unemployment rate (not seasonally adjusted) for 1999 through October was 3.6% in Delaware County and 2.5% in Chester County as compared to 4.1% for the Philadelphia PMSA. 2 4 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, --------------------------------------------------------------------------------- 1999 1998 1997 1996 ------------------ ------------------ ------------------ ------------------ Amount % Amount % Amount % Amount % -------- ------- -------- ------- -------- ------- -------- ------- (Dollars in thousands) Real estate loans: Single-family $166,802 69.82% $148,088 71.34% $135,168 68.53% $122,270 68.68% Multi-family and commercial 31,188 13.05 20,563 9.91 18,305 9.28 11,129 6.25 Construction and land 18,426 7.71 15,858 7.64 16,400 8.31 17,682 9.93 -------- ------ -------- ------ -------- ------ -------- ------ Total real estate loans 216,416 90.58 184,509 88.89 169,873 86.12 151,081 84.86 -------- ------ -------- ------ -------- ------ -------- ------ Consumer: Home equity loans and lines of credit 18,624 7.80 19,609 9.45 22,964 11.64 20,444 11.48 Deposit 243 .10 181 .09 348 .18 457 .26 Education 365 .15 449 .21 365 .19 917 .52 Other (1) 1,080 .45 1,429 .69 1,690 .86 2,212 1.24 -------- ------ -------- ------ -------- ------ -------- ------ Total consumer loans 20,312 8.50 21,668 10.44 25,367 12.87 24,030 13.50 -------- ------ -------- ------ -------- ------ -------- ------ Commercial business loans 2,190 .92 1,390 .67 2,000 1.01 2,923 1.64 -------- ------ -------- ------ -------- ------ -------- ------ Total loans receivable (2) 238,918 100.00% 207,567 100.00% 197,240 100.00% 178,034 100.00% -------- ====== -------- ====== -------- ====== -------- ====== Less: Loans in process (construction and land) 9,005 5,781 5,670 6,368 Deferred loan origination fees and discounts 1,610 1,705 1,653 1,512 Allowance for loan losses 1,928 1,738 1,628 2,624 -------- -------- -------- -------- 12,543 9,224 8,951 10,504 -------- -------- -------- -------- Total loans receivable, net $226,375 $198,343 $188,289 $167,530 ======== ======== ======== ======== September 30, ------------------ 1995 ------------------ Amount % -------- ------- (Dollars in thousands) Real estate loans: Single-family $115,225 69.01% Multi-family and commercial 11,789 7.06 Construction and land 16,343 9.79 -------- ------ Total real estate loans 143,357 85.86 -------- ------ Consumer: Home equity loans and lines of credit 18,229 10.92 Deposit 350 .21 Education 1,010 .60 Other (1) 1,491 .89 -------- ------ Total consumer loans 21,080 12.62 -------- ------ Commercial business loans 2,533 1.52 -------- ------ Total loans receivable (2) 166,970 100.00% -------- ====== Less: Loans in process (construction and land) 6,070 Deferred loan origination fees and discounts 1,411 Allowance for loan losses 1,487 -------- 8,968 -------- Total loans receivable, net $158,002 ======== - ----------------------------- (1) Consists primarily of credit cards and consumer lease receivables. (2) Does not include $1.8 million, $2.8 million, $4.6 million, $2.4 million, and $57,000 of loans held for sale at September 30, 1999, 1998, 1997, 1996, and 1995, respectively. 3 5 Contractual Principal Repayments. The following table sets forth the scheduled contractual maturities of the Bank's loans held to maturity at September 30, 1999. Demand loans, loans having no stated schedule of repayments and no stated maturity and overdraft loans are reported as due in one year or less. The amounts shown for each period do not take into account loan prepayments and normal amortization of the Bank's loan portfolio held to maturity. Real Estate Loans ------------------------------------------------------ Multi-family Consumer and and Construction Commercial Single-family Commercial and Land Total Business Loans Total ------------- ---------- -------- ----- -------------- ----- (In thousands) Amounts due in: One year or less $ 7,037 $ 2,275 $18,426 $ 27,738 $ 5,255 $ 32,993 After one year through three years 12,580 6,287 18,867 4,614 23,481 After three years through five years 12,551 10,147 22,698 3,380 26,078 After five years through ten years 33,599 10,344 43,943 5,743 49,686 After ten years through twenty years 34,120 1,117 35,237 2,050 37,287 Over twenty years 66,915 1,018 67,933 1,460 69,393 -------- ------- ------- -------- ------- -------- Total(1) $166,802 $31,188 $18,426 $216,416 $22,502 $238,918 ======== ======= ======= ======== ======= ======== Interest rate terms on amounts due after one year: Fixed $146,625 $15,249 $161,874 Adjustable 42,053 1,998 44,051 -------- ------- -------- Total(1) $188,678 $17,247 $205,925 ======== ======= ======== - ----------------------------- (1) Does not include adjustments relating to loans in process, allowances for loan losses and deferred fee income. 4 6 Scheduled contractual amortization of loans does not reflect the expected term of the Bank's loan portfolio. The average life of loans is substantially less than their contractual terms because of prepayments and due-on-sale clauses, which give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are higher than rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans are lower than current mortgage loan rates (due to refinancings of adjustable-rate and fixed-rate loans at lower rates). Under the latter circumstances, the weighted average yield on loans decreases as higher yielding loans are repaid or refinanced at lower rates. Loan Origination, Purchase and Sales Activity. The following table shows the loan origination, purchase and sale activity of the Bank during the periods indicated. Year Ended September 30, --------------------------------------- 1999 1998 1997 --------- --------- --------- (In thousands) Gross loans at beginning of period(1) $ 210,366 $ 201,817 $ 180,491 --------- --------- --------- Loan originations for investment: Real estate: Residential 49,970 39,226 18,016 Commercial and multi-family 18,031 3,578 8,458 Construction 22,313 14,662 16,298 --------- --------- --------- Total real estate loans originated for investment 90,314 57,466 42,772 Consumer 7,309 4,819 8,859 Commercial business 3,594 4,231 2,755 --------- --------- --------- Total loans originated for investment 101,217 66,516 54,386 Loans originated for resale 46,199 56,398 37,209 --------- --------- --------- Total originations 147,416 122,914 91,595 --------- --------- --------- Deduct: Principal loan repayments and prepayments (68,549) (55,982) (34,779) Transferred to real estate owned (1,317) (207) (411) Loans sold in secondary market (47,206) (58,176) (35,079) --------- --------- --------- Subtotal 117,072 114,365 70,269 --------- --------- --------- Net increase in loans(1) 30,344 8,549 21,326 --------- --------- --------- Gross loans at end of period(1) $ 240,710 $ 210,366 $ 201,817 ========= ========= ========= - ------------------------------ (1) Includes loans held for sale of $1.8 million, $2.8 million, and $4.6 million at September 30, 1999, 1998 and 1997, respectively. 5 7 The lending activities of the Bank are subject to written underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. Applications for all types of loans are taken at all of the Bank's branch offices by the branch manager or other designated loan officers. Applications for single-family residential mortgage loans for portfolio retention also are obtained through loan originators who are employees of the Bank. The Bank's loan originators will take loan applications outside of the Bank's offices at the customer's convenience and are compensated on a commission basis. The Mortgage Lending Department supervises the process of obtaining credit reports, appraisals and other documentation involved with a loan. The Bank generally requires that a property appraisal be obtained in connection with all new mortgage loans. Property appraisals generally are performed by an independent appraiser from a list approved by the Bank's Board of Directors. The Bank requires that title insurance (other than with respect to home equity loans) and hazard insurance be maintained on all security properties and that flood insurance be maintained if the property is within a designated flood plain. Residential mortgage loan applications are primarily developed from referrals from real estate brokers and builders, existing customers and walk-in customers. Residential mortgage loans also are originated through correspondents. Commercial and multi-family real estate loan applications are obtained primarily from previous borrowers, direct solicitations by Bank personnel, as well as referrals. Consumer loans originated by the Bank are obtained primarily through existing and walk-in customers who have been made aware of the Bank's programs by advertising and other means. Applications for single-family residential mortgage loans which are originated for resale in the secondary market or loans designated for portfolio retention that conform to the requirements for resale into the secondary market and do not exceed Fannie Mae ("FNMA")/Freddie Mac ("FHLMC") limits are approved by the Bank's Chief Lending Officer or in his absence, by the Senior Loan Underwriter or Loan Committee (a committee comprised of four directors and the Bank's Chief Lending Officer). All other first mortgage loans (commercial and multi-family residential real estate and construction loans) and residential mortgage loans in excess of FNMA/FHLMC maximum amounts (currently $240,000) but less than $1.0 million must be approved by the Loan Committee. All first mortgage loans in excess of $1.0 million must be approved by the Bank's Board of Directors or the Executive Committee thereof. All mortgage loans which do not require approval by the Board of Directors are submitted to the Board at its next meeting for review and ratification. Home equity loans and lines of credit up to $100,000 can be approved by the Chief Lending Officer, the Vice President of Construction Loans or the Administrative Vice President of Mortgage Lending. Loans in excess of such amount must be approved by the Loan Committee. Applications for non-conforming and sub-prime residential real estate loans, submitted by correspondents and sold servicing released into the secondary market, are packaged and submitted for pre-approval to the buyer prior to closing. The Bank, on occasion will originate non-conforming loans in accordance with the buyers' underwriting standards and sells them in bulk to such buyers. See "- Mortgage Banking Activities." Single-Family Residential Loans. Substantially all of the Bank's single-family residential mortgage loans consist of conventional loans. Conventional loans are loans that are neither insured by the Federal Housing Administration or partially guaranteed by the Department of Veterans Affairs. The vast majority of the Bank's single-family residential mortgage loans are secured by properties located in Pennsylvania, primarily in Delaware and Chester Counties, and are originated under terms and documentation which permit their sale to the FHLMC or FNMA. The Bank, consistent with its asset/liability management strategies, sells some of its newly originated longer term fixed-rate residential mortgage loans and to a limited degree, existing longer term fixed-rate residential mortgage loans while retaining adjustable-rate mortgage loans and shorter term fixed-rate residential mortgage loans. See "- Mortgage-Banking Activities." The single-family residential mortgage loans offered by the Bank currently consist of fixed-rate loans, including bi-weekly and balloon loans, and adjustable-rate loans. Fixed-rate loans generally have maturities ranging from 15 to 30 years and are fully amortizing with monthly loan payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank's fixed-rate loans are originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies, such as the FHLMC and the FNMA, and other investors 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 6 8 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 to-be-determined rate for the remaining 25 or 23 years, respectively, of the amortization period. At September 30, 1999, $134.2 million, or 56.2%, of the Bank's single-family residential mortgage loans held in portfolio were fixed-rate loans, including $29.0 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 or three years in accordance with a designated index, such as U.S. Treasury obligations, adjusted to a constant maturity ("CMT"), plus a stipulated margin. The Bank's adjustable-rate single-family residential real estate loans generally have a cap of 2% on any increase or decrease in the interest rate at any adjustment date, and a cap of 6% over the life of the loan. In order to increase acceptance of adjustable-rate loans, the Bank recently has been originating loans which are fixed for a period of one to three 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, or so-called negative amortization. Although the Bank does offer adjustable-rate loans with initial rates below the fully indexed rate, such loans are underwritten using methods approved by FHLMC and FNMA which requires borrowers to be qualified at 2% above the discounted loan rate under certain conditions. At September 30, 1999, $43.3 million or 29.2% of the Bank's single-family residential mortgage loans held for portfolio were adjustable-rate loans. Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because as interest rates increase the loan payment by the borrower increases to the extent permitted by the terms of the loan, thereby increasing the potential for default. 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 because of the generally stable interest rate environment in recent years, generally are less than the risks associated with holding fixed-rate loans in an increasing interest rate environment. For conventional residential mortgage loans held in portfolio and also for those loans originated for sale in the secondary market, the Bank's maximum loan-to-value ("LTV") ratio is 97%, and is based on the lesser of sales price or appraised value. On most loans with a LTV ratio of over 80%, private mortgage insurance is required to be obtained. Commercial and Multi-Family Residential Real Estate Loans. The Bank has moderately increased its investment in commercial and multi-family lending. Such loans are being extended primarily to small and medium-sized businesses located in the Bank's primary market area, a portion of the market that the Bank believes has been underserved in recent years. Loans secured by commercial and multi-family real estate amounted to $31.2 million, or 13.1%, of the Bank's total loan portfolio, at September 30, 1999. 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 one-year or three-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 are also originated. Generally, fees of 1% to 3% of the principal loan balance are charged to the borrower upon closing. Although terms for multi-family residential and commercial real estate loans may vary, the Bank's underwriting standards generally provide for terms of up to 25 years with amortization of principal over the term of the loan and loan-to-value 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 also 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 7 9 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 Member of the Appraisal Institute ("MAI") qualified) 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 Bank 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 can also be significantly affected by supply and demand conditions in the local market for apartments, offices, warehouses or other commercial space. The Bank attempts to minimize its risk exposure by limiting such lending to proven developers/owners, only considering properties with existing operating performance which can be analyzed, requiring conservative debt coverage ratios, and periodically monitoring the operation and physical condition of the collateral. Construction Loans. Substantially all of the Bank's construction loans consist of loans to construct single-family properties extended either to individuals or to selected developers with whom the Bank is familiar to build such properties on a pre-sold or limited speculative basis. To a lesser extent, the Bank provides financing for construction to permanent commercial loan properties. The loan converts to permanent commercial term loan upon completion of construction. With respect to construction loans to individuals, such loans have a maximum term of six months, have variable rates of interest based upon the prime rate published in the Wall Street Journal plus a margin and have loan-to-value ratio of 80% or less of the appraised value upon completion and generally do not require the amortization of principal during the term. Upon completion of construction, the loans convert to permanent residential mortgage loans. Commercial construction loans have a maximum term of 12 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 70% or less of the appraised value upon completion. The loans convert to permanent commercial term loans upon completion of construction. The Bank also provides construction loans and lines of credit to developers. The majority of construction loans consist of loans to selected local developers with whom the Bank is familiar to 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 which a developer may have under construction in a project. Such loans generally have terms of 24 to 36 months or less, have maximum loan-to-value ratios of 75% of the appraised value upon completion and generally do not require the amortization of the principal during the term. The loans are made with floating rates of interest based on the Prime Rate plus a margin adjusted on a monthly basis. The Bank also receives origination fees which generally range from 1.0% to 3.0% of the commitment. The borrower is required to fund a portion of the project's costs, the exact amount being determined on a case-by-case basis. Loan proceeds are disbursed in stages after inspections of the project indicate that such disbursements are for costs already incurred and which have added to the value of the project. Only interest payments are due during the construction phase and the Bank may provide the borrower with an interest reserve from which it can pay the stated interest due thereon. The Bank's construction loans include loans to developers to acquire the necessary land, develop the site and construct the residential units ("ADC loans"). At September 30, 1999, residential construction loans totaled $13.6 million, or 5.7%, of the total loan portfolio, which primarily consisted of construction loans to developers. At September 30, 1999, commercial construction loans totaled $585,000, or .25% of the total loan portfolio. The Bank also will originate ground or land loans, both to individuals to purchase a building lot on which he intends to build his primary residence, as well as to developers to purchase lots to build speculative homes at a later date. Such loans have terms of 36 months or less with a maximum loan-to-value ratio of 75% of the lower of appraised value or sale price. The loans are made with floating 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, 1999, land loans (including loans to acquire and develop land) totaled $4.2 million or 1.8% of the total loan portfolio. 8 10 Loans to developers include both secured and unsecured lines of credit with outstanding commitments totaling $800,000. All have personal guaranties of the principals and are cross-collateralized with existing loans. Loans outstanding under builder lines of credit totaled $592,000, or .25% of the total loan portfolio at September 30, 1999. These loans were unsecured and given only to the Bank's most creditworthy and long standing customers. Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property by an independent state-licensed and qualified 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 is generally 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, environmental or other restrictions on future use. Consumer Lending Activities. The Bank offers consumer loans in order to provide a full range of retail financial services to its customers. At September 30, 1999, $20.3 million, or 8.5%, of the Bank's total loan portfolio was comprised of consumer loans. The Bank originates substantially all of such loans in its primary market area. The largest component of the Bank's consumer loan portfolio consists of home equity loans and home equity lines of credit (a form of revolving credit), both of which are secured by the underlying equity in the borrower's primary residence. Home equity loans are amortizing loans with fixed interest rates and maximum terms of 15 years while equity lines of credit have adjustable interest rates indexed to the Prime Rate. Generally home equity loans or home equity lines do not exceed $100,000. The Bank's home equity loans and lines of credit generally require combined loan-to-value ratios of 80% or less. Loans with higher LTV are available but with higher interest rates and stricter credit standards. At September 30, 1999, home equity loans and lines of credit amounted to $18.6 million, or 7.8%, of the Bank's total loan portfolio. At September 30, 1999, the remaining portion of the Bank's consumer loan portfolio was comprised of education, deposit and other consumer loans. At September 30, 1999, the Bank had $365,000 or .15% of the total loan portfolio invested in education loans, all of which were underwritten to conform with the standards of the Pennsylvania Higher Education Agency. Deposit loans and other consumer loans (including credit card loans) totaled $1.3 million, or .55%, of the Bank's total loan portfolio at September 30, 1999. In April 1995, the Bank introduced its own credit card program. The credit cards were offered to only the Bank's most creditworthy customers. At September 30, 1999, these loans totaled $574,000 or .24% of the total loan portfolio. Consumer loans also included certain consumer leases totaling $507,000 purchased from a leasing company. Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral and, in certain cases, the absence of collateral. These risks are not as prevalent in the case of the Bank's consumer loan portfolio, however, because a high percentage of the portfolio is comprised of home equity loans and home equity lines of credit which are secured by real estate and underwritten in a manner such that they result in a lending risk which is substantially similar to single-family residential loans. Commercial Business Loans. The Bank grants commercial business loans directly to business enterprises that are located in its market area. The Bank actively targets and markets to small and medium sized businesses. The majority of the loans are for less than $1.0 million. 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 lenders. As of September 30, 1999, commercial business loans amounted to $2.2 million or .92% of the Bank's total loan portfolio. 9 11 The commercial business loans consist of a limited number of commercial lines of credit secured by real estate, some working capital financing 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 and adjustable rates tied to the Prime Rate plus a margin. Such loans are generally secured by real estate, receivables, equipment or inventory and are generally backed by personal guarantees of the borrower. Although commercial business loans generally are considered to involve increased credit risk than other certain types of loans, management intends to offer commercial business loans to small, medium sized businesses in an effort to better serve our community's needs, obtain core noninterest-bearing deposits and increase the Bank's interest rate spread. Mortgage-Banking Activities. Due to customer preference for fixed-rate loans, especially during the declining mortgage interest rate environment in early 1999 and 1998 and the stable interest rate environment in 1997, the Bank has continued to originate fixed-rate loans. Long-term, generally 30 years, fixed-rate loans not taken into portfolio for asset/liability purposes are sold into the secondary market. In addition, the Bank has developed for sale in the secondary market non-conforming (loans not conforming to FHLMC/FNMA underwriting guidelines) and impaired credit loans. The Bank's net gain on sales of mortgage loans amounted to $325,000, $526,000, and $285,000 during the years ended September 30, 1999, 1998 and 1997, respectively. Although originations of sub-prime loans have slowed from the record level in 1998, the Bank continues to focus on market penetration for this type of product. The Bank had $1.8 million and $2.8 million of mortgage loans held for sale at September 30, 1999 and 1998, respectively. The Bank's conforming mortgage loans sold to others are sold, generally with servicing retained, on a loan-by-loan basis primarily to the FHLMC and the FNMA. A period of less than five days generally elapses between the closing of the loan by the Bank and its purchase by the investor. Mortgages with established interest rates generally will decrease in value during periods of increasing interest rates. Accordingly, fluctuations in prevailing interest rates may result in a gain or loss to the Bank as a result of adjustments to the carrying value of loans held for sale or upon sale of loans. The Bank attempts to protect itself from these market fluctuations through the use of forward commitments at the time of the commitment by the Bank of a loan rate to the borrower. These commitments are mandatory delivery contracts with FHLMC and FNMA within a certain time frame and within certain dollar amounts by a price determined at the commitment date. Market risk does exist as non-refundable points paid by the borrower may not be sufficient to offset fees associated with closing the forward commitment contract. Non-conforming mortgage loans sold to others are sold, servicing released, on a loan-by-loan basis and are generally pre-approved by the buyer prior to closing the loan with the borrower. Borrowers are generally charged an origination fee, which is a percentage of the principal balance of the loan. In accordance with the provisions of Statement of Financial Accounting Standards ("SFAS") No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases," the various fees received by the Bank in connection with the origination of loans are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. However, when such loans are sold, the remaining unamortized fees (which is all or substantially all of such fees due to the relatively short period during which such loans are held) are recognized 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 which it retains in portfolio. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, making advances to cover delinquent payments, making inspections as required of mortgaged premises, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults and generally administering the loans. Funds that have been escrowed by borrowers for the payment of mortgage-related expenses, such as property taxes and hazard and mortgage insurance premiums, are maintained in noninterest-bearing accounts at the Bank. 10 12 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, ---------------------------------- 1999 1998 1997 -------- -------- -------- (In thousands) Loans originated by the Bank and serviced for: FNMA $ 2,752 $ 3,796 $ 5,228 FHLMC 74,031 92,065 108,895 Others 403 414 431 -------- -------- -------- Total loans serviced for others $ 77,186 $ 96,275 $114,554 ======== ======== ======== The Bank receives fees for servicing mortgage loans, which generally amount to 0.25% per annum on the declining principal balance of mortgage loans. Such fees serve to compensate the Bank for the costs of performing the servicing function. Other sources of loan servicing revenues include late charges. For years ended September 30, 1999, 1998 and 1997, the Bank earned gross fees of $205,000, $246,000 and $293,000, respectively, from loan servicing. The Bank retains a portion of funds received from borrowers on the loans it services for others in payment of its servicing fees received on loans serviced for others. Loans-to-One Borrower Limitations. Regulations impose limitations on the aggregate amount of loans that a savings institution could make to any one borrower, including related entities. Under such regulations, the permissible amount of loans-to-one borrower follows the national bank standard for all loans made by savings institutions, which generally does not permit loans-to-one borrower to exceed 15% of unimpaired capital and surplus. Loans in an amount equal to an additional 10% of unimpaired capital and surplus also may be made to a borrower if the loans are fully secured by readily marketable securities. At September 30, 1999, the Bank's five largest loans or groups of loans-to-one borrower, including related entities, ranged from an aggregate of $2.2 million to $3.2 million, and the Bank's loans-to-one borrower limit was $5.3 million at such date. ASSET QUALITY General. As a part of the Bank's efforts to improve its asset quality, it has developed and implemented an asset classification system. All of the Bank's assets are subject to review under the classification system, but particular emphasis is placed on the review of multi-family residential and commercial real estate loans, construction loans and commercial business loans. All assets of the Bank are periodically reviewed and the classification recommendations submitted to the Asset Classification Committee at least monthly. The Asset Classification Committee is composed of the President and Chief Executive Officer, the Chief Financial Officer, the Vice President of Loan Administration, the Internal Auditor and the Vice President of Construction Lending. All assets are placed into one of the four following categories: Pass, Substandard, Doubtful and Loss. The criteria used to review and establish each asset's classification are substantially identical to the asset classification system used by the Office of Thrift Supervision (the "OTS") in connection with the examination process. As of September 30, 1999, the Bank did not have any assets which it had classified as doubtful or loss. See "- Non-Performing Assets" and "- Other Classified Assets" for a discussion of certain of the Bank's assets which have been classified as substandard and regulatory classification standards generally. When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made 30 days after a payment is due. In most cases, deficiencies are cured promptly. If a delinquency continues, late charges are assessed and additional efforts are made 11 13 to collect the loan. While the Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 90 days delinquent, the Bank institutes foreclosure or other proceedings, as necessary, to minimize any potential loss. Loans are placed on non-accrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on non-accrual status, previously accrued but unpaid interest is deducted from interest income. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more. See Note 2 of the Notes to Consolidated Financial Statements included in the Company's Annual Report. Real estate acquired by the Bank as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until sold. Real estate owned is initially recorded at the lower of fair value less estimated costs to sell the property, or cost (generally the balance of the loan on the property at the date of acquisition). After the date of acquisition, all costs incurred in maintaining the property are expenses and costs incurred for the improvement or development of such property are capitalized up to the extent of their net realizable value. Under generally accepted accounting principles ("GAAP"), the Bank is required to account for certain loan modifications or restructuring as "troubled debt restructuring." 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 do not necessarily result in non-accrual loans. 12 14 Delinquent Loans. The following table sets forth information concerning delinquent loans at the dates indicated, in dollar amounts and as a percentage of each category of the Bank's loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due. September 30, 1999 September 30, 1998 ------------------------------------- ------------------------------------- 30-59 Days 60-89 Days 30-59 Days 60-89 Days ----------------- ----------------- ----------------- ----------------- Percent Percent Percent Percent of of of of Loan Loan Loan Loan Amount Category Amount Category Amount Category Amount Category ------ -------- ------ -------- ------ -------- ------ -------- (Dollars in thousands) Real estate loans: Single-family residential $704 .42% $442 .27% $557 .38% $98 .07% Construction 86 .54% 39 .25 Consumer loans 10 .05 23 .11 1 10 .05 Commercial business loans 1 .05 1 .07 ---- ---- ---- ---- Total $715 .30% $465 .19% $645 .31% $147 .07% ==== === ==== === ==== === ==== === 13 15 Non-Performing Assets. The following table sets forth the amounts and categories of the Bank's non-performing assets and troubled debt restructurings at the dates indicated. September 30, ------------------------------------------------------ 1999 1998 1997 1996 1995 ------ ------ ------ ------ ------ (Dollars in thousands) Non-performing loans: Single-family residential $2,312 $2,341 $1,661 $1,466 $1,986 Commercial and multi- family(1) 289 323 22 55 22 Construction(2) 556 895 275 888 Consumer 16 43 14 1,666 2 Commercial business 6 83 100 2,165 258 ------ ------ ------ ------ ------ Total non-performing loans 3,179 3,685 2,072 5,352 3,156 ------ ------ ------ ------ ------ Accruing loans greater than 90 days delinquent 1 19 5 ------ ------ ------ ------ ------ Total non-performing loans 3,180 3,704 2,077 5,352 3,156 ------ ------ ------ ------ ------ REO 297 1,663 1,672 1,557 465 ------ ------ ------ ------ ------ Total non-performing assets $3,477 $5,367 $3,749 $6,909 $3,621 ====== ====== ====== ====== ====== Troubled debt restructurings (3) $ 24 $ 46 $ 384 $ $2,348 ====== ====== ====== ====== ====== Total non-performing loans and troubled debt restructurings as a percentage of gross loans receivable (4) 1.39% 1.85% 1.29% 3.10% 3.45% ====== ====== ====== ====== ====== Total non-performing assets as a percentage of total assets .77% 1.29% 1.00% 2.35% 1.29% ====== ====== ====== ====== ====== Total non-performing assets and troubled debt restructurings as percentage of total assets .78% 1.30% 1.11% 2.35% 2.12% ====== ====== ====== ====== ====== - ----------------------------- (1) Consists of two loans at September 30, 1999, 1998 and 1996 and one loan at September 30, 1997 and 1995, respectively. (2) Consists of three loans from two borrowers at September 30, 1999, six loans from three borrowers at September 30, 1998 and two loans at September 30, 1997 and 1995. (3) Consists of lease financing receivables at September 30, 1999, 1998 and 1997 from the Bennett Funding Group of Syracuse, New York ("Bennett Funding") and one loan at September 30, 1995. The troubled debt restructurings in 1997 and 1995 have been performing in accordance with the terms of the agreements since the restructurings. (4) Includes loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 14 16 The Bank's total non-performing assets and troubled debt restructurings have decreased from $5.4 million, or 1.30% of total assets, at September 30, 1998 to $3.5 million, or .78% of total assets at September 30, 1999. The primary reason for the $1.9 million decrease was due to the completion of the Bank's only real estate owned development project. The $2.3 million of single-family residential loans at September 30, 1999 consisted of 34 loans with principal balances, ranging from $2,000 to $650,000, with an average balance of approximately $70,000. At September 30, 1999, the $297,000 of REO consisted of six single-family residential properties, one with a carrying value of $168,000. Other Classified Assets. Federal regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. At September 30, 1999, the Bank had $3.9 million of assets classified as substandard, respectively, and no assets classified as doubtful or loss. Substantially all classified assets are also non-performing. Allowance for Loan Losses. The Bank's policy is to establish reserves for estimated losses on delinquent loans when it determines that losses are expected to be incurred on such loans and leases. The allowance for losses on loans is maintained at a level believed adequate by management to absorb potential losses in the portfolio. Management's determination of the adequacy of the allowance is based on an evaluation of the portfolio, past loss experience, current economic conditions, volume, growth and composition of the portfolio, and other relevant factors. The allowance is increased by provisions for loan losses which are charged against income. The activity in the Bank's allowance for loan losses has remained relatively stable (other than the $956,000 Bennett Funding charge-off in fiscal 1997) and the level of provisions has been relatively small with the exception in fiscal 1996 of an additional $1.1 million provision related to Bennett Funding. As shown in the table below, at September 30, 1999, the Bank's allowance for loan losses amounted to 60.63% and .84% of the Bank's non-performing loans and gross loans receivable, respectively. 15 17 The following table summarizes changes in the allowance for loan losses and other selected statistics for the periods presented. Year Ending September 30, --------------------------------------------------------------- 1999 1998 1997 1996 1995 ------- ------- ------- ------- ------- (Dollars in thousands) Allowance for loan losses, beginning of period $ 1,738 $ 1,628 $ 2,624 $ 1,487 $ 1,540 Charged-off loans: Single-family residential (12) (86) (119) (113) (163) Construction Commercial lease purchases (956) Consumer and commercial business (60) (28) (177) (5) ------- ------- ------- ------- ------- Total charged-off loans (72) (114) (1,252) (113) (168) ------- ------- ------- ------- ------- Recoveries on loans previously charged off: Single-family residential 2 22 7 12 Construction 14 10 43 Commercial and multi- family residential 8 Consumer and commercial business 1 2 ------- ------- ------- ------- ------- Total recoveries 3 38 17 63 ------- ------- ------- ------- ------- Net loans charged-off (69) (76) (1,235) (113) (105) Provision for loan losses 259 186 239 1,250 52 ------- ------- ------- ------- ------- Allowance for loan losses, end of period $ 1,928 $ 1,738 $ 1,628 $ 2,624 $ 1,487 ======= ======= ======= ======= ======= Net loans charged-off to average loans outstanding(1) .03% .04% .68% .07% .07% ======= ======= ======= ======= ======= Allowance for loan losses to gross loans receivable(1) .84% .86% .86% 1.54% .93% ======= ======= ======= ======= ======= Net loans charged-off to allowance for loan losses 3.58% 4.37% 75.86% 4.31% 7.06% ======= ======= ======= ======= ======= Recoveries to charge-offs 4.17% 33.33% 1.36% % 37.50% ======= ======= ======= ======= ======= - ---------- (1) Gross loans receivable and average loans outstanding include loans receivable and loans held for sale, less construction and land loans in process and deferred loan origination fees and discounts. 16 18 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, ------------------------------------------------------------------------------- 1999 1998 1997 ------------------------ ------------------------ ----------------------- % of Loans % of Loans % of Loans in Each in Each in Each Category to Category to Category to Amount Total Loans Amount Total Loans Amount Total Loans ------ ----------- ------ ----------- ------ ----------- (Dollars in thousands) Single-family residential $ 572 69.82% $ 446 71.34% $ 439 68.53% Commercial and multi- family residential 166 13.05 109 9.91 77 9.28 Construction 320 7.71 382 7.64 300 8.31 Consumer 42 8.50 63 10.44 67 12.87 Commercial business 14 .92 20 .67 31 1.01 Unallocated 814 718 714 ------ ------ ------ ------ ------ ------ Total allowance for loan losses $1,928 100.00% $1,738 100.00% $1,628 100.00% ====== ====== ====== ====== ====== ====== September 30, --------------------------------------------------- 1996 1995 ------------------------ ------------------------ % of Loans % of Loans in Each in Each Category to Category to Amount Total Loans Amount Total Loans ------ ----------- ------ ----------- (Dollars in thousands) Single-family residential $ 204 68.68% $ 226 69.01% Commercial and multi- family residential 3 6.25 12 7.06 Construction 290 9.93 615 9.79 Consumer 370 13.50 100 12.62 Commercial business 1,152 1.64 55 1.52 Unallocated 605 479 ------ ------ ------ ------ Total allowance for loan losses $2,624 100.00% $1,487 100.00% ====== ====== ====== ====== 17 19 Effective December 21, 1993, the OTS, in conjunction with the Office of the Comptroller of the Currency, the FDIC and the Federal Reserve Board, issued a joint policy statement ("Policy Statement") regarding an institution's allowance for loan and lease losses. The Policy Statement, which reflects the position of the issuing regulatory agencies and does not necessarily constitute GAAP, includes guidance (i) on the responsibilities of management for the assessment and establishment of an adequate allowance and (ii) for the agencies' examiners to use in evaluating the adequacy of such allowance and the policies utilized to determine such allowance. The Policy Statement also sets forth quantitative measures for the allowance with respect to assets classified substandard and doubtful and with respect to the remaining portion of an institution's loan portfolio. While the Policy Statement sets forth quantitative measures, such guidance is not intended as a "floor" or "ceiling." The review of the Policy Statement did not and has not resulted in a material adjustment to the Bank's policy for establishing loan losses. Management of the Bank presently believes that its allowance for loan losses is adequate to cover any probable losses in the Bank's loan portfolio. However, future adjustments to this allowance may be necessary, and the Bank's results of operations could be adversely affected if circumstances differ substantially from the assumptions used by management in making its determinations in this regard. MORTGAGE-RELATED SECURITIES AND INVESTMENT SECURITIES Mortgage-Related Securities. Federally chartered savings institutions have authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies and of state and municipal governments, certificates of deposit at federally-insured banks and savings and loan associations, certain bankers' acceptances and Federal funds. Subject to various restrictions, federally chartered savings institutions may also 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 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-related 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 the FHLMC, the FNMA and the Government National Mortgage Association ("GNMA"). The Bank also invests to a limited degree in certain privately issued, credit enhanced mortgage-related securities rated AAA by national securities rating agencies. The FHLMC is a public corporation chartered by the U.S. Government. The FHLMC issues participation certificates backed principally by conventional mortgage loans. The FHLMC guarantees the timely payment of interest and the ultimate return of principal on participation certificates. The FNMA is a private corporation chartered by the U.S. Congress with a mandate to establish a secondary market for mortgage loans. The 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 the FHLMC and the FNMA are U.S. Government-sponsored enterprises, these securities are considered to be among the highest quality investments with minimal credit risks. The 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 FHA-insured and 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 the FHLMC, the FNMA and the 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 limit is currently $240,000. 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 18 20 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. The life of a mortgage-backed pass-through security thus approximates the life of the underlying mortgages. The Bank's mortgage-related securities include regular interests in collateralized mortgage obligations ("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 collateralized by loans or securities which are insured or guaranteed by the FNMA, the 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. 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 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 yield less than the loans which underlie such securities because of their payment guarantees or credit enhancements which offer nominal credit risk. In addition, mortgage-related securities are more liquid than individual mortgage loans and may be used to collateralize certain obligations of the Bank. At September 30, 1999, $37.5 million of the Bank's mortgage-related securities were pledged to secure various obligations of the Bank, including reverse repurchase agreements, treasury tax and loan processing, and as collateral for certain government deposits. The Bank's mortgage-related securities are classified as either "held to maturity" or "available for sale" based upon the Bank's intent and ability to hold such securities to maturity at the time of purchase, in accordance with GAAP. As of September 30, 1999, the Bank had an aggregate of $127.5 million, or 28.3%, of total assets invested in mortgage-related securities, net, of which $14.5 million was held to maturity and $113.0 million was available for sale. The mortgage-related securities of the Bank which are held to maturity are carried at cost, adjusted for the amortization of premiums and the accretion of discounts using a method which approximates a level yield, while mortgage-related securities available for sale are carried at the current fair value. See Notes 1 and 4 of the Notes to Consolidated Financial Statements in the Annual Report. 19 21 The following table sets forth the composition of the Bank's mortgage-related securities portfolio, both held to maturity and available for sale, at the dates indicated. September 30, -------------------------------------- 1999 1998 1997 -------- -------- -------- Held to maturity: (In thousands) Mortgage-backed securities: FHLMC $ 3,156 $ 4,698 $ 2,747 FNMA 6,832 8,747 10,053 -------- -------- -------- Total mortgage-backed securities 9,988 13,445 12,800 -------- -------- -------- Collateralized mortgage obligations: FHLMC 25 233 2,026 FNMA 4,484 5,091 5,740 Other 141 -------- -------- -------- Total collateralized mortgage obligations 5,324 7,907 -------- -------- Total mortgage-related securities, amortized cost 4,509 $ 18,769 $ 20,707 -------- ======== ======== Total fair value(1) $ 14,100 $ 18,700 $ 20,200 ======== ======== ======== Available for sale: Mortgage-backed securities: FHLMC $ 11,927 $ 10,968 $ 17,540 FNMA 32,795 25,600 14,587 GNMA 34,639 41,379 28,938 -------- -------- -------- Total mortgage-backed securities 79,361 77,947 61,065 -------- -------- -------- Collateralized mortgage obligations: FHLMC 6,502 2,704 5,356 FNMA 4,515 15,284 17,301 GNMA 536 994 1,338 Other 24,501(1) 17,040 18,819 -------- -------- -------- Total collateralized mortgage obligations 36,054 36,022 42,814 -------- -------- -------- Total mortgage-related securities, amortized cost $115,415 $113,969 $103,879 ======== ======== ======== Total fair value(2) $113,046 $115,486 $104,472 ======== ======== ======== - -------- (1) Includes "AAA" rated securities of Norwest Asset Securities Corporation, Chase Mortgage Services, GE Capital Mortgage Services and Residential Asset Securitization Trust with book values of $6.9 million, $6.7 million, $3.7 million and $2.5 million, respectively, and fair values of $6.8 million, $6.5 million, $3.6 million and $2.4 million, respectively. (2) See Note 4 of the Notes to Consolidated Financial Statements in the Annual Report. 20 22 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, ------------------------------------------- 1999 1998 1997 --------- --------- --------- (In thousands) Mortgage-related securities, beginning of period(1)(2) $ 134,255 $ 125,179 $ 83,432 --------- --------- --------- Purchases: CMOs - held to maturity 2,687 Mortgage-backed securities - available for sale 21,210 42,422 33,584 CMOs - available for sale 24,685 10,000 18,069 Sales: Mortgage-backed securities - available for sale (13,200) CMOs - available for sale (1,047) Repayments and prepayments: Mortgage-backed securities (22,759) (14,456) (7,668) CMOs (25,493) (18,336) (4,057) Increase (decrease) in net premium (469) 82 535 Change in net unrealized gain (loss) on mortgage-related securities available for sale (3,886) 924 1,284 --------- --------- --------- Net (decrease) increase in mortgage-related securities (6,712) 9,076 41,747 --------- --------- --------- Mortgage-related securities, end of period(1) $ 127,543 $ 134,255 $ 125,179 ========= ========= ========= - -------------------------- (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, 1999, the weighted average contractual maturity of the Bank's fixed-rate mortgage-related securities was approximately 6.4 years. The actual maturity of a mortgage-backed security is less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and adversely affect its yield to maturity. The yield is based upon the interest income and the amortization of any premium or discount related to the mortgage-backed security. In accordance with GAAP, premiums and discounts are amortized over the estimated lives of the loans, 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 rising 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 slow the prepayment of the underlying mortgages and the related securities. Conversely, during periods of falling mortgage interest rates, if the coupon rates of the underlying mortgages exceed the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages and the related securities. Under such circumstances, the Bank may be subject to reinvestment risk because to the extent that the Bank's mortgage-related securities amortize or prepay faster than anticipated, the Bank may not be able to reinvest the proceeds of such repayments and prepayments at a comparable yield. At September 30, 1999, of the $14.5 million of mortgage-related securities held to maturity, an aggregate of $7.0 million were secured by fixed-rate securities and an aggregate of $7.5 million were secured by adjustable-rate securities. 21 23 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, ---------------------------------------------------------------------------------------------- 1999 1998 1997 --------------------------- --------------------------- -------------------------- Carrying Fair Carrying Fair Carrying Fair Value Value Value Value Value Value ---------- ---------- ---------- ---------- ---------- ---------- (In thousands) FHLB stock $ 6,157 $ 6,157 $ 5,079 $ 5,079 $ 3,769 $ 3,769 U.S. Government and agency obligations 1 to 5 years 5,746 5,652 4,000 4,015 5 to 10 years 6,994 6,780 12,000 12,109 3,000 2,983 Over 10 years 10,000 9,960 Municipal securities 18,924 17,873 18,993 19,477 3,138 3,213 Corporate bonds 4,909 4,639 Mutual funds 2,000 1,972 2,000 1,992 Preferred stocks 5,534 5,248 5,500 5,763 Other equity investments 2,390 2,151 1,390 1,280 ---------- ---------- ---------- ---------- ---------- ---------- Total $ 52,654 $ 50,472 $ 44,962 $ 45,700 $ 23,907 $ 23,940 ========== ========== ========== ========== ========== ========== At September 30, 1999, the Company had an aggregate of $52.7 million, or 11.7%, of total assets invested in investment securities, of which $6.2 million consist of FHLB stock and $46.5 million was investment securities available for sale. Included in U.S. Government and agency obligations are callable bonds with a term of three years. The Bank's investment securities (excluding equity securities and FHLB stock) had a weighted average maturity to the call date of 5.9 years and a weighted average yield of 6.85% (adjusted to a fully taxable equivalent yield). SOURCES OF FUNDS General. The Bank's principal source of funds for use in lending and for other general business purposes has traditionally come from deposits obtained through the Bank's branch offices. The Bank also derives funds from contractual payments and prepayments of outstanding loans and mortgage-related securities, from sales of loans, from maturing investment securities and from advances from the FHLB of Pittsburgh and other borrowings. Loan repayments are a relatively stable source of funds, while deposits inflows and outflows are significantly influenced by general interest rates and money market conditions. The Bank uses borrowings to supplement its deposits as a source of funds. Deposits. The Bank's current deposit products include passbook accounts, NOW accounts, MMDA, certificates of deposit ranging in terms from 30 days to five years and noninterest-bearing personal and business checking accounts. The Bank's deposit products also include Individual Retirement Account ("IRA") certificates and Keogh accounts. The Bank's deposits are obtained primarily from residents in Delaware and Chester Counties in southeastern Pennsylvania. The Bank attracts local deposit accounts by offering a wide variety of accounts, competitive interest rates, and convenient branch office locations and service hours. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including print media and 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. The Bank participates in the regional ATM network known as MAC(R). 22 24 The Bank has been competitive in the types of accounts and in interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. With the significant decline in interest rates paid on deposit products, the Bank in recent years has experienced disintermediation of deposits into competing investment products. 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, -------------------------------------------------------------------------------------------------- 1999 1998 1997 ---------------------------- ---------------------------- ---------------------------- Amount Percent Amount Percent Amount Percent ---------- ---------- ---------- ---------- ---------- ---------- (Dollars in thousands) Passbook $ 40,324 15.46% $ 37,988 15.36% $ 38,035 16.69% MMDA 19,417 7.45 16,087 6.50 16,429 7.21 NOW 33,412 12.81 28,181 11.40 27,754 12.18 Certificates of deposit 159,761 61.25 156,801 63.40 139,535 61.22 Noninterest-bearing deposits 7,912 3.03 8,254 3.34 6,165 2.70 ---------- ---------- ---------- ---------- ---------- ---------- Total deposits $ 260,826 100.00% $ 247,311 100.00% $ 227,918 100.00% ========== ========== ========== ========== ========== ========== The following table sets forth the net savings flows of the Bank during the periods indicated. Year Ended September 30, -------------------------------------------- 1999 1998 1997 ---------- ---------- ---------- (In thousands) Increase before interest credited $ 4,336 $ 9,737 $ 99 Interest credited 9,179 9,656 8,614 ---------- ---------- ---------- Net savings increase $ 13,515 $ 19,393 $ 8,713 ========== ========== ========== The following table sets forth maturities of the Bank's certificates of deposit of $100,000 or more at September 30, 1999 by time remaining to maturity. Amounts in Thousands -------------------- Three months or less $ 9,847 Over three months through six months 2,904 Over six months through twelve months 4,261 Over twelve months 4,048 ------- $21,060 ======= 23 25 The following table presents, by various interest rate categories, the amount of certificates of deposit at September 30, 1999 and 1998 and the amounts at September 30, 1999 which mature during the periods indicated. Amounts at September 30, 1999 September 30, Maturing Within ------------------------ --------------------------------------------------------------- Certificates of Deposit 1999 1998 One Year Two Years Three Years Thereafter ------- ---- ---- -------- --------- ----------- ---------- (In thousands) 4.0% or less $ 741 $ 647 $ 741 4.01% to 5.0% 76,007 141,948 70,767 $ 2,492 $ 554 $ 2,194 5.01% to 6.0% 72,000 43,089 17,565 3,778 7,568 6.01% to 7.0% 11,013 13,248 8,000 2,978 35 Over 7.01% 958 -------- -------- -------- -------- -------- -------- Total certificate accounts $159,761 $156,801 $122,597 $ 23,035 $ 4,332 $ 9,797 ======== ======== ======== ======== ======== ======== 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, --------------------------------------------------------------------------------------------------------- 1999 1998 1997 ----------------------------- ------------------------------ ---------------------------------- Average Average Average Average Rate Average Rate Average Rate Balance Paid Balance Paid Balance Paid ------------ -------------- --------------- --------------- --------------- --------------- Passbook accounts $ 39,625 2.41% $ 38,273 2.41% $ 39,199 2.42% MMDA accounts 17,833 2.82 16,368 2.76 16,350 2.75 Certificates of deposit 157,134 5.33 145,105 5.64 133,091 5.58 NOW accounts 34,581 1.27 29,412 1.28 28,143 1.28 Noninterest-bearing deposits 6,360 5,779 4,357 -------- -------- -------- Total deposits $255,533 4.02% $234,937 4.23% $221,140 4.15% ======== ==== ======== ==== ======== ==== 24 26 Borrowings. The Bank may obtain advances from the FHLB of Pittsburgh upon the security of the common stock it owns in the FHLB and certain of its residential mortgage loans and securities held to maturity, provided certain standards related to creditworthiness have been met. Such advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. The Bank, during fiscal 1999 and 1998, increased its FHLB borrowings to fund asset growth. At September 30, 1999, the Bank had $123.1 million in outstanding FHLB advances. See Note 10 of the Notes to Consolidated Financial Statements in the Annual Report for additional information. The Bank has entered into agreements to sell securities under terms which require it to repurchase the same or substantially similar securities by a specified date. Repurchase agreements are considered borrowings which are secured by the sold securities. At September 30, 1999, the Bank had $19.3 million of repurchase agreements outstanding scheduled to mature in 2002. See Note 11 of the Notes to Consolidated Financial Statements in the Annual Report. Both the FHLB advances and the repurchase agreements have certain call features whereby the issuer can call the borrowings after the expiration of certain time frames. The time frames on the callable borrowings range from three months to seven years. SUBSIDIARIES The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, service corporations, with an additional investment of 1% of assets when such additional investment is utilized primarily for community development purposes. It may invest essentially unlimited amounts in subsidiaries deemed operating subsidiaries that can only engage in activities that the Bank is permitted to engage in. Under such limitations, as of September 30, 1999, the Bank was authorized to invest up to approximately $8.9 million in the stock of, or loans to, service corporations. As of September 30, 1999, the net book value of the Bank's investment in stock, unsecured loans, and conforming loans to its service corporations was $28,300. At September 30, 1999, in addition to the Bank, the Company has five direct or indirect subsidiaries: First Keystone Capital Trust I, FKF Management Corp., Inc., State Street Services Corp., First Pointe, Inc. ("First Pointe"), and First Chester Services, Inc. First Keystone Capital Trust I (the "Trust") is a Delaware statutory business trust wholly owned by the Company formed in 1997 for the purpose of issuing trust preferred securities and investing the proceeds therefrom in Junior Subordinated Debentures issued by the Company. See Note 18 of the Notes to Consolidated Financial Statements in the Annual Report for further discussion regarding the issuance of trust preferred securities. FKF Management Corp., Inc., a Delaware corporation, is a wholly owned operating subsidiary of the Bank established in 1997 for the purpose of managing assets of the Bank. Assets under management totaled $135.1 million at September 30, 1999 and comprised principally of investment and mortgage-related securities. State Street Services Corp., a wholly owned subsidiary of the Bank established in 1999 for the purpose of offering a full array of insurance products by entering in a partnership, as a 51% interest , in First Keystone Insurance Services, LLC. In addition, it holds a 30% equity position in a title company which offers title services. First Pointe, is a wholly owned subsidiary of the Bank which was formed for the purpose of developing a real estate parcel received in a deed-in-lieu of foreclosure action. At September 30, 1999, all of the townhomes have been completed and sold. The Bank has one remaining subsidiay which was involved in real estate management. With the Bank's cessation of its involvement in such activities and the resolution of the various development projects in which the subsidiaries were involved, this subsidiary was placed on an inactive status. See "-Asset Quality - Non-Performing Assets" and Notes 1 and 7 of the Notes to Consolidated Financial Statements in the Annual Report. 25 27 COMPETITION The Bank faces strong competition both in attracting deposits and making real estate loans. Its most direct competition for deposits has historically come from other savings associations, credit unions and commercial banks located in its market area including many large financial institutions which have greater financial and marketing resources available to them. In addition, during times of high interest rates, the Bank has faced additional significant competition for investors' funds from short-term money market securities, mutual funds and other corporate and government securities. The ability of the Bank to attract and retain savings deposits depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. The Bank experiences strong competition for real estate loans principally from other savings associations, commercial banks and mortgage banking companies. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers and the convenient locations of its branch office network. Competition may increase as a result of the continuing reduction of restrictions on the interstate operations of financial institutions. EMPLOYEES The Bank had 76 full-time employees and 13 part-time employees as of September 30, 1999. None of these employees is represented by a collective bargaining agreement. The Bank believes that it enjoys excellent relations with its personnel. 26 28 REGULATION The Company. The Company as a savings and loan holding company within the meaning of the Home Owners' Loan Act, as amended ("HOLA"), is required to register as such with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof. Federal Activities Restrictions. There are generally no restrictions on the activities of a savings and loan holding company which holds only one subsidiary savings association. However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the Director may impose such restrictions as deemed necessary to address such risk, including limiting (i) payment of dividends by the savings association; (ii) transactions between the savings association and its affiliates; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the above rules as to permissible business activities of unitary savings and loan holding companies, if the savings association subsidiary of such a holding company fails to meet a QTL test, then such unitary holding company also shall become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the savings association qualifies as a QTL within one year thereafter, shall register as, and become subject to the restrictions applicable to, a bank holding company. See "- The Bank - Qualified Thrift Lender Test." If the Company were to acquire control of another savings association, other than through merger or other business combination with the Bank, the Company would thereupon become a multiple savings and loan holding company. Except where such acquisition is pursuant to the authority to approve emergency thrift acquisitions and where each subsidiary savings association meets the QTL test, as set forth below, the activities of the Company and any of its subsidiaries (other than the Bank or other subsidiary savings associations) would thereafter be subject to further restrictions. No multiple savings and loan holding company or subsidiary thereof which is not a savings association shall commence or continue for a limited period of time after becoming a multiple savings and loan holding company or subsidiary thereof any business activity, other than: (i) furnishing or performing management services for a subsidiary savings association; (ii) conducting an insurance agency or escrow business; (iii) holding, managing, or liquidating assets owned by or acquired from a subsidiary savings association; (iv) holding or managing properties used or occupied by a subsidiary savings association; (v) acting as trustee under deeds of trust; (vi) those activities authorized by regulation as of March 5, 1987 to be engaged in by multiple savings and loan holding companies; or (vii) unless the Director of the OTS by regulation prohibits or limits such activities for savings and loan holding companies, those activities authorized by the Federal Reserve Board as permissible for bank holding companies. The activities described in (i) through (vi) above may only be engaged in after giving the OTS prior notice and being informed that the OTS does not object to such activities. In addition, the activities described in (vii) above also must be approved by the Director of the OTS prior to being engaged in by a multiple savings and loan holding company. 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. An affiliate of a savings association is any company or entity which controls, is controlled by or is under common control with the savings association. In a holding company context, the parent holding company of a savings association (such as the Company) and any companies which are controlled by such parent holding company are affiliates of the savings association. Generally, Sections 23A and 23B (i) limit the extent to which the savings association or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such association's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the association or subsidiary as those provided to a non-affiliate. The term "covered transaction" includes, among other things, the making of loans or extension of credit to an affiliate, purchase of assets, issuance of a guarantee and similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, under OTS regulations no savings association may (i) loan or otherwise extend credit to an affiliate, 27 29 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. The OTS regulation generally excludes all non-bank and non-savings association subsidiaries of savings associations from treatment as affiliates, except to the extent that the OTS or the Federal Reserve Board decides to treat such subsidiaries as affiliates. The regulation also requires savings associations to make and retain records that reflect affiliate transactions in reasonable detail, and provides that certain classes of savings associations may be required to give the OTS prior notice of affiliate transactions. In addition, Sections 22(g) and (h) of the FRA place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than 10% stockholder of a savings institution (a "principal stockholder"), and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the savings institution's loans to one borrower limit (generally equal to 15% of the institution's unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered to employees of the Bank and also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a savings institution to all insiders cannot exceed the institution's unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. At September 30, 1999, the Bank was in compliance with the foregoing restrictions. Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the Director of the OTS, (i) control of any other savings association or savings and loan holding company or substantially all the assets thereof or (ii) more than 5% of the voting shares of a savings association or holding company thereof which is not a subsidiary. Except with the prior approval of the Director of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company's stock, may acquire control of any savings association, other than a subsidiary savings association, or of any other savings and loan holding company. Federal Securities Laws. The Company's Common Stock is registered with the Securities and Exchange Commission ("SEC") under the Securities Exchange Act of 1934 ("Exchange Act"). The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act. Shares of common stock owned by an affiliate of the Company are subject to the resale restrictions of Rule 144 under the Securities Act of 1933, as amended ("Securities Act"). If the Company meets the current public information requirements of Rule 144 under the Securities Act, each affiliate of the Company who complies with the other conditions of Rule 144 (including those that require the affiliate's sale to be aggregated with those of certain other persons) is able to sell in the public market, without registration, a number of shares not to exceed, in any three-month period, the greater of (i) 1% of the outstanding shares of the Company or (ii) the average weekly volume of trading in such shares during the preceding four calendar weeks. The Bank. The OTS has extensive regulatory authority over the operations of savings associations. As part of this authority, savings associations are required to file periodic reports with the OTS and are subject to periodic examinations by the OTS. The investment and lending authority of savings associations are prescribed by federal laws and regulations and they are prohibited from engaging in any activities not permitted by such laws and regulations. Those laws and regulations generally are applicable to all federally chartered savings associations and may also apply to state-chartered savings associations. Such regulation and supervision is primarily intended for the protection of depositors. 28 30 The OTS' enforcement authority over all savings associations and their holding companies was substantially enhanced by Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"). This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS. FIRREA significantly increased the amount of and grounds for civil money penalties. FIRREA requires, except under certain circumstances, public disclosure of final enforcement actions by the OTS. Insurance of Accounts. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the United States Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action. The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is not aware of any existing circumstances which could result in termination of the Bank's deposit insurance. The BIF fund met its target reserve level in September 1995, but the SAIF was not expected to meet its target reserve level until at least 2002. Consequently, in late 1995, the FDIC approved a final rule regarding deposit insurance premiums which, effective with respect to the semi-annual premium assessment beginning January 1, 1996, reduced deposit insurance premiums for BIF member institutions to zero basis points (subject to an annual minimum of $2,000) for institutions in the lowest risk category. Deposit insurance premiums for SAIF members were maintained at their existing levels (23 basis points for institutions in the lowest risk category). On September 30, 1996, President Clinton signed into law legislation (the "Deposit Insurance Funds Act of 1996") to eliminate the premium differential between SAIF-insured institutions and BIF-insured institutions by recapitalizing the SAIF's reserves to the required ratio. The legislation provided that all SAIF member institutions pay a one-time special assessment to recapitalize the SAIF, which in the aggregate was sufficient to bring the reserve ratio in the SAIF to 1.25% of insured deposits. The legislation also provided for the merger of the BIF and the SAIF, with such merger being conditioned upon, among other things, the prior elimination of the federal thrift charter. Effective October 8, 1996, pursuant to the provision of the Deposit Insurance Funds Act of 1996, FDIC regulations imposed a one-time special assessment equal to 65.7 basis points for all SAIF-assessable deposits as of March 31, 1995, which was collected on November 27, 1996. The Bank's one-time special assessment amounted to approximately $1.4 million. Net of related tax benefits, the one-time special assessment amounted to $876,000. Following the imposition of the one-time special assessment, the FDIC lowered assessment rates for SAIF members to reduce the disparity in the assessment rates paid by BIF and SAIF members. Beginning October 1, 1996, effective BIF and SAIF rates both range from zero basis points to 27 basis points. From 1997 through 1999, SAIF members will pay 6.4 basis points to fund the Financing Corporation while BIF member institutions will pay approximately 1.3 basis points. 29 31 Capital requirements. Federally insured savings associations are required to maintain minimum levels of regulatory capital. Pursuant to FIRREA, the OTS has established capital standards applicable to all savings associations. These standards generally must be as stringent as the comparable capital requirements imposed on national banks. The OTS also is authorized to impose capital requirements in excess of these standards on individual associations on a case-by-case basis. Current OTS capital standards require savings associations to satisfy three different capital requirements. Under these standards, savings associations must maintain "tangible" capital equal to 1.5% of adjusted total assets, "core" capital equal to 4% of adjusted total assets and "total" capital (a combination of core and "supplementary" capital) equal to 8.0% of "risk-weighted" assets. For purposes of the regulation, core capital generally consists of common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, minority interests in the equity accounts of fully consolidated subsidiaries, certain nonwithdrawable accounts and pledged deposits and "qualifying supervisory goodwill." Tangible capital is given the same definition as core capital but does not include qualifying supervisory goodwill and is reduced by the amount of all the savings association's intangible assets, with only a limited exception for purchased mortgage servicing rights ("PMSRs"). Both core and tangible capital are further reduced by an amount equal to a savings association's debt and equity investments in subsidiaries engaged in activities not permissible for national banks (other than subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities and subsidiary depository institutions or their holding companies). In addition, under the Prompt Corrective Action provisions of the OTS regulations, all but the most highly rated institutions must maintain a minimum leverage ratio of 4% in order to be adequately capitalized. See "- Prompt Corrrective Action." At September 30, 1999, 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 final OTS rules effective March 4, 1994, (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, 1999, the Bank had PMSRs totalling $111,000. 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. Under OTS regulations, an institution with a greater than "normal" level of interest rate exposure must deduct an interest rate risk ("IRR") component from total capital for purposes of calculating risk-based capital requirement. Interest rate exposure is measured, generally, as the decline in an institution's net portfolio value that would result from a 200 basis point increase or decrease in market interest rates (whichever would result in lower net portfolio value), 30 32 divided by the estimated economic value of the savings association's assets. The interest rate risk component to be deducted from total capital is equal to one-half of the difference between an institution's measured exposure and "normal" IRR exposure (which is defined as 2%), multiplied by the estimated economic value of the institution's assets. Although the OTS has decided to delay implementation of this rule, it will continue to closely monitor the level of interest rate risk at individual savings associations and it retains the authority, on a case-by-case basis, to impose additional capital requirements for individual savings associations with significant interest rate risk. The OTS recently updated its standards regarding the management of interest rate risk to include summary guidelines to assist savings associations in determining their exposures to interest rate risk. 31 33 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, 1999, 1998 and 1997. September 30, 1999 September 30, 1998 September 30, 1997 ------------------------------ ---------------------------------- ------------------------------ Tangible Core Risk-based Tangible Core Risk-based Tangible Core Risk-based Capital Capital Capital Capital Capital Capital Capital Capital Capital --------- ------- ---------- ----------- -------- --------- -------- -------- ---------- (In thousands) GAAP equity $36,467 $36,467 $36,467 $33,701 $33,701 $33,701 $30,254 $30,254 $30,254 General valuation allowances 1,813 1,688 1,578 ------- ------- ------- ------- ------- ------- ------- ------- ------- Total regulatory capital 36,467 36,467 38,280 33,701 33,701 35,389 30,254 30,254 31,832 Minimum capital requirement per FIRREA published guidelines 6,696 17,586 16,294 6,113 12,225 13,424 5,594 11,188 12,792 ------- ------- ------- ------- ------- ------- ------- ------- ------- Excess $29,771 $18,881 $21,986 $27,588 $21,476 $21,965 $24,660 $19,066 $19,040 ======= ======= ======= ======= ======= ======= ======= ======= ======= 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 the regulations provide that higher individual minimum regulatory capital requirements may be appropriate in circumstances where, among others: (1) a savings association has a high degree of exposure to interest rate risk, prepayment risk, credit risk, concentration of credit risk, certain risks arising from nontraditional activities, or similar risks or a high proportion of off-balance sheet risk; (2) a savings association is growing, either internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by OTS regulations; and (3) a savings association may be adversely affected by the activities or condition of its holding company, affiliates, subsidiaries or other persons or savings associations with which it has significant business relationships. The Bank is not subject to any such individual minimum regulatory capital requirement. 32 34 Prompt Corrective Action. Under Section 38 of the FDIA as added by FDICIA, the OTS adopted in 1992 regulations implementing Section 38 of the FDIA. Under the regulations, 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%. Section 38 of the FDIA and the OTS regulations promulgated thereunder also specify circumstances under the OTS may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). At September 30, 1999, the Bank meet the requirements of a "well capitalized" institution under OTS regulations. Liquidity Requirements. All savings associations are required to maintain an average daily balance of liquid assets equal to a certain percentage of the sum of its average daily balance of net withdrawable deposit accounts and borrowings payable in one year or less. The liquidity requirement may vary from time to time (between 4% and 10%) depending upon economic conditions and savings flows of all savings associations. At the present time, the required minimum liquid asset ratio is 4%. The Bank has consistently exceeded such regulatory liquidity requirement and, at September 30, 1999, had a average liquidity ratio of 6.17%. Qualified Thrift Lender Test. Under Section 2303 of the Economic Growth and Regulatory Paper work Reduction Act of 1996, 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"). The QTL Test set forth in the HOLA requires that Qualified Thrift Investments ("QTLs") represent 65% of portfolio 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 association 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 association shall be restricted to those of a national bank; (iii) the association shall not be eligible to obtain any advances from its FHLB; and (iv) payment of dividends by the association 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). Portfolio assets are defined as total assets less intangibles, property used by a savings association in its business and liquidity investments in an amount not exceeding 20% of assets. Generally, QTLs are residential housing related assets, The recent legislation allows small business loans, credit card loans, student loans and loans for personal, family and household purposes to be included without limitation as qualified investments. In addition, commercial loans may be made in an amount up to 10% of total assets. At September 30, 1999, approximately 81.10% of the Bank's assets were invested in QTLs, which was in excess of the percentage required to qualify the Bank under the QTL Test in effect at that time. Restrictions on Capital Distributions. OTS regulations govern capital distributions by savings associations, which include cash dividends, stock redemptions or repurchases, cash-out mergers, interest payments on certain convertible debt and other transactions charged to the capital account of a savings association to make capital distributions. Generally, the regulation creates a safe harbor for specified levels of capital distributions (as a percentage of income) from associations meeting at least their minimum capital requirements, so long as such associations notify the OTS and 33 35 receive no objection to the distribution from the OTS. Savings institutions and distributions that do not qualify for the safe harbor are required to obtain prior OTS approval before making any capital distributions. Generally, savings associations such as the Bank includes in a subsidiary of a savings and loan holding company can, upon 30 days prior notice, distribute during each calendar year an amount equal to or less than its net income for the year to date plus retained net income for the preceding two years. Amounts in excess of this must be approved by the OTS. OTS regulations also prohibit the Bank from declaring or paying any dividends or from repurchasing any of its stock if, as a result, the regulatory (or total) capital of the Bank would be reduced below the amount required to be maintained for the liquidation account established by it for certain depositors in connection with its conversion from mutual to stock form. Community Reinvestment. Under the Community Reinvestment Act of 1977, as amended ("CRA"), as implemented by OTS regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The Bank received a satisfactory rating as a result of its last OTS evaluation. Policy Statement on Nationwide Branching. Effective May 11, 1992, the OTS amended and codified its policy statement on branching by federally chartered savings associations to delete then-existing regulatory restrictions on the branching authority of such associations and to permit nationwide branching to the extent allowed by federal statute. (Prior OTS policy generally permitted interstate branching for federally chartered savings associations only to the extent allowed state-chartered savings associations in the states where the association's home office was located and where the branch was sought or if the branching resulted from OTS approval of a supervisory interstate acquisition of a troubled institution.) Current OTS policy generally permits a federally chartered savings association to establish branch offices outside of its home state if the association meets the domestic building and loan test in Section 7701(a)(19) of the Code or the asset composition test of subparagraph (c) of that section, and if, with respect to each state outside of its home state where the association has established branches, the branches, taken alone, also satisfy one of the two tax tests. An association seeking to take advantage of this authority would have to have a branching application approved by the OTS, which would consider the regulatory capital of the association and its record under the CRA, as amended, among other things. Federal Home Loan Bank System. The Bank is a member of the FHLB of Pittsburgh, which is one of 12 regional FHLBs that administers the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. As a member, the Bank is required to purchase and maintain stock in the FHLB of Pittsburgh in an amount equal to at least 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year or 5% of its advances from the FHLB of Pittsburgh, whichever is greater. At September 30, 1999, 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 insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLBs pay to their members and could also result in the FHLBs imposing a higher rate of interest on advances to their members. For the years ended September 30, 1999, 1998 and 1997, dividends from the FHLB to the Bank amounted to approximately $375,000, $261,000 and $196,000, respectively. If dividends were reduced, the Bank's net interest income would likely also be reduced. Further, there can be no assurance that the impact of recent or future legislation on the FHLBs will not also cause a decrease in the value of FHLB stock held by the Bank, if any. 34 36 Federal Reserve System. The Federal Reserve Bank ("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, 1999, the Bank was in compliance with applicable requirements. However, because required reserves must be maintained in the form of vault cash or a noninterest-bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce an institution's earning assets. Safety and Soundness Guidelines. The OTS and the other federal banking agencies have established guidelines for safety and soundness, addressing operational and managerial, as well as compensation matters for insured financial institutions. Institutions failing to meet these standards are required to submit compliance plans to their appropriate federal regulators. The OTS and the other agencies have also established guidelines regarding asset quality and earnings standards for insured institutions. Recent Regulatory Developments. On November 12, 1999, President Clinton signed into law the Gramm-Leach-Bliley Act (the "Act") which will, effective March 11, 2000, permit qualifying bank holding companies to become financial holding companies and thereby affiliate with securities firms and insurance companies and engage in other activities that are financial in nature. The Act defines "financial in nature" to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. A qualifying national bank also may engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development, and real estate investment, through a financial subsidiary of the Bank. The Act also prohibits new unitary thrift holding companies from engaging in nonfinancial activities or from affiliating with an nonfinancial entity. As a grandfathered unitary holding company, the Company will retain its authority to engage in nonfinancial activities. FEDERAL AND STATE TAXATION General. The Company and the Bank are subject to the corporate tax provisions of the Code, as well as certain additional provisions of the Code which apply to thrift and other types of financial institutions. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to the Company and the Bank. Fiscal Year. The Company and the Bank and its subsidiaries file a consolidated federal income tax return on a fiscal year basis ending September 30. Method of Accounting. The Bank maintains its books and records for federal income tax purposes using the accrual method of accounting. The accrual method of accounting generally requires that items of income be recognized when all events have occurred that establish the right to receive the income and the amount of income can be determined with reasonable accuracy, and that items of expense be deducted at the later of (i) the time when all events have occurred that establish the liability to pay the expense and the amount of such liability can be determined with reasonable accuracy or (ii) the time when economic performance with respect to the item of expense has occurred. Bad Debt Reserves. The Bank is permitted to establish reserves for bad debts and to make annual additions thereto which qualify as deductions from taxable income. The Company, as of October 1, 1996, changed its method of computing reserves for bad debts to the experience method (the "Experience Method"). The bad debt deduction allowable under this method is available to small banks with assets less than $500 million. Generally, this method will allow the Company to deduct an annual addition to the reserve for bad debts equal to the increase in the balance of the Company's reserve for bad debts at the end of the year to an amount equal to the percentage of total loans at the end of the year, computed using the ratio of the previous six years net charge offs divided by the sum of the previous six years total outstanding loans at year end. 35 37 The Bank treated such change as a change in a method of accounting determined solely with respect to the "applicable excess reserves" of the institution. The amount of the applicable excess reserves will be taken into account ratably over a six-taxable year period, beginning with the first taxable year beginning after December 31, 1995. The timing of the recapture may be delayed for a two-year period provided certain residential lending requirements are met. For financial reporting purposes, the Company will not incur any additional tax expense. At September 30, 1997, under SFAS No. 109, deferred taxes were provided on the difference between the book reserve at September 30, 1997 and the applicable excess reserve in an amount equal to the Bank's increase in the tax reserve from December 31, 1987 to September 30, 1997. Prior to September 30, 1996, the Bank had the option of electing either the experience method or the percentage of taxable income method (the "Percentage Method") for its annual addition to the bad debt reserves. Under the Experience Method, the deductible annual addition is the amount necessary to increase the balance of the reserve at the close of the taxable year to the greater of (i) the amount which bears the same ratio to loans outstanding at the close of the taxable year as the total net bad debts sustained during the current and five preceding taxable years bear to the sum of the loans outstanding at the close of those six years or (ii) the balance in the reserve account at the close of the Bank's "base year," which was its tax year ended December 31, 1987. Under the Percentage Method, the bad debt deduction with respect to qualifying real property loans is computed as a percentage of the Bank's taxable income before such deduction, as adjusted for certain items (such as capital gains and the dividends received deduction). Under this method, a qualifying institution such as the Bank generally may deduct 8% of its taxable income. In the absence of other factors, the availability of the Percentage Method has permitted a qualifying savings institution, such as the Bank, to be taxed at an effective federal income tax rate of 31.28%, as compared to 34% for corporations generally. For taxable years ended on or before December 31, 1988, the Bank has generally elected to use the Percentage Method to compute the amount of its bad debt deduction with respect to its qualifying real property loans. For all taxable years ended after December 31, 1988 with the exception of the September 30, 1996 tax year, the Bank elected to use the Experience Method to compute the amount of its bad debt deduction with respect to its qualifying real property loans. The income of the Company or any non-bank subsidiaries would not be subject to the bad debt deduction allowed the Bank, whether or not consolidated tax returns are filed. Distributions. While the Bank maintains a bad debt reserve, if it were to distribute cash or property to its sole stockholder having a total fair market value in excess of its accumulated tax-paid earnings and profits, or were to distribute cash or property to its stockholder in redemption of its stock, the Bank would generally be required to recognize as income an amount which, when reduced by the amount of federal income tax that would be attributable to the inclusion of such amount in income, is equal to the lesser of: (i) the amount of the distribution or (ii) the sum of (a) the amount of the accumulated bad debt reserve of the Bank with respect to qualifying real property loans (to the extent that additions to such reserve exceed the additions that would be permitted under the experience method) and (b) the amount of the Bank's supplemental bad debt reserve. Minimum Tax. The Code imposes an alternative minimum tax at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The alternative minimum tax is payable to the extent such AMTI is in excess of an exemption amount. The Code provides that an item of tax preference is the excess of the bad debt deduction allowable for a taxable year pursuant to the percentage of taxable income method over the amount allowable under the experience method. The other items of tax preference that constitute AMTI include (a) tax-exempt interest on newly-issued (generally, issued on or after August 8, 1986) private activity bonds other than certain qualified bonds and (b) for taxable years beginning after 1989, 75% of the excess (if any) of (i) adjusted current earnings as defined in the Code, over (ii) AMTI (determined without regard to this preference and prior to reduction 36 38 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, 1995 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 1999 is 9.99% and is imposed on the Company's unconsolidated taxable income for federal purposes with certain adjustments. In general, the Capital Stock Tax is a property tax imposed at the rate of 1.2% of a corporation's capital stock value, which is determined in accordance with a fixed formula. The Bank is taxed under the Pennsylvania Mutual Thrift Institutions Tax Act (the ("MTIT"), as amended to include thrift institutions having capital stock. Pursuant to the MTIT, the Bank's tax rate is 11.5%. The MTIT exempts the Bank from all other taxes imposed by the Commonwealth of Pennsylvania for state income tax purposes and from all local taxation imposed by political subdivisions, except taxes on real estate and real estate transfers. The MTIT is a tax upon net earnings, determined in accordance with GAAP with certain adjustments. The MTIT, in computing GAAP income, allows for the deduction of interest earned on state and federal securities, while disallowing a percentage of a thrift's interest expense deduction in the proportion of interest income on those securities to the overall interest income of the Bank. Net operating losses, if any, thereafter can be carried forward three years for MTIT purposes. 37 39 ITEM 2. PROPERTIES At September 30, 1999, the Bank conducted business from its executive offices located in Media, Pennsylvania and six full-service offices located in Delaware and Chester Counties, Pennsylvania. See also Note 8 of the Notes to Consolidated Financial Statements in the Annual Report. The following table sets forth certain information with respect to the Bank's offices at September 30, 1999. Net Book Value Amount of Description/Address Leased/Owned of Property Deposits - --------------------------------------- ------------- ------------------ ------------------------ (In thousands) Executive Offices: 22 West State Street Media, Pennsylvania 19063 Owned(1) $1,094 $ 80,775 Branch Offices: 3218 Edgmont Avenue Brookhaven, Pennsylvania 19015 Owned 498 81,678 Routes 1 and 100 Chadds Ford, Pennsylvania 19318 Leased(2) 204 24,284 23 East Fifth Street Chester, Pennsylvania 19013 Leased(3) 221 19,677 31 Baltimore Pike Chester Heights, Pennsylvania 19017 Leased(4) 232 Route 82 and 926 Kennett Square, Pennsylvania 19348 Leased(5) 62 5,287 330 Dartmouth Avenue Swarthmore, Pennsylvania 19081 Owned 114 49,125 ------ -------- $2,425 $260,826 ====== ======== - ------------------ (1) Also a branch office. (2) Lease expiration date is September 30, 2000. The Bank has two five year renewal options. (3) Lease expiration date is December 31, 2005. The Bank has one ten year renewal option. (4) Lease expiration date is December 31, 2028. The Bank has options to cancel on the 15th , 20th and 25th year of the lease. (5) Lease expiration date is September 30, 2001. The Bank has four five year renewal options. 38 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 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. The information required herein is incorporated by reference on page 36 of the Company's Annual Report. ITEM 6. SELECTED FINANCIAL DATA. The information required herein is incorporated by reference from pages 5 to 6 of the Registrant's Annual Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANAYLSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION. The information required herein is incorporated by reference from pages 7 to 16 of the Registrant's Annual Report. ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. The Company's balance sheet consists of interest-earning assets and interest-bearing liabilities, and is therefore exposed to interest rate risk. The following additional information is being provided regarding the exposure to this interest rate risk. The Company utilizes reports prepared by the OTS to measure interest rate risk. Using data from the Bank's quarterly thrift financial reports, the OTS models the net portfolio value ("NPV") of the Bank over a variety of interest rate scenarios. The NPV is defined as the present value of expected cash flows from existing assets less the present value of expected cash flows from existing liabilities plus the present value of net expected cash inflows from existing off-balance sheet contracts. The model assumes instantaneous, parallel shifts in the U.S. Treasury Securities yield curve of 100 to 300 basis points, either up or down, and in 100 basis point increments. The interest rate risk measures used by the OTS include an "Exposure Measure" or "Post-Shock" NPV ratio and a "Sensitivity Measure". The "Post-Shock" NPV ratio is the net present value as a percentage of assets over the various yield curve shifts. A low "Post-Shock" NPV ratio indicates greater exposure to interest rate risk and can result from a low initial NPV ratio or high sensitivity to changes in interest rates. The "Sensitivity Measure" is the decline in the NPV ratio, in basis points, caused by a 2% increase or decrease in rates, whichever produces a larger decline. The following sets forth the Bank's NPV as of September 30, 1999. 39 41 Net Portfolio Value (Dollars in thousands) - --------------------------------------------------------------------------------------------------------- Changes in Rates in Dollar Percentage Net Portfolio Value As a Change in Basis Points Amount Change Change % of Assets Percentage (1) - --------------------------------------------------------------------------------------------------------- 200 $23,774 $(18,739) (44.08)% 5.57% (40.93)% 100 33,479 (9,035) (21.25) 7.62 (19.19) 0 42,513 9.43 (100) 49,347 6,834 16.08 10.73 13.79 (200) 52,254 9,741 22.91 11.22 18.98 (1) Based on the portfolio value of the Bank's assets in the base case scenario Certain shortcomings are inherent in the methodology used in the above interest rate risk measurements. Modeling changes in NPV require the making of certain assumptions which may or may not reflect the manner in which actual yields and costs respond to changes in market interest rates. In this regard, the NPV Table presented assumes that the composition of the Bank's interest sensitive assets and liabilities existing at the beginning of a period remains constant over the period being measured and also assumes that a particular change in interest rates is reflected uniformly across the yield curve regardless of the duration to maturity or repricing of specific assets and liabilities. Also, the model does not take into account the Bank's business or strategic plans. Accordingly, although the NPV table provides an indication of the Bank's interest rate risk exposure at a particular point in time, such measurements are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Bank's net interest income and may differ from actual results. See also discussion on pages 7 to 8 of the Annual Report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA. The financial statements and supplementary data required herein are incorporated by reference from pages 18 to 36 of the Annual Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE. Not applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required herein is incorporated by reference from pages 2 to 5 and page 15 of the Registrant's Proxy Statement dated December 23, 1999 ("Proxy Statement"). 40 42 ITEM 11. EXECUTIVE COMPENSATION. The information required herein is incorporated by reference from pages 8 to 9 of the Registrant's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT. The information required herein is incorporated by reference from pages 6 to 8 of the Registrant's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS. The information required herein is incorporated by reference from pages 14 to 15 of the Registrant's Proxy Statement. PART IV. ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. (a) Documents filed as part of this Report. (1) The following documents are filed as part of this report and are incorporated herein by reference from the Registrant's Annual Report. Report of Independent Auditors. Consolidated Statements of Financial Condition at September 30, 1999 and 1998. Consolidated Statements of Income for the Years Ended September 30, 1999, 1998 and 1997. Consolidated Statements of Changes in Stockholders' Equity for the Years Ended September 30, 1999, 1998 and 1997. Consolidated Statements of Cash Flows for the Years Ended September 30, 1999, 1998 and 1997. Notes to the Consolidated Financial Statements. (2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto. (3) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index. 41 43 No Description 3.1 Amended and Restated Articles of Incorporation of First Keystone Financial, Inc. * 3.2 Amended and Restated Bylaws of First Keystone Financial, Inc. * 4 Specimen Stock Certificate of First Keystone Financial, Inc. * 10.1 Employee Stock Ownership Plan and Trust of First Keystone Financial, Inc. * 10.2 401(K)/ Profit Sharing Plan of First Keystone Federal Savings Bank * 10.3 Employment Agreement between First Keystone Financial, Inc. and Donald S. Guthrie dated May 26, 1999. 10.4 Employment Agreement between First Keystone Financial, Inc. and Stephen J. Henderson dated May 26, 1999. 10.5 Employment Agreement between First Keystone Financial, Inc. and Thomas M. Kelly dated May 26, 1999. 10.6 Form of Severance Agreement between First Keystone Financial, Inc. and Elizabeth M. Mulcahy dated May 26, 1999. 10.8 Form of Severance Agreement between First Keystone Financial, Inc. and Carol Walsh dated May 26, 1999. 10.9 1995 Stock Option Plan (incorporated by reference from Exhibit 10.9 to Registrant's Form 10-KSB for the year ended September 30, 1995). 42 44 10.10 1995 Recognition and Retention Plan and Trust Agreement, (incorporated by reference from Exhibit 10.10 to Registrant's Form 10-KSB for the year ended September 30, 1995). 10.11 1998 Stock Option Plan (incorporated from Appendix A of The Registrant's definitive proxy statement dated December 24, 1998. 10.12 Employment Agreement between First Keystone Federal Savings Bank and Donald S. Guthrie dated May 26, 1999. 10.13 Employment Agreement between First Keystone Federal Savings Bank and Stephen J. Henderson dated May 26, 1999. 10.14 Employment Agreement between First Keystone Federal Savings Bank and Thomas M. Kelly dated May 26, 1999. 10.15 Form of Severance Agreement between First Keystone Federal Savings Bank and Elizabeth M. Mulcahy dated May 26, 1999. 10.16 Form of Severance Agreement between First Keystone Federal Savings Bank and Carol Walsh dated May 26, 1999. 13 Annual Report to Stockholders. 21 Subsidiaries of the Registrant - Reference is made to Item 1 "Business," for the required information. 23 Consent of Deloitte & Touche LLP. 27 Financial Data Schedule - ----------------------- (*) Incorporated by reference from the Registration Statement Form S-1 (Registration No. 33-84824) filed by the Registrant with the SEC on October 6, 1994, as amended. (b) Reports filed on Form 8-K. None. 43 45 SIGNATURES Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. FIRST KEYSTONE FINANCIAL, INC. By:/s/ Donald S. Guthrie ----------------------------- Donald S. Guthrie President and Chief Executive Officer Pursuant to the requirements of the Securities and Exchange Act of 1934, this report had been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ Donald S. Guthrie December 29, 1999 - -------------------------------------------------- Donald S. Guthrie President and Chief Executive Officer (Principal Executive Officer) /s/ Thomas M. Kelly December 29, 1999 - ----------------------------------------------- Thomas M. Kelly Executive Vice-President and Chief Financial Officer (Principal Financial and Accounting Officer) /s/ Donald A. Purdy December 29, 1999 - ------------------------------------------------ Donald A. Purdy Chairman of the Board /s/ William K. Betts December 29, 1999 - ------------------------------------------------ William K. Betts Director /s/ Edward Calderoni December 29, 1999 - ------------------------------------------------ Edward Calderoni Director /s/ Silvio F. D'Ignazio December 29, 1999 - ------------------------------------------------ Silvio F. D'Ignazio Director 44 46 /s/ Olive J. Faulkner December 29, 1999 - ------------------------------------------------ Olive J. Faulkner Director /s/ Edmund Jones December 29, 1999 - ------------------------------------------------ Edmund Jones Director /s/ Willard F. Letts December 29, 1999 - ------------------------------------------------ Willard F. Letts Director /s/ Walter J. Lewicki December 29, 1999 - ---------------------------------------------- Walter J. Lewicki Director /s/ Joan G. Taylor December 29, 1999 - ----------------------------------------------- Joan G. Taylor Director 45