SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------- FORM 10-K (Mark One) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the fiscal year ended December 31, 1999 or [ ] TRANSITIONAL REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934. COMMISSION FILE NUMBER: 000-25077 SEACOAST FINANCIAL SERVICES CORPORATION --------------------------------------- (Exact name of Registrant as Specified in its Charter) MASSACHUSETTS 04-1659040 ------------------------ ----------------------------------- (State of Incorporation) (IRS Employer Identification Number) 791 PURCHASE STREET, NEW BEDFORD, MASSACHUSETTS 02740 - ----------------------------------------------- ----- (Address of Principal Executive Offices) (Zip Code) (508) 984-6000 ------------------------------ (Registrant's Telephone Number) SECURITIES REGISTERED PURSUANT TO SECTION 12 (b) OF THE ACT: None 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 to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _ X__ No _____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. [X] The aggregate market value of the voting stock held by non-affiliates of the registrant, based on the closing price on March 17, 2000, on the Nasdaq National Market was $233,501,797. Although directors and executive officers of the registrant were assumed to be "affiliates" of the registrant for the purposes of this calculation, this classification is not to be interpreted as an admission of such status. As of March 17, 2000, 25,467,036 shares of the registrant's common stock were outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the annual meeting of stockholders to be held on May 18, 2000 are incorporated by reference into the annual report as portions of Part III of Form 10-K. PART I ITEM 1. BUSINESS GENERAL Until the completion of a mutual to stock conversion and initial public offering of its stock on November 20, 1998, Seacoast Financial Services Corporation (the "Company" or "Seacoast Financial") was a mutual holding company created in connection with Compass Bank for Savings' (the "Bank" or "Compass") reorganization into a mutual holding company form of organization in 1994. The Company is registered with the Board of Governors of the Federal Reserve System (the "FRB") as a bank holding company under the Bank Holding Company Act of 1956, as amended (the "BHCA"). Since its formation, the Company has owned 100% of Compass's outstanding capital stock. On December 4, 1998, the Company acquired by merger all of the issued and outstanding capital stock of Sandwich Bancorp, Inc. ("Sandwich") in a stock-for-stock exchange and merged Sandwich's wholly-owned subsidiary, the Sandwich Co-operative Bank ("Sandwich Bank"), into Compass. This acquisition has been accounted for as a pooling of interests and, accordingly, all financial data is presented herein as if the Company and Sandwich had always been combined. At December 31, 1999, the Company had $2,122.8 million of total assets. Compass was organized in 1855 as a Massachusetts-chartered mutual savings bank, and reorganized into mutual holding company form in 1994. Compass's principal business has been, and continues to be, gathering deposits from customers within its market area and investing those funds in residential and commercial real estate loans, indirect automobile loans, commercial loans, construction loans, home equity loans and other consumer loans and investment securities. Compass's investment portfolio consists primarily of U.S. Government and Agency securities, corporate debt obligations, mortgage-backed securities, collateralized mortgage obligations and, to a lesser extent, marketable equity securities. Individual and business customers of Compass have a variety of deposit accounts with Compass, including NOW (checking) and other demand deposit accounts, passbook savings accounts, money market deposit accounts, Individual Retirement Accounts ("IRAs") and various certificates of deposit. Compass's deposits are insured by the Bank Insurance Fund (the "BIF"), as administered by the Federal Deposit Insurance Corporation (the "FDIC"), up to the maximum amount permitted by law, except that certain deposits that Compass acquired from a savings association are insured by the Savings Association Insurance Fund (the "SAIF"), also administered by the FDIC. Deposit amounts in excess of FDIC insurance limits are insured by the Depositors Insurance Fund (the "DIF"), a deposit insuring entity for Massachusetts savings banks. Compass is a voluntary member of the Federal Home Loan Bank of Boston (FHLB), which serves principally as a credit source in providing funds for residential loans. On January 28, 1999, the Board of Directors voted to change the Company's yearend from October 31 to December 31. MARKET AREA AND COMPETITION At December 31, 1999, Compass conducted business from its corporate headquarters in New Bedford, Massachusetts and 35 full-service banking offices, six of which are located in New Bedford and the remaining 29 of which are located in the Massachusetts communities of Fall River (two offices), Plymouth (four offices), Fairhaven, North Dartmouth, Somerset, Swansea, Wareham, Westport, Assonet and Carver, Cape Cod (ten offices) and the island of Martha's Vineyard (five offices). Compass also has two limited service high school branches and five remote service ATMs. In addition, Compass's indirect auto lending business extends into the state of Rhode Island. Compass faces significant competition both in generating loans and in attracting deposits. Compass's primary market area is highly competitive and Compass faces direct competition from a significant number of financial institutions, many with a state-wide, a regional and, in some cases, a national presence. Many of these financial institutions are significantly larger and have greater financial resources than Compass. Compass's competition for loans comes principally from commercial banks, savings banks, credit unions, mortgage brokers, mortgage banking companies and insurance companies. Its most direct competition for deposits has historically come from savings, cooperative and commercial banks and credit unions, particularly in Fall River and New Bedford. In addition, Compass faces increasing competition for deposits from non-bank institutions, such as brokerage firms and insurance companies which offer instruments such as short-term money-market funds, corporate and government securities funds, mutual funds and 1 annuities. Competition may also increase as a result of the lifting of restrictions on the interstate operations of financial institutions. Finally, credit unions do not pay federal or state income taxes and are generally subject to fewer regulatory constraints than savings banks. Numerous credit unions are located in Fall River, New Bedford and Rhode Island and, because of their tax and regulatory status, they enjoy a competitive advantage over Compass. PERSONNEL As of December 31, 1999, Compass had 485 full-time employees and 81 part-time employees. None of the Bank's employees are represented by a labor union and management considers its relationship with its employees to be good. LENDING ACTIVITIES GENERAL. Compass's gross loan portfolio totaled $1,747.2 million as of December 31, 1999, representing 82.3% of Compass's total assets on that date. Compass primarily makes residential real estate loans secured by one- to four-family residences, indirect auto loans and commercial real estate loans. Such loans represented 51.3%, 24.2% and 12.8%, respectively, of Compass's loan portfolio as of December 31, 1999. Compass also makes home equity line of credit loans, residential and commercial construction loans, commercial loans, fixed rate home equity loans, personal installment loans, education loans and passbook loans. Real estate secures a majority of Compass's loans, including some loans classified as commercial loans. Compass makes loans throughout its market area and originated $716.0 million in loans during 1998 and $818.2 million in loans during 1999. It sold, on a servicing retained basis, $151.8 million and $6.9 million in residential loans in the secondary market during those same periods, respectively. The types of loans that Compass may originate are subject to federal and state law and regulations. Interest rates charged by Compass on loans are affected primarily by the demand for such loans, the supply of money available for lending purposes, secondary mortgage market rates and the rates offered by competitors. These factors are, in turn, affected by national, regional and local economic conditions, the levels of federal government spending and revenue, monetary policies of the FRB and tax policies. 2 The following table summarizes the composition of Compass's loan portfolio as of the dates indicated: At December 31, At October 31, --------------------------------------- ----------------------------------------- 1999 1998 1998 1997 ------------------- ------------------ ------------------ ------------------ Percent Percent Percent Percent Amount of total Amount of total Amount of total Amount of total ------ -------- ------ -------- ------ -------- ------ -------- (Dollars in thousands) Real estate loans: Residential (one - to four-family) $ 896,479 51.3 % $ 697,031 49.6% $ 629,779 47.7% $ 618,084 51.9% Commercial (1) 223,500 12.8 201,636 14.4 209,366 15.8 202,781 17.0 Home equity 26,076 1.5 25,984 1.9 27,471 2.1 27,835 2.3 Construction, net 71,735 4.1 66,373 4.7 63,189 4.8 59,178 5.0 ---------- ----- ---------- ----- ---------- ----- ---------- ----- Total real estate loans 1,217,790 69.7 991,024 70.6 929,805 70.4 907,878 76.2 ---------- ----- ---------- ----- ---------- ----- ---------- ----- Commercial loans 66,360 3.8 58,829 4.2 50,344 3.8 43,496 3.7 ---------- ----- ---------- ----- ---------- ----- ---------- ----- Consumer loans: Indirect auto loans 439,753 358,101 343,910 238,114 Less: unearned discount 17,370 37,394 37,201 30,066 ---------- ---------- ---------- ---------- Indirect auto loans, net 422,383 24.2 320,707 22.8 306,709 23.2 208,048 17.5 Other 40,673 2.3 33,494 2.4 33,822 2.6 31,517 2.6 ---------- ----- ---------- ----- ---------- ----- ---------- ----- Total consumer loans, net 463,056 26.5 354,201 25.2 340,531 25.8 239,565 20.1 ---------- ----- ---------- ----- ---------- ----- ---------- ----- Total loans $1,747,206 100.0 %$1,404,054 100.0% $1,320,680 100.0% $1,190,939 100.0% ========== ===== ========== ===== ========== ===== ========== ===== At October 31, ---------------------------------------- 1996 1995 ----------------- ------------------ Percent Percent Amount of total Amount of total ------ -------- ------ -------- Real estate loans: Residential (one - to four-family) $ 550,178 51.5% $ 504,534 53.1 % Commercial (1) 202,447 18.9 175,675 18.5 Home equity 29,766 2.8 32,228 3.4 Construction, net 49,576 4.6 30,635 3.2 ---------- ----- ---------- ----- Total real estate loans 831,967 77.8 743,072 78.2 ---------- ----- ---------- ----- Commercial loans 41,618 3.9 40,060 4.2 ---------- ----- ---------- ----- Consumer loans: Indirect auto loans 189,865 159,433 Less: unearned discount 24,232 19,911 ---------- ---------- Indirect auto loans, net 165,633 15.5 139,522 14.7 Other 29,739 2.8 27,448 2.9 ---------- ----- ---------- ----- Total consumer loans, net 195,372 18.3 166,970 17.6 ---------- ----- ---------- ----- Total loans $1,068,957 100.0% $ 950,102 100.0 % ========== ===== ========== ===== (1) In September 1996, Compass reclassified approximately $28.0 million in multifamily loans from residential real estate to commercial real estate loans. A corresponding reclassification for 1995 has not been made. 3 LOAN ORIGINATION AND UNDERWRITING. Loan officers based in each of Compass's five regions -- Plymouth, Fall River, New Bedford, Cape Cod and Martha's Vineyard -- originate and underwrite Compass's mortgage and commercial loans. Compass underwrites consumer loans at its main office, although it originates such loans at its branches and, in the case of indirect auto loans, through a network of car dealers. Compass also employs external loan originators, based in each of the regions, who originate residential mortgage loans. In August 1998, Compass began to fund adjustable rate residential mortgage loans originated by two loan correspondents. During the year ended December 31, 1999, Compass funded $74.2 million of such loans. Loans originated through correspondents were significantly curtailed beginning in the third quarter of 1999. Compass relies on print, radio, television and cable advertising, on referrals from existing customers, accountants, attorneys and real estate professionals and on relationships with existing borrowers to originate loans. In addition, Compass solicits consumer loans, including home equity loans, by direct mail to existing deposit and residential mortgage loan customers. Compass tries to develop relationships with its customers in which customers see Compass as a source of support in the management of their personal finances or in the conduct of their businesses. Based on those relationships, many customers have more than one account with and/or loan from Compass. Finally, Compass has historically relied on relationships with automobile dealers operating throughout its current market area and Rhode Island to generate new indirect auto loans. During 2000, Compass intends to expand its geographic market for indirect auto loans to communities contiguous to the metropolitan Boston area. Accordingly, management anticipates that a higher percentage of its indirect auto loan originations in 2000 will come from dealers outside its primary market area. Compass's underwriting of loans varies depending on the type of loan. It generally includes the use of credit applications, property appraisals and verification of an applicant's credit history, employment and banking relationships to the extent management deems appropriate in each case. With respect to indirect auto loans, the dealers originate the loans, send loan applications to Compass and Compass underwrites them. Additional information concerning the underwriting of specific types of loans is set forth in sections that discuss those loans and in the discussion of environmental factors that affect lending. See "-- Lending Activities," "-- Residential Real Estate Loans," "-- Indirect Auto and Other Consumer Loans," "-- Commercial Real Estate Loans," "-- Commercial Loans," "-- Construction Loans" and "-- Environmental Issues." Four senior loan officers oversee loan origination and underwriting. Individual loan officers may originate loans within certain approved lending limits. A credit committee, consisting of senior loan officers, must approve all commercial and commercial real estate loans that exceed $500,000 and Compass's Board of Directors, or the executive committee thereof, must approve all loans over $1.5 million. Pursuant to its loan policy, Compass generally will not make loans aggregating more than $10.0 million to any one borrower. Exceptions to this "house" lending limit must be approved by the Board. At December 31, 1999, no customers had aggregate borrowing capacity with Compass exceeding the $10.0 house limit. The Bank's legal lending limit, which is set at 20% of its capital, was approximately $45 million at December 31, 1999. 4 The following table sets forth loan activity within Compass's portfolio for the periods indicated: Two months ended Year ended December 31, Year ended October 31, December 31, 1999 1998 1999(1) ---------- ---------- ---------- (In thousands) Loans outstanding at beginning period ... $1,404,054 $1,320,680 $1,190,939 Loans originated: Mortgage loans: Residential ................... 323,913 90,374 313,417 Commercial real estate ........ 46,549 12,150 40,123 Construction .................. 100,725 6,862 80,920 Home equity ................... 16,592 1,344 16,882 ---------- ---------- ---------- Total mortgage loans ..... 487,779 110,730 451,342 ---------- ---------- ---------- Commercial loans .............. 42,846 8,915 39,959 Indirect auto loans ........... 260,043 36,014 203,923 Other consumer loans .......... 27,550 3,097 20,744 ---------- ---------- ---------- Total loans originated ... 818,218 158,756 715,968 ---------- ---------- ---------- Purchases of mortgage loans ............. 13,343 4,158 11,911 Less: Principal repayments ............... 479,117 66,535 442,597 Loans sold or securitized .......... 6,899 12,665 151,817 Transfers to other real estate owned 755 326 2,124 Principal charged-off .............. 1,638 14 1,600 ---------- ---------- ---------- Loans outstanding at end of period ...... $1,747,206 $1,404,054 $1,320,680 ========== ========== ========== - -------------------------------------- (1) Loan activity for this period includes Sandwich Bank for the ten months then ended. Compass charges origination fees, or points, and collects fees to cover the costs of appraisals and credit reports on most new residential mortgage loans. Compass also collects late charges on real estate and consumer loans. For information regarding Compass's recognition of loan fees and costs, see Note 1 of the Notes to the Consolidated Financial Statements presented elsewhere herein. LOAN PURCHASES. Compass occasionally purchases participation interests in commercial and residential real estate loans originated by other banks. Compass underwrites such loans as if it had originated them itself. Compass's interest in participation loans as of December 31, 1999 totaled $44.2 million, of which $26.7 million was acquired from a bank located on the island of Nantucket, Massachusetts. 5 LOAN MATURITY AND REPRICING. The following table shows the contractual maturity and repricing dates of Compass's loan portfolio at December 31, 1999. The table does not reflect prepayments. AT DECEMBER 31, 1999 ------------------------------------------------------------------------------------------ REAL ESTATE MORTGAGE LOANS OTHER ------------------------------------------- HOME INDIRECT CONSUMER TOTAL RESIDENTIAL COMMERCIAL CONSTRUCTION EQUITY COMMERCIAL AUTO LOANS LOANS LOANS ----------------------------------- ------ ---------- ---------- ----- ----- (IN THOUSANDS) Amounts due (1): Within one year ........................ $ 23,856 $ 14,200 $ 14,616 $ 3,751 $ 42,947 $ 121,387 $ 8,524 $ 229,281 --------- --------- --------- --------- -------- ----------- --------- ---------- After one year: More than one year to three years . 50,843 21,217 4,400 129 11,666 215,755 15,531 319,541 More than three years to five years 53,718 21,052 2,465 208 6,892 99,626 7,727 191,688 More than five years to ten years . 147,727 57,025 7,644 2,174 4,111 2,985 6,543 228,209 More than ten years ............... 620,335 110,006 42,610 19,814 744 -- 2,348 795,857 --------- --------- --------- --------- -------- ----------- --------- ---------- Total due after December 31, 2000 ........ 872,623 209,300 57,119 22,325 23,413 318,366 32,149 1,535,295 --------- --------- --------- --------- -------- ----------- --------- ---------- Total amount due .............. $ 896,479 $ 223,500 $ 71,735 $ 26,076 $ 66,360 $ 439,753 $ 40,673 1,764,576 ========= ========= ========= ========= ======== =========== ========= Less: Unearned discount ................. (17,370) Allowance for loan losses ......... (16,828) ---------- Net loans ..................... $1,730,378 ========== - ------------------------ (1) Amounts due are net of unadvanced funds on loans. The following table sets forth, at December 31, 1999, the dollar amount of gross loans, net of unadvanced funds on loans, contractually due or scheduled to reprice after December 31, 2000 and whether such loans have fixed interest rates or adjustable interest rates: DUE AFTER DECEMBER 31, 2000 FIXED ADJUSTABLE TOTAL ----- ---------- ----- (IN THOUSANDS) Real estate mortgage loans: Residential .............................................................. $ 359,172 $ 513,451 $ 872,623 Commercial ............................................................... 19,613 189,687 209,300 Construction ............................................................. 23,072 34,047 57,119 Home equity .............................................................. -- 22,325 22,325 ---------- ---------- ---------- Total real estate mortgage loans ...................................... 401,857 759,510 1,161,367 ---------- ---------- ---------- Commercial loans ............................................................ 8,558 14,855 23,413 Indirect auto loans ......................................................... 318,366 -- 318,366 Other consumer loans ........................................................ 32,149 -- 32,149 ---------- ---------- ---------- Total loans ........................................................... $ 760,930 $ 774,365 $1,535,295 ========== ========== ========== RESIDENTIAL REAL ESTATE LOANS. As of December 31, 1999, adjustable rate mortgage loans represented approximately 60% and fixed-rate mortgage loans represented approximately 40% of Compass's portfolio of residential mortgage loans secured by one- to four-family owner-occupied properties. Compass originated $313.4 million of residential real estate loans during the year ended October 31, 1998, $90.4 million during the two months ended December 31, 1998 and $323.9 million during the year ended December 31, 1999. Compass's portfolio of residential real estate loans totaled $896.5 million, which represented 51.3% of Compass's total loan portfolio at December 31, 1999. Over 90% of this portfolio is secured by single-family owner-occupied homes and the remainder is secured primarily by two-, three- or four-family owner-occupied homes. Until November 1998, Compass generally sold most of the fixed-rate residential mortgage loans it originated with terms of 15 years or longer to the Federal Home Loan Mortgage Corporation ("FHLMC"). Compass is also authorized to sell loans to the Federal National Mortgage Association ("FNMA") and to service those loans. Compass continues to service loans that it has sold to FHLMC and receives a monthly fee for servicing such loans equal to .25% to service loans that it has sold to FHLMC and receives a monthly fee for servicing such loans equal to .25% per annum 6 of the amounts outstanding on them. Compass serviced loans for others aggregating $339.9 million as of December 31, 1999 and $405.9 million as of October 31, 1998 and it earned $587,000 and $759,000 in servicing fees, net of the amortization of capitalized mortgage servicing rights, representing 5.87% and 7.56%, of its non-interest income in 1999 and 1998, respectively. Compass generally retains for its own portfolio fixed-rate residential mortgage loans with terms of less than 15 years and fixed-rate residential mortgage loans that amortize on a bi-weekly basis and have terms between 10 and 30 years. Compass had $116.1 million of such loans in its portfolio as of December 31, 1999. Compass also retains in its portfolio fixed-rate mortgage loans that exceed the size limits of FHLMC's underwriting criteria, and loans made under its program for low-to-moderate income borrowers, as described below. Beginning in November 1998, Compass changed its practice and is currently no longer selling its fixed rate residential mortgage loans. This change was based on the Bank's assessment of the impact which the Sandwich acquisition and the capital raised in the initial public offering would have on the sensitivity of its balance sheet to changes in interest rates. In assessing its options, the Bank concluded that, at this time, the retention of fixed rate mortgages offered the best alternative as to yield and duration. The Bank intends to continue this strategy so long as it does not result in an interest rate risk exposure inconsistent with its stated policies. Compass's asset liability strategy is reviewed quarterly and changes are expected to be made to this practice when circumstances warrant. Compass originates adjustable-rate residential mortgage loans mostly for its own portfolio. Compass originated $101.2 million and $169.8 million in such loans during 1998 and 1999, respectively, including $9.4 million in 1998 and $74.2 million in 1999 originated through two loan correspondents, and had $533.9 million of such loans in its residential loan portfolio, representing approximately 60% of such portfolio, as of December 31, 1999. Compass offers adjustable-rate mortgage loans that reprice annually, every three years or after five years and annually thereafter. The interest rate adjustments on these loans are indexed to the applicable one-year or three-year U.S. Treasury CMT Index with corresponding add-on margins of varying amounts. Such loans are subject to certain requirements and limitations set forth in guidelines issued by the Massachusetts Commissioner of Banks, including limitations on the amount and frequency of interest rate changes. Rates adjust by no more than one or two percentage points in each adjustment period and by no more than five or six points over the life of a loan. Adjustable rate loans are generally originated at a discount, generally ranging from 1.25% to 2.75%, from the fully margined index rate. Compass's residential mortgage loans are generally written in amounts up to 95% of the appraised value or selling price, whichever is less, of the property securing the loan, although the majority of such loans are written with ratios of 80% or less. Compass generally requires borrowers to obtain private mortgage insurance with respect to loans with a greater than 80% loan-to-value ratio. In 1994, Compass initiated a program to originate residential mortgage loans to low-to-moderate income borrowers. The loans have fixed or adjustable interest rates that are typically lower than prevailing market rates, are closed without points, have substantially lower closing costs than Compass's other residential loans and have terms of up to 30 years. The loans may have up to a 95% loan-to-value ratio, although borrowers must obtain private mortgage insurance if the loan-to-value ratio exceeds 80%. Compass does not sell these loans in the secondary market. Compass partially funds the loans with borrowings under the Community Investment Program ("CIP") and the New England Fund ("NEF") housing programs of the FHLB. These programs permit Compass to borrow from the FHLB at below market rates to finance the loans. Compass had $17.5 million of CIP-funded loans and $19.1 million of NEF-funded loans in its residential loan portfolio, representing 4.1% of such portfolio, as of December 31, 1999. COMMERCIAL REAL ESTATE LOANS. Compass makes commercial real estate loans throughout its market area. Compass originated $40.1 million and $46.5 million in commercial real estate loans in 1998 and 1999, respectively, and had $223.5 million in commercial real estate loans in its loan portfolio, representing 12.8% of such portfolio, as of December 31, 1999. Properties that are used for borrowers' businesses, such as small office buildings, restaurants, inns, retail facilities or multi-family income properties, normally collateralize Compass's commercial real estate loans. The loans typically have terms of up to 20 years and interest rates which adjust over periods of one to five years based on one of various rate indices. Commercial real estate loans with fixed interest rates have terms generally ranging from one to five years. 7 Compass primarily considers the quality of the borrower's management and the borrower's cash flows when it underwrites commercial real estate loans. Compass generally makes commercial real estate loans in an amount equal to no more than 80% of the appraised value of the property securing the loan. Compass generally requires the owners of businesses seeking commercial real estate loans to personally guarantee those loans. At December 31, 1999, $21.3 million of the commercial real estate loans in Compass's portfolio were secured by multi-family income properties. A majority of these properties are located in Fall River and New Bedford and contain between five and twelve residential units. Commercial real estate lending entails greater credit risks than residential mortgage lending to owner occupants. The repayment of commercial real estate loans depends on the business and financial condition of the borrower. Economic events and changes in government regulations, which Compass and its borrowers cannot control, could have an adverse impact on the cash flows generated by properties securing Compass's commercial real estate loans and on the value of such properties. Commercial properties tend to decline in value more rapidly than residential owner-occupied properties during economic recessions. CONSTRUCTION LOANS. Compass makes both residential and commercial construction loans, primarily in Plymouth County, Cape Cod, in and around New Bedford and on Martha's Vineyard. Compass typically makes the loans to either owner-borrowers who will occupy the properties (residential construction) or licensed and experienced developers for the construction of single-family home developments that have no more than 30 housing lots and, to a lesser extent, end users of commercial properties (commercial construction). Commercial construction loans to end users are generally originated with Compass committing to the related permanent financing. Compass makes commercial construction loans only to developers who have successful track records. Compass generally increases the loan-to-value ratios on such loans as construction progresses. Before any work has commenced, and while a construction loan's only collateral is a plot of land, Compass will typically finance only up to 70% of the value of that land. Once construction has begun, Compass will generally make residential construction loans in amounts up to 90% (for primary homes) and 80% (for secondary homes) of the lesser of the appraised value of the property, as completed, or the property's cost of construction. Compass generally makes commercial construction loans in amounts up to 75% of the lesser of the property's appraised value, as completed, or construction cost and generally requires developers seeking commercial construction loans to personally guarantee them. Compass disburses the proceeds of construction loans in stages and requires developers to pre-sell a certain percentage of the properties they plan to build before Compass will advance any construction financing. Compass officials or appointed professionals inspect each project's progress before Compass disburses additional funds to verify that borrowers have completed project phases. Residential construction loans to owner-borrowers generally convert to a fully amortizing long-term mortgage loan upon completion of construction. Commercial construction loans generally have terms of six months to a maximum of two years. Some construction loans have fixed interest rates but Compass originates mostly adjustable-rate construction loans. Compass originated $80.9 million and $100.7 million in construction loans during 1998 and 1999, respectively, and had $71.7 million in construction loans in its loan portfolio, representing 4.1% of such portfolio, as of December 31, 1999. Construction lending, particularly commercial construction lending, entails greater credit risk than residential mortgage lending to owner occupants. The repayment of construction loans depends on the business and financial condition of the borrower and on the economic viability of the project financed. A number of Compass's borrowers have more than one construction loan outstanding with the Bank. Economic events and changes in government regulations, which Compass and its borrowers cannot control, could have an adverse impact on the value of properties securing construction loans and on the borrowers' ability to complete projects financed and, if not the borrower's residence, sell them for expected amounts at the time the projects were commenced. HOME EQUITY LOANS. Compass has a portfolio of home equity lines of credit secured by one- to four-family owner-occupied properties. These loans are revolving lines of credit and are typically secured by second mortgages. Interest rates on home equity loans normally adjust based on Compass's prime rate of interest. The lines of credit are available for up to ten years, at the end of which they become term loans which are amortized for the same amount of time as the 8 original revolving lines of credit. Compass generally originates home equity line of credit loans in amounts from $10,000 to $150,000 but not, in any event, more than the difference between 80% (for primary homes) or 70% (for secondary homes) of the appraised value of the property securing the loan, or 70% (for primary homes) or 60% (for secondary homes) of the value of such property as assessed for tax purposes, and the outstanding balance of the first mortgage on such property. Compass had $26.1 million in home equity loans in its loan portfolio, representing 1.5% of the portfolio, as of December 31, 1999. The undrawn portion of home equity lines of credit totaled $33.5 million at December 31, 1999. COMMERCIAL LOANS. Compass primarily makes commercial loans to businesses that operate in and around Southeastern Massachusetts including Martha's Vineyard. In recent years Compass increased its efforts to originate more such loans in Plymouth and Fall River by adding a commercial loan officer dedicated to each of those markets. As a result of its recent merger with Sandwich Bank, Compass also has commercial loan officers dedicated to the Cape Cod market. Compass reviews the financial resources, debt-to-equity ratios, cash flows and its own experience with businesses when underwriting commercial loans. Compass generally requires business owners to personally guarantee commercial loans. Compass's commercial loans are generally collateralized by equipment, leases, inventory and/or accounts receivable. Many of Compass's commercial loans are also collateralized by real estate, but are not classified as commercial real estate loans because such loans are not made for the purpose of acquiring, refinancing or constructing the real estate securing the loan. Commercial loans provide, among other things, working capital, equipment financing, financing for leasehold improvements and financing for acquisitions. Compass offers both term and revolving commercial loans. The former have either fixed or adjustable rates of interest and, generally, terms of between four and seven years. Term loans generally amortize during their life, although some loans require a lump sum payment at maturity. Revolving commercial lines of credit typically have one-year terms, renewable annually, and rates of interest which are normally indexed to Compass's prime rate of interest. Compass's commercial borrowers are not concentrated in any one particular industry. As of December 31, 1999, Compass's commercial loan portfolio included, among others, floor plan loans to auto dealerships, loans to hotels, inns and other tourism-related businesses, loans to building trade companies and loans to liquor stores. Compass originated $40.0 million and $42.8 million in commercial loans during 1998 and 1999, respectively, and had $66.4 million in commercial loans in its loan portfolio, representing 3.8% of such portfolio, as of December 31, 1999. Commercial lending entails greater credit risks than residential mortgage lending to owner occupants. Repayment of both secured and unsecured commercial loans depends substantially on the borrower's underlying business, financial condition and cash flows. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrower's business. Secured commercial loans are generally collateralized by equipment, leases, inventory and/or accounts receivable. Compared to real estate, such collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed. INDIRECT AUTO AND OTHER CONSUMER LOANS. Compass emphasizes indirect auto lending through a network of automobile dealers. Compass has been in the indirect auto lending business since 1985 and has increased its portfolio of indirect auto loans from $165.6 million at October 31, 1996 to $422.4 million at December 31, 1999, or 24.2% (net of unearned discount) of the loan portfolio on the latter date. No one dealership originated more than $15.1 million of the loan balances outstanding in Compass's loan portfolio at December 31, 1999. In developing its network, Compass has historically focused on dealers in its primary market areas and in Rhode Island. Because of increasing competition for these loans in its market area and management's intent to continue to increase this portion of the loan portfolio, Compass began to expand its network of auto dealers to communities contiguous to the metropolitan Boston area during 1999. This trend is expected to continue in 2000. The growth of the dealer network has been achieved through an emphasis on quality service and the development of long-term relationships with the owners and managers of the dealerships. Compass does not engage in auto lease financing. 9 Management believes that indirect auto lending has several advantages, including the following: (i) the dealer network creates numerous "loan centers" throughout Compass's market area; (ii) Compass can increase the network without increasing its operating expenses significantly; and (iii) the network develops a pool of customers to whom Compass can cross-sell other products and services. Compass makes indirect auto loans to purchase both new and used cars. The loans have terms of up to six years for those secured by new vehicles and five and a half years for those secured by used vehicles. As of December 31, 1999, approximately half of Compass's indirect auto loans were secured by new cars and the other half by used cars. Compass originated $203.9 million and $260.0 million in indirect auto loans during 1998 and 1999, respectively. To underwrite its indirect auto loans, Compass reviews the credit history of applicants and determines appropriate debt-to-equity and loan-to-value ratios. Compass also believes that the quality of its indirect auto portfolio is positively affected by its efforts to build and maintain relationships with auto dealers who attract creditworthy customers. Compass tries to identify such dealers based on Compass's knowledge of car dealers in its market area. In connection with the origination of indirect auto loans, the interest rate charged to the borrower on the underlying loan is generally one to two percentage points higher than the "buy rate" or rate earned by Compass. The difference between the two rates is referred to as the "spread". At loan inception, the dollar value of the spread over the contractual term of the loan is prepaid by Compass to the auto dealer. Such prepaid amounts have generally been subject to rebate to Compass in the event the underlying loan is prepaid or defaults although recently more dealers have opted to receive a reduced spread amount in exchange for elimination of their rebate obligation. Such arrangements are referred to as "split reserve" deals. The risk of loss of amounts previously advanced to the dealer in other than split reserve arrangements is primarily dependent upon loan performance but is also dependent upon the financial condition of the dealer. Consequently, the dealer's ability to refund any portion of the prepaid interest which is unearned is subject to economic conditions, generally, and the financial condition of the dealer. To mitigate this risk, Compass withholds a portion of the spread at loan origination as a dealer reserve. The amount withheld, in the aggregate, generally approximates 1% of the outstanding balance of loans originated by each dealer. At December 31, 1999, the balance of the dealer reserve was $4.4 million, or 1.0% of the balance of indirect auto loans. In some originations of indirect auto loans, the interest charged to the borrower is equal to the buy rate thereby eliminating the spread. In such transactions auto dealers are paid a flat fee which is not rebatable to the Bank in the event of loan prepayment or default. Beginning in January 1999, Compass implemented a new "tiered rate program" wherein the buy rate offered to auto dealers is based on the credit bureau's credit score for each borrower. Previously, the Bank offered a single rate for all borrowers. This program is also being used by most of the Bank's competitors. By making this change, Compass believes it is better able to offer competitive rates to attract lower risk credits while charging higher rates for higher risk credits. Indirect auto lending entails greater risks than residential mortgage lending to owner occupants. Although Compass has not experienced significant delinquencies in this portfolio, borrowers may be more likely to become delinquent on an automobile loan than on a residential mortgage loan secured by their primary residence. Moreover, automobiles depreciate rapidly and, in the event of default, principal loss as a percentage of the loan balance depends upon the mileage and condition of the vehicle at the time of repossession, over which Compass has no control. Compass makes a variety of other consumer loans, including personal installment loans, education loans, fixed-rate home equity loans, auto loans directly to customers and passbook loans. Compass does not have any credit card loans. Other consumer loans represented 2.3% of Compass's gross loan portfolio as of December 31, 1999. Compass's fixed-rate home equity loans are collateralized generally by second mortgages on residential properties. The loans have terms of up to 15 years and are available in amounts up to $100,000. Compass generally makes fixed-rate home equity loans that, together with any first mortgage loans on the properties collateralizing such loans, have a loan-to-value ratio of 80% or less (if the first mortgage is with another bank) or up to 90% (if the first mortgage is with Compass). ENVIRONMENTAL ISSUES Compass encounters certain environmental risks in its lending. Under federal and state environmental laws, lenders may become liable for the costs of cleaning up hazardous materials found on properties securing their loans. In addition, the presence of hazardous materials on such properties may make it unattractive for Compass to foreclose on them. 10 Also, the presence of environmentally hazardous materials near but not on properties in which Compass has a security interest may have a negative effect on the values of those properties. Commercial real estate loans typically involve such risks but multi-family and other residential real estate loans are also subject to them. Compass has procedures for the assessment of environmental risks and it believes that those procedures are adequate. Generally, before originating commercial real estate loans in excess of $250,000, Compass requires prospective borrowers to make a preliminary assessment of whether environmentally hazardous materials are located on the properties that would collateralize such loans. If a preliminary assessment raises concerns, Compass requires borrowers to conduct further environmental analyses of the properties. Before originating a commercial real estate loan below $250,000, a loan officer must review the appraisal of the property that will collateralize the loan to make sure that the borrower does not need to undertake a preliminary assessment of its environmental condition. Compass does not know of any environmental problems that might expose it to any material liabilities. No assurance can be given, however, that the values of properties securing loans in Compass's portfolio will not be adversely affected by environmental risks. DELINQUENT LOANS, OTHER REAL ESTATE OWNED, CLASSIFICATION OF ASSETS AND LOAN REVIEW DELINQUENT LOANS. Management performs a monthly review of all delinquent loans with a principal balance in excess of $150,000. Compass's Collection Department Manager discusses the status of each account with Lending Department Managers, the Executive Vice President of Lending and Account Officers. In addition, Compass's Board of Directors reviews delinquency statistics by loan class on a monthly basis. The actions taken with respect to delinquencies vary depending upon the nature of the delinquent loans and the period of delinquency. Compass's collection philosophy is predicated upon early detection and response to delinquent and default situations. Compass seeks to make arrangements to cure the entire default over the shortest time frame. Generally, Compass requires that a delinquency notice be mailed no later than the 10th day of delinquency. A second notice is mailed on the 15th day of delinquency. A late charge is usually assessed on loans where the scheduled payment is unpaid after 15 days. After mailing the delinquency notices, Compass's loan collection personnel call the borrower to ascertain the reasons for delinquency and the prospects for payment. On loans secured by one- to four-family owner occupied properties, Compass attempts to work out a payment schedule with the borrower in order to avoid foreclosure. If these efforts do not achieve a satisfactory arrangement, Compass generally refers the loan to legal counsel and counsel initiates foreclosure proceedings. At any time prior to a sale of the property at foreclosure, Compass will terminate foreclosure proceedings if the borrower and Compass are able to work out a satisfactory payment plan. On loans secured by commercial real estate properties, Compass also seeks to reach a satisfactory payment plan so as to avoid foreclosure. Prior to foreclosure, Compass will generally obtain an updated appraisal of the property. 11 The following table sets forth delinquencies in Compass's loan portfolio as of the dates indicated: AT DECEMBER 31, 1999 AT OCTOBER 31, 1998 ------------------------------------------ ---------------------------------------------- 60-89 DAYS 90 DAYS OR MORE 60-89 DAYS 90 DAYS OR MORE -------------------- --------------------- ----------------------- ---------------------- PRINCIPAL PRINCIPAL PRINCIPAL PRINCIPAL NUMBER BALANCE NUMBER BALANCE NUMBER BALANCE NUMBER BALANCE OF LOANS OF LOANS OF LOANS OF LOANS OF LOANS OF LOANS OF LOANS OF LOANS -------- -------- -------- -------- -------- -------- -------- -------- (DOLLARS IN THOUSANDS) Mortgage loans: Residential ............... 20 $1,501 30 $2,002 17 $1,374 33 $2,229 Commercial real estate .... 1 27 9 942 7 598 7 646 Construction .............. -- -- 1 56 -- -- -- -- Home equity ............... 6 304 10 614 3 53 6 268 Commercial loans .............. 2 115 9 570 7 138 3 7 Indirect auto loans ........... 148 883 106 725 67 536 48 418 Other consumer loans .......... 30 38 14 26 36 83 31 58 ------ ------ ------ ------ ------ ------ ------ ------ Total ................... 207 $2,868 179 $4,935 137 $2,782 128 $3,626 ====== ====== ====== ====== ====== ====== ====== ====== Delinquent loans to total loans 0.16% 0.28% 0.21% 0..27% ====== ====== ====== ====== AT OCTOBER 31, 1997 60-89 DAYS 90 DAYS OR MORE PRINCIPAL PRINCIPAL NUMBER BALANCE NUMBER BALANCE OF LOANS OF LOANS OF LOANS OF LOANS -------- -------- -------- -------- (DOLLARS IN THOUSANDS) Mortgage loans: Residential ............... 18 $1,297 33 $3,298 Commercial real estate .... 3 232 13 1546 Construction .............. -- -- 1 148 Home equity ............... 1 18 4 98 Commercial loans .............. 3 178 3 414 Indirect auto loans ........... 33 223 40 435 Other consumer loans .......... 17 56 16 26 ------ ------ ------ ------ Total ................... 75 $2,004 110 $5,965 ====== ====== ====== ====== Delinquent loans to total loans 0.17% 0.50% ====== ====== OTHER REAL ESTATE OWNED. Compass classifies property acquired through foreclosure or acceptance of a deed in lieu of foreclosure as OREO in its financial statements. When a property is placed in OREO, the excess of the loan balance over the estimated fair market value of the collateral is charged to the allowance for loan losses. Estimated fair value usually represents the sales price a buyer would be willing to pay on the basis of current market conditions, including normal loan terms from other financial institutions, less estimated costs to sell the property. Management inspects all OREO properties periodically. Subsequent write down in the carrying value of OREO are charged to expense if the carrying value exceeds the OREO's fair value less estimated selling costs. At December 31, 1999, OREO totaled $552,000, the majority of which consisted of properties sold by Compass from its OREO portfolio to buyers, financed by Compass, whose cash down payments were insufficient to permit such transactions to be accounted for as a sale under GAAP. There were six loans in this category five of which were substantially current at December 31, 1999. 12 CLASSIFICATION OF ASSETS AND LOAN REVIEW. Compass uses an internal rating system to monitor and evaluate the credit risk inherent in its loan portfolio. At the time of loan approval, all commercial, commercial real estate and commercial construction loans are assigned a rating based on all of the factors considered in originating the loan. The initial loan rating is recommended by the loan officer who originated the loan and approved by the individuals or committee responsible for approving it. Loan quality ratings are utilized as major criteria in the compilation of Compass's Asset Watch List. All loans with loan ratings of 4 (Special Mention), 5 (Substandard) or 6 (Doubtful) are included in a monthly Asset Watch List. Watch List ratings are an integral part of the evaluation of the adequacy of Compass's loan loss reserve. Loan officers are expected to submit appropriate rating changes to the Lending Administration Officer when facts come to their attention that warrant an upgrade or downgrade in a loan rating. In addition, loan ratings are generally reviewed on an annual basis. Loans that are rated Substandard or Doubtful coincide with the classifications used by federal regulators in their examination of financial institutions. Generally, a loan is considered Substandard if it is inadequately protected by the current net worth and paying capacity of the obligors and/or the collateral pledged. Substandard loans include those characterized by the distinct possibility that Compass will sustain some loss if the deficiencies are not corrected. Loans classified as Doubtful have all the weaknesses inherent in those classified Substandard with the added characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, highly questionable and improbable. Loans classified as Loss are those considered uncollectible and of such little value that their continuance as assets without establishment of a specific loss reserve and/or charge-off is not warranted. Loans which do not currently expose Compass to sufficient risk to warrant classification in one of the aforementioned categories but possess weaknesses are designated "Special Mention." Compass also utilizes an independent third party to conduct periodic (generally semi-annual) credit analysis of its commercial and commercial real estate loan portfolios and to analyze trends in loan delinquency and non-performing loans. The level of Classified Loans as determined by Compass is reconciled to the level of Classified Loans as determined by the independent loan review. On a quarterly basis, a management group comprised of the Senior Vice President and Treasurer, the Executive Vice President of Lending and other key officers reviews the status and classification of each loan assigned a rating of Substandard, Doubtful or Loss. Loans, or portions of loans, classified Loss are charged off against the reserve for loan losses. This group also assesses the overall adequacy of the allowance for loan losses, including the general valuation allowance established to recognize the inherent risk associated with each specific category of lending. Compass's classification of its loans and the amount of the valuation allowances it sets aside for estimated losses is subject to review by the FDIC and the Commissioner. Based on their reviews, these agencies can order the establishment of additional general or specific loss allowances. The FDIC, in conjunction with the other federal banking agencies, has adopted an interagency policy statement on allowances for loan and lease losses. The policy statement provides guidance for banks on both the responsibilities of management for the assessment and establishment of adequate allowances and guidance for banking agency examiners to use in determining the adequacy of a bank's valuation methodology. Generally, the policy statement recommends that banks have effective systems and controls to identify, monitor and address asset quality problems; that management analyze all significant factors that affect the collectibility of loans in a reasonable manner; and that management establish acceptable valuation processes that meet the objectives set forth in the policy statement. While Compass believes that it has established adequate specific and general allowances for losses on loans, actual losses are dependent upon future events and, as such, further additions to the allowance for loan losses may become necessary. See "-- Allowance for Loan Losses." At December 31, 1999, loans designated as Substandard and Special Mention totaled $3.7 million and $4.3 million, respectively. One loan with a balance of $75,000 was designated Doubtful. The Substandard loans include 4 commercial loans with individual borrower balances ranging from $3,000 to $289,000 and a total outstanding principal balance of $459,000; 19 commercial real estate loans with individual borrower balances ranging from $30,000 to $759,000 and a total outstanding principal balance of $3.2 million, and one construction loan with a balance of $32,000. The delinquency status of the commercial real estate loans classified as Substandard was as follows: current - -- $1.3 million; 30-60 days past due -- $1.2 million; 60-90 days past due -- $0; and >90 days past due -- $765,000. 13 Included in Special Mention loans at December 31, 1999 were 6 commercial loans with individual borrower balances ranging from $9,000 to $61,000 and a total outstanding principal balance of $211,000. There were 17 commercial real estate loans with individual borrower balances ranging from $30,000 to $1.2 million and a total outstanding principal balance of $4.1 million classified as Special Mention at December 31, 1999. Of these, all but $871,000 were current. NON-ACCRUAL LOANS, NON-PERFORMING ASSETS AND RESTRUCTURED LOANS The following table sets forth information regarding non-accrual loans, other real estate owned and restructured loans: AT DECEMBER 31, AT OCTOBER 31, --------------- -------------------------------------- 1999 1998 1997 1996 1995 (DOLLARS IN THOUSANDS) Non-accrual loans (1): Mortgage loans: Residential ............................ $ 2,591 $ 3,685 $ 4,286 $ 4,650 $ 6,071 Commercial real estate ................. 2,613 2,330 8,957 7,953 5,340 Construction ........................... 56 42 220 230 172 Home equity ............................ -- 42 82 195 196 Commercial loans .............................. 474 415 919 1,294 1,260 Indirect auto loans (4) ....................... -- -- -- -- -- Other consumer loans (4) ...................... -- -- -- -- -- ------- ------- ------- ------- ------- Total non-accrual loans ................ 5,734 6,514 14,464 14,322 13,039 Other real estate owned ............................. 552 1,299 2,303 3,063 4,285 ------- ------- ------- ------- ------- Total non-performing assets ............ $ 6,286 $ 7,813 $16,767 $17,385 $17,324 ======= ======= ======= ======= ======= Restructured loans (2) .............................. $ -- $ -- $ 235 $ 4,525 $ 4,181 ======= ======= ======= ======= ======= Allowance for loan losses as a percent of total loans 0.96% 1.14% 1.24% 1.32% 1.42% Allowance for loan losses as a percent of total non-performing loans (3) ...................... 293.48% 232.07% 101.92% 98.28% 103.72% Non-performing loans as a percent of total loans .... 0.33% 0.49% 1.21% 1.34% 1.37% Non-performing assets as a percent of total assets .. 0.30% 0.43% 1.03% 1.17% 1.23% (1) Non-accrual loans include all loans 90 days or more past due and other loans which have been identified by Compass as presenting uncertainty with respect to the collectibility of interest or principal. See Note 4 for exception to this policy. (2) Restructured loans represent performing loans for which concessions (such as reductions of interest rates to below market terms and/or extension of repayment terms) have been granted due to borrower's financial condition. The balances presented exclude restructured loans on non-accrual status. (3) Non-performing loans are comprised of non-accrual loans. (4) Consumer loans, including indirect auto loans, are not placed on non-accrual status due to the expedited manner in which these loans are resolved and the immaterial balance of individual loans. During 1998, the balance of non-accrual loans decreased by $8.0 million. The majority of this decrease was attributable to two loan relationships. In one instance, the loan was repaid and, in the other, the borrower, whose payments had been current, also had shown improved operating performance sufficient to warrant an upgrade in loan classification and placement on accrual status. ALLOWANCE FOR LOAN LOSSES The allowance for loan losses is established through provisions for loan losses based on management's on-going evaluation of the risks inherent in Compass's loan portfolio. Factors considered in the evaluation process include growth of the loan portfolio, the risk characteristics of the types of loans in the portfolio, geographic and large borrower concentrations, current regional economic and real estate market conditions that could affect the ability of borrowers to pay, the value of underlying collateral and trends in loan delinquencies and charge-offs. The allowance for loan losses is maintained at an amount management considers adequate to cover estimated losses in its loan portfolio which are deemed probable and estimable based on information currently known to management. See "-Delinquent Loans, Other Real Estate Owned, Classification of Assets and Loan Review." 14 The following table sets forth the activity in Compass's allowance for loan losses for the periods indicated: YEAR ENDED DECEMBER 31, YEAR ENDED OCTOBER 31, ------------ ---------------------- 1999 1998 1997 1996 1995 ---- ---- ---- ---- ---- (IN THOUSANDS) Balance at beginning of period .................... $ 15,914 $ 14,742 $ 14,075 $ 13,524 $ 10,257 Provision for loan losses ......................... 2,000 1,736 2,615 1,431 246 Acquired allowance ................................ -- -- -- -- 3,541 Charge-offs: Mortgage loans: Residential .......................... -- 229 196 180 944 Commercial ........................... -- 371 785 342 186 Home equity .......................... -- 49 -- 121 21 Construction ......................... -- -- -- -- -- Commercial loans ......................... 379 213 688 156 59 Indirect auto loans ...................... 1,116 614 546 373 227 Other consumer loans ..................... 143 124 199 164 156 -------- -------- -------- -------- -------- Total charge-offs ........... 1,638 1,600 2,414 1,336 1,593 -------- -------- -------- -------- -------- Recoveries: Mortgage loans: Residential .......................... 5 32 73 33 402 Commercial ........................... 6 41 134 204 506 Home equity .......................... -- 3 -- -- -- Construction ......................... -- -- -- -- -- Commercial loans ............................ 300 213 75 100 5 Indirect auto loans ......................... 185 113 144 70 93 Other consumer loans ........................ 56 114 40 49 67 -------- -------- -------- -------- -------- Total recoveries ............ 552 516 466 456 1,073 -------- -------- -------- -------- -------- Net charge-offs ................................... (1,086) (1,084) (1,948) (880) (520) -------- -------- -------- -------- -------- Effect of difference in year-ends ................. -- (277) -- -- -- -------- -------- -------- -------- -------- Balance at end of period .......................... $ 16,828 $ 15,117 $ 14,742 $ 14,075 $ 13,524 ======== ======== ======== ======== ======== Ratio of net charge-offs to average loans ............................ 0.07% 0.09% 0.17% 0.09% 0.06% ======== ======== ======== ======== ======== 15 The following tables set forth the allocation of Compass's allowance for loan losses, the percent of allowance by loan category and the percent of loans to total loans in each of the categories listed at the dates indicated: AT DECEMBER 31, AT OCTOBER 31, --------------------------------- ------------------------------------ 1999 1998 --------------------------------- ------------------------------------ PERCENT PERCENT OF LOANS OF LOANS PERCENT OF IN EACH PERCENT OF IN EACH ALLOWANCE CATEGORY ALLOWANCE CATEGORY TO TOTAL TO GROSS TO TOTAL TO GROSS AMOUNT ALLOWANCE LOANS AMOUNT ALLOWANCE LOANS ------ --------- ----- ------ --------- ----- (DOLLARS IN THOUSANDS) Mortgage loans: Residential ................................... $ 4,455 26.5% 51.3% $ 3,548 23.5% 47.7% Commercial real estate ........................ 5,311 31.6 12.8 5,434 35.9 15.8 Construction .................................. 547 3.3 4.1 818 5.4 4.8 Home equity ................................... 197 1.2 1.5 220 1.5 2.1 Commercial loans ................................... 1,933 11.5 3.8 1,767 11.7 3.8 Indirect auto loans ................................ 3,855 22.9 24.2 2,837 18.8 23.2 Other consumer loans ............................... 530 3.0 2.3 493 3.2 2.6 ------- ----- ----- ------- ----- ----- Total ......................................... $16,828 100.0% 100.0% $15,117 100.0% 100.0% ======= ===== ===== ======= ===== ===== AT OCTOBER 31, ------------------------------- 1997 ------------------------------- PERCENT OF LOANS PERCENT OF IN EACH ALLOWANCE CATEGORY TO TOTAL TO GROSS AMOUNT ALLOWANCE LOANS ------ --------- ----- (DOLLARS IN THOUSANDS) Mortgage loans: Residential ................................... $ 3,542 24.0% 51.9% Commercial real estate ........................ 5,968 40.5 17.0 Construction .................................. 716 4.8 5.0 Home equity ................................... 217 1.5 2.3 Commercial loans ................................... 2,021 13.7 3.7 Indirect auto loans ................................ 1,837 12.5 17.5 Other consumer loans ............................... 441 3.0 2.6 ------- ----- ----- Total ......................................... $14,742 100.0% 100.0% ======= ===== ===== AT OCTOBER 31, ---------------------------------------------------------------------- 1996 1995 ---------------------------------------------------------------------- PERCENT PERCENT OF LOANS OF LOANS PERCENT OF IN EACH PERCENT OF IN EACH ALLOWANCE CATEGORY ALLOWANCE CATEGORY TO TOTAL TO GROSS TO TOTAL TO GROSS AMOUNT ALLOWANCE LOANS AMOUNT ALLOWANCE LOANS ------ --------- ----- ------ --------- ----- (DOLLARS IN THOUSANDS) Mortgage loans: Residential ................................... $ 3,484 24.8% 51.5% $ 4,160 30.8% 53.1% Commercial real estate ........................ 5,719 40.6 18.9 4,321 31.9 18.5 Construction .................................. 535 3.8 4.6 585 4.3 3.2 Home equity ................................... 239 1.7 2.8 508 3.8 3.4 Commercial loans ................................... 2,197 15.6 3.9 2,113 15.6 4.2 Indirect auto loans ................................ 1,498 10.6 15.5 1,403 10.4 14.7 Other consumer loans ............................... 403 2.9 2.8 434 3.2 2.9 ------- ----- ----- --------- ----- ----- Total ......................................... $14,075 100.0% 100.0% $ 13,524 100.0% 100.0% ======= ===== ===== ========= ===== ===== INVESTMENT ACTIVITIES The investment policy of Compass is reviewed and updated by senior management and submitted to the Board of Directors for their approval on an annual basis. The primary objective of the investment portfolio is to achieve a competitive rate of return on the investments over a reasonable period of time based on prudent management practices and sensible risk taking. In view of Compass's lending capacity and generally higher rates of return on loans, management prefers lending activities as its primary source of revenue with the securities portfolio serving a secondary role. The investment portfolio, however, is expected to continue to represent a relatively stable portion of Compass's assets, with such portfolio consisting of U.S. Government and Agency securities, mortgage-backed securities, collateralized mortgage obligations, high quality corporate debt obligations and a limited amount of corporate equities. The portfolio will continue to serve Compass's liquidity needs as projected by management and as required by regulatory authorities. Compass's current investment strategy, developed with the assistance of an outside professional advisor, has emphasized the purchase of U.S. Government and Agency obligations and corporate debt obligations generally maturing within two to three years and with weighted average lives of 7-10 years. Compass's investment policy permits investments in mortgage-backed securities which are traditionally long-term assets. However, the policy limits Compass's investment in these types of securities to 25% of total assets. 16 The investment policy prohibits the use of hedging with such instruments as financial futures, interest rate options and swaps without specific approval from Compass's Board of Directors. The President and Chief Executive Officer, the Executive Vice President and Chief Operating Officer and the Senior Vice President and Treasurer are authorized to execute portfolio transactions but are limited in the amount they can purchase without Board approval. Portfolio sales require the approval of any two of these three officers regardless of the amount. It is the responsibility of Compass's Board of Directors to ensure compliance with the investment policy and report such activity to Seacoast Financial's Board. The status of Compass's investment portfolio is reviewed by Compass's Board of Directors on a monthly basis and by Seacoast Financial's Board on a quarterly basis. At December 31, 1999, Compass had $272.9 million, or 12.9% of total assets, in securities consisting primarily of U.S. Government and Agency obligations ($126.1 million), corporate bonds ($39.1 million), mortgage-backed securities ($67.8 million), collateralized mortgage obligations ($15.1 million), and marketable common and preferred equity securities ($10.0 million). Also included in investments is $14.9 million in restricted equity securities, $14.5 million of which is in the stock of the FHLB. To avail itself of services offered by that organization, in particular the ability to borrow funds, Compass is required to invest in the stock of the FHLB in an amount determined on the basis of Compass's residential mortgage loans and borrowings from the FHLB. The stock is redeemable at par and earns dividends at the discretion of the FHLB. SFAS No. 115 requires Compass to designate its securities as held to maturity, available for sale or trading depending on Compass's intent regarding its investments at the time of purchase. As of December 31, 1999, $245.6, or 90.0% of the portfolio, was classified as available for sale, $12.4 million, or 4.5% of the portfolio, was classified as held to maturity and $14.9 million, or 5.5% of the portfolio, was invested in restricted equity securities. The net unrealized loss on securities classified as available for sale was $3.7 million, consisting of net unrealized losses of $5.9 million on debt securities partially offset by $2.2 million of net unrealized gains on marketable equity securities as of December 31, 1999. U.S. GOVERNMENT AND AGENCY OBLIGATIONS. At December 31, 1999, Compass's U.S. Government and Agency securities portfolio totaled $126.1 million, $113.7 million of which was classified as available for sale and $12.4 million of which was classified as held to maturity. There were no structured notes in the portfolio. CORPORATE BONDS. At December 31, 1999, Compass's portfolio of corporate bonds totaled $39.1 million, all of which was classified as available for sale. Compass policy requires that investments in corporate bonds be restricted only to those obligations rated "A" or better by a nationally recognized rating agency at the time of purchase and are confined only to those that are readily marketable. As of December 31, 1999, all corporate bonds were rated "A" or better. MORTGAGE-BACKED SECURITIES. At December 31, 1999, Compass's portfolio of mortgage-backed securities totaled $67.8 million. Such securities include issues guaranteed by either the Government National Mortgage Association, FNMA or FHLMC and securities issued by private entities which are not guaranteed ("non-agency issues"). All mortgage-backed securities were classified as available for sale. Mortgage-backed securities generally yield less than the loans that underlie such securities because of the cost of payment guarantees or credit enhancements that reduce credit risk. Mortgage-backed securities are more liquid than individual mortgage loans and may be used to collateralize borrowings. COLLATERALIZED MORTGAGE OBLIGATIONS (CMOS). At December 31, 1999, Compass's portfolio of CMOs totaled $15.1 million. Such securities are issued by FNMA and FHLMC as well as non-agency issuers and are a form of mortgage-backed security. CMOs are structured with various payment tranches each with different maturities and cash flow patterns. Non-agency issues owned by Compass, which totaled $8.8 million at December 31, 1999, are generally collateralized by the issuer to achieve a credit rating of AA or better. MARKETABLE EQUITY SECURITIES. At December 31, 1999, Compass's marketable equity securities portfolio totaled $10.0 million, $7.0 million of which was in common stock, $2.3 million in preferred stock and $738,000 in mutual funds. Compass's policy requires that investments in common stock be confined to quality issuers that have a past record of profitability and growth with the prospect of continued performance. The policy requires that Compass invest in common stocks that are liquid and traded on major exchanges, and that a reasonable and prudent industry distribution of common stocks be maintained in the portfolio and be held for the long-term. Compass does not view short-term trading, short sales, margin transactions and option speculation as prudent investment policy objectives and does not permit them. Investments in preferred stocks, including money market preferred, auction preferred and adjustable-rate preferred, are subject to similar quality ratings and activities as common stocks. 17 The following table sets forth certain information regarding the amortized cost and market value of the investment portfolio at the dates indicated: AT DECEMBER 31, AT OCTOBER 31, ---------------------------------------- ---------------------------------------- 1999 1998 1998 1997 ---------------------------------------- ---------------------------------------- AMORTIZED MARKET AMORTIZED MARKET AMORTIZED MARKET AMORTIZED MARKET COST VALUE COST VALUE COST VALUE COST VALUE --------- ------ --------- ------ --------- ------ --------- ------ (IN THOUSANDS) Securities available for sale: Debt securities: U.S. Government and Agency obligations ................ $117,937 $113,644 $123,390 $124,450 $109,128 $110,796 $128,711 $129,006 Corporate bonds ....................... 39,604 39,055 46,888 47,362 47,771 48,425 45,774 45,967 Mortgage-backed securities ............ 68,642 67,850 84,641 85,146 93,117 93,459 90,401 91,156 Collateralized mortgage obligations ... 15,359 15,071 26,698 26,748 29,819 30,052 50,209 50,255 -------- -------- -------- -------- -------- -------- -------- -------- Total debt securities .......... 241,542 235,620 281,617 283,706 279,835 282,732 315,095 316,384 -------- -------- -------- -------- -------- -------- -------- -------- Marketable equity securities: Common stocks ......................... 4,656 6,975 6,184 7,977 1,118 2,332 792 2,207 Preferred stocks ...................... 2,400 2,250 2,400 2,417 5,400 5,400 1,000 1,000 Mutual funds .......................... 708 738 395 400 472 468 305 305 -------- -------- -------- -------- -------- -------- -------- -------- Total marketable equity securities .............. 7,764 9,963 8,979 10,794 6,990 8,200 2,097 3,512 -------- -------- -------- -------- -------- -------- -------- -------- Total securities available for sale $249,306 $245,583 $290,596 $294,500 $286,825 $290,932 $317,192 $319,896 ======== ======== ======== ======== ======== ======== ======== ======== Securities held to maturity: U.S. Government and Agency obligations ................ $ 12,408 $ 12,312 $ 12,693 $ 12,897 $ 13,694 $ 13,980 $ 12,633 $ 12,694 ======== ======== ======== ======== ======== ======== ======== ======== Restricted equity securities: Federal Home Loan Bank of Boston stock ................... $ 14,478 $ 14,478 $ 8,605 $ 8,605 $ 8,605 $ 8,605 $ 8,475 $ 8,475 Massachusetts Savings Bank Life Insurance Company stock ...... 251 251 251 251 251 251 251 251 Depositors Insurance Fund ............. 179 179 179 179 179 179 179 179 Other ................................. 28 28 27 27 27 27 -- -- -------- -------- -------- -------- -------- -------- -------- -------- Total restricted equity securities $ 14,936 $ 14,936 $ 9,062 $ 9,062 $ 9,062 $ 9,062 $ 8,905 $ 8,905 ======== ======== ======== ======== ======== ======== ======== ======== 18 The following table sets forth certain information regarding the relative composition of the investment portfolio at the dates indicated: AT DECEMBER 31, ------------------------------------------------ 1999 1998 --------------------- ---------------------- CARRYING PERCENT CARRYING PERCENT VALUE OF TOTAL VALUE OF TOTAL ----- -------- ----- -------- (DOLLARS IN THOUSANDS) Debt securities: U.S. Government and agency obligations ................... $126,052 46.2% $137,143 43.4% Corporate bonds .......................................... 39,055 14.3 47,362 15.0 Mortgage-backed securities ............................... 67,850 24.9 85,146 26.9 Collateralized mortgage obligations ...................... 15,071 5.5 26,748 8.4 -------- ----- -------- ----- Total debt securities ................... 248,028 90.9 296,399 93.7 -------- ----- -------- ----- Marketable equity securities ................................... 9,963 3.6 10,794 3.4 Restricted equity securities ................................... 14,936 5.5 9,062 2.9 -------- ----- -------- ----- Total securities ........................ $272,927 100.0% $316,255 100.0% ======== ===== ======== ===== Debt and equity securities available for sale ....................................... $245,583 90.0% $294,500 93.1% Debt securities held to maturity ............................... 12,408 4.5 12,693 4.0 Restricted equity securities ................................... 14,936 5.5 9,062 2.9 -------- ----- -------- ----- Total securities ........................ $272,927 100.0% $316,255 100.0% ======== ===== ======== ===== AT OCTOBER 31, ----------------------------------------------------- 1998 1997 -------------------- ------------------------- CARRYING PERCENT CARRYING PERCENT VALUE OF TOTAL VALUE OF TOTAL ----- -------- ----- -------- (DOLLARS IN THOUSANDS) Debt securities: U.S. Government and agency obligations $124,490 39.7% $141,639 41.5% Corporate and other obligations ...... 48,425 15.4 45,967 13.5 Mortgage-backed securities ........... 93,459 29.8 91,156 26.7 Collateralized mortgage obligations .. 30,052 9.6 50,255 14.7 -------- ----- -------- ----- Total debt securities 296,426 94.5 $329,017 96.4 -------- ----- -------- ----- Marketable equity securities ............... 8,200 2.6 3,512 1.0 Restricted equity securities ............... 9,062 2.9 8,905 2.6 -------- ----- -------- ----- Total securities .... $313,688 100.0% $341,434 100.0% ======== ===== ======== ===== Debt and equity securities available for sale ................... $290,932 92.7% $319,896 93.7% Debt securities held to maturity ........... 13,694 4.4 12,633 3.7 Restricted equity securities ............... 9,062 2.9 8,905 2.6 -------- ----- -------- ----- Total securities .... $313,688 100.0% $341,434 100.0% ======== ===== ======== ===== 19 The following table sets forth certain information regarding the carrying value, weighted average yield and contractual maturities of the investment portfolio as of December 31, 1999: AFTER ONE YEAR AFTER FIVE YEARS ONE YEAR OR LESS THROUGH FIVE YEARS THROUGH TEN YEARS AFTER TEN YEARS TOTAL ------------------ ------------------ ----------------- ----------------- ------------------- WEIGHTED WEIGHTED WEIGHTED WEIGHTED WEIGHTED CARRYING AVERAGE CARRYING AVERAGE CARRYING AVERAGE CARRYING AVERAGE CARRYING AVERAGE VALUE YIELD VALUE YIELD VALUE YIELD VALUE YIELD VALUE YIELD -------- --------- ------- ------ -------- -------- -------- -------- -------- --------- (DOLLARS IN THOUSANDS) Securities available for sale: Debt securities: U.S. Government and Agency obligations ....... $32,722 5.69% $18,602 7.19 % $62,320 7.75% $ -- $113,644 7.07% Corporate obligations ........ 16,522 6.29 17,280 7.05 5,253 7.14 -- 39,055 6.74 Mortgage-backed securities and CMOs ................ 1,429 6.30 4,006 6.85 8,425 6.44 69,061 6.05% 82,921 6.13 ------- ------- ------- ------- -------- Total debt securities .... 50,673 5.90 39,888 7.10 75,998 7.56 69,061 6.05 235,620 6.68 Marketable equity securities: Common stocks ................ 6,975 2.32 Preferred stocks ............. 2,250 7.40 Mutual funds ................. 738 1.96 -------- Total marketable equity securities ... 9,963 3.44 ------- ------- ------- ------- -------- ---- Total securities available for sale ............ 50,673 5.90 39,888 7.10 75,998 7.56 69,061 6.05 245,583 6.55 ------- ------- ------- ------- -------- Securities held to maturity: U.S. Government and Agency obligations ....... 1,000 5.54 11,408 5.71 -- -- -- -- 12,408 5.70 ------- ------- ------- ------- -------- Total securities held to maturity ................. 1,000 5.54 11,408 5.71 -- -- -- -- 12,408 5.70 ------- ------- ------- ------- -------- Restricted equity securities: Federal Home Loan Bank of Boston stock ..... 14,478 6.55 Massachusetts Savings Bank Life Insurance Company stock ............ 251 2.99 Depositors Insurance Fund .... 179 6.60 Other ........................ 28 0.41 -------- Total restricted equity securities ......... 14,936 6.48 ------- ------- ------- ------- -------- ---- Total securities ............. $51,673 5.89% $51,296 6.79% $75,998 7.56% $69,061 6.05% $272,927 6.51% ======= ======= ======= ======= ======== SOURCES OF FUNDS GENERAL. Compass uses deposits, repayments and prepayments of loans, proceeds from sales of loans and securities and proceeds from maturing securities, borrowings and cash flows generated by operations to fund its lending, investing and general operations. Deposits have historically represented Compass's primary source of funds. During 1999, Compass relied, to a greater extent, on borrowings to fund its lending, investing and general operations. DEPOSITS. Compass offers a variety of deposit accounts with a range of interest rates and other terms. The accounts include passbook savings accounts, NOW accounts (checking), demand deposit accounts, money market deposit accounts, club accounts and certificates of deposit. Compass also offers IRA's, Roth/IRA, Education IRA and Simple IRA accounts and SEP accounts. Both individuals and commercial enterprises maintain accounts with Compass. The FDIC insures deposits up to certain limits (generally, $100,000 per depositor). The DIF fully insures amounts in excess of such limits. 20 At December 31, 1999, Compass's deposits of $1,515.6 million were comprised of $101.2 million of non-interest-bearing checking accounts and $1,414.4 million of interest-bearing deposit accounts, of which $736.9 million, or 52.1% were certificates of deposit. Of the total of certificates of deposit at December 31, 1999, $584.2 million, or 79.3% were scheduled to mature within one year. Based on Compass's monitoring of historical trends, its current pricing strategy for deposits and its general avoidance of brokered deposits, management believes that Compass will retain a significant portion of its certificates of deposit accounts upon maturity. Deposit flows are influenced greatly by economic conditions, the general level of interest rates and the relative attractiveness of competing deposit and investment alternatives. During the past few years, the strength of the stock market has adversely affected deposit flows within the banking industry as some customers have opted to place their funds in instruments, such as mutual funds, not directly offered by Compass (other than through its contractual relationship with INVEST Financial Corporation), rather than in deposit accounts which they perceive to have less attractive returns. During the last half of 1999, due to increases in interest rates initiated by the Federal Reserve Board, several area financial institutions have substantially increased the rates they pay for certificates of deposit. Such aggressive pricing has also adversely affected Compass's retention of this type of deposit. Compass competed for deposits in five distinct market areas during 1999 - -- New Bedford, Fall River, Plymouth, Cape Cod and Martha's Vineyard. Compass has generally experienced steady deposit inflows during the last three years, primarily influenced by regional bank consolidations and its strong community bank image. Compass's strategy has been to grow deposit levels through targeted promotions, branch expansion and bank acquisition. Compass has expanded its presence in Plymouth with one new branch opened in 1995 and another in May 1998 and on Cape Cod with the opening of a new branch in Hyannis in September 1999. In addition, Compass improved its presence in the town of Westport with an upgraded branch in July 1998. Two new branches, as well as a new main office, are scheduled to be opened in 2000. In addition, one branch will undergo a major renovation in 2000. Compass places emphasis on sales of its products and quality of its service to attract and retain customers. During 1999, all branch managers and staff completed extensive sales training. Management measures the sales performance of customer service personnel based on the cross-sales of additional products and services above the initial product that the customer requests. In the interest of customer convenience and product alternatives, Compass maintains a "call center" with extended hours, staffed with individuals trained to answer telephone inquiries about customer accounts and about Compass's various products and services. Compass also utilizes a 24-hour automated touch-tone telephone voice response system, which allows customers to obtain information about their accounts, to make account transfers, to pay bills and to receive information about Compass's products and services. Compass offers relationship-based checking account products, entitled Flagship Checking, Compass 50 Checking and Preferred Checking, respectively, which offer packages of select benefits. Services to commercial customers also include a Sweep Account, Simple IRA accounts, a touch tone telephone electronic tax filing service and merchant credit card services. Compass uses direct mail and customer service personnel at each of its branches and at its main office to solicit deposits and advertises its deposits through the print media, on billboards and through radio and television. Compass began to offer its on-line banking services, including a new bill payment service, over the Internet in October 1998. Compass has a contract with INVEST Financial Corporation ("Invest") pursuant to which Invest offers Compass's customers investments in mutual funds and securities. Invest representatives work out of Compass's main office and branches and Compass's customer service personnel refer to Invest customers who are looking for such investments. Compass receives a portion of commissions earned by Invest from Invest's operations on Compass's premises. Such commissions amounted to $176,400 in 1999. 21 The following table sets forth certain information regarding the distribution of the average balance of Compass's deposit accounts and the weighted average interest rate on each category of deposits during the periods indicated: YEAR ENDED DECEMBER 31, 1999 YEAR ENDED OCTOBER 31, 1998 ---------------------------- --------------------------- PERCENT PERCENT OF TOTAL WEIGHTED OF TOTAL WEIGHTED AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE BALANCE DEPOSITS RATE BALANCE DEPOSITS RATE ------- -------- -------- ------- -------- -------- (DOLLARS IN THOUSANDS) NOW accounts .................. $ 151,180 10.0% 0.97% $ 129,956 9.2% 1.27% Savings accounts .............. 215,088 14.2 2.31 199,874 14.1 2.51 Money market savings accounts . 295,393 19.4 2.92 261,212 18.5 2.99 Non-interest-bearing demand checking accounts ........ 118,956 7.9 -- 102,047 7.2 -- ---------- ----- ---------- ----- Total transaction deposit accounts ............ 780,617 51.5 1.93 693,089 49.0 2.09 Certificate of deposit accounts 734,995 48.5 5.19 720,590 51.0 5.70 ---------- ----- ---------- ----- Total average deposits ... $1,515,612 100.0% 3.51% $1,413,679 100.0% 3.93% ========== ===== ========== ===== YEAR ENDED OCTOBER 31, 1997 ------------------------------ PERCENT OF TOTAL WEIGHTED AVERAGE AVERAGE AVERAGE BALANCE DEPOSITS RATE ------- --------- -------- (DOLLARS IN THOUSANDS) NOW accounts .................. $ 115,507 8.8% 1.32% Savings accounts .............. 194,995 14.9 2.53 Money market savings accounts . 228,761 17.5 2.88 Non-interest-bearing demand checking accounts ............ 97,136 7.4 -- ---------- ----- Total transaction deposit accounts .................... 636,399 48.6 2.05 Certificate of deposit accounts 672,652 51.4 5.69 ---------- ----- Total average deposits ........ $1,309,051 100.0% 3.92% ========== ===== Compass had $157.1 million in certificates of deposit of $100,000 or more outstanding as of December 31, 1999, maturing as follows: WEIGHTED AVERAGE MATURITY PERIOD AMOUNT RATE -------- --------- (DOLLARS IN THOUSANDS) Three months or less ................................ $ 30,019 4.97% Over three months through six months ................ 44,643 5.15 Over six months through twelve months ............... 48,155 5.39 Over twelve months .................................. 34,296 5.58 -------- $157,113 5.28% ======== BORROWINGS. Compass borrows funds from the FHLB. FHLB loans finance Compass's loans to low- and moderate-income borrowers and other funding needs. FHLB loans are collateralized primarily by certain of Compass's mortgage loans and mortgage-backed securities and by Compass's holdings of FHLB stock. The maximum amount that the FHLB will loan fluctuates from time to time based on the FHLB's policies. At December 31, 1999, Compass had approximately $394 million in available borrowing capacity with the FHLB that is contingent upon the purchase of additional FHLB stock. 22 Compass had $271.9 million in advances from the FHLB as of December 31, 1999. The FHLB charges a fixed rate of interest on its loans. The following table sets forth certain information regarding borrowed funds during the periods indicated: YEAR ENDED ------------------------------- DECEMBER 31, OCTOBER 31, 1999 1998 1997 ------- ----- ----- (DOLLARS IN THOUSANDS) SHORT TERM BORROWINGS: FHLB line of credit: Average balance ..................................... $ 11,964 $ -- $ -- Maximum month end amount ............................ 22,430 -- -- Balance at end of period ............................ 17,661 -- -- Weighted average interest rate during the period..... 5.93% -- -- Weighted average interest rate at end of period...... 4.90% -- -- Securities sold under agreements to repurchase: Average balance ..................................... $ 16,971 $ 10,875 $ 3,923 Maximum month end amount ............................ 22,466 14,830 9,533 Balance at end of period ............................ 21,126 14,830 9,533 Weighted average interest rate during the period .... 4.01% 4.73% 4.70% Weighted average interest rate at end of period ..... 4.00% 4.20% 4.75% Treasury Tax and Loan Notes: Average balance ..................................... $ 1,144 $ 1,186 $ 1,163 Maximum month end amount ............................ 2,112 2,070 2,117 Balance at end of period ............................ 2,000 971 164 Weighted average interest rate during the period .... 4.37% 5.21% 5.00% Weighted average interest rate at end of period ..... 4.52% 5.04% 5.41% Total short term borrowings: Average balance ..................................... $ 30,079 $ 12,061 $ 5,086 Maximum month end amount ............................ 46,895 15,801 9,742 Balance at end of period ............................ 40,787 15,801 9,697 Weighted average interest rate during the period .... 4.79% 4.78% 4.77% Weighted average interest rate at end of period ..... 4.42% 4.25% 4.76% FEDERAL HOME LOAN BANK OF BOSTON ADVANCES: Average balance ..................................... $147,486 $103,066 $102,731 Maximum month end amount ............................ 271,900 116,879 126,457 Balance at end of period ............................ 271,900 85,111 96,607 Weighted average interest rate during the period .... 5.86% 6.23% 6.25% Weighted average interest rate at end of period ..... 5.81% 6.16% 6.25% SUBSIDIARY ACTIVITIES LIGHTHOUSE SECURITIES CORPORATION. Lighthouse Securities Corporation ("Lighthouse") is a wholly-owned subsidiary of Seacoast Financial established in 1998 as a Massachusetts securities corporation. Lighthouse engages exclusively in buying, selling and holding investment securities on its own behalf and not as a broker. The income earned on Lighthouse investments securities is subject to a significantly lower rate of state tax than that assessed on income earned on investment securities owned by Compass. At December 31, 1999, Lighthouse had total assets of $25.1 million, consisting primarily of certificates of deposit maintained at Compass. CB SECURITIES CORPORATION. CB Securities Corporation ("CBS Corporation") is a wholly-owned subsidiary of Compass established in 1990 as a Massachusetts securities corporation. CBS Corporation engages exclusively in buying, selling and holding investment securities on its own behalf and not as a broker. The income earned on CBS Corporation's investment securities is subject to a significantly lower rate of state tax than that assessed on income earned on investment securities owned by Compass. At December 31, 1999, CBS Corporation had total assets of $138.2 million, consisting primarily of cash maintained at Compass and investment securities. 23 SANDWICH SECURITIES CORPORATION. Sandwich Securities Corporation ("Sandwich Corporation") is a wholly-owned subsidiary of Compass established in 1993 as a Massachusetts securities corporation. Sandwich Corporation engages exclusively in buying, selling and holding investment securities on its own behalf and not as a broker. The income earned on Sandwich Corporation's investment securities is subject to a significantly lower rate of state tax than that assessed on income earned on investment securities owned by Compass. At December 31, 1999, Sandwich Corporation had total assets of $45.5 million, consisting primarily of cash maintained at Compass and investment securities. SEXTANT SECURITIES CORPORATION. Sextant Securities Corporation ("SSC" )is a wholly-owned subsidiary of Compass established in 1995 as a Massachusetts securities corporation. SSC engages exclusively in buying, selling and holding investment securities on its own behalf and not as a broker. The income earned on SSC's investment securities is subject to a significantly lower rate of state tax than that assessed on income earned on investment securities owned by Compass. At December 31, 1999, SSC had total assets of $34.7 million, consisting primarily of cash maintained at Compass and investment securities. COMPASS CREDIT CORP. Compass Credit Corp. ("CC Corp.") is a wholly-owned subsidiary of Compass established in 1997 as a Massachusetts corporation. Through December 31, 1999, CC Corp. originated auto loans in Rhode Island through a network of auto dealers. CC Corp. is a licensed lender in Rhode Island. On December 31, 1999, CC Corp. sold its loan portfolio to Compass and is not expected to engage in auto loan origination activities in the future. At December 31, 1999, CC Corp. had total assets of $43.6 million, consisting primarily of an intercompany receivable. BUFFINTON BROOK REALTY CORPORATION. Buffinton Brook Realty Corporation ("BBR Corporation") is a wholly-owned subsidiary of Compass established in 1977 as a Massachusetts corporation. BBR Corporation purchases and holds real estate and is the owner of 100% of the common stock of Compass Preferred Capital Corporation ("Compass Preferred"). At December 31, 1999, BBR Corporation had total assets of $419.6 million, consisting primarily of its investment in Compass Preferred. COMPASS PREFERRED CAPITAL CORPORATION. Compass Preferred Capital Corporation ("Compass Preferred") is a subsidiary of BBR Corporation. It was established in 1998 to engage in real estate business activities (including the acquisition and holding of securities and real estate loans) that enable it to be taxed as a "real estate investment trust" under federal and Massachusetts tax laws. Compass Preferred had total assets of $421.2 million at December 31, 1999, $374.9 million of which were mortgage loans originated by Compass. THE SEXTANT CORPORATION. The Sextant Corporation (Sextant) is a wholly-owned subsidiary of Compass originally formed to purchase equipment on behalf of the Bank for tax favored purposes. Since then, Sextant was involved in real estate development activities and, at December 31, 1999, is holding for sale commercial condominium units with a carrying value of $672,000. THE 1855 CORPORATION. The 1855 Corporation ("1855 Corporation") is a wholly-owned subsidiary of Compass established in 1971 as a Massachusetts corporation. 1855 Corporation is principally engaged in the acquisition and holding of real estate used for banking purposes. At December 31, 1999, 1855 Corporation had total assets of $6.7 million of which $1.8 million consisted of real estate used for banking purposes and $3.5 million consisted of investments in subsidiaries. PURCHASE CORPORATION. Purchase Corporation, a wholly-owned subsidiary of 1855 Corporation, was established in 1981 as a Massachusetts corporation. Purchase Corporation acquires, manages and develops real estate, purchases equipment and makes investments. At December 31, 1999, Purchase Corporation had total assets of $2.4 million which consisted solely of cash maintained at Compass. NORTH FRONT STREET, INC. North Front Street, Inc. ("NFS, Inc.") is a wholly-owned subsidiary of 1855 Corporation established in 1991 as a Massachusetts corporation. NFS, Inc. acquires, manages, develops, rehabilitates, leases, finances, holds and makes real estate investments. At December 31, 1999, NFS, Inc. had total assets of $1.1 million which consisted solely of cash maintained at Compass. 24 SUPERVISION AND REGULATION GENERAL As a Massachusetts-chartered stock savings bank, Compass is subject to extensive regulation by the Massachusetts Division of Banks (the "Division"), and by the FDIC. Compass is required to file reports with, and is periodically examined by, the FDIC and the Division concerning its activities and financial condition and must obtain regulatory approvals prior to entering into certain transactions, including, but not limited to, mergers with or acquisitions of other financial institutions. Compass is a member of the FHLB and is subject to certain limited regulation by the FRB. Seacoast Financial, as a bank holding company, is subject to regulation by the FRB and is required to file reports with the FRB. MASSACHUSETTS BANK REGULATION GENERAL. As a Massachusetts-chartered savings bank, Compass is subject to supervision, regulation and examination by the Division and to various Massachusetts statutes and regulations which govern, among other things, investment powers, lending and deposit-taking activities, borrowings, maintenance of surplus and reserve accounts, distribution of earnings and payment of dividends. In addition, Compass is subject to Massachusetts consumer protection and civil rights laws and regulations. The Commissioner's approval is required for a Massachusetts bank to establish or close branches, merge with other banks, organize a holding company, issue stock, engage in insurance agency activities and undertake certain other activities. In response to a Massachusetts law enacted in 1996, the Commissioner adopted rules that generally give Massachusetts banks powers equivalent to those of national banks. The Commissioner also has adopted procedures reducing regulatory burdens and expense and expediting branching by well-capitalized and well-managed banks. REGULATORY ENFORCEMENT AUTHORITY. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Commissioner may be subject to sanctions for non-compliance, including seizure of the property and business of the bank and suspension or revocation of its charter. The Commissioner may under certain circumstances suspend or remove officers or directors who have violated the law, conducted Compass's business in a manner which is unsafe, unsound or contrary to the depositors' interests or been negligent in the performance of their duties. In addition, upon finding that a bank has engaged in an unfair or deceptive act or practice, the Commissioner may issue an order to cease and desist and impose a fine on the bank concerned. Finally, Massachusetts consumer protection and civil rights statutes applicable to Compass permit private individual and class action lawsuits and provide for the rescission of consumer transactions, including loans, and the recovery of statutory and punitive damages and attorney's fees in the case of certain violations of those statutes. DIF. All Massachusetts-chartered savings banks are required to be members of the DIF, a corporation that insures savings bank deposits not covered by federal deposit insurance. The DIF is authorized to charge an annual assessment of up to 1/16th of 1% of a savings bank's deposits. INSURANCE OF ACCOUNTS AND REGULATION BY THE FDIC As an insurer, the FDIC charges deposit insurance premiums and 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 that the FDIC determines by regulation or order to pose a risk to the insurance fund. The FDIC also has the authority to initiate enforcement actions against savings banks, after giving the Commissioner an opportunity to take such action, and may terminate deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices or is in an unsafe or unsound condition. Based upon its assessable deposits, Compass expensed $225,000 in FDIC insurance premiums during 1999. 25 REGULATORY CAPITAL REQUIREMENTS FDIC-insured savings banks are subject to risk-based capital guidelines that establish a framework for making regulatory capital requirements more sensitive to the risk profiles of each institution. Compass is required to maintain certain levels of regulatory capital in relation to risk-weighted assets. The ratio of such regulatory capital to risk-weighted assets is referred to as Compass's "risk-based capital ratio." Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items to four risk-weighted categories ranging from 0% to 100%, with higher levels of capital being required for the categories perceived as representing greater risk. These guidelines divide a bank's capital into two tiers. The first tier ("Tier 1") includes common equity, retained earnings, certain non-cumulative perpetual preferred stock (excluding auction rate issues) and minority interests in equity accounts of consolidated subsidiaries, less goodwill and other intangible assets (except mortgage servicing rights and purchased credit card relationships subject to certain limitations). Supplementary ("Tier 2") capital includes, among other items, cumulative perpetual and long-term limited-life preferred stock, mandatory convertible securities, certain hybrid capital instruments, term subordinated debt and the allowance for loan and lease losses, subject to certain limitations, less required deductions. Banks are required to maintain a total risk-based capital ratio equal to at least 8% of risk-weighted assets, and at least half of such capital must be Tier 1 capital. In addition, the FDIC has established regulations prescribing a minimum Tier 1 leverage capital ratio (Tier 1 capital to adjusted total assets as specified in the regulations). These regulations provide for a minimum Tier 1 leverage ratio of 3% plus an additional cushion of at least 100 to 200 basis points. The FDIC may, however, set higher leverage and risk-based capital requirements on individual institutions when particular circumstances warrant. Savings banks experiencing or anticipating significant growth are expected to maintain capital ratios, including tangible capital positions, well above the minimum levels. LIMITATIONS ON DIVIDENDS AND OTHER CAPITAL DISTRIBUTIONS The FDIC has the authority to use its enforcement powers to prohibit a bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice. Federal law also prohibits the payment of dividends by a bank that will result in the bank failing to meet its applicable capital requirements on a pro forma basis. Massachusetts law also restricts Compass from declaring a dividend which would reduce its capital below (i) the amount required to be maintained by state and federal law and regulations or (ii) the amount of Compass's liquidation account established in connection with the conversion of the Company from mutual to stock form. PROMPT CORRECTIVE ACTION The federal banking agencies have promulgated regulations to implement a system of prompt corrective action required by federal law. Under the regulations, a bank is deemed to be: (i) "well capitalized" if it has total risk-based capital of 10.0% or more, has a Tier 1 risk-based capital ratio of 6.0% or more, has a Tier 1 leverage capital ratio of 5.0% or more and is not subject to any written capital order or directive; (ii) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and Tier 1 leverage capital ratio of 4.0% or more (3.0% 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 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a Tier 1 leverage capital ratio that is less than 3.0%; and (v) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Federal law and regulations also specify circumstances under which a federal banking agency may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution to comply with supervisory actions as if it were in the next lower capitalization category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized). Based on the foregoing, Compass is currently classified as a "well capitalized" bank. 26 ACTIVITIES AND INVESTMENTS OF INSURED STATE-CHARTERED BANKS Federal law generally limits the activities and equity investments of FDIC-insured, state-chartered banks to those that are permissible for national banks, notwithstanding state laws. Under regulations dealing with equity investments, an insured state bank generally may not, directly or indirectly, acquire or retain any equity investment of a type, or in an amount, that is not permissible for a national bank. Federal law and FDIC regulations permit certain exceptions to this restriction. For example, certain state-chartered banks, such as Compass, may continue to invest, up to certain limits, in common or preferred stock listed on a national securities exchange or the National Market System of Nasdaq, and in the shares of an investment company registered under the Investment Company Act of 1940, as amended. Such banks may also continue to sell savings bank life insurance. As of December 31, 1999, Compass held marketable equity securities with a carrying value of $9.2 million pursuant to this exception. HOLDING COMPANY REGULATION GENERAL. Seacoast Financial, as a bank holding company, is subject to comprehensive regulation and regular examinations by the FRB. The FRB also has extensive enforcement authority over bank holding companies, including, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to require that a holding company divest subsidiaries (including its bank subsidiaries). In general, enforcement actions may be initiated for violations of law and regulations and unsafe or unsound practices. Seacoast Financial is subject to capital adequacy guidelines for bank holding companies (on a consolidated basis) which are substantially similar to those of the FDIC for Compass. Under FRB policy, a bank holding company must serve as a source of strength for its subsidiary banks. Under this policy, the FRB may require, and has required in the past, a holding company to contribute additional capital to an undercapitalized subsidiary bank. Seacoast Financial must obtain Massachusetts Board of Bank Incorporation and FRB approval before: (i) acquiring, directly or indirectly, ownership or control of any voting shares of another bank or bank holding company if, after such acquisition, it would own or control more than 5% of such shares (unless it already owns or controls the majority of such shares); (ii) acquiring all or substantially all of the assets of another bank or bank holding company; or (iii) merging or consolidating with another bank holding company. The BHCA also prohibits a bank holding company, with certain exceptions, from acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or bank holding company, or from engaging directly or indirectly in activities other than those of banking, managing or controlling banks, or providing services for its subsidiaries. The principal exceptions to these prohibitions involve certain non-bank activities which, by statute or by FRB regulation or order, have been identified as activities closely related to the business of banking or managing or controlling banks. The list of activities permitted by the FRB includes, among other things: (i) operating a savings institution, mortgage company, finance company, credit card company or factoring company; (ii) performing certain data processing operations; (iii) providing certain investment and financial advice; (iv) underwriting and acting as an insurance agent for certain types of credit-related insurance; (v) leasing property on a full-payout, non-operating basis; (vi) selling money orders, travelers' checks and United States Savings Bonds; (vii) appraising real estate and personal property; (viii) providing tax planning and preparation services; and (ix) subject to certain limitations, providing securities brokerage services for customers. INTERSTATE BANKING AND BRANCHING. Federal law allows the FRB to approve an application of an adequately capitalized and adequately managed bank holding company to acquire control of, or acquire all or substantially all of the assets of, a bank located in a state other than such holding company's home state, without regard to whether the transaction is prohibited by the laws of any state. The FRB may not approve the acquisition of a bank that has not been in existence for the minimum time period (not exceeding five years) specified by the statutory law of the host state. The FRB is prohibited from approving an application if the applicant (and its depository institution affiliates) controls or would control more than 10% of the insured deposits in the United States or 30% or more of the deposits in the target bank's home state or in any state in which the target bank maintains a branch. Individual states continue to have authority to limit the percentage of total insured deposits in the state which may be held or controlled by a bank or bank holding company to the extent such limitation does not discriminate against out-of-state banks or bank holding companies. Individual states may also waive the 30% state-wide concentration limit referred to above. 27 Additionally, beginning on June 1, 1997, the federal banking agencies were authorized to approve interstate merger transactions without regard to whether such transactions are prohibited by the law of any state, unless the home state of one of the banks "opted out" by adopting a law which applies equally to all out-of-state banks and expressly prohibits merger transactions involving out-of-state banks. Interstate acquisitions of branches are permitted only if the law of the state in which the branch is located permits such acquisitions. In 1996, the Massachusetts legislature enacted a new interstate banking statute pursuant to which an out-of-state bank may (subject to various regulatory approvals and to reciprocity in its home state) establish and maintain bank branches in Massachusetts by (i) merging with a Massachusetts bank that has been in existence for at least three years, (ii) acquiring a branch or branches of a Massachusetts bank without acquiring the entire bank or (iii) opening such branches de novo. Massachusetts banks' ability to exercise similar interstate banking powers in other states depend upon the laws of those other states. DIVIDENDS. The FRB has issued a policy statement on the payment of cash dividends by bank holding companies, which expresses the FRB's view that a bank holding company should pay cash dividends only to the extent that the holding company's net income for the past year is sufficient to cover both the cash dividends and a rate of earning retention that is consistent with the holding company's capital needs, asset quality and overall financial condition. The FRB also indicated that it would be inappropriate for a company experiencing serious financial problems to borrow funds to pay dividends. Furthermore, under the prompt corrective action regulations adopted by the FRB, the FRB may prohibit a bank holding company from paying any dividends if the holding company's bank subsidiary is classified as "undercapitalized." Bank holding companies are required to give the FRB prior written notice of any purchase or redemption of its outstanding equity securities if the gross consideration for the purchase or redemption, when combined with the net consideration paid for all such purchases or redemptions during the preceding 12 months, is equal to 10% or more of the consolidated net worth of the bank holding company. The FRB may disapprove such a purchase or redemption if it determines that the proposal would constitute an unsafe or unsound practice or would violate any law, regulation, FRB order or any condition imposed by, or written agreement with, the FRB. This notification requirement does not apply to any company that meets the well-capitalized standard for banks, is "well managed" within the meaning of the FRB regulations and is not subject to any unresolved supervisory issues. FEDERAL RESERVE SYSTEM The FRB requires all depository institutions to maintain noninterest-bearing reserves at specified levels against their transaction accounts (primarily checking, NOW and Super NOW checking accounts). Banks are authorized to borrow from the Federal Reserve Bank's "discount window," but FRB regulations require banks to exhaust other reasonable alternative sources of funds, including FHLB borrowings, before borrowing from the Federal Reserve Bank. COMMUNITY REINVESTMENT ACT Under the Community Reinvestment Act, as amended (the "CRA"), as implemented by FDIC regulations, a bank 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 CRA does require the FDIC, in connection with its examination of a bank, to assess the institution's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution, including applications to acquire or build branches and to acquire other financial institutions. The CRA requires the FDIC to provide a written evaluation of an institution's CRA performance utilizing a four-tiered descriptive rating system. Compass's latest FDIC CRA rating was "satisfactory". Massachusetts has its own statutory counterpart to the CRA which is also applicable to Compass. The Massachusetts version is generally similar to the CRA but utilizes a five-tiered descriptive rating system. Massachusetts law requires the Commissioner of Banks to consider, but not be limited to, a bank's record of performance under Massachusetts law in considering any application by the bank to establish a branch or other deposit-taking facility, to relocate an office or to merge or consolidate with or acquire the assets and assume the liabilities of any other banking institution. Compass's most recent rating under Massachusetts law was "outstanding". 28 CONSUMER PROTECTION AND FAIR LENDING REGULATIONS Compass is subject to a variety of federal and Massachusetts statutes and regulations that are intended to protect consumers and prohibit discrimination in the granting of credit. These statutes and regulations provide for a range of sanctions for non-compliance with their terms, including imposition of administrative fines and remedial orders, and referral to the Attorney General for prosecution of a civil action for actual and punitive damages and injunctive relief. Certain of these statutes authorize private individual and class action lawsuits and the award of actual, statutory and punitive damages and attorneys' fees for certain types of violations. FEDERAL HOME LOAN BANK SYSTEM Compass is a member of the FHLB, which is one of 12 regional Federal Home Loan Banks, that administer the home financing credit function of savings institutions. Each Federal Home Loan Bank 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 Federal Home Loan Bank system. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of each Federal Home Loan Bank. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances to Compass from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB . As a member, Compass is required to purchase and maintain stock in the FHLB. At December 31, 1999, Compass owned $14.5 million of FHLB stock. 29 ITEM 2. PROPERTIES At December 31, 1999 Compass conducted its business through 35 full-service branches, two seasonal high school offices, 37 branch and remote ATMs and three non-branch properties, including its corporate headquarters, an operations center and a mortgage origination office. In the Greater New Bedford market, Compass operates eight full service branches, including six branches in the City of New Bedford (five of which are owned by Compass or a subsidiary and one of which is operated under a land lease), one owned branch in the town of Fairhaven and one leased branch and an operations center in the town of Dartmouth. Compass's corporate headquarters are also located in the City of New Bedford, as are two other back-office facilities. All of these buildings are owned by Compass or a subsidiary. Two of Compass's remote ATMs are located in the City of New Bedford. One of Compass's limited service high school branches is located in the City of New Bedford. In the Greater Fall River market, Compass operates six full service branches, including one owned and one leased branch in the City of Fall River, one leased branch in Assonet and owned branches in each of Somerset, Swansea and Westport. One of Compass's remote ATMs is also located in the City of Fall River, as is one of Compass's limited service high school branches. In the Greater Plymouth market, Compass operates six full service branches, including two owned and two leased branches in the town of Plymouth and leased branches in each of Carver and Wareham. Compass also leases a non-branch mortgage office in the town of Lakeville, located in the Greater Plymouth market. In the Martha's Vineyard market, Compass operates five full service branches, including one owned and one leased branch in the town of Edgartown, and three owned branches in the towns of Chilmark, Vineyard Haven and Oak Bluffs. One of Compass's remote ATMs is located in the Martha's Vineyard town of West Tisbury. In the Cape Cod market, Compass operates ten full-service branches, including two leased offices in Sandwich, leased offices in Buzzards Bay and South Yarmouth and owned offices in Pocasset, Falmouth, Hyannis (two), Chatham and Orleans. Compass also owns commercial condominiums in Sandwich previously used for loan operations which are currently being marketed for sale. In December 1998, Compass acquired several parcels of land in downtown New Bedford from the New Bedford Redevelopment Authority on which a five story office building with approximately 147,000 square feet of space is being constructed to house all employees other than retail branch and regional lending personnel. Compass's New Bedford main banking office will be located in the lobby of the new building. Construction of this new corporate headquarters is proceeding on schedule and on budget (approximately $20 million) with a planned occupancy of early summer of 2000. See Note 5 of the Notes to Consolidated Financial Statements included herein for additional information. ITEM 3. LEGAL PROCEEDINGS Compass is not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes that those routine proceedings involve, in the aggregate, amounts which are immaterial to the consolidated financial condition and results of operations of Seacoast Financial. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Not applicable. 30 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Seacoast Financial's common stock is traded on the Nasdaq National Market System under the symbol "SCFS". At March 17, 2000, there were 25,467,036 shares of common stock outstanding and approximately 6,216 shareholders of record. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms. As of that date, the closing sales price, as reported by Nasdaq, was $9 5/8. Seacoast Financial completed its conversion from mutual to stock form and initial public offering of common stock on November 20, 1998, and issued additional shares of common stock on December 4, 1998 in connection with the consummation of its acquisition of Sandwich. Prior to November 20, 1998, Seacoast Financial had no stockholders and, accordingly, has no historical stock price or dividend information to report for the fiscal year ended October 31, 1998 or earlier. High and low sales prices and dividends declared, stated on a per share basis, since Seacoast Financial's initial public offering are as follows: Dividends High Low Declared ----------- ----------- ----------- 2000 First quarter (through March 17, 2000).............. $ 10 1/8 $8 3/4 $0.06 1999 First quarter....................................... 11 1/4 9 3/4 -- Second quarter...................................... 11 5/8 9 1/2 -- Third quarter....................................... 12 5/16 9 11/16 0.05 Fourth quarter...................................... 11 1/4 9 9/16 0.05 1998 November 20 to December 31.......................... 10 3/8 9 1/2 -- 31 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA Set forth below are the selected consolidated financial data of Seacoast Financial. The financial data are derived in part from, and should be read in conjunction with, the Consolidated Financial Statements of Seacoast Financial and Subsidiaries and notes thereto presented elsewhere herein. At December 31, At October 31 -------------------------------------------------- 1999 (1) 1998 1997 1996 1995 ----------------- ----------- ----------- ------------ ------------ (In thousands) SELECTED FINANCIAL CONDITION DATA: Total assets................................... $ 2,122,785 $ 1,806,523 $ 1,625,260 $ 1,491,906 $ 1,410,480 Loans (2)...................................... 1,747,206 1,320,680 1,190,939 1,068,957 950,102 Allowance for loan losses...................... 16,828 15,117 14,742 14,075 13,524 Debt securities (3): Available for sale........................ 235,620 282,732 316,384 308,395 100,609 Held to maturity.......................... 12,408 13,694 12,633 11,752 243,273 Marketable equity securities................... 9,963 8,200 3,512 4,229 3,699 Deposits....................................... 1,515,622 1,531,663 1,360,962 1,270,857 1,237,696 Borrowed funds................................. 314,622 102,906 108,042 82,021 49,326 Stockholders' equity/Surplus................... 274,021 153,570 140,128 123,137 110,268 Net unrealized gain (loss) on securities available for sale, net of taxes, included in equity........................ (2,430) 2,558 1,741 (143) 44 Non-performing loans........................... 5,734 6,514 14,464 14,322 13,039 Non-performing assets.......................... 6,286 7,813 16,767 17,385 17,324 SELECTED OPERATING DATA: Interest income................................ $ 137,952 $ 122,934 $ 115,949 $ 106,435 $ 97,145 Interest expense............................... 63,510 62,692 58,025 52,935 49,372 ------------ ----------- ----------- ------------ ------------- Net interest income....................... 74,442 60,242 57,924 53,500 47,773 Provision for loan losses...................... 2,000 1,736 2,615 1,431 246 ------------ ----------- ----------- ------------ ------------- Net interest income after provision for loan losses........................... 72,442 58,506 55,309 52,069 47,527 Gains (losses) on sales of securities, net..... 164 67 92 60 (84) Gains on sales of loans, net................... 56 1,755 717 431 134 Gain on pension plan termination............... 1,472 -- -- -- -- Other non-interest income...................... 8,302 8,220 7,727 7,392 7,071 Other real estate owned expense, net........... 54 265 520 690 1,224 Other non-interest expense..................... 44,462 39,542 36,516 35,801 35,822 ------------ ----------- ----------- ------------ ------------- Income before income taxes..................... 37,920 28,741 26,809 23,461 17,602 Provision for income taxes..................... 13,394 10,651 10,165 9,169 6,680 ------------ ----------- ----------- ------------ ------------- Net income..................................... $ 24,526 $ 18,090 $ 16,644 $ 14,292 $ 10,922 ============ =========== =========== ============ ============= Earnings per share - diluted(9)................ $ 0.97 ============ Cash dividends per share (9)................... $ 0.10 ============ 32 Year Ended Year Ended October 31, ------------------------------------------- December 31, 1999 (1) 1998 1997 1996 1995 --------------------- -------- -------- -------- --------- SELECTED FINANCIAL RATIOS AND OTHER DATA (4): Performance Ratios: Return on average assets........................ 1.23% 1.06% 1.07% .99% .82% Return on average stockholders' equity/surplus............................... 8.97 12.00 12.66 12.27 10.45 Stockholders' equity/surplus to total assets at end of period...................... 12.91 8.50 8.62 8.25 7.82 Net interest rate spread (5).................... 3.26 3.20 3.38 3.45 3.39 Net interest margin (6)......................... 3.93 3.72 3.88 3.92 3.78 Average interest-earning assets to average interest-bearing liabilities................. 120.12 113.36 113.03 111.91 110.09 Total non-interest expense to average assets.... 2.24 2.34 2.37 2.54 2.77 Efficiency ratio (7)............................ 52.72 56.64 55.73 59.45 67.49 Regulatory Capital Ratios (4): Tier 1 leverage capital......................... 13.11 8.34 8.38 8.21 7.53 Tier 1 risk-based-capital....................... 18.98 12.45 12.94 12.74 11.65 Total risk-based capital........................ 20.17 13.70 14.19 13.99 12.90 Asset Quality Ratios (4): Non-performing loans as a percent of loans (8).................................... .33 .49 1.21 1.34 1.37 Non-performing assets as a percent of total assets................................. .30 .43 1.03 1.17 1.23 Allowance for loan losses as a percent of loans..................................... .96 1.14 1.24 1.32 1.42 Allowance for loan losses as a percent of total non-performing loans................... 293.48 232.07 101.92 98.28 103.72 Number of Full-Service Customer Facilities (10)...... 35 34 33 33 33 (1) In January 1999, the Board of Directors voted to change the Company's year-end to December 31. Selected consolidated financial data for the two month transition period ended December 31, 1998 is not presented herein. See the audited financial statements contained herein for the balance sheet as of December 31, 1998 and the results of operations for the two month period then ended. (2) Loans are comprised of gross loan balances, less unearned discounts, loans held for sale and net unadvanced funds on loans plus net deferred loan origination costs and fees. (3) In November 1995, Compass reclassified securities having a market value of $228.1 million from its held-to-maturity portfolio to its available-for-sale portfolio pursuant to a Financial Accounting Standards Board (the "FASB") interpretation of SFAS No. 115. (4) Asset Quality Ratios and Regulatory Capital Ratios are end-of-period ratios. With the exception of end-of-period ratios, all ratios are based on average daily balances during the periods indicated. (5) The net interest rate spread represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of average interest-bearing liabilities. (6) The net interest margin represents net interest income as a percentage of average interest-earning assets. (7) The efficiency ratio represents the ratio of non-interest expenses to the sum of net interest income and non-interest income. (8) Non-performing loans consist of all loans 90 days or more past due and other loans which have been identified by Compass as presenting uncertainty with respect to the collectibility of interest or principal. It is Compass's policy to generally cease accruing interest on all such loans, except indirect auto loans and other consumer loans. (9) Diluted earnings and cash dividends per share are inapplicable for periods prior to the Company's mutual to stock conversion in November 1998. (10) In February 2000, Compass opened its 36th full service branch at Braley Road in New Bedford. 33 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD-LOOKING STATEMENTS This Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual events could differ materially from those anticipated in the forward-looking statements. Important factors that might cause such a difference include, among other things, general economic conditions, particularly the real estate market, in the Company's primary market area, potential increases in the Company's non-performing assets (as well as increases in the allowance for loan losses that might be necessary), concentrations of loans in a particular geographic area or with certain large borrowers, changes in government regulation and supervision, including increased deposit insurance premiums or capital or reserve requirements, changes in interest rates, and increased competition and bank consolidations in the Company's market area. These and other factors that might cause differences between actual and anticipated results, performance and achievements are discussed in greater detail in this Form 10-K under "Management's Dicussion and Analysis of Financial Condition and Results of Operations" and "Business". GENERAL Seacoast Financial's results of operations depend primarily on its net interest income, which is the difference between the income earned on its loan and securities portfolios and its cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by Seacoast Financial's provision for loan losses, as well as noninterest income and expenses. Seacoast Financial's noninterest income consists principally of gains and losses from sales of loans and securities, deposit and other banking fees. Seacoast Financial's non-interest expenses consist principally of compensation and employee benefits, occupancy, data processing, marketing and professional services costs and other operating expenses. Results of operations are also significantly affected by general economic and competitive conditions and changes in interest rates as well as government policies and actions of regulatory authorities. Future changes in applicable law, regulations or government policies may materially affect Seacoast Financial and Compass. STOCK CONVERSION AND MERGER On November 20, 1998, the Company completed its mutual-to-stock conversion and initial public offering of common stock whereby 14,000,000 shares were sold at a purchase price of $10 per share. Net proceeds of the stock offering were $121.4 million. On December 4, 1998, the Company merged with Sandwich and issued 12,758,136 shares of its common stock in exchange for all of the outstanding common stock of Sandwich (other than shares owned by Seacoast Financial and fractional shares) based on an exchange ratio of 6.385 shares of Seacoast Financial common stock for each share of Sandwich common stock. The consolidated financial statements give retroactive effect to the merger in a transaction accounted for as a pooling of interests. The pooling of interests method of accounting requires the restatement of all periods presented as if Seacoast Financial and Sandwich had always been combined. CHANGE IN FISCAL YEAR-END In January 1999, the Board of Directors voted to change the Company's year-end from October 31 to December 31. The accompanying Management's Discussion and Analysis of Financial Condition and Results of Operations includes a comparison of financial condition at December 31, 1998 and October 31, 1998. The results of operations for the two month transition period ended December 31, 1998 are separately presented in the accompanying financial statements at page 50 of this Form 10-K. Unless otherwise indicated, all references to 1999 are for the calendar year ended December 31, 1999 and all references to 1998 and 1997 are for the fiscal years ended October 31. 34 COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 1999 AND DECEMBER 31, 1998 Total assets increased by $234.7 million, or 12.4%, from $1,888.1 million at December 31, 1998 to $2,122.8 million at December 31, 1999. This growth was due to a $343.2 million, or 24.4%, increase in loans, partially offset by a $43.3 million, or 13.7%, decrease in investment securities and a $72.0 million decrease in cash, federal funds sold and other short-term investments. Asset growth was funded primarily by a $215.8 million, or 218.4% increase in borrowings and, to a lesser extent, a $18.4 million, or 1.2% , increase in deposits. The increase in loans occurred primarily in Compass's indirect auto and residential mortgage loan portfolios. From December 31, 1998 to December 31, 1999, indirect auto loans (net of unearned discounts) increased by $101.7 million, or 31.7%. This growth is primarily attributable to the generally favorable interest rate environment and economic conditions which prevailed during the period and the continued emphasis of this area of lending. Residential mortgage loans increased by $199.4 million, or 28.6%, during 1999. Due to the favorable conditions cited above and the utilization of two loan correspondents with whom Compass originated $74.2 million in residential mortgage loans, Compass originated $323.9 million of residential mortgage loans in 1999, a 3.3% increase over 1998. The net growth in this portion of the loan portfolio was also affected by the strategy to retain in portfolio fixed rate mortgage loan originations that in recent years were generally sold in the secondary mortgage market. Total deposits at December 31, 1999 were $1,515.6 million, an increase of $18.4 million, or 1.2%, compared to $1,497.2 million at December 31, 1998. This modest increase included an increase in core deposits of $26.8 million, or 3.6%, partially offset by a decrease of $8.4 million, or 1.1%, in certificates of deposit. The increase in core deposits was primarily due to the expansion of the Compass brand to the Cape Cod market through the acquisition of the former Sandwich Bank in December 1998, partially offset by a continuing low interest rate environment wherein Compass competes against other instruments available to the public such as mutual funds and annuities. The decline in certificates of deposits reflects the same competitive factors which have impacted core deposit growth and, in addition, reflects aggressive price competition for such accounts among local financial institutions in reaction to rate increases initiated by the Federal Reserve Bank during the second half of the year. Total borrowed funds were $314.6 million at December 31, 1999 compared to $98.8 million at December 31, 1998, an increase of $215.8 million, or 218.4%. During the year ended December 31, 1999, Compass's net borrowings from the FHLB increased by $205.6 million and its retail repurchase agreements increased by $8.5 million. Management believes that it will continue to expand its FHLB borrowings to fund loan growth which is expected to exceed deposit growth throughout 2000. The increase in stockholders' equity of $2.5 million to $274.0 million at December 31, 1999 resulted from net income of $24.5 million for the year ended December 31 1999, partially offset by a $4.8 million decrease in net unrealized gains and losses (net of taxes) on securities available for sale, repurchases of common stock totaling $15.9 million and cash dividends of $2.5 million. During 1999, the Company announced two stock repurchase programs aggregating 2,231,900 shares. As of January 27, 2000, 1,468,500 shares had been repurchased leaving up to 763,400 shares for repurchase. Management expects to fully repurchase the remaining 763,400 shares under these programs during 2000. COMPARISON OF FINANCIAL CONDITION AT DECEMBER 31, 1998 AND OCTOBER 31, 1998 Total assets increased by $81.6 million, or 4.5%, from $1,806.5 million at October 31, 1998 to $1,888.1 million at December 31, 1998. This growth was entirely due to an $83.4 million, or 6.3% increase in loans. Asset growth was funded by the net proceeds of the stock offering which amounted to $121.4 million, of which $33.5 million at October 31, 1998 was included in deposits earmarked for the purchase of common stock in the stock offering. The increase in loans occurred primarily in the residential mortgage and indirect auto loan portfolios. From October 31, 1998 to December 31, 1998, residential mortgage loans increased by $56.4 million (exclusive of a transfer of loans previously classified as held-for-sale), or 9.0%, and indirect auto loans (net of unearned discounts) increased by $13.7 million, or 4.5%. The growth during the two months ended December 31, 1998 is generally attributable to the favorable interest rate environment and economic conditions which prevailed during this period and, more specifically, is due to the previously disclosed temporary change in practice, which began in November 1998, to retain in portfolio all fixed rate residential mortgage loan originations. The Company has continued to emphasize the origination of indirect auto loans through its network of automobile dealers causing the growth in this portfolio. 35 Total deposits at December 31, 1998 were $1,497.2 million, a decrease of $34.5 million, or 2.3% compared to $1,531.7 million at October 31, 1998. As indicated above, a portion of the proceeds of the stock offering was funded by either deposit accounts of Bank customers or by non-customers who had funded their stock subscription with the Bank at October 31, 1998. Of the $121.4 million of net proceeds of the stock offering, $24.6 million was funded from the deposits of Bank customers and $31.9 million was funded from non-customer subscription accounts, of which $18.0 was held by the Bank as deposits at October 31, 1998. These funds, totaling $42.6 million, were transferred to stockholders' equity in November 1998 when the stock offering was completed. Exclusive of this transfer, deposits increased by less than 1% during the two months ended December 31, 1998, a cyclical period which has historically been one of modest deposit growth. Total borrowed funds were $98.8 million at December 31, 1998 compared to $102.9 million at October 31, 1998, a decrease of $4.1 million, or 4.0%. The increase in stockholders' equity of $117.9 million to $271.5 million at December 31, 1998 resulted from the net proceeds of the stock offering of $121.4 million partially offset by the net loss of $3.3 million for the two months ended December 31, 1998. As discussed more fully in Notes 2 and 5 to the accompanying consolidated financial statements, the net loss was caused by certain one time charges including merger costs of $6.8 million associated with the Sandwich acquisition and a writedown of banking premises and equipment of $2.0 million necessitated by the decision to consolidate most banking functions in a new corporate headquarters which will result in the ultimate disposal of several buildings currently in use. COMPARISON OF FINANCIAL CONDITION AT OCTOBER 31, 1998 AND OCTOBER 31, 1997 Total assets increased by $181.2 million, or 11.1%, from $1,625.3 million at October 31, 1997 to $1,806.5 million at October 31, 1998. This growth was due primarily to a $57.6 million, or 118.3%, increase in cash and cash equivalents and a $129.7 million, or 10.9%, increase in loans, partially offset by a $27.7 million, or 8.1%, decrease in investment securities. Asset growth was funded primarily by a $170.7 million, or 12.5%, increase in deposits. The increase in cash and cash equivalents at October 31, 1998 was primarily attributable to the receipt of significant funds being held in escrow in connection with the Company's subscription offering of stock. The increase in loans occurred primarily in Compass's indirect auto and residential mortgage loan portfolios. From October 31, 1997 to October 31, 1998, indirect auto loans (net of unearned discounts) increased by $98.7 million, or 47.5%. This growth is primarily attributable to the favorable interest rate environment and economic conditions which prevailed during the period and the continued emphasis of this area of lending. Residential mortgage loans increased by $11.7 million, or 1.9%, during 1998. Due to the favorable interest rate environment which prevailed, Compass originated $313.4 million of residential mortgage loans in 1998, a 84.8% increase over 1997. As the Bank continued to sell fixed rate loans with terms of 15 years or longer during 1998 and due to the high volume of loan refinancing attributable to lower interest rates, the net growth in this portion of the loan portfolio was constrained. Total deposits at October 31, 1998 were $1,531.7 million, an increase of $170.7 million, or 12.5%, compared to $1,361.0 million at October 31, 1997. The increase in deposits was primarily due to favorable economic conditions and the impact of escrowed deposits of $21.9 million received in the subscription offering portion of the Company's initial public offering of stock, partially offset by a continuing low interest rate environment wherein Compass competes against other instruments available to the public such as mutual funds and annuities. Total borrowed funds were $102.9 million at October 31, 1998 compared to $108.0 million at October 31, 1997, a decrease of $5.1 million, or 4.7%. During the year ended October 31, 1998, Compass's net borrowings from the FHLB decreased by $11.5 million and its retail repurchase agreements increased by $5.3 million. The increase in surplus of $13.4 million to $153.6 million at October 31, 1998 resulted from net income of $18.1 million for the year ended October 31, 1998 and a $1.0 million increase in unrealized gains (net of taxes) on securities available for sale, most of which pertained to the marketable equity securities portfolio, partially offset by elimination of the portion of the Company's pre-acquisition stock investment in Sandwich which had been purchased in 1998. 36 RESULTS OF OPERATIONS NET INTEREST INCOME The Company's performance is primarily attributable to its level of net interest income. General economic conditions, corporate strategies, asset/liability management and the policies of regulatory authorities all have a significant impact on the level of net interest income achieved. During the period 1997 to 1999, the Company's net interest income increased from $57.9 million for the year ended October 31, 1997 to $74.4 for the year ended December 31, 1999, an increase of $16.5 million, or 28.5%. This achievement has been attributable to the Company's growth in average interest-earning assets and the increase in the ratio of interest-earning assets to interest bearing liabilities over that same period. The increase in such ratio is primarily attributable to the $121.4 of net proceeds from the Company's initial public stock offering in November 1998. During the period 1997 to 1999, the Company's interest rate spread (the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities) has declined slightly from 3.38% in 1997 to 3.26% in 1999. This decrease is primarily attributable to the relative increase in Compass's utilization of borrowings, rather than lower cost deposits, to fund asset growth. 37 The following table presents average balances, interest income and expense and yields earned or rates paid on the major categories of assets and liabilities for the years indicated. Year Ended December 31 Years Ended October 31, -------------------------------------------------------------------------------------------- 1999 1998 1997 -------------------------------------------------------------------------------------------- Average Average Average Average yield/ Average yield/ Average yield/ balance Interest cost balance Interest cost balance Interest cost --------------------------------------------------------------------------------------------- (Dollars in thousands) ASSETS: Interest-earning assets: Short-term investments............ $ 8,206 $ 377 4.59% $ 37,626 $ 2,198 5.84 % $ 27,983 $ 1,600 5.72% Debt securities (1)............... 265,204 16,086 6.07 311,921 18,358 5.89 326,788 20,013 6.12 Equity securities (1)............. 21,875 1,271 5.81 17,259 796 4.61 11,000 632 5.75 Mortgage loans (2)................ 1,121,684 84,235 7.51 928,739 74,862 8.06 872,174 72,248 8.28 Commercial loans (2).............. 66,178 5,846 8.83 44,672 4,333 9.70 43,237 4,203 9.72 Indirect auto loans............... 373,088 27,017 7.24 245,679 19,423 7.91 180,600 14,497 8.03 Other consumer loans.............. 36,833 3,120 8.47 33,177 2,964 8.93 30,549 2,756 9.02 ---------- -------- ---------- --------- ---------- -------- Total interest-earning assets.. 1,893,068 137,952 7.29 1,619,073 122,934 7.59 1,492,331 115,949 7.77 -------- -------- --------- ------- -------- -------- Allowance for loan losses......... (16,153) (14,696) (14,409) Non-interest earning assets....... 109,540 96,320 84,777 ---------- ---------- ---------- Total assets................... $1,986,455 $1,700,697 $1,562,699 ========== ========== ========== LIABILITIES AND EQUITY: Interest-bearing liabilities: Deposits: NOW accounts................... $ 151,180 $ 1,466 0.97% $ 129,956 $ 1,650 1.27 % $ 115,507 $ 1,523 1.32% Savings accounts............... 215,088 4,978 2.31 199,874 5,019 2.51 194,995 4,926 2.53 Money market savings accounts..................... 295,393 8,638 2.92 261,212 7,823 2.99 228,761 6,597 2.88 Certificates of deposit........ 734,995 38,171 5.19 720,590 41,075 5.70 672,652 38,277 5.69 ---------- -------- ---------- --------- ---------- -------- Total deposits............... 1,396,656 53,253 3.81 1,311,632 55,567 4.24 1,211,915 51,323 4.23 ---------- -------- ---------- --------- ---------- -------- Borrowed funds: Short-term borrowings (3)...... 31,896 1,610 5.05 13,744 723 5.26 5,670 283 4.99 FHLB advances.................. 147,486 8,647 5.86 102,843 6,402 6.23 102,732 6,419 6.25 ---------- -------- ---------- --------- ---------- -------- Total borrowings............. 179,382 10,257 5.72 116,587 7,125 6.11 108,402 6,702 6.18 ---------- -------- ---------- --------- ---------- -------- Total interest-bearing...... liabilities........... 1,576,038 63,510 4.03 1,428,219 62,692 4.39 1,320,317 58,025 4.39 -------- -------- --------- ------- -------- -------- Non-interest bearing demand checking accounts.............. 117,416 102,270 97,131 Other liabilities................. 19,542 19,440 13,758 ---------- ---------- ---------- Total liabilities.............. 1,712,996 1,549,929 1,431,206 Stockholders' equity / surplus.... 273,459 150,768 131,493 ---------- ---------- ---------- Total liabilities and stockholders' equity / surplus...................... $1,986,455 $1,700,697 $1,562,699 ========== ========== ========== Net interest income/interest rate spread (4)..................... $ 74,442 3.26% $ 60,242 3.20 % $ 57,924 3.38% ======== ======== ========= ======= ======== ======== Net interest margin (5)........... 3.93% 3.72 % 3.88% ======== ======= ======== Ratio of interest-earning assets to interest-bearing liabilities.................... 120.12% 113.36 % 113.03% ======== ======= ======== - --------------------------- (1) Average balances include unrealized gains on securities available for sale. Equity securities include marketable equity securities and restricted\ equity securities. (2) Loans on non-accrual status are included in the average balances. (3) Short-term borrowings include immaterial balances of other borrowings. (4) Interest rate spread represents the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities. (5) Net interest margin represents net interest income divided by average interest-earning assets. 38 RATE/VOLUME ANALYSIS. The following table presents the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected Seacoast Financial's interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate. Year Ended Year ended December 31, 1999 October 31, 1998 compared to compared to year ended year ended October 31, 1998 October 31, 1997 ------------------------------- ------------------------------- Increase (decrease) due to Increase (decrease) due to ------------------------------- ------------------------------- Volume Rate Net Volume Rate Net --------- ---------- --------- --------- --------- -------- (In thousands) Interest-earning assets: Short-term investments........................ $ (1,430)$ (391) $ (1,821) $ 563 $ 35 $ 598 Debt securities............................... (2,819) 547 (2,272) (891) (764) (1,655) Equity securities............................. 241 234 475 307 (143) 164 Mortgage loans................................ 14,753 (5,380) 9,373 4,597 (1,983) 2,614 Commercial loans.............................. 1,929 (416) 1,513 139 (9) 130 Indirect auto loans........................... 9,344 (1,750) 7,594 5,148 (222) 4,926 Other consumer loans.......................... 315 (159) 156 234 (26) 208 --------- ---------- --------- --------- --------- -------- Total interest-earning assets.............. $ 22,333 $ (7,315) $ 15,018 $ 10,097 $ (3,112) $ 6,985 --------- ---------- --------- --------- --------- -------- Interest-bearing liabilities: Deposits: NOW accounts............................... $ 243 $ (427) $ (184) $ 185 $ (58) $ 127 Savings accounts........................... 367 (408) (41) 123 (30) 93 Money market savings accounts.............. 1,003 (188) 815 964 262 1,226 Certificates of deposit.................... 808 (3,712) (2,904) 2,732 66 2,798 --------- ---------- --------- --------- --------- -------- Total deposits........................... 2,421 (4,735) (2,314) 4,004 240 4,244 --------- ---------- --------- --------- --------- -------- Borrowed funds: Short-term borrowings...................... 917 (30) 887 424 16 440 FHLB advances.............................. 2,622 (377) 2,245 21 (38) (17) --------- ---------- --------- --------- --------- -------- Total borrowings......................... 3,539 (407) 3,132 445 (22) 423 --------- ---------- --------- --------- --------- -------- Total interest-bearing liabilities....... 5,960 (5,142) 818 4,449 218 4,667 --------- ---------- --------- --------- --------- -------- Net change in net interest income............. $ 16,373 $ (2,173) $ 14,200 $ 5,648 $ (3,330) $ 2,318 ========= ========== ========= ========= ========= ======== COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED DECEMBER 31, 1999 AND OCTOBER 31, 1998 GENERAL. Net income was $24.5 million in 1999 compared to $18.1 million in 1998, an increase of $6.4 million or 35.4%. Due primarily to an increase in average interest-earning assets of $274.0 million, or 16.9%, net interest income increased by $14.2 million, or 23.6%, from $60.2 million in 1998 to $74.4 million in 1999. The other significant factors affecting the change in net income was an increase of $264,000 in the provision for loan losses and an increase of $4.7 million in non-interest expense. The Company's effective rate declined to 35.3% in 1999 from 37.1% in 1998. INTEREST INCOME. Interest income was $138.0 million in 1999, compared to $122.9 million in 1998, an increase of $15.1 million, or 12.3%. This increase in interest income resulted exclusively from average interest-earning asset growth of $274.0 million or 16.9%. The yield on interest-earning assets decreased 30 basis points in 1999 from 7.59% in 1998 to 7.29% in 1999. A significant portion of the increase in average interest-earning assets was attributable to the indirect auto loan portfolio, which increased from $245.7 million at October 31, 1998 to $373.1 million at December 31, 1999, and the mortgage loan portfolio, which increased from $928.7 million to $1,121.7 million, at those dates, respectively. 39 The net proceeds of the November 1998 stock offering of $121.4 million had a significant impact on the Company's interest income. Of the increase of $15.1 million in interest income in 1999, approximately $6.5 million was attributable to the earnings on the use of the net proceeds of the stock offering after consideration of the impact of stock repurchases. INTEREST EXPENSE. Interest expense increased by $818,000, or 1.3%, from $62.7 million in 1998 to $63.5 million in 1999. The increase resulted from a $147.8 million, or 10.3%, increase in average interest-bearing liabilities partially offset by a 36 basis point decrease in the average rate paid on such liabilities. Total average interest-bearing deposits increased by $85.0 million, or 6.5%, with most of the increase occurring in lower cost core deposits. Because of the level of loan growth, Compass increased its advances from the FHLB with the average amount of such borrowings outstanding increasing by $44.7 million, or 43.5%, from $102.8 million in 1998 to $147.5 million in 1999. PROVISION FOR LOAN LOSSES. Compass establishes provisions for loan losses, which are charged to operations, in order to maintain the allowance for loan losses at a level that management estimates is appropriate to absorb future charge-offs of loans deemed uncollectible. In determining the appropriate level of the allowance for loan losses, management considers past and anticipated loss experience, evaluations of real estate collateral, current and anticipated economic conditions, volume and type of lending and the levels of nonperforming and other classified loans. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates. Management assesses the allowance for loan losses on a quarterly basis and makes provisions for loan losses monthly in order to maintain the adequacy of the allowance. The provision for loan losses increased by $264,000, or 15.2%, from $1.7 million in 1998 to $2.0 million in 1999. The total allowance of $16.8 million at December 31, 1999 represented .96% of total loans, a decrease from 1.14% at October 31, 1998. This decrease reflects the impact of the 24.4% growth in the loan portfolio in 1999 which growth has occurred in the historically less risky residential mortgage loan and indirect auto loan portfolios. At December 31, 1999, the allowance for loan losses as a percentage of non-performing loans was 293.5% compared to 232.1% at December 31, 1998. NON-INTEREST INCOME. Non-interest income is comprised of fees and charges for bank services, net interchange fees on the processing of merchant credit card receipts, gains or losses from sales of assets, loan servicing fees and other income resulting from various types of banking transactions. Total non-interest income was $10.0 million in 1999 and 1998. Included in non-interest income in 1999 is a $1.5 million gain on termination of the Bank's pension plan. Exclusive of this non-recurring item, non-interest income declined $1.5 million due entirely to a $1.6 million decrease in gains on the sale of loans and investments. Such decline is a result of the change in practice, beginning in November 1998, whereby Compass is no longer selling fixed rate residential mortgage loans with terms of 15 years or longer in the secondary mortgage market. As a result of the decision to terminate its defined benefit pension plan and to enhance its 401(k) plan, Compass expects to realize annual savings of approximately $450,000 beginning in 2000 and a non-recurring settlement gain of approximately $1.5 million in 2000. NON-INTEREST EXPENSE. Non-interest expense increased by $4.7 million, or 11.8%, from $39.8 million for the year ended October 31, 1998 to $44.5 million for the year ended December 31, 1999. Of this increase, $1.1 million related to salaries and employee benefits, which rose 4.9% to $22.4 million in 1999. This increase is attributable to overall salary increases averaging 4% in 1999, costs associated with the ESOP established in November 1998 ($585,000) and restricted stock awarded in July 1999 ($637,000), partially offset by elimination of certain executive positions at the former Sandwich Bank. Occupancy and equipment expenses increased $738,000, or 14.5%, to $5.8 million for the year ended December 31, 1999. This increase was due to an increase in rent expense and depreciation attributable to the relocation of the Bank's Operations and Consumer Lending Departments and the opening of new branches in Plymouth and Hyannis. Data processing expenses increased $1.2 million, or 37.8%, to $4.5 million for the year ended December 31, 1999. This increase was due to a number of factors such as new services, including imaging, laser printing and Internet services, the installation of additional communication lines and related network changes, outsourcing of cash letter processing, Y2K compliance costs, expansion of the ATM network on Cape Cod and volume-related core processing costs due to increases in loans and deposits. 40 Marketing expenses increased $382,000, or 18.4%, to $2.5 million for the year ended December 31, 1999. This increase was due to lower than normal marketing costs at the former Sandwich Bank in the 1998 period due to the impending merger with the Company and increased costs in 1999 associated with a program to attract new customers affected by the branch divestiture required by the Fleet/BankBoston merger. Professional services expenses increased $669,000, or 51.2%, to $2.0 million for the year ended December 31, 1999. This increase was primarily due to costs associated with being a public company as well as costs incurred to develop the Bank's strategic plan, assess business expansion opportunities, implement the stock award program, implement the dividend reinvestment and stock purchase plan and review the defined benefit pension plan. Other non-interest expenses increased $441,000, or 6.5%, for the year ended December 31, 1999. This increase was due primarily to certain nonrecurring costs associated with the merger with Sandwich. INCOME TAXES. Total income tax expense was $13.4 million in 1999 compared to $10.7 million in 1998. The effective tax rate was lower in 1999 (35.3%) than in 1998 (37.1%) primarily because of greater utilization of non-bank subsidiaries that were taxed at a lower rate for state tax purposes and an increase in federal low income housing tax credits. COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED OCTOBER 31, 1998 AND OCTOBER 31, 1997 GENERAL. Net income increased by $1.5 million or 8.7%, from $16.6 million for the year ended October 31, 1997 to $18.1 million for the year ended October 31, 1998. The improvement was attributable to higher net interest income of $2.3 million, a $879,000 decrease in the provision for loan losses due to a continuation of the favorable trends in the various factors considered by management in evaluating the adequacy of the allowance for loan losses and an increase in net gains on sales of loans of $1.0 million. Also impacting the change in net income was an increase of $2.8 million in non-interest expense due to higher salaries, occupancy and equipment expenses, data processing expenses and marketing costs. The increase in net interest income was due to growth in average interest-earning assets. INTEREST INCOME. Interest income for the year ended October 31, 1998 was $122.9 million, compared to $115.9 million for the year ended October 31, 1997, an increase of $7.0 million, or 6.0%. All of the increase in interest income resulted from growth in average interest-earning assets of $126.7 million, or 8.5% as the yield on interest-earning assets decreased 18 basis points in 1998 from 7.77% in 1997 to 7.59% in 1998. The principal areas of growth related to real estate loans (up $56.6 million, or 6.5%) and indirect auto loans (up $65.1 million, or 36.1%). Most of the real estate loan growth resulted from increased originations of one- to four-family real estate loans. The increase in indirect auto loans resulted from an improved economic environment within Compass's local markets, the expansion of such lending into Rhode Island and the continued emphasis of this area of lending. INTEREST EXPENSE. Interest expense for the year ended October 31, 1998 was $62.7 million, compared to $58.0 million for the year ended October 31, 1997, an increase of $4.7 million, or 8.1%. This increase resulted entirely from a higher average balance of interest-bearing liabilities (up $107.9 million, or 8.2%). Average interest-bearing deposit balances increased $99.7 million, or 8.2%, primarily as a result of the introduction and promotion of relationship-based retail checking account products in 1996 and 1997. Compass increased its average borrowings from both the FHLB and customers under retail repurchase agreements during the year ended October 31, 1998. Interest expense on borrowed funds increased $423,000, or 6.3%, in the year ended October 31, 1998 due to an $8.2 million, or 7.6%, increase in the average balance of such funds to $116.6 million, which was partially offset by an 7 basis point reduction in the average rate paid on borrowed funds to 6.11% in 1998 compared to 1997. PROVISION FOR LOAN LOSSES. Compass provided $1.7 million for loan losses in the year ended October 31, 1998 compared to $2.6 million in the year ended October 31, 1997, a decrease of $879,000, or 33.6%. The total allowance of $15.1 million at October 31, 1998 represented 1.14% of total loans, a decrease from 1.24% at October 31, 1997. These decreases were primarily influenced by a reduction in the balance of adversely classified loans and fewer delinquencies. NON-INTEREST INCOME. Total non-interest income was $10.0 million for the year ended October 31, 1998 compared to $8.5 million for the year ended October 31, 1997, an increase of $1.5 million, or 17.6%. The increase resulted primarily from an increase of $1.0 million in the gain on sale of mortgage loans, from $717,000 in the year ended October 31, 1997 to $1.8 million in the year ended October 31, 1998. With the reduction in interest rates on 15- and 41 30-year fixed rate mortgages which occurred in 1997 and 1998, the volume of fixed-rate mortgage loan originations increased which contributed to this increase. Also, Compass earned $270,000 of fees in 1998 under a new relationship with an outside vendor which processes its official checks. This fee is determined based on the average length of time such checks, which are drawn on the account of the outside vendor, remain outstanding. Prior to 1998, income on such float was classified as interest income. NON-INTEREST EXPENSE. Non-interest expense increased by $2.8 million, or 7.6%, from $37.0 million for the year ended October 31, 1997 to $39.8 million for the year ended October 31, 1998. Of this increase, $1.4 million related to compensation and employee benefits, which rose 7.2% to $21.3 million for the year ended October 31, 1998. The higher level of compensation and employee benefits was caused by overall salary increases averaging 4%, increased commissions related to higher mortgage loan originations, an increase in incentive compensation and other employee benefits as well as staffing increases in the lending area and in a new branch opened in May 1998. Occupancy and equipment expenses increased $239,000, or 4.9%, to $5.1 million for the year ended October 31, 1998. This increase was primarily due to an increase in rent expense attributable to the relocation of the Bank's Operations Department, the opening of a new branch, an upgraded branch and a one-time reduction in rent expense in 1997 of $36,000 attributable to a leased facility no longer utilized. Data processing expenses increased $430,000, or 15.2%, to $3.3 million for the year ended October 31, 1998. This increase was due to new services, including laser printing and Internet services, and volume-related increases in loans and deposits. Marketing expenses increased $301,000, or 17.0%, to $2.1 million for the year ended October 31, 1998. This increase was primarily attributable to advertising campaigns related to the Roth IRA accounts allowed by changes in the tax law, the advertising of Compass's Preferred Checking account and Flagship Money Market programs, promotion of the new Plymouth branch and on-line banking capabilities through the Internet. Other non-interest expenses increased $423,000, or 6.7%, for the year ended October 31, 1998. Included in other non-interest expense in 1997 and 1998 were recoveries of life insurance premiums from an insurance company which emerged from receivership in 1997. The net impact of the resolution of this matter resulted in an unfavorable change in non-interest expense in 1998 compared to 1997 of $273,000. In addition, increases in office supplies, charitable contributions and telephone expenses also caused the overall increase in non-interest expenses in the year ended October 31, 1998. Partially offsetting these increases was a decrease of $255,000 in OREO expense due to the continuation of the decline in the number of properties held as OREO and stable real estate market values. INCOME TAXES. Income tax expense was $10.7 million for the year ended October 31, 1998, an increase of $486,000, or 4.8%, compared to the 1997 period. The effective tax rate was 37.1% in 1998 compared to 37.9% in 1997 which decrease was caused by the greater utilization of non-bank subsidiaries that were taxed at a lower rate for state tax purposes. LIQUIDITY AND CAPITAL RESOURCES Compass's liquidity, represented by cash and cash equivalents and debt securities is a product of its operating, investing, and financing activities. The Bank's primary sources of funds are deposits, borrowings, principal and interest payments on outstanding loans and mortgage-backed securities, maturities of investment securities and funds provided from operations. While scheduled payments from the amortization of loans and mortgage related securities and maturing investment securities are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates and, in the case of deposits, other instruments available to the public such as mutual funds and annuities. As a voluntary number of the FHLB of Boston, Compass is entitled to borrow an amount up to the value of its qualified collateral that has not been pledged to others. Qualified collateral generally consists of residential first mortgage loans, U.S. Government and Agency securities and funds on deposit at the FHLB. At December 31, 1999, Compass had $394 million in unused borrowing capacity that is contingent upon the purchase of additional FHLB of Boston stock. Use of this borrowing capacity may also be impacted by regulatory capital requirements. 42 Liquidity management is both a daily and long term function of business management. The measure of a bank's liquidity is its ability to meet its cash commitments at all times with available cash or by conversion of other assets to cash at a reasonable price. At December 31, 1999, the Company maintained cash and due from banks, short-term investments and debt securities maturing within one year of $112.1 million, or 5.3% of total assets. Compass invests excess funds, if any, in federal funds sold which provides liquidity to meet lending requirements. At December 31, 1999, construction of the Bank's new corporate headquarters was in-progress. At that date, the estimated remaining construction and related costs to be incurred were $13.5 million. Compass believes it has adequate sources of liquidity to fund these expenditures. At December 31, 1999, Compass had commitments to originate loans, unused outstanding lines of credit, standby letters of credit and undisbursed proceeds of loans totaling $180.5 million. Compass anticipates that it will have sufficient funds available to meet its current loan commitments. Certificates of deposit maturing within one year from December 31, 1999 amounted to $584.2 million. Compass expects that substantially all maturing certificate accounts will be retained by Compass at maturity, although the percentage retained may be below historical levels due to increased price competition for these deposits. Compass's Tier 1 capital measured 15.8% of risk-weighted assets at December 31, 1999. Total capital, including the Tier 2 allowance for loan losses, was 17.0% of risk weighted assets. The leverage ratio was 10.9%. These ratios placed Compass in the "well capitalized" category according to regulatory standards. The Company's Tier 1 capital measured 19.0% of risk-weighted assets at December 31, 1999. Total capital, including the Tier 2 allowance for loan losses, was 20.2% of risk-weighted assets. The leverage ratio was 13.1%. These ratios placed the Company in excess of regulatory standards set forth by the Federal Reserve Board. IMPACT OF INFLATION AND CHANGING PRICES The consolidated financial statements and notes thereto presented herein have been prepared in accordance with GAAP, which requires the measurement of financial position and operating results in terms of historical dollar amounts without considering changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike industrial companies, nearly all of the Company's assets and liabilities are monetary in nature. As a result, interest rates have a greater impact on its performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services. IMPACT OF NEW ACCOUNTING STANDARDS In June 1999, the Financial Accounting Standards Board (FASB) issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities- Deferral of the Effective Date of FASB Statement No. 133" which is effective for fiscal years beginning after June 15, 2000. The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. Management does not anticipate that the adoption of this statement will have a material impact on the financial position or operating results of the Company. YEAR 2000 ISSUE The Year 2000 issue (commonly referred to as "Y2K") is the result of computer programs being written using two digits, rather than four digits, to define the applicable year. The Y2K issue, which was common to most corporations, including banks, concerns the inability of information systems, primarily (but not exclusively) computer software programs, to properly recognize and process date-sensitive information as the Year 2000 approaches and beyond. The following constitutes the Company's Y2K readiness disclosure under the Year 2000 Information and Readiness Disclosure Act. Compass took numerous remedial steps over the past several years to prepare for the change of century. These steps included forming a Y2K Project Team to develop and implement a Y2K Action Plan; replacing or upgrading noncompliant hardware and software; working with third party service bureaus and other vendors to ensure that 43 Compass's mission critical information systems were Y2K compliant; and establishing contingency plans in the event that an unforseen problem were to arise. Compass has experienced no problems or issues relating to Y2K as of the date of this report. Compass's technology infrastructure performed without any disruption, loss of data or customer inconvenience during "rollover weekend", which was the period from Friday, December 31, 1999 through the opening of normal business activities on Monday, January 3, 2000. Extensive monitoring and testing was performed with service bureaus and key outside vendors to satisfy connectivity and performance requirements. There were no Y2K reportable incidents that weekend or thereafter. All mission critical systems that included hardware, software, program interfaces, operating systems as well as other mechanical or computer-generated requirements, including Compass's main central processing system and network performed normally, as expected. Bank customers were able to make deposits to or withdrawals from deposit accounts, credit loan payments, apply for new loans, etc., and engage in normal banking activities. The Y2K Project Team will continue to monitor performance of mission critical systems in 2000 for potential Y2K issues. The chief components of Compass's expense related to the Y2K issue has been the replacement of personal computer equipment and the purchase or upgrade of third-party software. External maintenance and internal modification costs have been expensed as incurred. Costs of new hardware and software have been capitalized and are being depreciated in accordance with Compass's policies. Management expended approximately $1.1 million on its Year 2000 readiness efforts through December 31, 1999 of which $907,000 was for capitalizable items. Compass completed five mailings of Y2K information to all customers with statement accounts. Also, letters have been sent to major commercial loan customers and automobile dealerships informing them of the Year 2000 Issue and how it can impact businesses. An overall assessment of the Y2K readiness of Compass's commercial loan customers was completed in October 1998, with an overall assessment of low to medium risk. The Bank will continue to monitor its large commercial loan relationships through account officers contact programs. To date, Compass is not aware that any of its commercial loan customers have encountered any material Y2K problems with their computer systems. If Compass's commercial customers are not Year 2000 compliant and suffer adverse effects on their operations, their ability to meet their obligations to the Bank could be adversely affected. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK GENERAL. The chief market risk factor affecting the financial condition and operating results of Seacoast Financial and Compass is interest rate risk. This risk is managed by periodic evaluation of the interest rate risk inherent in certain balance sheet accounts, determination of the level of risk considered appropriate given Compass's capital and liquidity requirements, business strategy, performance objectives and operating environment and maintenance of such risks within guidelines approved by the Board. Through such management, Compass seeks to reduce the vulnerability of its net earnings to changes in interest rates. Compass's Asset/Liability Committee, comprised of senior management, is responsible for managing interest rate risk and reviewing with Compass's Board of Directors on a quarterly basis its activities and strategies, the effect of those strategies on Compass's and Seacoast Financial's operating results, Compass's interest rate risk position and the effect changes in interest rates would have on Compass's net interest income. The extent of movement of interest rates is an uncertainty that could have a negative impact on earnings. The principal strategies Seacoast Financial and Compass use to manage interest rate risk include (i) emphasizing the origination and retention of adjustable-rate loans, origination of indirect auto loans which have relatively short maturities and origination of loans with maturities at least partially matched with those of the deposits and borrowings funding the loans, (ii) investing in debt securities with relatively short maturities and (iii) classifying a significant majority of its investment portfolio as available for sale so as to provide sufficient flexibility in liquidity management. Seacoast Financial quantifies its interest-rate risk exposure using a sophisticated simulation model. Simulation analysis is used to measure the exposure of net interest income to changes in interest rates over a specified time horizon. Simulation analysis involves projecting future interest income and expense under various rate scenarios. Compass's internal guidelines on interest rate risk specify that for every 100 basis points immediate shift in interest rates, its estimated net interest income over the next 12 months should decline by less than 5%. In utilizing a 300 basis point increase in rates in its simulation model, the full impact of annual rate caps of 200 basis points common to most adjustable rate mortgage loan products is considered. The rate shocks used assume an instantaneous and parallel change in interest rates. Prepayment speeds for loans are based on published median dealer forecasts for each interest rate scenario. 44 As of December 31, 1999, Seacoast Financial's estimated exposure as a percentage of estimated net interest income for the next twelve and twenty-four month periods is as follows: PERCENTAGE CHANGE IN ESTIMATED NET INTEREST INCOME OVER: ------------------------------------------------ 12 MONTHS 24 MONTHS ------------------------------------------------ 300 basis point increase in rates (14.40%) (12.82%) 200 basis point decrease in rates (1.89%) (6.17%) Based on the scenario above, net income would be adversely affected (within Compass's internal guidelines) in both the twelve and twenty-four month periods. For each one percentage point change in net interest income, the effect on net income would be $524,000, assuming a 37% tax rate. 45 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA HISTORICAL FINANCIAL STATEMENTS: PAGE Reports of Independent Public Accountants................................................................. 47 Consolidated Balance Sheets as of December 31, 1999 and 1998 and October 31, 1998......................... 49 Consolidated Statements of Income for the Year Ended December 31, 1999, the Two Months Ended December 31, 1998 and the Years Ended October 31, 1998 and 1997.................................................... 50 Consolidated Statements of Changes in Stockholders' Equity for the Year Ended December 31, 1999, the Two Months Ended December 31, 1998 and the Years Ended October 31, 1998 and 1997.............................. 51 Consolidated Statements of Cash Flows for the Year Ended December 31, 1999, the Two Months Ended December 31, 1998 and the Years Ended October 31, 1998 and 1997..................................... 52 Notes to Consolidated Financial Statements................................................................ 54-83 All schedules are omitted because they are not required or applicable, or the required information is shown in the financial statements or notes thereto. 46 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Audit Committee of Seacoast Financial Services Corporation: We have audited the accompanying consolidated balance sheets of Seacoast Financial Services Corporation and subsidiaries (the Bank) as of December 31, 1999 and 1998 and October 31, 1998, and the related consolidated statements of income, changes in stockholders' equity and cash flows for the year ended December 31, 1999, the two months ended December 31, 1998, and the years ended October 31, 1998 and 1997. These consolidated financial statements are the responsibility of the Bank's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the separate consolidated balance sheet of Sandwich Bancorp, Inc. and subsidiaries as of October 31, 1998 and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years ended October 31, 1998 and December 31, 1997, which consolidated statements reflect total assets of $546.9 million at October 31, 1998 and net income of $4.6 million for the twelve months ended October 31, 1998 and $4.9 million for the year ended December 31, 1997. Those consolidated financial statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Sandwich Bancorp, Inc. for such periods, is based solely on the report of such other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Seacoast Financial Services Corporation and subsidiaries as of December 31, 1999 and 1998 and October 31, 1998, and the results of their operations and their cash flows for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997, in conformity with generally accepted accounting principles. /s/ ARTHUR ANDERSEN LLP Boston, Massachusetts January 27, 2000 47 INDEPENDENT AUDITORS' REPORT The Board of Directors Sandwich Bancorp, Inc.: We have audited the consolidated balance sheet of Sandwich Bancorp, Inc. and subsidiaries as of October 31, 1998 and the related consolidated statements of operations, changes in stockholders' equity and cash flows for the years ended October 31, 1998 and December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sandwich Bancorp, Inc. and subsidiaries as of October 31, 1998, and the results of their operations and their cash flows for the years ended October 31, 1998 and December 31, 1997, in conformity with generally accepted accounting principles. /s/ KPMG LLP Boston Massachusetts December 3, 1998 48 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) December 31, ------------------------- October 31, 1999 1998 1998 ----------- ----------- ------------ ASSETS: Cash and due from banks .................................................. $ 60,245 $ 54,006 $ 65,340 Federal funds sold ....................................................... 106 47,413 41,033 ----------- ----------- ------------ Total cash and cash equivalents ........................................ 60,351 101,419 106,373 Other short-term investments ............................................. 231 31,119 10,015 Investment securities (Note 3)-- Available-for-sale, at fair value ...................................... 245,583 294,500 290,932 Held to maturity, at amortized cost .................................... 12,408 12,693 13,694 Restricted equity securities ........................................... 14,936 9,062 9,062 Loans held-for-sale ...................................................... 756 -- 13,495 Loans, net (Note 4) ...................................................... 1,730,378 1,388,140 1,305,563 Accrued interest receivable .............................................. 9,426 8,523 8,463 Banking premises and equipment, net (Note 5) ............................. 26,585 19,887 21,145 Other real estate owned .................................................. 552 1,391 1,299 Net deferred tax asset (Note 9) .......................................... 12,527 10,715 9,526 Other assets ............................................................. 9,052 10,631 16,956 ----------- ----------- ------------ Total assets ......................................................... $ 2,122,785 $ 1,888,080 $ 1,806,523 =========== =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY: Deposits (Note 6) ........................................................ $ 1,515,622 $ 1,497,215 $ 1,531,663 Short-term borrowings (Note 7) ........................................... 40,787 12,835 15,801 Federal Home Loan Bank advances (Note 8) ................................. 271,900 83,951 85,111 Other borrowings ......................................................... 1,935 1,987 1,994 Mortgagors' escrow payments .............................................. 3,829 3,411 2,527 Accrued expenses and other liabilities (Note 12) ......................... 14,691 17,169 15,857 ----------- ----------- ------------ Total liabilities .................................................... 1,848,764 1,616,568 1,652,953 ----------- ----------- ------------ COMMITMENTS AND CONTINGENCIES (Notes 10 and 14) Stockholders' equity (Notes 11, 13, 17, 18 and 19): Preferred stock, par value $.01 per share; authorized 10,000,000 shares; none issued .......................................................... -- -- -- Common stock, par value $.01 per share; authorized 100,000,000 shares; 26,758,136 shares issued ............................................. 268 268 -- Additional paid-in capital ............................................. 152,702 152,936 -- Surplus ................................................................ -- -- 151,012 Treasury stock, at cost, 898,500 shares in 1999 ........................ (9,310) -- -- Retained earnings ...................................................... 149,256 127,263 -- Accumulated other comprehensive income (loss) .......................... (2,430) 2,337 2,558 Unearned compensation - ESOP and restricted stock ...................... (16,326) (11,153) -- Shares held in employee trust .......................................... (139) (139) -- ----------- ----------- ------------ Total stockholders' equity ........................................... 274,021 271,512 153,570 ----------- ----------- ------------ Total liabilities and stockholders' equity ........................... $ 2,122,785 $ 1,888,080 $ 1,806,523 =========== =========== ============ The accompanying notes are an integral part of these consolidated financial statements. 49 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS) Years Ended Year Ended Two Months Ended October 31, December 31, December 31, -------------------- 1999 1998 1998 1997 --------- --------- --------- -------- INTEREST AND DIVIDEND INCOME: Interest on loans ......................................... $ 120,218 $ 17,790 $ 101,582 $ 93,704 Interest and dividends on investments securities........... 17,357 3,067 19,154 20,645 Interest on federal funds sold and short-term investments.. 377 775 2,198 1,600 --------- --------- --------- --------- Total interest and dividend income..................... 137,952 21,632 122,934 115,949 --------- --------- --------- --------- INTEREST EXPENSE: Interest on deposits....................................... 53,253 9,498 55,567 51,323 Interest on borrowed funds................................. 10,257 1,025 7,125 6,702 --------- --------- --------- --------- Total interest expense................................. 63,510 10,523 62,692 58,025 --------- --------- --------- --------- Net interest income.................................... 74,442 11,109 60,242 57,924 PROVISION FOR LOAN LOSSES (Note 4) ........................... 2,000 416 1,736 2,615 --------- --------- --------- --------- Net interest income after provision for loan losses...................................... 72,442 10,693 58,506 55,309 --------- --------- --------- --------- NONINTEREST INCOME: Deposit and other banking fees............................. 5,187 871 5,370 5,124 Loan servicing fees, net .................................. 587 121 759 821 Card fee income, net....................................... 712 90 572 524 Other loan fees............................................ 428 115 560 556 Gain on sales of investment securities, net (Note 3)....... 164 22 67 92 Gain on sales of loans, net................................ 56 244 1,755 717 Gain on pension plan termination (Note 12)................. 1,472 -- -- -- Other income............................................... 1,388 176 959 702 --------- --------- --------- --------- Total noninterest income............................... 9,994 1,639 10,042 8,536 --------- --------- --------- --------- NONINTEREST EXPENSE: Salaries and employee benefits (Note 12)................... 22,362 3,963 21,316 19,876 Occupancy and equipment expenses (Notes 5 and 10).......... 5,824 924 5,086 4,847 Data processing expenses................................... 4,486 651 3,255 2,825 Marketing expenses......................................... 2,455 460 2,073 1,772 Professional services expenses............................. 1,976 307 1,307 1,369 Other operating expenses................................... 7,211 1,127 6,770 6,347 Merger-related expenses (Note 2)........................... -- 6,813 -- -- Write-down of banking premises and equipment (Note 5)...... 202 1,967 -- -- --------- --------- --------- --------- Total noninterest expense.............................. 44,516 16,212 39,807 37,036 --------- --------- --------- --------- Income (loss) before provision (benefit) for income taxes 37,920 (3,880) 28,741 26,809 PROVISION (BENEFIT) FOR INCOME TAXES (Note 9)................. 13,394 (544) 10,651 10,165 --------- --------- --------- --------- Net income (loss)...................................... $ 24,526 $ (3,336) $ 18,090 $ 16,644 ========= ========= ========= ========= EARNINGS (LOSS) PER SHARE (Note 1): Basic...................................................... $ 0.97 $ (0.15) ========= ========= Diluted.................................................... $ 0.97 $ (0.15) ========= ========= Weighted average common shares outstanding................. 26,710,211 22,388,272 Weighted average unallocated ESOP shares and unvested restricted stock ........................ (1,374,301) (771,148) ----------- ----------- Weighted average common shares outstanding - basic......... 25,335,910 21,617,124 Dilutive effect of common stock equivalents................ 19,669 9,543 ----------- ----------- Weighted average common and common stock equivalent shares outstanding - diluted.................. 25,355,579 21,626,667 =========== =========== The accompanying notes are an integral part of these consolidated financial statements. 50 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY FOR THE YEAR ENDED DECEMBER 31, 1999, THE TWO MONTHS ENDED DECEMBER 31, 1998 AND THE YEARS ENDED OCTOBER 31, 1998 AND 1997 (IN THOUSANDS, EXCEPT PER SHARE AMOUNT) Additional Common Paid-In Retained Treasury Stock Capital Surplus Earnings Stock ---------- ---------- ----------- -------- ------- Balance, October 31, 1996..................................... $ -- $ -- $123,280 $ -- $ -- Net income.................................................... -- -- 16,644 -- -- Other comprehensive income-- Change in unrealized gain on securities available for sale, net of taxes................ -- -- -- -- -- Comprehensive income..................................... Transactions with stockholders of acquired entity............. -- -- (1,537) -- -- Change in intercorporate investment........................... -- -- -- -- -- ------ -------- -------- ------- ------- Balance, October 31, 1997..................................... -- -- 138,387 -- -- Net income.................................................... -- -- 18,090 -- -- Other comprehensive income -- Change in unrealized gain on securities available for sale, net of taxes................ -- -- -- -- -- Comprehensive income..................................... Transactions with stockholders of acquired entity............. -- -- 496 -- -- Change in intercorporate investment........................... -- -- (4,254) -- -- Effect of difference in year-ends............................. -- -- (1,707) -- -- ------ -------- -------- ------- ------- Balance, October 31, 1998..................................... -- -- 151,012 -- -- Transactions with stockholders of acquired entity............. -- 81 -- -- -- Stock offering, net of expenses of $7,290..................... 140 132,570 -- -- -- Reclassification of equity accounts due to merger with Sandwich Bancorp, Inc. and mutual-to-stock conversion...... 128 20,285 (151,012) 130,599 -- Net loss...................................................... -- -- -- (3,336) -- Other comprehensive income -- Change in unrealized gain on securities available for sale, net of taxes................ -- -- -- -- -- Comprehensive income (loss).............................. Amortization of unearned compensation......................... -- -- -- -- -- ------ -------- -------- ------- ------- Balance, December 31, 1998.................................... 268 152,936 -- 127,263 -- Grant of restricted stock awards.............................. -- 6,370 -- -- -- Repurchase of common stock.................................... -- -- -- -- (15,939) Issuance of restricted stock awards........................... -- (6,629) -- -- 6,629 Net income.................................................... -- -- -- 24,526 -- Other comprehensive income -- Change in unrealized gain (loss) on securities available for sale, net of taxes............. -- -- -- -- Comprehensive income..................................... Cash dividends - $.10 per share............................... -- -- -- (2,533) -- Amortization of unearned compensation......................... -- 25 -- -- -- ------ -------- -------- ------- ------- Balance, December 31, 1999.................................... $ 268 $152,702 $ -- $149,256 $(9,310) ====== ======== ======== ======= ======= Unearned Accumulated Other Compensation Shares Held Comprehensive ESOP/Restricted in Employee Income (Loss) Stock Trust Total ---------------- --------------- ----------- --------- Balance, October 31, 1996..................................... $ (143) $ -- $ -- $123,137 Net income.................................................... -- -- -- 16,644 Other comprehensive income-- Change in unrealized gain on securities available for sale, net of taxes................ 1,925 -- -- 1,925 --------- Comprehensive income..................................... 18,569 Transactions with stockholders of acquired entity............. -- -- -- (1,537) Change in intercorporate investment........................... (41) -- -- (41) ------- --------- ------ --------- Balance, October 31, 1997..................................... 1,741 -- -- 140,128 Net income.................................................... -- -- -- 18,090 Other comprehensive income -- Change in unrealized gain on securities available for sale, net of taxes................ 1,027 -- -- 1,027 --------- Comprehensive income..................................... 19,117 Transactions with stockholders of acquired entity............. -- -- -- 496 Change in intercorporate investment........................... (236) -- -- (4,490) Effect of difference in year-ends............................. 26 -- -- (1,681) ------- --------- ------ --------- Balance, October 31, 1998..................................... 2,558 -- -- 153,570 Transactions with stockholders of acquired entity............. -- -- -- 81 Stock offering, net of expenses of $7,290..................... -- (11,200) (139) 121,371 Reclassification of equity accounts due to merger with Sandwich Bancorp, Inc. and mutual-to-stock conversion...... -- -- -- -- Net loss...................................................... -- -- -- (3,336) Other comprehensive income -- Change in unrealized gain on securities available for sale, net of taxes................ (221) -- -- (221) --------- Comprehensive income (loss).............................. (3,557) Amortization of unearned compensation......................... -- 47 -- 47 ------- --------- ------ --------- Balance, December 31, 1998.................................... 2,337 (11,153) (139) 271,512 Grant of restricted stock awards.............................. -- (6,370) -- -- Repurchase of common stock.................................... -- -- -- (15,939) Issuance of restricted stock awards........................... -- -- -- -- Net income.................................................... -- -- -- 24,526 Other comprehensive income -- Change in unrealized gain (loss) on securities available for sale, net of taxes............. (4,767) -- -- (4,767) --------- Comprehensive income..................................... 19,759 Cash dividends - $.10 per share............................... -- -- -- (2,533) Amortization of unearned compensation......................... -- 1,197 -- 1,222 ------- --------- ------ --------- Balance, December 31, 1999.................................... $(2,430) $ (16,326) $ (139) $274,021 ======= ========= ====== ========= The accompanying notes are an integral part of these consolidated financial statements. 51 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) Years Ended Year Ended Two Months Ended October 31, December 31, December 31, --------------------- 1999 1998 1998 1997 -------------- ------------------- ---------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss).................................................... $ 24,526 $ (3,336) $ 18,090 $ 16,644 Adjustments to reconcile net income (loss) to net cash provided by operating activities -- Amortization, depreciation and writedowns of premises and equipment...................................................... 3,810 2,627 3,344 3,517 Merger-related expenses.............................................. -- 6,813 -- -- Stock-based compensation............................................. 1,222 47 -- -- Provision for loan losses............................................ 2,000 416 1,736 2,615 Gain on sale of investment securities, net........................... (164) (22) (67) (92) Provision for other real estate losses............................... (63) 18 82 233 Gain on pension plan termination..................................... (1,472) -- -- -- Gain on sale of other real estate owned.............................. -- -- (62) (96) Provision for deferred (prepaid) taxes............................... 1,209 (1,836) (221) (56) Originations of loans held-for-sale.................................. (7,655) -- (166,481) (48,211) Proceeds from sales of loans originated for resale................... 6,955 12,909 158,964 52,506 Gain on sales of loans, net.......................................... (56) (244) (1,755) (717) (Gain) loss on sale of premises and equipment........................ (96) -- 42 -- Net (increase) decrease in accrued interest receivable............... (903) (60) 73 (539) Net (increase) decrease in other assets.............................. 1,246 3,431 (2,119) (2,397) Net increase (decrease) in accrued expenses and other liabilities.... (231) 1,003 938 (564) ---------- ----------- ---------- ---------- Net cash provided by operating activities...................... 30,328 21,766 12,564 22,843 ---------- ----------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of securities classified as available-for-sale.............. (68,183) (23,864) (135,992) (146,158) Purchase of securities classified as held-to-maturity................ (5,078) -- (7,480) (7,050) Purchase of restricted equity securities............................. (5,874) -- (130) (1,591) Proceeds from sales, calls, paydowns and maturities of securities classified as available-for-sale........................ 109,101 18,973 165,074 146,078 Proceeds from paydowns, maturities and calls of securities classified as held-to-maturity..................................... 5,360 1,000 6,300 5,069 Purchase of premises and equipment................................... (10,331) (974) (4,654) (1,487) Purchase of loans.................................................... (13,343) (4,158) (11,911) (22,803) Net increase in loans................................................ (330,761) (78,021) (120,122) (111,767) Recoveries of loans previously charged off........................... 552 395 516 466 Proceeds from sales of other real estate owned....................... 216 216 1,874 3,510 Net decrease in other real estate owned and real estate investments.. -- -- 132 94 Net (increase) decrease in short-term investments.................... 30,888 (21,104) (8,953) 535 Proceeds from sales of premises and equipment........................ 529 18 1,055 1,055 ---------- ----------- ---------- ---------- Net cash used in investing activities.......................... (286,924) (107,519) (114,291) (134,049) ---------- ----------- ---------- ---------- The accompanying notes are an integral part of these consolidated financial statements. 52 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (Countinued) (IN THOUSANDS) Years Ended Year Ended Two Months Ended October 31, December 31, December 31, ---------------------- 1999 1998 1998 1997 --------- --------- --------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Increase (decrease) in NOW, money market deposit and demand deposit accounts ............................ $ 17,946 $ (64) $ 83,431 $ 1,096 Increase (decrease) in passbook and other savings accounts ................................... 8,831 (26,756) 42,989 30,038 Increase (decrease) in term certificates ............. (8,370) (7,548) 45,012 58,971 Advances from Federal Home Loan Bank ................. 230,000 -- 46,377 101,061 Repayments of Federal Home Loan Bank advances ........ (42,051) (1,160) (62,373) (81,902) Proceeds of stock offering, net of expenses .......... -- 123,008 (1,637) -- Repurchase of common stock ........................... (15,939) -- -- -- Cash dividends ....................................... (2,533) -- -- -- Transactions with stockholders of acquired entity .... -- (649) 496 (1,537) Payment of merger-related costs ...................... (674) (3,949) (1,824) -- Increase (decrease) in short-term and other borrowings 27,900 (2,967) 6,388 5,124 Increase in mortgagors' escrow payments .............. 418 884 221 801 --------- --------- --------- --------- Net cash provided by financing activities ...... 215,528 80,799 159,080 113,652 --------- --------- --------- --------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ................................. (41,068) (4,954) 57,353 2,446 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR .................................... 101,419 106,373 48,728 46,282 NET CHANGE IN CASH AND CASH EQUIVALENTS DUE TO DIFFERENCE IN YEAR-ENDS ....................... -- -- 292 -- CASH AND CASH EQUIVALENTS, --------- --------- --------- --------- END OF YEAR .......................................... $ 60,351 $ 101,419 $ 106,373 $ 48,728 ========= ========= ========= ========= SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Interest paid on deposits and borrowed funds ....... $ 62,731 $ 10,419 $ 62,859 $ 57,933 Income taxes paid .................................. 13,892 -- 10,316 11,417 SUPPLEMENTAL DISCLOSURE OF NONCASH TRANSACTIONS: Transfers from loans to other real estate owned .... 755 326 2,124 4,578 Financed other real estate owned sales ............. 1,441 -- 1,112 1,460 Loans securitized into mortgage-backed investments . -- -- -- 3,595 Transfer from loans held-for-sale to loans ......... -- 10,469 -- -- Stock offering proceeds funded by customer deposit accounts ............................... -- 24,567 -- -- The accompanying notes are an integral part of these consolidated financial statements. 53 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES BASIS OF PRESENTATION On November 20, 1998, Seacoast Financial Services Corporation (the Company) completed its conversion from a mutual bank holding company to a stock holding company with the issuance of 14,000,000 shares of common stock in an initial public offering (see Note 17). On December 4, 1998, the Company completed its acquisition of Sandwich Bancorp, Inc. (Sandwich) in a stock-for-stock exchange and the merger of Sandwich's wholly-owned subsidiary, Sandwich Co-operative Bank (Sandwich Bank), into Compass Bank for Savings (Compass or the Bank) (see Note 2). The consolidated financial statements give retroactive effect to the acquisition in a transaction accounted for as a pooling of interests, with all periods presented as if the Company and Sandwich had always been combined. The following presentation summarizes the impact of the Company's acquisition of Sandwich on its previously reported equity at October 31, 1998, 1997 and 1996 (in thousands): 1998 1997 1996 ----------------------------- -------------------------- ---------------------------- Accumulated Accumulated Accumulated other comprehensive other comprehensive other comprehensive Surplus income Surplus income Surplus income (loss) ---------- ------------------ -------- ---------------- ---------- ------------------ Balance, as previously reported..........$ 110,020 $ 2,552 $ 96,527 $ 1,614 $ 84,743 $ 174 Effect of Sandwich merger................ 45,315 186 41,929 85 38,606 27 Elimination of intercorporate investment............................ (4,323) (309) (69) (73) (69) (32) Reclassification of Sandwich investment.. securities to available-for-sale...... -- 129 -- 115 -- (312) ---------- -------- --------- -------- ---------- ------ Balance, as restated.....................$ 151,012 $ 2,558 $138,387 $ 1,741 $ 123,280 $(143) ========== ======== ========= ======== ========== ====== Sandwich's fiscal year end was December 31. For periods prior to 1998, the accompanying financial statements combine Sandwich's financial data as of December 31 with the Company's financial data as of October 31. For 1998, Sandwich's information is as of October 31, 1998 and the twelve months then ended. The results of operations for the two month period ended December 31, 1997, which amounted to a $1,027,000 increase in equity, are included both in surplus at October 31, 1997 and net income for the year ended October 31, 1998. This amount has been included as part of the reduction of surplus due to difference in year-ends in the accompanying statement of changes in stockholders' equity. On January 28, 1999, the Board of Directors voted to change the Company's year end from October to December 31. The accompanying consolidated financial statements include a balance sheet as of December 31, 1998 and the results of operations, changes in stockholders' equity and cash flows for the two month transition period then ended. The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Compass and Lighthouse Securities Corporation (collectively referred to as the Company). The Bank has seven wholly owned subsidiaries-Compass Credit Corp. which engages in the origination of automobile loans; The Sextant Corporation, which owns real estate which is currently being marketed for sale; The 1855 Corporation which engages in leasing of property primarily for Bank use; CB Securities Corporation, Sandwich Securities Corporation and Sextant Securities Corporation, each of which engages in the investment of securities; and Buffinton-Brook Realty Corporation, the owner of Compass Preferred Capital Corporation which is involved in real estate activities enabling it to be taxed as a real estate investment trust (REIT). The 1855 Corporation has two wholly-owned subsidiaries-Purchase Corporation and North Front Street, Inc., which engage in the management of real estate acquired from the Bank through foreclosure. All significant intercompany balances and transactions have been eliminated in consolidation. 54 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Countinued) All deposits of the Bank are insured by the Federal Deposit Insurance Corporation (FDIC) or the Depositors Insurance Fund, an excess deposit insurer for Massachusetts-chartered savings banks. The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and income and expenses during the reporting periods. Actual results could differ from those estimates. Material estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses. CASH AND CASH EQUIVALENTS For purposes of reporting cash flows, cash and cash equivalents include cash, amounts due from banks and federal funds sold. INVESTMENT SECURITIES Debt securities that the Bank has the positive intent and ability to hold to maturity are classified as held-to-maturity and reported at cost, adjusted for amortization of premiums and accretion of discounts, both computed by a method that approximates the effective yield method; debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity or trading are classified as available-for-sale and reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity, net of taxes. The Bank classifies its securities based on the Bank's intention at the time of purchase. Restricted equity securities are reported at cost and consist principally of the Bank's investment in stock of the Federal Home Loan Bank of Boston. Unrealized losses deemed to be other than temporary declines in value are charged to operations. When securities are sold, the adjusted cost of the specific securities sold is used to compute gains or losses on the sale. LOANS, DEFERRED COSTS AND FEES AND ALLOWANCE FOR LOAN LOSSES Loans are stated at the amount of unpaid principal, reduced by amounts due to borrowers on unadvanced loans, unearned discount and the allowance for loan losses plus net deferred loan costs and fees. Unearned discount is recognized on the level-yield method for discounted indirect auto loans. All other interest on loans is recognized on a simple interest basis. Beginning January 1, 1999 all indirect auto loans have been originated on a simple interest basis. Accordingly, the balance of unearned discount will decline significantly as the pre-1999 indirect auto loans are repaid. Deferred loan origination fees and certain deferred loan origination costs are amortized over the contractual life of the related loan using the level-yield method. At December 31, 1999, the Bank had net deferred loan costs of $9,169,000, including $8,199,000 paid to auto dealers who assist the Bank in the origination of indirect auto loans. 55 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Countinued) It is the policy of the Bank to discontinue the accrual of interest on loans, except consumer loans, delinquent in excess of 90 days or sooner if, in the judgment of management, the ultimate collectibility of principal or interest becomes doubtful and to reverse and charge against current earnings any interest previously accrued. Interest income is subsequently recognized only to the extent cash payments are received. When there is doubt regarding the ultimate collectibility of principal, all cash receipts thereafter are applied to reduce the recorded investment in the loan. Loans are identified as impaired when it is probable that the Bank will not be able to collect principal, interest and fees according to the contractual terms of the loan agreement. Management considers the payment history, net worth and earnings potential of a borrower, and the value and cash flow of the collateral as factors to determine whether a loan will be paid in accordance with its contractual terms. The amount judged to be impaired is the difference between the present value of the expected future cash flows discounted at the loan's original contractual effective interest rate and the net carrying amount of the loan. If foreclosure on a collateralized loan is probable, impairment is measured based on the fair value of the collateral compared to the net carrying amount. If appropriate, a valuation reserve is established to recognize the difference between the recorded investment and the present value. Impaired loans are charged off when management believes that the collectibility of the loan is remote. The Bank considers nonaccrual loans, except for smaller balance homogeneous residential mortgage loans, and troubled debt restructurings to be impaired. The allowance for loan losses is maintained at a level considered adequate to provide for potential loan losses. The allowance is increased by provisions charged to operations, and realized losses, net of recoveries, are charged directly to the allowance. The provision and the level of the allowance are based on management's periodic review of the loan portfolio in light of historical experience and prevailing economic conditions. The allowance is an estimate, and ultimate losses may vary from current estimates. As adjustments become necessary, they are reported in the results of operations of the period in which they become known. LOAN SALES AND SERVICING RIGHTS Loans held for sale are valued at the lower of the recorded loan balance or market value. The Bank periodically enters into forward commitments to sell loans for the purpose of reducing interest rate risk associated with the origination of loans for sale. The Bank recognizes, as a separate asset, the right to service mortgage loans for others. The amount capitalized is based on an allocation of the cost of the loan based on the total relative fair value of the loan and the servicing right. The amortization of servicing rights is recognized in proportion to estimated net servicing revenue. The value of servicing rights is periodically assessed for impairment based on the fair value of those rights. In measuring for impairment, servicing assets are stratified by interest rate, which is the predominant risk characteristic affecting the prepayment of loans. Included in other assets in the accompanying consolidated balance sheets are mortgage servicing rights of $1,278,000, $1,646,000 and $1,588,000 at December 31, 1999 and 1998 and October 31, 1998, respectively. BANKING PREMISES AND EQUIPMENT Land is stated at cost. Buildings, leasehold improvements and equipment are stated at cost, less accumulated depreciation and amortization, computed on the straight-line method over the estimated useful lives of the assets or the terms of the leases, if shorter. Maintenance and repairs are expensed when incurred; major expenditures for betterments are capitalized and depreciated. Interest incurred during construction of the new corporate headquarters is being capitalized based on the Bank's overall cost of funds. During the year ended December 31, 1999, $107,000 of interest was capitalized. 56 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Countinued) OTHER REAL ESTATE OWNED Other real estate owned (OREO) is composed of properties acquired through foreclosure or receipt of a deed in lieu of foreclosure. Foreclosed assets are presumed to be held-for-sale and are recorded at the lower of the carrying value of the related loan or the fair value of property, less estimated costs to sell. The excess, if any, of the loan balance over the fair value of the property at the time of transfer to OREO is charged to the allowance for loan losses. Subsequent write-downs of the carrying value of the foreclosed assets are charged to expense. Costs relating to the development and improvement of foreclosed assets are capitalized while other costs are charged to expense. Included in other operating expenses for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 are OREO-related expenses, including gains and losses on disposition, of $54,000, $62,000, $265,000 and $520,000, respectively. INCOME TAXES The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are recognized subject to management's judgment that realization is more likely than not. CORE DEPOSIT INTANGIBLE ASSET The core deposit intangible asset is being amortized over periods ranging from six to ten years using accelerated and straight-line methods. Amortization expense was $619,000, $110,000, $716,000 and $787,000 for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997, respectively. The core deposit intangible asset amounted to $1,777,000, $2,396,000 and $2,506,000 at December 31, 1999 and 1998 and October 31, 1998, respectively. STOCK-BASED COMPENSATION Stock options issued to officers and directors are accounted for in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25) under which there is generally no charge to earnings for stock option grants. EARNINGS PER SHARE Basic earnings per share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Unallocated ESOP shares and unvested restricted stock awards are not considered outstanding in computing basic earnings per share. Diluted earnings per share reflects the potential dilution that could occur if contracts to issue common stock were exercised and has been computed after giving consideration to the dilutive effect of stock options, stock awards and the shares held in an employee trust. Earnings per share is not presented for periods prior to the Company's conversion from a mutual to a stock form of ownership in November 1998. 57 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Countinued) COMPREHENSIVE INCOME Effective November 1, 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income." This statement establishes standards for reporting and displaying comprehensive income, which is defined as all changes to equity except investments by and distributions to stockholders. Net income is a component of comprehensive income with all other components referred to in the aggregate as other comprehensive income. As of December 31, 1999, the Company's other comprehensive income consisted of unrealized gains (losses) on securities classified as available-for-sale, net of taxes. The Company has presented its components of comprehensive income as part of its statements for comparative purposes. Included in net income are gains on the sale of investment securities, net of taxes, of $39,000 and $53,000 for the years ended October 31, 1998 and 1997, respectively, $13,000 for the two months ended December 31, 1998 and $95,000 for the year ended December 31, 1999 that had previously been classified with other comprehensive income. RECLASSIFICATIONS Certain reclassifications have been made to the 1997 and 1998 financial statements to conform to the 1999 presentation. Such reclassifications have no effect on previously reported net income (loss). (2) ACQUISITION OF SANDWICH On February 2, 1998 the Company and the Bank entered into a definitive agreement under which the Bank agreed to acquire Sandwich, a one-bank holding company with $518.7 million in total assets at December 31, 1997. On February 24, 1998, Sandwich announced that its Board of Directors determined that it was appropriate to request additional information and a clarification of renewed expressions of interest that it had received from other parties subsequent to February 2, 1998. Following a review of the other expressions of interests for Sandwich, the Company and Sandwich jointly announced on March 23, 1998 that they had signed an amendment to their previously announced agreement of February 2, 1998 (the Amended Agreement) by which the Company would acquire Sandwich. Under the terms of the Amended Agreement, the Company would convert to a 100% publicly owned stock holding company and, thereafter, issue stock having a value of $64.00 per share to Sandwich shareholders in a tax-free exchange of common stock. The value to be received by Sandwich shareholders was subject to adjustment pursuant to a formula based on the value of the Company's stock near the transaction date. On December 4, 1998, the Company completed its acquisition of Sandwich. Pursuant to the Amended Agreement, each share of common stock of Sandwich (other than 90,000 shares held by the Company and the Bank and other than fractional shares) was converted into and became exchangeable for 6.385 shares of the Company's common stock. As set forth in the preceding paragraph, the exchange ratio was adjusted using a formula based on the Company's stock trading price between the date of the Conversion and the closing of the acquisition. A total of 12,758,136 shares were issued in connection with the acquisition. The transaction was accounted for as a pooling of interests. 58 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (2) ACQUISITION OF SANDWICH (Countinued) The following table sets forth the results of operations for the separate companies and the combined amounts for periods prior to the acquisition of Sandwich. YEARS ENDED OCTOBER 31, --------------------------------- 1998 1997 ---------- --------- (IN THOUSANDS) Revenues (interest and non-interest income): Seacoast.................................................... $ 94,210 $ 85,975 Sandwich.................................................... 38,898 38,638 Reclassification............................................ (132) (128) ---------- ---------- $ 132,976 $ 124,485 ========== ========== Net Income: Seacoast.................................................... 13,493 11,784 Sandwich.................................................... 4,597 4,860 ---------- ---------- $ 18,090 $ 16,644 ========== ========== In connection with the Sandwich transaction, certain costs were incurred which have been classified in the statement of income as merger-related costs. Merger-related costs encompass both costs directly identifiable to the merger, such as professional fees for investment bankers, attorneys and accountants, and contractual severance pay as well as costs incurred by Sandwich and the Bank that result from the integration of the operations of Compass and Sandwich and which do not generally benefit the on-going activities of the banks. Merger-related costs consisted of the following items (in thousands): Professional fees ......................................... $ 2,692 Severance pay ............................................. 2,555 Asset write-offs .......................................... 143 Contractual obligations ................................... 406 Shareholder meeting (including printing costs) ............ 283 Customer service (including checkbook replacements) ....... 662 Other 72 ---------- $ 6,813 ========== These costs were expensed by the Company in the two-month period ended December 31, 1998. 59 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (3) INVESTMENT SECURITIES The amortized cost and fair value of securities available-for-sale at December 31, 1999 and 1998 and October 31, 1998 are as follows: December 31, 1999 ------------------------------------------------ Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---- ----- ------ ----- (In thousands) U.S. Government and agency obligations..........................$ 117,937 $ 8 $ 4,301 $ 113,644 Corporate bonds................................................. 39,604 15 564 39,055 Mortgage-backed investments..................................... 68,642 158 950 67,850 Collateralized mortgage obligations............................. 15,359 80 368 15,071 ---------- -------- ------- ---------- Total debt securities...................................... 241,542 261 6,183 235,620 ---------- -------- ------- ---------- Marketable equity securities and mutual funds................... 7,764 2,561 362 9,963 ---------- -------- ------- ---------- Total securities available-for-sale........................$ 249,306 $ 2,822 $ 6,545 $ 245,583 ========== ======== ======= ========== December 31, 1998 ---------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---- ----- ------ ----- (In thousands) U.S. Government and agency obligations..........................$ 123,390 $ 1,171 $ 111 $ 124,450 Corporate bonds................................................. 46,888 488 14 47,362 Mortgage-backed investments..................................... 84,641 729 224 85,146 Collateralized mortgage obligations............................. 26,698 127 77 26,748 ---------- -------- ------ ---------- Total debt securities...................................... 281,617 2,515 426 283,706 ---------- -------- ------ ---------- Marketable equity securities and mutual funds................... 8,979 1,880 65 10,794 ---------- -------- ------ ---------- Total securities available-for-sale........................$ 290,596 $ 4,395 $ 491 $ 294,500 ========== ======== ====== ========== October 31, 1998 ----------------------------------------------- Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ---- ----- ------ ----- (In thousands) U.S. Government and agency obligations..........................$ 109,128 $ 1,670 $ 2 $ 110,796 Corporate bonds................................................. 47,771 683 29 48,425 Mortgage-backed investments..................................... 93,117 596 254 93,459 Collateralized mortgage obligations............................. 29,819 264 31 30,052 ---------- -------- ------ ---------- Total debt securities...................................... 279,835 3,213 316 282,732 ---------- -------- ------ ---------- Marketable equity securities and mutual funds................... 6,990 1,248 38 8,200 ---------- -------- ------ ---------- Total securities available-for-sale........................$ 286,825 $ 4,461 $ 354 $ 290,932 ========== ======== ====== ========== 60 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (3) INVESTMENT SECURITIES (Countinued) A schedule of the maturity distribution of debt securities available-for-sale at December 31, 1999 is as follows: Carrying Percent of Amortized Amount Total Cost ---------- ----------- ---------- (Dollars in thousands) One year or less................................................ $ 50,673 21.5% $ 50,757 Over 1 year to 5 years.......................................... 39,888 16.9 40,617 Over 5 years to 10 years........................................ 75,998 32.3 80,188 Over 10 years................................................... 69,061 29.3 69,980 --------- ------ ---------- $ 235,620 100.0% $ 241,542 ========= ====== ========== Mortgage-backed investments and collateralized mortgage obligations are shown at their contractual maturity dates, but actual maturities may differ as borrowers have the right to prepay obligations without incurring prepayment penalties. The amortized cost and fair value of securities held-to-maturity, consisting of U.S. Government and agency obligations, at December 31, 1999 and 1998 and October 31, 1998 are as follows: Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value ------------- -------- -------- --------- (In thousands) December 31, 1999................................... $ 12,408 $ -- $ 96 $ 12,312 ========= ====== ====== ========= December 31, 1998................................... $ 12,693 $ 204 $ -- $ 12,897 ========= ====== ====== ========= October 31, 1998.................................... $ 13,694 $ 286 $ -- $ 13,980 ========= ====== ====== ========= A schedule of the maturity distribution of debt securities held-to-maturity at December 31, 1999 is as follows: Carrying Percent of Amount Total Fair Value --------- --------- ---------- (Dollars in thousands) One year or less................................................ $ 1,000 8.1% $ 1,000 Over 1 year to 5 years.......................................... 11,408 91.9 11,312 --------- ------- --------- $ 12,408 100.0% $ 12,312 ========= ======= ========= 61 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (3) INVESTMENT SECURITIES (Countinued) Proceeds from the sales of investment securities and related gains and losses for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 (all classified as available-for-sale) were as follows: Years Ended October 31, Year Ended Two Months Ended ----------------------- December 31, 1999 December 31, 1998 1998 1997 ------------------------ ---------------------- -------- --------- (In thousands) Proceeds from sales..................... $ 24,191 $ 6,001 $ 6,488 $ 24,927 Gross gains............................. 165 23 89 124 Gross losses............................ 1 1 22 32 At December 31, 1999, investment securities carried at $35,141,000 were pledged to secure public deposits under the Treasury, Tax and Loan program, as required by law, deposits held by various municipalities and retail repurchase agreements. Pledged investment securities are maintained under the Bank's control. (4) LOANS The Bank's loan portfolio consisted of the following: December 31, ------------ October 31, 1999 1998 1998 ----------- ----------- ------------ (In thousands) Real estate loans: Residential (one-to-four family)................... $ 896,479 $ 697,031 $ 629,779 Commercial......................................... 223,500 201,636 209,366 Home equity lines of credit........................ 26,076 25,984 27,471 Construction....................................... 71,735 66,373 63,189 ----------- ----------- ----------- Total real estate loans....................... 1,217,790 991,024 929,805 ----------- ----------- ----------- Commercial loans........................................ 66,360 58,829 50,344 ----------- ----------- ----------- Consumer loans: Indirect auto loans................................ 439,753 358,101 343,910 Less: Unearned discount............................ 17,370 37,394 37,201 ----------- ----------- ----------- Indirect auto loans, net...................... 422,383 320,707 306,709 Other.............................................. 40,673 33,494 33,822 ----------- ----------- ----------- Total consumer loans, net..................... 463,056 354,201 340,531 ----------- ----------- ----------- Total loans................................... 1,747,206 1,404,054 1,320,680 Less--Allowance for loan losses.......................... 16,828 15,914 15,117 ----------- ----------- ----------- Total loans, net.............................. $ 1,730,378 $ 1,388,140 $ 1,305,563 =========== =========== =========== At December 31, 1999 and 1998 and October 31, 1998, troubled debt restructurings, all of which are included in nonaccrual loans, totaled $1,573,000 , $1,427,000 and $1,681,000 respectively. There are no commitments to extend additional credit on these loans. Non-accrual loans, amounted to $5,734,000, $5,841,000 and $6,514,000 at December 31, 1999 and 1998 and October 31, 1998, respectively. 62 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (4) LOANS (Countinued) The following table presents information about impaired loans: December 31, ---------------- October 31, 1999 1998 1998 ------ ------ ---------- (In thousands) At year-end-- Impaired loans at year end ................. $2,220 $1,946 $1,966 Impaired loans with valuation allowance .... 960 716 728 Total valuation allowances (included in allowance for loan losses) ............ 170 79 79 During the period-- Average balance of impaired loans .......... 2,346 1,954 6,271 Interest income recognized on impaired loans 163 39 484 For the year ended October 31, 1997, the average balance of impaired loans was $10,339,000 and the interest income recognized on impaired loans was $601,000. In the ordinary course of business, the Bank makes loans to its executive officers, directors and related parties at substantially the same terms as loans made to unrelated borrowers. The Bank rarely extends credit to its officers. An analysis of related party loans for the year ended December 31, 1999, the two months ended December 31, 1998 and the year ended October 31, 1998 is as follows: Year Ended Two Months Ended Year Ended December 31, 1999 December 31, 1998 October 31, 1998 -------------------- -------------------- ----------------- (In thousands) Balance, beginning of year.......................... $1,203 $ 2,208 $ 5,816 New loans...................................... 484 37 40 Payments....................................... (973) (41) (134) Other (due primarily to director resignations). (100) (1,001) (3,514) ------- -------- -------- Balance, end of year................................ $ 614 $ 1,203 $ 2,208 ======= ======== ======== Loans serviced for others on a non-recourse basis at December 31, 1999 and 1998 and October 31, 1998 amounted to $339,897,000, $394,463,000 and $405,940,000, respectively. An analysis of the allowance for loan losses follows: Years Ended October 31, Year Ended Two Months Ended --------------------- December 31, 1999 December 31, 1998 1998 1997 ------------------- -------------------- ---------- -------- (In thousands) Balance, beginning of year...................... $ 15,914 $ 15,117 $ 14,742 $ 14,075 Provision for loan losses....................... 2,000 416 1,736 2,615 Charge-offs..................................... (1,638) (14) (1,600) (2,414) Recoveries...................................... 552 395 516 466 Effect of difference in year-ends............... -- -- (277) -- --------- --------- ---------- --------- Balance, end of year............................ $ 16,828 $ 15,914 $ 15,117 $ 14,742 ========= ========= ========== ========= 63 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (5) BANKING PREMISES AND EQUIPMENT A summary of the cost and accumulated depreciation and amortization of banking premises and equipment and their estimated useful lives is as follows: December 31, ---------------------- October 31, Estimated 1999 1998 1998 Useful Lives ---------- -------- ------------- -------------- (In thousands) Land and improvements................................. $ 3,691 $ 3,628 $ 3,714 Buildings and improvements............................ 11,670 12,199 13,714 30 to 50 years Property under capital lease.......................... 1,738 1,738 1,738 20 years Leasehold improvements................................ 2,394 2,394 2,384 8 to 10 years Furniture and equipment............................... 12,671 10,910 11,083 3 to 20 years Construction-in-progress.............................. 8,167 1,264 403 ---------- --------- --------- 40,331 32,133 33,036 Less-Accumulated depreciation and amortization..................................... 13,746 12,246 11,891 ---------- --------- --------- $ 26,585 $ 19,887 $ 21,145 ========== ========= ========= Total depreciation and amortization of banking premises and equipment for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 amounted to $2,464,000, $391,000, $2,142,000 and $2,084,000, respectively, and is included in occupancy and equipment expenses in the accompanying consolidated statements of income. On December 1, 1998, the Bank acquired several parcels of land in downtown New Bedford, Massachusetts for $550,000 to be used for the development of the Company's and the Bank's corporate headquarters and main banking office. In connection with this transaction, the Bank agreed to donate one of its downtown New Bedford buildings to the City at the time it takes occupancy of its new corporate headquarters. Based on estimates by its architectural consultants, the Bank expects to expend approximately $20 million in the construction of the building and the purchase of land, furniture, fixtures and equipment. At completion, which is estimated to be in the second quarter of 2000, all Bank personnel, except retail branch and regional lending personnel, are expected to be located in this building. As part of this transaction, the Bank entered into a Tax Increment Financing Agreement with the City of New Bedford. This agreement provides a reduction in future property taxes in return for the Bank's investment, through this project, in downtown New Bedford. The tax incentives extend over a twenty year period and could produce an estimated $1.2 million in property tax reductions. This agreement is conditional and requires the Bank to retain and create permanent jobs in the City. The construction of the Bank's new corporate headquarters will result in the disposal of several buildings currently in use. One location is currently being marketed for sale. Two other buildings will continue to be utilized by the Bank until it relocates to its new corporate headquarters (title to one of which will be transferred to the City of New Bedford at that time as part of the transaction). Based on estimates of the fair value of these buildings and the benefits associated with their continuing utilization through the estimated date of relocation, the Bank recognized a write-down of $1,967,000 in December 1998. 64 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (6) DEPOSITS A summary of deposit balances is as follows: December 31, ------------------------- October 31, 1999 1998 1998 ----------- ----------- ------------ (In thousands) Demand deposit accounts ................... $ 101,218 $ 116,104 $ 116,106 NOW and money market deposit accounts ..... 463,152 430,320 430,462 Passbook and other savings accounts ....... 214,317 205,486 232,217 ---------- ---------- ---------- Total noncertificate accounts ..... 778,687 751,910 778,785 ---------- ---------- ---------- Term certificates- Term certificates of $100,000 and over 157,113 154,589 159,460 Term certificates less than $100,000 . 579,822 590,716 593,418 ---------- ---------- ---------- Total term certificate accounts ... 736,935 745,305 752,878 ---------- ---------- ---------- $1,515,622 $1,497,215 $1,531,663 ========== ========== ========== In connection with the Company's stock offering completed in November 1998, certain funds used to purchase shares were held by the Bank in deposit accounts at October 31, 1998. Of the $121.4 million of net proceeds of the stock offering, $24.6 million was funded from the deposit accounts of customers and $31.9 was funded from a non-customer escrow savings account, of which $18.0 million was held on October 31, 1998. The maturity distribution of term certificates with weighted average interest rates is as follows as of December 31, 1999: Weighted Average Amount Rate -------------- ----------- (In thousands) Within 1 year.................................. $ 584,169 5.12% Over 1 to 2 years.............................. 113,060 5.47 Over 2 to 3 years.............................. 28,458 5.55 Over 3 to 5 years.............................. 11,248 5.32 ---------- $ 736,935 5.19 ========== 65 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (7) SHORT-TERM BORROWINGS Short-term borrowings consisted of the following: December 31, ------------------ October 31, 1999 1998 1998 ------- -------- -------- (In thousands) Federal Home Loan Bank line of credit ........ $17,661 $ -- $ -- Securities sold under agreements to repurchase 21,126 12,584 14,830 Treasury tax and loan note account ........... 2,000 251 971 ------- ------- ------- $40,787 $12,835 $15,801 ======= ======= ======= The weighted average interest rates on short-term borrowings during the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 were 4.79%, 4.69%, 4.78% and 4.77%, respectively. The Bank's line of credit with the Federal Home Loan Bank (FHLB) amounted to $38,000,000 at December 31, 1999. The interest on borrowings under this line of credit adjust daily based on a formula. (8) FEDERAL HOME LOAN BANK ADVANCES FHLB advances are collateralized by a blanket-type pledge agreement on the Bank's FHLB stock, certain qualified investment securities, deposits at the FHLB and first mortgages on residential property. As a member of the FHLB, the Bank is required to invest in stock of the FHLB at an amount equal to the greater of 1% of its outstanding first mortgage residential loans, .3% of total assets or 5% of its outstanding advances from the FHLB. When such stock is redeemed, the Bank will receive from the FHLB an amount equal to the par value of the stock. The maturity distribution of FHLB advances (based on final maturity dates) with weighted average interest rates is as follows: December 31, -------------------------------------------------- October 31, 1999 1998 1998 ------------------------- ----------------------- ------------------------ Weighted Weighted Weighted Average Average Average Amount Rate Amount Rate Amount Rate ---------- ---------- --------- ----------- ----------- ------------ (Dollars in thousands) Within 1 year...................... $ 129,000 5.84% $ 3,250 6.01% $ 3,296 6.15% Over 1 to 5 years.................. 73,756 5.76 41,298 5.91 45,731 6.03 Over 5 to 10 years................. 55,405 5.54 20,061 5.72 16,612 5.42 Over 10 years...................... 13,739 6.53 19,342 7.15 19,472 7.12 --------- --------- ---------- $ 271,900 5.81% $ 83,951 6.15% $ 85,111 6.16% ========= ========= ========== Outstanding advances of $82,000,000 at December 31, 1999 are callable, at the option of FHLB, of which $67,000,000 are initially callable in 2000 and $15,000,000 become callable in 2002. The Bank is generally subject to a substantial penalty upon prepayment of FHLB advances. 66 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (9) INCOME TAXES The components of the provision (benefit) for income taxes and the reconciliation between the statutory federal income tax rate and the effective income tax rate for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 are as follows: Years Ended October 31, Year Ended Two Months Ended ----------------------- December 31, 1999 December 31, 1998 1998 1997 -------------------- ---------------------- -------- --------- (Dollars in thousands) Current-- Federal................................... $ 11,735 $ 1,152 $ 9,267 $ 8,145 State..................................... 450 140 1,605 2,076 --------- --------- -------- --------- Total current........................ 12,185 1,292 10,872 10,221 --------- --------- -------- --------- Deferred (prepaid)-- Federal................................... 924 (1,455) (221) (195) State..................................... 285 (381) -- 139 --------- --------- -------- --------- Total deferred (prepaid)............. 1,209 (1,836) (221) (56) --------- --------- -------- --------- $ 13,394 $ (544) $10,651 $ 10,165 ========= ========= ======== ========= Statutory tax rate........................... 35.0% (35.0)% 35.0% 35.0% State taxes, net of federal benefit.......... 1.3 (4.0) 3.6 5.4 Tax credits.................................. (0.5) -- -- -- Non-deductible merger costs.................. -- 25.7 -- -- Change in valuation allowance................ -- -- (1.2) (2.1) Other, net................................... (0.5) (0.7) (0.3) (0.4) ------ ------ ----- ------ Effective tax rate................... 35.3% (14.0)% 37.1% 37.9% ====== ====== ===== ====== 67 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (9) INCOME TAXES (Countinued) The Company's net deferred tax asset consisted of the following components: December 31, October 31, ---------------------------- 1999 1998 1998 ------------ --------- ------------ (In thousands) Gross deferred tax assets: Allowance for loan losses.................................... $ 6,600 $ 6,217 $ 5,734 Deferred compensation and benefits........................... 3,236 3,802 3,662 Core deposit intangible...................................... 928 849 825 Acquired NOL carryforward.................................... 488 673 760 Merger costs................................................. -- 69 -- Reserves for asset impairment................................ 679 717 -- Other real estate owned...................................... 78 164 179 Deferred interest............................................ 485 473 579 Deferred gain on sale/leaseback.............................. 224 238 235 Restricted stock............................................. 271 -- -- Unrealized loss on available-for-sale securities............. 1,318 -- -- Other........................................................ 169 8 148 --------- --------- -------- 14,476 13,210 12,122 --------- --------- -------- Gross deferred tax liabilities Unrealized gain on available-for-sale securities............. -- (1,668) (1,416) REIT dividend................................................ (1,079) (55) -- Gain on sale of loans........................................ (535) (681) (653) Depreciation................................................. -- -- (240) Other........................................................ (335) (91) (287) --------- --------- -------- (1,949) (2,495) (2,596) --------- --------- -------- Net deferred tax asset................................... $ 12,527 $ 10,715 $ 9,526 ========= ========= ======== In August 1996, Congress passed the Small Business Job Protection Act of 1996. One effect of this legislation was to suspend the Bank's bad debt reserve for income tax purposes as of its base year (October 31, 1988). Any bad debt reserve in excess of the base year amount is subject to recapture over a six-year period. The suspended (i.e., base year) amount is subject to recapture only upon the occurrence of certain events, such as excess distributions to stockholders or if the Bank ceases to qualify as a bank for income tax purposes. Since the Bank does not intend to use the suspended bad debt reserve for purposes other than to absorb the losses for which it was established, deferred taxes in the amount of $6,100,000 have not been recorded with respect to such reserve. 68 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (10) COMMITMENTS AND CONTINGENCIES Pursuant to the terms of noncancellable agreements pertaining to banking premises and equipment, future minimum lease payment commitments for both operating and capital leases are as follows: Years Ending Operating Capital December 31, Leases Lease - ------------------- ---------------- ----------------------------- (In thousands) 2000............... $ 718 $ 182 2001............... 518 182 2002............... 430 182 2003............... 361 182 2004............... 284 182 Thereafter......... 1,400 2,406 -------- 3,316 Less: interest included above (1,653) -------- $ 1,663 ======== Certain leases contain renewal options for periods ranging from 8 to 85 years, the effect of which is not included above. Rent expense for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 amounted to $882,000, $149,000, $662,000 and $450,000 respectively, and is included in occupancy and equipment expenses in the accompanying consolidated statements of income. The Bank has actual and expected commitments in connection with the construction of its corporate headquarters building, currently in progress, totaling $13.5 million. Aggregate cash reserves (in the form of deposits with the Federal Reserve Bank and vault cash) of $16,362,000 were maintained to satisfy regulatory requirements at December 31, 1999. In the ordinary course of business, the Bank is a defendant in litigation matters. Although there can be no assurance, based on its review of current litigation and discussion with legal counsel, management believes that the ultimate resolution of these legal proceedings would not be likely to have a material adverse impact on its financial position, results of operations or liquidity. (11) REGULATORY CAPITAL REQUIREMENTS The Company and Bank are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgements by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined). 69 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (11) REGULATORY CAPITAL REQUIREMENTS (Countinued) Management believes, as of December 31, 1999, that the Company and the Bank met all capital adequacy requirements to which they are subject. As of December 31, 1999, the most recent notification from the Federal Reserve Bank of Boston classified the Company's capital as satisfactory, and the most recent notification from the FDIC categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an insured depository institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the accompanying table and not be subject to a directive, order, or written agreement to meet and maintain specific capital levels. There are no conditions or events since such notifications that management believes would have changed these classifications. The Company's and the Bank's actual capital amounts and ratios are as follows: To Be Well Capitalized For Capital Under Prompt Adequacy Corrective Actual Purposes Action Provisions ------------------ ---------------------- ------------------- Amount Ratio Amount Ratio Amount Ratio -------- -------- ------------ -------- -------- -------- (Dollars in thousands) As of December 31, 1999: Company (consolidated)- Total capital (to risk weighted assets).......................$291,705 20.17% > $115,706 > 8.0% N/A N/A = = Tier 1 capital (to risk weighted assets)...................... 274,523 18.98 > 57,853 > 4.0 N/A N/A = = Tier 1 capital (to average assets)............................ 274,523 13.11 > 83,760 > 4.0 N/A N/A Bank - = = Total capital (to risk weighted assets).......................$245,605 16.98 > $115,706 > 8.0% > $144,633 > 10.0% = = = = Tier 1 capital (to risk weighted assets)...................... 228,777 15.82 > 57,853 > 4.0 > 86,780 > 6.0 = = = = Tier 1 capital (to average assets)............................ 228,777 10.93 > 83,724 > 4.0 > 104,655 > 5.0 As of December 31, 1998: = = = = Company (consolidated) - Total capital (to risk weighted assets).......................$282,725 22.96% > $ 98,528 > 8.0% N/A N/A = = Tier 1 capital (to risk weighted assets)...................... 266,783 21.66 > 49,263 > 4.0 N/A N/A = = Tier 1 capital (to average assets)............................ 266,783 14.13 > 75,522 > 4.0 N/A N/A Bank - = = Total capital (to risk weighted assets).......................$143,832 11.69% > $ 98,407 > 8.0% > $123,009 > 10.0 = = = = Tier 1 capital (to risk weighted assets)...................... 128,447 10.44 > 49,215 > 4.0 > 73,823 > 6.0 = = = = Tier 1 capital (to average assets)............................ 128,447 7.03 > 73,085 > 4.0 > 91,356 > 5.0 As of October 31, 1998: = = = = Company (consolidated) - Total capital (to risk weighted assets).......................$161,510 13.70% > $ 94,373 > 8.0% N/A N/A = = Tier 1 capital (to risk weighted assets)...................... 146,764 12.45 > 47,187 > 4.0 N/A N/A = = Tier 1 capital (to average assets)............................ 146,764 8.34 > 70,400 > 4.0 N/A N/A Bank - = = Total capital (to risk weighted assets).......................$155,650 13.28% > $ 93,796 > 8.0% > $117,245 > 10.0 = = = Tier 1 capital (to risk weighted assets)...................... 141,118 12.03 > 46,898 > 4.0 > 70,347 > 6.0 = = = = Tier 1 capital (to average assets)............................ 141,118 8.01 > 70,501 > 4.0 > 88,126 > 5.0 = = = = 70 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (12) EMPLOYEE BENEFITS Through October 31, 1999, the Bank provided basic and supplemental pension benefits for eligible employees through the Savings Bank's Employees Retirement Association Pension Plan (the SBERA Plan). Each employee having reached the age of 21 and having completed at least 1,000 hours of service in two consecutive 12-month periods beginning with such employee's date of employment automatically became a participant in the SBERA Plan. Benefits were based on an employee's years of service and annual compensation, as defined. The Bank's funding policy was to contribute annually the maximum amount that can be deducted for federal income tax purposes. In September 1999, the Board of Directors voted to freeze benefits under the SBERA Plan effective October 31, 1999 and to terminate the SBERA Plan on or about December 31, 1999. In connection with this decision, the SBERA Plan was also amended to improve the benefit formula for current employees and permit payment of lump sums. Excess assets of the SBERA Plan, after considering the impact of Plan amendments, are expected to be less than $500,000. Such excess will be refunded to the Bank upon final settlement of the SBERA Plan's obligations. The following tables summarize the components of net periodic pension cost and the funded status of the SBERA Plan for the plan years ended October 31. 1999 1998 --------- -------- (In thousands) Benefit obligation at beginning of year ......... $ 11,339 $ 10,273 Service cost ................................. 698 651 Interest cost ................................ 765 745 Actuarial loss (gain) ........................ 72 (95) Benefits paid ................................ (186) (235) Plan amendments .............................. 3,492 -- Plan curtailment ............................. (4,964) -- -------- -------- Benefit obligation at end of year ............... $ 11,216 $ 11,339 ======== ======== Accumulated benefit obligation (all vested) ..... $ 11,216 $ 6,067 ======== ======== Change in plan assets: Fair value of plan assets at beginning of year $ 9,779 $ 8,369 Actual return on plan assets ................. 1,372 698 Contributions ................................ 644 947 Benefits paid ................................ (186) (235) -------- -------- Fair value of plan assets at end of year ... $ 11,609 $ 9,779 ======== ======== Funding status: Transition asset ............................. $ (345) $ (372) Deferred gain ................................ (1,356) (874) Accrued expense .............................. 1,308 2,806 -------- -------- Net amount recognized ...................... $ 393 $ 1,560 ======== ======== 71 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (12) EMPLOYEE BENEFITS (Countinued) Years Ended October 31, ----------------------------- 1999 1998 1997 ------- ------ ------- (In thousands) Components of net periodic benefit cost: Service cost ..................... $ 698 $ 651 $ 517 Interest cost .................... 765 745 656 Expected return on plan assets ... (782) (670) (544) Amortization of transition asset . (27) (26) (27) Recognized net actuarial gain/loss (36) (33) (30) ----- ----- ----- Net periodic benefit cost ...... $ 618 $ 667 $ 572 ===== ===== ===== Weighted average assumptions: Discount rate .................... 5.00% 7.25% 7.50% Expected return on plan assets ... 5.00 8.00 8.00 Rate of compensation increase .... N/A 5.00 5.00 As a result of the decision to terminate the SBERA Plan, the Bank recognized a curtailment gain of $1,472,000 in 1999, representing the difference between the estimated benefit obligation and the accumulated benefit obligation at the effective date of termination. The Bank will also recognize a settlement gain, estimated at $1.5 million, upon receipt of all necessary regulatory approvals and settlement of plan obligations which are expected to occur in 2000. Prior to the acquisition of Sandwich Bank in December 1998, its employees participated in a multi-employer, non-contributory defined benefit plan which was accounted for as a defined contribution plan. Pension expense for the years ended October 31, 1998 and 1997 amounted to $295,000 and $317,000, respectively. No liability arose as a result of Sandwich Bank's withdrawal from that plan. The Bank also sponsors a postretirement life insurance plan (the Life Insurance Plan) that primarily covers pre-1996 retirees and a postretirement medical insurance plan that covers certain retirees of the former Sandwich Bank. In total, 57 individuals are covered by these plans. The Life Insurance Plan generally provides lifetime coverage to retired employees equal to their final rate of pay, but not more than $50,000, and to active employees equal to three times the employee's annual salary, but not more than $350,000. Annual expense for these plans has averaged $60,000 during the past three years. At December 31, 1999, the accrued liability was $561,000, while the accumulated benefit obligation was $729,000 measured using a 7.25% discount rate. The Bank has entered into agreements with certain officers to provide supplemental retirement benefits based on 25% of average compensation at normal retirement computed over a three-year period. The present value of these future payments is being accrued over the estimated remaining terms of employment. The accrued supplemental retirement liability is $1,572,000, $1,376,000 and $1,366,000 December 31, 1999 and 1998 and at October 31, 1998 respectively. The agreements are being funded through a life insurance program with policy benefits accruing to the Bank. The cash surrender value of the policies is $2,234,000, $1,795,000 and $1,746,000 at December 31, 1999 and 1998 and October 31, 1998 respectively, and is included in other assets in the accompanying consolidated balance sheets. Net expense for these supplemental retirement benefits for the year ended December 31, 1999, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997 amounted to $206,000, $26,000, $128,000 and $70,000 respectively, and is included in salaries and employee benefits in the accompanying consolidated statements of income. 72 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (12) EMPLOYEE BENEFITS (Countinued) The Bank has an Employee Bonus and Management Incentive Compensation Plan (the Bonus Plan) in which employees are eligible to participate. The Bonus Plan provides for awards based on a combination of Bank and individual performance objectives being met, subject to the approval of the Board of Directors. Amounts charged to operations under the Bonus Plan amounted to $1,045,000, $200,000 $1,410,000 and $1,272,000 for the year ended December 31, the two months ended December 31, 1998 and the years ended October 31, 1998 and 1997, respectively. The Bank offers a 401(k) Retirement Savings Plan for employees. Participating employees are able to contribute up to 15% of their W-2 compensation, and the Bank matches 50% of a participant's deferral contribution on the first 6% of the deferral amount subject to the maximum allowable under federal regulations. Beginning in November 1999, this plan was amended to include a 3% automatic contribution for all eligible participants based on their W-2 compensation. The Bank's 401(k) expense was $437,000, $78,000 $287,000 and $256,000 for the year ended December 31,1999, the two months ended December 31, 1998 and for the years ended October 31, 1998 and 1997 respectively, which is included in salaries and employee benefits in the accompanying consolidated statements of income. In connection with its conversion from mutual-to-stock form and initial public offering, the Bank established an Employee Stock Ownership Plan ("ESOP") which acquired 8%, or 1,120,000, of the shares which were sold at a price of $10 per share. The purchase of the shares by the ESOP was funded by a loan of $11,200,000 from the Company. The loan is to be repaid in eighty equal quarterly installments of $276,580. Interest on the loan is fixed at 7.75%. The loan is secured by the unallocated shares of the ESOP. ESOP expense for the year ended December 31, 1999 amounted to $585,000. ESOP expense is based on the market value of the Company's common stock at the time shares are allocated to employees, which may differ from the $10 cost of those shares. Such changes in market value impact the Company's results of operations but have no impact on stockholders' equity. Sandwich Bank maintained certain employee and director benefit programs including an ESOP, directors deferred compensation plan and supplemental executive retirement plans which have been discontinued. During the years ended October 31, 1998 and 1997 the cost of such plans amounted to $495,000 and $518,000, respectively. Included in accrued expenses and other liabilities are $3,241,000, $3,231,000 and $3,009,000 related to such plans at December 31, 1999 and 1998 and October 31, 1998, respectively. (13) STOCK INCENTIVE PLAN In March 1999, the Company's Board of Directors voted to adopt the 1999 Stock Incentive Plan (the Stock Incentive Plan) for officers, employees and directors of Compass and the Company. The Stock Incentive Plan was approved at the adjourned annual meeting of stockholders in June 1999. The Stock Incentive Plan is administered by a committee consisting of those members of the Compensation Committee of the Company's Board of Directors who qualify as "outside directors". The maximum number of shares of common stock issuable as a result of awards under the Stock Incentive Plan shall be 1,960,000, which equals 14% of the number of shares issued in connection with the Company's conversion from mutual to stock form (subject to adjustment upon the occurrence of a stock dividend, stock split or similar change in capitalization affecting the Company's common stock). Of this number, up to 560,000 shares are issuable in connection with "conditioned stock awards". A conditioned stock award is an award entitling the recipient to acquire, at no cost or for a purchase price to be determined by the Compensation Committee, shares of common stock subject to restrictions and conditions determined at the date of grant. Conditions may be based on continuing employment and/or achievement of performance goals. The remaining 1,400,000 shares issuable in connection with the Stock Incentive Plan may be either incentive stock options (as defined in the Internal Revenue Code) or options that do not so qualify (non-qualified options). 73 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (13) STOCK INCENTIVE PLAN (Countinued) Incentive stock options shall have an exercise price that is not less than the fair market value at the date of grant and shall not be exercisable more than ten years after the date of grant. All incentive stock options and non-qualified options shall vest and become exercisable based on the determination of the Compensation Committee. Payment of the exercise price for option shares may be made (1) by cash or check, (2) with the consent of the Compensation Committee, by delivery of shares of common stock, (3) with the consent of the Compensation Committee, by reducing the number of option shares otherwise issuable upon exercise of the option or (4) by other means acceptable to the Compensation Committee, including any combination of the foregoing. At the discretion of the compensation Committee, options may include a so-called "reload" feature whereby an optionee exercising an option by delivery of shares of common stock would automatically be granted an additional option at the fair market value of stock when such additional option is granted equal to the number of shares so delivered. The Stock Incentive Plan also provides for the issuance of unrestricted stock awards, performance share awards and stock appreciation rights (SARs). SARs may be granted, at the discretion of the Compensation Committee, in conjunction with the grant of a stock option, subsequent to and in conjunction with the grant of a non-qualified option or alone and are deemed to be exercised on the last day of their term, if not otherwise exercised by the holder, provided that the fair value of the common stock subject to the SAR exceeds the exercise price on such date. The amount paid upon exercise may be in additional stock or, in the discretion of the Compensation Committee, in cash. In July 1999, the Compensation Committee approved the award of 560,000 shares of the Company's common stock to a group of officers and directors. Under the terms of the award, there is no cost to the recipient for the shares, which will vest annually over a five year period conditioned on continued employment with the Company. Shares that do not vest are forfeited and are returned to the Company. While the shares issued under this conditioned stock award are outstanding, recipients have both voting and dividend rights in such shares. The total compensation cost of the conditioned stock award was determined at the award date since both the number of shares and price to be paid (zero) were known. This cost, which amounts to $6,370,000, is being amortized ratably over five years beginning in July 1999 and ending when all risks of forfeiture have passed. Forfeitures will be recognized as a reduction of compensation cost in the period in which they occur. No forfeitures have occurred since the award date. For the year ended December 31, 1999, the Company expensed $637,000 in connection with its conditioned stock award grants. In July 1999, the Compensation Committee also approved the grant of stock options to officers and directors to acquire 1,243,000 shares of common stock at $11.375 per share, the fair market value at the date of grant. An additional grant of stock options to acquire 15,000 shares at $11.375 per share was approved in December 1999. Such options will become exercisable at a rate of 20% per year over the next five years. No stock options were forfeited in 1999. As disclosed in Note 1, the Company accounts for its stock-based compensation plan in accordance with APB No. 25 and, under such accounting rules, no compensation cost was recognized in 1999 in connection with the granting of stock options. Alternatively, FASB rules (SFAS No. 123) would permit a method under which a compensation cost for all stock awards would be calculated and recognized over the service period (generally equal to the vesting period). This compensation cost would be determined in a manner prescribed by the FASB using option pricing models intended to estimated the fair value of the stock awards at the grant date. Such alternative accounting would not result in additional compensation cost recorded for the conditioned stock awarded in 1999. 74 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (13) STOCK INCENTIVE PLAN (Continued) Had the Company applied SFAS No. 123 in accounting for its stock option grants, net income and earning per share (basic and diluted) for the year ended December 31, 1999 would have been the pro-forma amounts indicated below (in thousands): Earnings Net income per share ---------------- -------------- Actual....................................... $ 24,526 $ 0.97 ========= ======= Pro forma.................................... $ 24,294 $ 0.96 ========= ======= The fair value of stock options is estimated on the grant date using the Black-Scholes option pricing models using the following valuation assumptions: Expected volatility.................. 21% Risk-free interest rate.............. 5.8% Expected annual forfeitures.......... 5% Expected dividend yield.............. 2.5% Expected life of options............. 7 years The weighted average fair value of stock options granted in 1999, based on the above assumptions, was $3.00 per share. (14) FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATION OF CREDIT RISK The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments may involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the accompanying consolidated balance sheets. The contract amounts of those instruments reflect the extent of involvement the Bank has in particular classes of financial instruments. The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments. Off-balance-sheet financial instruments whose contract amounts present credit risk included the following: December 31, October 31, ----------------------- 1999 1998 1998 ---------- ---------- --------------- (In thousands) Unused portion of existing lines of credit................. $ 78,021 $ 68,200 $ 61,771 Standby letters of credit.................................. 1,391 1,872 1,960 Unadvanced construction loans.............................. 41,429 42,555 30,449 Firm commitments to extend credit.......................... 59,650 70,785 63,138 75 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (14) FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK AND CONCENTRATION OF CREDIT RISK (Continued) Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since some of the commitments may expire without being drawn upon, the total commitment amounts do not necessarily require future cash requirements. The Bank evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained upon extension of the credit is based on management's credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income-producing commercial real estate. Standby letters of credit are conditional commitments issued by the Bank to guarantee performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. Most guarantees extend for one year. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The collateral supporting those commitments varies and may include real property, accounts receivable or inventory. The Bank originates primarily residential and commercial real estate loans as well as auto loans to customers primarily located in southeastern Massachusetts and, to a lesser extent, Rhode Island. The Bank estimates that approximately 90% of its loan portfolio is based in Massachusetts, the majority of which is located in southeastern Massachusetts. (15) FAIR VALUE OF FINANCIAL INSTRUMENTS The reported fair values of financial instruments are based on a variety of valuation techniques. In some cases, fair values represent quoted market prices for identical or comparable instruments. In other cases, fair values have been estimated based on assumptions concerning the amount and timing of estimated future cash flows, assumed discount rates reflecting varying degrees of risk and future expected loss assumptions. These estimates involve a high degree of judgment. The estimates do not reflect any premium or discount that could result from offering significant holdings of financial instruments at bulk sale. Tax implications of unrealized gains and losses can also have a significant effect on fair value of the financial instruments that could have been realized as of December 31, 1999 and 1998 and October 31, 1998 or that will be realized in the future. Changes in economic conditions may dramatically affect the fair value of financial instruments. The following methods and assumptions were used to estimate the fair value of the Bank's financial instruments: For cash and due from banks and federal funds sold, the carrying amount approximates fair value due to the short maturity of those instruments. The fair values of investment securities are based on published market prices or quotations received from securities dealers. The fair values of loans are estimated for loan portfolios with similar financial characteristics. Loans are segregated by type, fixed- and adjustable-rate interest terms and by performing and nonperforming status. The fair values of performing residential real estate loans are estimated by discounting the anticipated future cash flows at rates currently required by the secondary mortgage market for the purchase of similar loans. For performing commercial real estate loans and performing commercial loans, fair values are estimated by discounting the anticipated future cash flows using estimated market discount rates that reflect the credit and interest rate risk inherent in the loan as determined by the loan's terms and credit rating. For home equity loans and consumer loans, fair values are estimated by discounting the anticipated cash flows using current interest rates. 76 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (15) FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued) The fair value of noncertificate deposits does not include the value of the Bank's long-term relationships with its depositors and does not reflect the value associated with possessing this relatively inexpensive source of funds that may be available for a considerable length of time. The reported fair value of noncertificate deposits is equal to the amount payable on demand at the reporting date. The fair values of fixed-maturity certificates of deposit are estimated by discounting the contractual future cash flows at rates currently offered for certificates of deposit with similar remaining maturities. The fair values of FHLB advances are determined by discounting the anticipated future cash payments by using the rates currently available to the Bank for advances with similar terms and remaining maturities. For other borrowings, the carrying amount approximates fair value due to the short maturity of those instruments. The fair value of commitments to extend credit is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The fair value of financial standby letters of credit is based on fees currently charged for similar agreements or on the estimated cost to terminate them or otherwise settle the obligations with the counter parties. The Bank has estimated the fair value of all such commitments to be immaterial. Certain items are excluded from disclosure requirements, including banking premises and equipment, the value of the Bank's portfolio of loans serviced for others, the intangible value inherent in the Bank's deposit relationships (i.e., core deposits), leases and pension benefit obligations, among others. Accordingly, the aggregate fair value amounts presented in the accompanying table do not include all data integral to a full assessment of the Company's financial position and the value of its net assets. The estimated fair values of the Bank's financial instruments are as follows: December 31, ------------------------------------------------ 1999 1998 October 31, 1998 ------------------------- ---------------------- ----------------------- Carrying Estimated Carrying Estimated Carrying Estimated Amount Fair Value Amount Fair Value Amount Fair Value ------------- ----------- ----------- ---------- ----------- ----------- (In thousands) Financial assets: Cash and due from banks.................. $ 60,245 $ 60,245 $ 54,006 $ 54,006 $ 65,340 $ 65,340 Federal funds sold....................... 106 106 47,413 47,413 41,033 41,033 Short-term investments................... 231 231 31,119 31,119 10,015 10,015 Investment securities.................... 272,927 272,831 316,255 316,459 313,688 313,974 Loans held-for-sale...................... 756 756 -- -- 13,495 13,567 Loans.................................... 1,747,206 1,404,054 1,320,680 Less: Allowance for loan losses.......... (16,828) (15,914) (15,117) ---------- ----------- ----------- Total loans, net......................... 1,730,378 1,721,071 1,388,140 1,390,822 1,305,563 1,317,695 ========== =========== =========== Financial liabilities: Noncertificate deposits.................. 778,687 778,687 751,910 751,910 778,785 778,785 Term certificates........................ 736,935 736,008 745,305 748,598 752,878 755,896 Borrowings............................... 42,722 42,774 13,118 13,118 16,085 16,085 FHLB advances............................ 271,900 274,243 83,951 86,156 85,111 88,599 77 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (16) CONDENSED PARENT COMPANY FINANCIAL STATEMENTS The condensed financial statements of the Company are as follows: December 31, October 31, ------------------------ 1999 1998 1998 ----------- ----------- ----------- (In thousands) BALANCE SHEETS ASSETS: Cash and due from banks (primarily in Compass)............ $ 8,175 $ 126,434 $ 4,788 Investment securities available-for-sale.................. 2,133 2,058 2,052 ESOP loan................................................. 10,840 11,200 -- Investment in subsidiaries................................ 253,008 132,332 147,067 Other assets.............................................. 270 207 117 ----------- ----------- ---------- Total assets....................................... $ 274,426 $ 272,231 $ 154,024 =========== =========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY: Accrued expenses and other liabilities.................... $ 405 $ 719 $ 454 Stockholders' equity...................................... 274,021 271,512 153,570 ----------- ----------- ---------- Total liabilities and stockholders' equity.......................................... $ 274,426 $ 272,231 $ 154,024 =========== =========== ========== Two Months Year Ended Ended Years Ended December 31, December 31, October 31, -------------------- 1999 1998 1998 1997 --------------- -------------- ---------- --------- (In thousands) STATEMENTS OF INCOME INCOME: Interest and dividends on investment securities..... $ 88 $ 40 $ 191 $ 217 Interest on ESOP loan............................... 856 96 -- -- Dividends from subsidiaries......................... -- 731 2,108 768 Gain on sales of investment securities.............. -- -- 2 -- --------- ---------- ---------- --------- Total income..................................... 944 867 2,301 985 --------- ---------- ---------- --------- NONINTEREST EXPENSE 1,123 78 306 120 INTEREST EXPENSE........................................ -- 52 -- -- --------- ---------- ---------- --------- Total expenses 1,123 130 306 120 --------- ---------- ---------- --------- Income (loss) before income taxes and equity in undistributed net income (loss) of subsidiaries.. (179) 737 1,995 865 PROVISION (BENEFIT) FOR INCOME TAXES.................... (106) (3) (32) 18 --------- ---------- ---------- --------- Income (loss) before equity in undistributed net income (loss) of subsidiaries.................... (73) 740 2,027 847 EQUITY IN UNDISTRIBUTED NET INCOME (LOSS) OF SUBSIDIARIES.................................. 24,599 (4,076) 16,063 15,797 --------- ---------- ---------- --------- Net income (loss).................................. $ 24,526 $ (3,336) $ 18,090 $ 16,644 ========= ========== ========== ========= 78 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (16) CONDENSED PARENT COMPANY FINANCIAL STATEMENTS (Continued) Two Months Year Ended Ended Years Ended December 31, December 31, October 31, ---------------------- 1999 1998 1998 1997 --------------- -------------- ---------- ---------- (In thousands) STATEMENTS OF CASH FLOWS CASH FLOWS FROM OPERATING ACTIVITIES: Net income (loss)........................................ $ 24,526 $ (3,336) $ 18,090 $ 16,644 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Gain on sales of investments............................ -- -- (2) -- Net (accretion) amortization............................ 13 2 4 (2) Stock-based compensation................................ 131 -- -- -- Equity in undistributed (earnings) loss of subsidiaries. (24,599) 4,076 (16,063) (15,797) Net (increase) decrease in other assets................. (80) (90) 1 (70) Net increase (decrease) in other liabilities............ (200) 265 (486) 32 ----------- ---------- ---------- ---------- Net cash provided by (used in) operating activities. (209) 917 1,544 807 ----------- ---------- ---------- ---------- CASH FLOWS FROM INVESTING ACTIVITIES: Investment in subsidiaries................................ (100,000) -- -- -- Proceeds from sales and maturities of securities.......... -- -- 2,494 -- Purchase of securities.................................... (332) -- (586) (96) Repayments on ESOP loan................................... 360 -- -- -- ----------- ---------- ---------- ---------- Net cash provided by (used in) investing activities. (99,972) -- 1,908 (96) ----------- ---------- ---------- ---------- CASH FLOWS FROM FINANCING ACTIVITIES: Transactions with stockholders of acquired entity, net.... -- (649) 496 (422) Proceeds of stock offering, net........................... -- 121,378 -- -- Repurchase of common stock................................ (15,939) -- -- -- Stock award reimbursement by Compass...................... 506 -- -- -- Cash dividends............................................ (2,645) -- -- -- ----------- ---------- ---------- ---------- Net cash provided by (used in) financing activities. (18,078) 120,729 496 (422) ----------- ---------- ---------- ---------- Net increase (decrease) in cash and due from banks.. (118,259) 121,646 3,948 289 CASH AND DUE FROM BANKS, BEGINNING OF YEAR......................................... 126,434 4,788 400 111 NET CHANGE IN CASH AND DUE FROM BANKS DUE TO DIFFERENCE IN YEAR-ENDS............................ -- -- 440 -- CASH AND DUE FROM BANKS, ----------- ---------- ---------- ---------- END OF YEAR............................................... $ 8,175 $ 126,434 $ 4,788 $ 400 =========== ========== ========== ========== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Income taxes paid..................................... $ 18 $ -- $ 2 $ 27 =========== ========== ========== ========== 79 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (17) STOCK CONVERSION On April 23, 1998, the Board of Trustees of the Company adopted a Plan of Conversion (the Conversion) pursuant to which the Company would convert to a stock form of ownership and offer for sale 100% of its common stock in a subscription offering initially to Bank depositors, employee benefit plans of the Bank and certain other eligible subscribers. Any shares of stock not sold in the subscription offering were to be sold to the public in a community offering. The Company completed its mutual-to-stock conversion and the initial public offering of common stock on November 20, 1998, whereby a total of 14,000,000 shares were sold at a purchase price of $10 per share. An Employee Stock Ownership Plan (ESOP) set up by the Company acquired 8%, or 1,120,000, of the shares issued which was funded by a loan from the Company. Net proceeds of the Conversion were $121.4 million which excludes the sale of ESOP shares which were internally funded. At October 31, 1998, the Company had deferred offering costs of $2,280,000, included in other assets in the accompanying consolidated balance sheet, that were subsequently recorded as a reduction of the proceeds received. As part of the Conversion, the Bank established a liquidation account in an amount equal to the net worth of the Bank as of May 31, 1998, the date of the latest consolidated balance sheet which appeared in the prospectus. The liquidation account will be maintained for the benefit of eligible account holders and supplemental eligible account holders who maintain their accounts at the Bank after the Conversion. The liquidation account will be reduced annually to the extent that such account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases will not restore an account holder's interest in the liquidation account. In the event of a complete liquidation, each eligible account holder will be entitled to receive balances for accounts then held. (18) STOCK REPURCHASE PROGRAM In July 1999, the Board of Directors authorized the Company to repurchase up to 1,000,000 shares in the open market to meet the anticipated needs of stock awards and stock options issued in connection with the Stock Incentive Plan. In October 1999, the Board of Directors, with the approval of the Commissioner of Banks, authorized the Company to repurchase up to an additional 1,231,900 shares in the open market. The Board of Directors delegated to the discretion of senior management the authority to determine the timing of the repurchase programs' commencement, the timing of subsequent repurchases and the prices at which repurchases will be made. As of January 27, 2000, the Company had repurchased 1,468,500 shares of its common stock under these programs at a total cost of $16,031,920, of which 1,458,500 shares at a cost of $15,939,420 had been repurchased as of December 31, 1999. (19) DIVIDEND REINVESTMENT AND STOCK PURCHASE PLAN In October 1999, the Board of Directors authorized a dividend reinvestment and stock purchase plan for up to 500,000 shares of common stock. Stockholders owning 100 or more shares will be eligible to enroll and may reinvest part of all of their cash dividends. Participants may also make optional cash payments from $100 to $5,000 maximum per quarter to purchase additional common stock. This plan commenced upon the Board's declaration of the Company's quarterly cash dividend in January 2000. 80 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (20) BUSINESS SEGMENT INFORMATION On November 1, 1998, the Company adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes standards for reporting operating segments of a business enterprise. The new rules establish revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. Operating segments are components of an enterprise which are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Company's chief operating decision maker is its President and Chief Executive Officer. The adoption of SFAS No. 131 did not have a material effect on the Company's primary financial statements, but did result in the disclosure of segment information contained herein. The Company has identified its reportable operating business segment as "Community Banking" based on how the business is strategically managed. The Company's community banking business segment consists of commercial and retail banking. The community banking business segment is managed as a single strategic unit which derives its revenues from a wide range of banking services, including investing and lending activities and acceptance of demand, savings and time deposits, merchant credit card services as well as servicing loans for investors. There is no major customer, as defined, and the Company operates within a single geographic area (southeastern Massachusetts). Non reportable operating segments of the Company's operations which do not have similar characteristics to the community banking operations and do not meet the quantitative thresholds requiring disclosure, are included in the Other category in the disclosure of business segments below. These non reportable segments include the Parent Company (Note 16). The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies. The consolidation adjustments reflect certain eliminations of intersegment revenue, cash and the Parent Company investments in subsidiaries. Reportable segment specific information and reconciliation to consolidated financial information is as follows (in thousands): Community Other Adjustments Banking Other and Eliminations Consolidated ---------------- ----------- --------------------- -------------- December 31, 1999 Investment securities.................. $ 270,794 $ 2,133 $ -- $ 272,927 Net loans.............................. 1,730,378 10,840 (10,840) 1,730,378 Total assets........................... 2,120,382 249,293 (246,890) 2,122,785 Total deposits......................... 1,515,622 -- -- 1,515,622 Total borrowings....................... 314,622 -- -- 314,622 Total liabilities...................... 1,848,359 405 -- 1,848,764 Net interest income.................... 74,354 944 (856) 74,442 Provision for loan losses.............. 2,000 -- -- 2,000 Total noninterest income............... 9,994 -- -- 9,994 Total noninterest expense.............. 43,393 1,123 -- 44,516 Net income............................. 24,599 24,526 (24,599) 24,526 81 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (20) BUSINESS SEGMENT INFORMATION (Continued) Other Community Adjustments Banking Other and Eliminations Consolidated ------------ ----------- ---------------- ------------ December 31, 1998 Investment securities.................. 314,197 2,058 -- 316,255 Net loans.............................. 1,388,140 11,200 (11,200) 1,388,140 Total assets........................... 1,885,815 272,231 (269,966) 1,888,080 Total deposits......................... 1,497,215 -- -- 1,497,215 Total borrowings....................... 98,773 -- -- 98,773 Total liabilities...................... 1,615,849 719 -- 1,616,568 Net interest income.................... 11,069 84 (44) 11,109 Provision for loan losses.............. 416 -- -- 416 Total noninterest income............... 1,639 -- -- 1,639 Total noninterest expense.............. 16,134 78 -- 16,212 Net income (loss)...................... (3,249) (3,336) (3,249) (3,336) October 31, 1998 Investment securities.................. 311,636 2,052 -- 313,688 Net loans.............................. 1,305,563 -- -- 1,305,563 Total assets........................... 1,804,354 154,024 (151,855) 1,806,523 Total deposits......................... 1,531,663 -- -- 1,531,663 Total borrowings....................... 102,906 -- -- 102,906 Total liabilities...................... 1,652,499 454 -- 1,652,953 Net interest income.................... 60,051 191 -- 60,242 Provision for loan losses.............. 1,736 -- -- 1,736 Total noninterest income............... 10,040 2 -- 10,042 Total noninterest expense.............. 39,501 306 -- 39,807 Net income............................. 18,171 18,090 (18,171) 18,090 October 31, 1997 Investment securities.................. 336,548 4,856 -- 341,404 Net loans.............................. 1,176,197 -- -- 1,176,197 Total assets........................... 1,620,228 140,730 (135,698) 1,625,260 Total deposits......................... 1,360,962 -- -- 1,360,962 Total borrowings....................... 108,042 -- -- 108,042 Total liabilities...................... 1,484,557 575 -- 1,485,132 Net interest income.................... 57,707 217 -- 57,924 Provision for loan losses.............. 2,615 -- -- 2,615 Total noninterest income............... 8,536 -- -- 8,536 Total noninterest expense.............. 36,916 120 -- 37,036 Net income............................. 16,565 16,644 (16,565) 16,644 82 SEACOAST FINANCIAL SERVICES CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1999 (21) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED) The following table summarizes the operating results on a quarterly basis for the year ended December 31, 1999: Fourth Third Second First Quarter Quarter Quarter Quarter ------------- ----------- ----------- ----------- (Dollars in thousands, except for per share amounts) Interest income............................................. $ 36,504 $ 35,142 $ 33,580 $ 32,726 Interest expense............................................ 17,084 16,092 15,482 14,852 --------- --------- -------- --------- Net interest income.................................... 19,420 19,050 18,098 17,874 --------- --------- -------- --------- Provision for loan losses................................... 775 650 350 225 Gain on pension plan termination............................ -- 1,472 -- -- Other non-interest income................................... 2,285 2,248 2,127 1,862 Non-interest expenses....................................... 11,565 11,295 11,052 10,604 --------- --------- -------- --------- Income before income taxes............................. 9,365 10,825 8,823 8,907 Provision for income taxes.................................. 3,206 3,880 3,018 3,290 --------- --------- -------- --------- Net income............................................. $ 6,159 $ 6,945 $ 5,805 $ 5,617 ========= ========= ======== ========= Diluted earnings per share.................................. $ 0.25 $ 0.27 $ 0.23 $ 0.22 ========= ========= ======== ========= Cash dividends per share.................................... $ 0.05 $ 0.05 $ -- $ -- ========= ========= ======== ========= 83 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required by Item 10 of this Form is incorporated by reference herein from the Company's Proxy Statement relating to the 2000 Annual Meeting of Stockholders of the Company. ITEM 11. EXECUTIVE COMPENSATION Information required by Item 11 of this Form is incorporated by reference herein from the Company's Proxy Statement relating to the 2000 Annual Meeting of Stockholders of the Company. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by Item 12 of this Form is incorporated by reference herein from the Company's Proxy Statement relating to the 2000 Annual Meeting of Stockholders of the Company. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by Item 13 of this Form is incorporated by reference herein from the Company's Proxy Statement related to the 2000 Annual Meeting of Stockholders of the Company. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Contents: 1. Financial Statements: All financial statements are included in Item 8. of Part II to this report. 2. Financial Statement Schedules: All financial statement schedules have been omitted because they are either not required, not applicable or are included in the consolidated financial statements or related notes. 3. Exhibits 3.1 Articles of Organization of Seacoast Financial Services Corporation+++ 3.2 By-Laws of Seacoast Financial Services Corporation+++ 4 Specimen certificate for the common stock of Seacoast Financial Services Corporation++ 10.1* Form of Employment Agreement by and among Seacoast Financial Services Corporation, Compass Bank for Savings and Kevin G. Champagne+ 10.2* Form of Employment Agreement by and among Compass Bank for Savings, Seacoast Financial Services Corporation and certain Officers of Compass Bank for Savings+ 10.3* Form of Change in Control Agreements by and among Seacoast Financial Services Corporation, Compass Bank for Savings, Kevin G. Champagne and certain other Officers of Compass Bank for Savings+ 84 10.4* Form of Change in Control Agreement by and among Seacoast Financial Services Corporation, Compass Bank for Savings and certain Officers of Compass Bank for Savings+ 10.5* Form of Executive Salary Continuation Agreements made and entered into by and between Compass Bank for Savings and Kevin G. Champagne, Arthur W. Short, John D. Kelleher and Francis S. Mascianica and forms of amendments thereto+ 10.6* Trust Agreement, made as of December 18, 1992, by and between Compass Bank for Savings and Shawmut Bank, N.A.+ 10.7* Compass Bank for Savings January 2000 Incentive Compensation Plan 10.12* Compass Bank for Savings Executive Deferred Compensation Plan+ 10.13* Rabbi Trust for Compass Bank for Savings Executive Deferred Compensation Plan+ 10.17* Sandwich Co-operative Bank 1992 Directors Deferred Compensation Plan+ 10.20* Seacoast Financial Services Corporation 1999 Stock Incentive Plan++++ 11 A statement regarding earnings per share is included in Item 8, Note 1, of this report. 23.1 Consent of Arthur Andersen LLP 23.2 Consent of KPMG LLP 27 EDGAR Financial Data Schedule ----------------- * Management compensatory plan or arrangement. + Incorporated by reference to the Company's Registration Statement on Form S-1 (333-52889), filed with the Securities and Exchange Commission under the Company's prior name, "The 1855 Bancorp", on May 15, 1998. ++ Incorporated by reference to Amendment No. 1 to the Company's Registration Statement on Form S-1 (333-52889), filed with the Securities and Exchange Commission under the Company's prior name, "The 1855 Bancorp", on August 14, 1998. +++ Incorporated by reference to the Company's Registration Statement on Form 8-A filed with the Securities and Exchange Commission on November 18, 1998. ++++ Incorporated by reference to the Company's Proxy Statement on Schedule 14A filed with the Securities and Exchange Commission on April 16, 1999. (b) Reports on Form 8-K: No reports have been filed during the fourth quarter and through the date of filing of this Form 10-K. 85 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. Seacoast Financial Services Corporation DATE: March 23, 2000 By: /s/ KEVIN G. CHAMPAGNE -------------------------------------- Kevin G. Champagne President and Chief Executive Officer By: /s/ FRANCIS S. MASCIANICA, Jr. -------------------------------------- Treasurer, as Principal Financial and Accounting Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. /s/ KEVIN G. CHAMPAGNE - ----------------------------------- Kevin G. Champagne President, Chief Executive March 23, 2000 Officer and Director /s/ MANUEL G. CAMACHO - ----------------------------------- Manuel G. Camacho, D.D.S. Director March 23, 2000 - ----------------------------------- David P. Cameron Director /s/ HOWARD C. DYER, Jr. - ----------------------------------- Howard C. Dyer, Jr. Director March 23, 2000 /s/ MARY F. HEBDITCH - ----------------------------------- Mary F. Hebditch Director March 23, 2000 /s/ GLEN F. JOHNSON - ----------------------------------- Glen F. Johnson Director March 23, 2000 /s/ THORNTON P. KLAREN, Jr. - ----------------------------------- Thornton P. Klaren, Jr. Director March 23, 2000 /s/ J. LOUIS LEBLANC - ----------------------------------- J. Louis LeBlanc Director March 23, 2000 /s/ FREDERIC D. LEGATE - ----------------------------------- Frederic D. Legate Director March 23, 2000 /s/ REALE J. LEMIEUX - ----------------------------------- Reale J. Lemieux Director March 23, 2000 /s/ A. WILLIAM MUNRO - ----------------------------------- A. William Munro Director March 23, 2000 /s/ CARL RIBEIRO - ----------------------------------- Carl Ribeiro Director March 23, 2000 /s/ JOSEPH H. SILVERSTEIN - ----------------------------------- Joseph H. Silverstein Director March 23, 2000 /s/ GERALD H. SILVIA - ----------------------------------- Gerald H. Silvia Director March 23, 2000