1 Greene County Bancshares, Inc. 1998 MD&A EXHIBIT 13 SELECTED FINANCIAL DATA 1998 1997 1996 1995 1994 --------- --------- --------- --------- --------- (In thousands of dollars, except per share data) Total interest income .................................... $ 50,792 $ 49,005 $ 39,521 $ 31,387 $ 23,625 Total interest expense ................................... 18,572 19,144 15,825 13,444 8,497 --------- --------- --------- --------- --------- Net interest income ...................................... 32,220 29,861 23,696 17,943 15,128 Provision for loan losses ................................ (3,417) (5,953) (2,973) (1,424) (994) Net interest income after provision for loan losses ...... 28,803 23,908 20,723 16,519 14,134 Non-interest income: Investment securities gains ............................ -- 2 -- 1 -- Other income ........................................... 4,555 3,919 3,411 2,597 2,368 Non-interest expense ..................................... (20,462) (17,009) (14,800) (11,257) (9,491) --------- --------- --------- --------- --------- Income before income taxes ............................... 12,897 10,820 9,334 7,860 7,011 Income tax expense ....................................... (4,690) (3,990) (3,371) (2,752) (2,510) --------- --------- --------- --------- --------- Net income ............................................... $ 8,207 $ 6,830 $ 5,963 $ 5,108 $ 4,501 ========= ========= ========= ========= ========= PER SHARE DATA:(1) Net income, basic ...................................... $ 6.05 $ 5.04 $ 4.43 $ 3.83 $ 3.39 Net income, assuming dilution .......................... $ 6.02 $ 5.03 $ 4.43 $ 3.82 $ 3.38 Dividends declared ..................................... $ 2.30 $ 1.92 $ 1.72 $ 1.53 $ 1.35 Book value ............................................. $ 40.81 $ 37.00 $ 33.76 $ 30.94 $ 28.02 FINANCIAL CONDITION DATA: Assets ................................................. $ 568,179 $ 534,102 $ 478,048 $ 420,581 $ 45,525 Loans, net ............................................. $ 466,661 $ 441,390 $ 381,272 $ 293,834 $ 241,253 Cash and investment securities ......................... $ 49,939 $ 62,166 $ 73,713 $ 83,998 $ 85,460 Federal funds sold ..................................... $ 24,300 $ 5,500 $ -- $ 23,800 $ 3,550 Deposits ............................................... $ 459,183 $ 461,728 $ 408,722 $ 365,951 $ 98,162 Long-term debt ......................................... $ 36,627 $ 15,487 $ 15,806 $ 3,448 $ 3,688 Other borrowed funds ................................... $ 2,416 $ 1,414 $ 3,272 $ 4,784 $ 3,879 Shareholders' equity ................................... $ 55,386 $ 50,113 $ 45,725 $ 41,074 $ 37,190 SELECTED RATIOS: Interest rate spread ................................... 5.96% 5.70% 5.16% 4.57% 4.57% Net yield on interest-earning assets ................... 6.53% 6.21% 5.65% 5.09% 4.96% Return on average assets ............................... 1.56% 1.33% 1.32% 1.35% 1.38% Return on average equity ............................... 15.63% 13.93% 13.23% 13.17% 12.32% Average equity to average assets ....................... 9.97% 9.55% 9.94% 10.24% 11.17% Dividend payout ratio .................................. 37.99% 38.08% 39.05% 40.17% 39.96% Ratio of nonperforming assets to total assets .......... 1.15% 0.81% 0.49% 0.57% 0.40% Ratio of allowance for loan losses to nonperforming assets ................................. 156.34% 210.15% 315.27% 225.05% 247.99% Ratio of allowance for loan losses to total loans ...... 2.11% 2.01% 1.87% 1.55% 1.39% (1) Amounts have been restated to reflect the effect of the Company's 3-for-1 stock split effected in October 1997. 1 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF CHANGES IN FINANCIAL CONDITION AND RESULTS OF OPERATION FORWARD-LOOKING INFORMATION THE INFORMATION CONTAINED HEREIN CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE A NUMBER OF RISKS AND UNCERTAINTIES. A NUMBER OF FACTORS, INCLUDING THOSE DISCUSSED HEREIN, COULD CAUSE RESULTS TO DIFFER MATERIALLY FROM THOSE ANTICIPATED BY SUCH FORWARD-LOOKING STATEMENTS. IN ADDITION, SUCH FORWARD-LOOKING STATEMENTS ARE NECESSARILY DEPENDENT UPON ASSUMPTIONS, ESTIMATES AND DATA THAT MAY BE INCORRECT OR IMPRECISE. ACCORDINGLY, ANY FORWARD-LOOKING STATEMENTS INCLUDED HEREIN DO NOT PURPORT TO BE PREDICTIONS OF FUTURE EVENTS OR CIRCUMSTANCES AND MAY NOT BE REALIZED. FORWARD-LOOKING STATEMENTS CAN BE IDENTIFIED BY, AMONG OTHER THINGS, THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS "INTENDS," "BELIEVES," "EXPECTS," "MAY," "WILL," "SHOULD," "SEEKS," "PRO FORMA" OR "ANTICIPATES," OR THE NEGATIVES THEREOF, OR OTHER VARIATIONS THEREON OF COMPARABLE TERMINOLOGY, OR BY DISCUSSIONS OF STRATEGY OR INTENTIONS. GENERAL Greene County Bancshares, Inc. (the "Company") was formed in 1985 and serves as the bank holding company for Greene County Bank ("GCB"), which is a Tennessee-chartered commercial bank that conducts the principal business of the Company. The Company also wholly owned American Fidelity Bank, whose assets were combined with GCB during 1996, and Premier Bank of East Tennessee, whose assets were combined with GCB in 1998. In addition to its commercial banking operations, GCB conducts separate businesses through four wholly-owned subsidiaries: Superior Financial Services, Inc. ("Superior Financial"), a consumer finance company; Superior Mortgage Company ("Superior Mortgage"), a mortgage banking company; GCB Acceptance Corporation ("GCB Acceptance"), a consumer finance company specializing in subprime automobile lending; and Fairway Title Co., a title company formed in 1998. The principal business of the Company consists of accepting deposits from the general public and investing these funds and borrowed funds primarily in loans and, to a limited extent, securities available for sale or held to maturity. Loans are originated by the Company within its primary market area of east Tennessee and include commercial loans, commercial real estate loans, mortgage installment loans and installment consumer loans. The Company's net income is dependent primarily on its net interest income, which is the difference between interest income earned on its loans, investment assets and other interest-earning assets and interest paid on deposits and other interest-bearing liabilities. To a lesser extent, the Company's net income also is affected by the level of non-interest expenses such as compensation and employee benefits and Federal Deposit Insurance Corporation premiums. The operations of the Company are significantly affected by prevailing economic conditions, competition and the monetary, fiscal and regulatory policies of governmental agencies. Lending activities are influenced by the general credit needs of small businesses in the Company's market area, competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of funds are influenced by prevailing market rates of interest, primarily on competing investments, account maturities and the levels of personal income and savings in the Company's market area. 2 3 LIQUIDITY AND CAPITAL RESOURCES LIQUIDITY. Liquidity refers to the ability or the financial flexibility to manage future cash flows to meet the needs of depositors and borrowers and fund operations. Maintaining appropriate levels of liquidity allows the Company to have sufficient funds available for reserve requirements, customer demand for loans, withdrawal of deposit balances and maturities of deposits and other liabilities. The Company's primary source of liquidity is dividends paid by the Bank. Applicable Tennessee statutes and regulations impose restrictions on the amount of dividends that may be declared by the Bank. Further, any dividend payments are subject to the continuing ability of the Bank to maintain compliance with minimum federal regulatory capital requirements and to retain its characterization under federal regulations as a "well-capitalized" institution. In addition, the Company maintains a line of credit of $20 million with the Federal Home Loan Bank of Cincinnati and three federal funds lines of credit totaling $20 million at three correspondent banks of which the aggregate $35.2 million was available at December 31, 1998. In 1998, operating activities of the Company provided $17,856,198 of cash flows. Net income of $8,206,419 adjusted for non-cash operating activities, including $3,417,010 in provision for loan losses and amortization and depreciation of $993,523, provided the bulk of the cash generated from operations. Investing activities, including lending, used $40,377,603 of the Company's cash flow, a 36.1% decline from 1997 levels. Loans originated net of principal collected used $30,247,073 in funds, down from $66,708,497 in 1997 as the Company's loan originations decreased in response to interest rate conditions. In response, the Company implemented a more competitive commercial loan rate structure in the fourth quarter of 1998 and also hired a senior commercial lender from a regional bank who brought new and significant seasoned lending relationships to the Bank and an experienced commercial lending staff. Excess funds available because of reduced loan growth as compared to 1997 is reflected in the increase in federal funds sold of $18,800,000 during 1998 as compared to $5,500,000 during 1997. These uses of funds were funded in part by cash received from other investing activities, including $8,770,371 from proceeds from maturities of available-for-sale securities and $4,065,000 from proceeds from maturities of securities held to maturity. Net additional cash inflows of $21,425,852 were provided by financing activities, a decrease of $28,136,918 from 1997 levels. The decline was attributable primarily to the $66,379,215 decline in growth of certificates of deposit during 1998, offset in part by the net increase in growth of $9,496,288 in demand deposits, NOW, money market and savings accounts and by an increase in long-term borrowings from the Federal Home Loan Bank of Cincinnati of $23,500,000 during 1998 from $19,500,637 during 1997. The effect of this change in borrowings is amplified by the $17,460,045 reduction in payments on long-term debt, from $19,769,657 during 1997 to $2,309,612 during 1998. CAPITAL RESOURCES. The Company's capital position is reflected in its shareholders' equity, subject to certain adjustments for regulatory purposes. Shareholders' equity, or capital, is a measure of the Company's net worth, soundness and viability. The Company's capital continued to exceed regulatory requirements at December 31, 1998 and its record of paying dividends to its stockholders continued uninterrupted during 1998. Management believes the capital base of the Company allows it to take advantage of business opportunities while maintaining the level of resources deemed appropriate by management of the Company to address business risks inherent in the Company's daily operations. Shareholders' equity on December 31, 1998 was $55,385,798, an increase of $5,272,938 or 10.52%, from $50,112,860 on December 31, 1997. The increase in shareholders' equity arises primarily from net income for 1998 of $8,206,419 ($6.05 per share, or $6.02 per share assuming dilution), offset in part by quarterly dividend payments during 1998 that totalled $3,117,842 ($2.30 per share). 3 4 Risk-based capital regulations adopted by the Board of Governors of the Federal Reserve Board (the "FRB") and the Federal Deposit Insurance Corporation ("FDIC") require bank holding companies and banks, respectively, to achieve and maintain specified ratios of capital to risk-weighted assets. The risk-based capital rules are designed to measure "Tier 1" capital (consisting of stockholders' equity, less goodwill) and total capital in relation to the credit risk of both on- and off-balance sheet items. Under the guidelines, one of four risk weights is applied to the different on-balance sheet items. Off-balance sheet items, such as loan commitments, are also subject to risk weighting after conversion to balance sheet equivalent amounts. All bank holding companies and banks must maintain a minimum total capital to total risk-weighted assets ratio of 8.00%, at least half of which must be in the form of core, or Tier 1, capital. At December 31, 1998, the Company and the Bank each satisfied their respective minimum regulatory capital requirements, and the Bank was "well-capitalized" within the meaning of federal regulatory requirements. ASSET/LIABILITY MANAGEMENT The operations and profitability of the Company are largely impacted by changes in interest rates and management's ability to control interest rate sensitivity. Management believes that its asset/liability strategy reduces the risk associated with fluctuation in interest rates. The Company strives to be neither asset sensitive nor liability sensitive by relying upon a mix of fixed rate and variable rate products. At December 31, 1998, approximately 46.2% of the Company's gross loans had adjustable rates. The Company has a mixture of fixed rate loans and loans tied to its Prime Rate, and this also applies to the investment portfolio. It is management's belief that while this mixture may not give maximum returns under certain market conditions, it can prevent severe swings in earnings under other conditions. Management believes the Company is somewhat asset sensitive; therefore, in a falling rate environment earnings will tend to fall, while in a rising rate environment earnings will tend to improve. Despite the implementation of strategies to achieve a matching position of assets and liabilities and to reduce the exposure to fluctuating interest rates, the results of operations of the Company will remain subject to the level and movement of interest rates. CHANGES IN RESULTS OF OPERATIONS NET INCOME. Net income for 1998 was $8,206,419, an increase of $1,376,245 or 20.15% as compared to net income of $6,830,174 for 1997. The increase resulted primarily from an increase in net interest income of $2,359,442, or 7.90%, to $32,220,308 in 1998 from $29,860,866 in 1997, and an increase in non-interest income of $634,373, or 16.17%, to $4,555,489 in 1998 from $3,921,116 in 1997. The increase in net interest income primarily reflects an increase in interest income attributable to loan growth and a decrease in interest expense associated with reliance on lower-cost debt. These changes were offset in part by the $3,453,123, or 20.30% increase in non-interest expense to $20,461,962 in 1998 from $17,008,839 in 1997, attributable primarily to increases in salaries and benefits and in other expenses. Net income for 1997 was $6,830,174, an increase of $866,912 or 14.54% as compared to net income of $5,963,262 for 1996. The increase resulted primarily from an increase in net interest income of $6,164,660, or 26.0%, to $29,860,866 in 1997 from $23,696,206 in 1996, and an increase in non-interest income of $510,336, or 15.0%, to $3,921,116 in 1997 from $3,410,780 in 1996. The increase in net interest income primarily reflects the Company's continued growth in loan production, primarily increases in mortgage installment, commercial real estate and commercial loans as the Company continues to take advantage of its branch network presence throughout East Tennessee. These increases were offset in part by the $2,208,929, or 14.93% increase in non-interest expense to $17,008,839 in 1997 from $14,799,910 in 1996, attributable primarily to increasing compensation and occupancy expenses associated with branch operations. 4 5 NET INTEREST INCOME. The largest source of earnings for the Company is net interest income, which is the difference between interest income on interest-earning assets and interest paid on deposits and other interest-bearing liabilities. The primary factors which affect net interest income are changes in volume and yields of earning assets and interest-bearing liabilities, which are affected in part by management's responses to changes in interest rates through asset/liability management. During 1998, net interest income was $32,220,308 as compared to $29,860,866 in 1997, an increase of 7.90%. This increase was due primarily to an increase in loan volume and lower deposit rates on non-time deposits. The loan volume increase was also due in part to the Company's implementation during 1998 of more competitive commercial loan rates. At the same time, the Company's net interest margin increased in 1998 to 6.53% from 6.21% in 1997. This increase in net interest margin reflects a reduction in the cost of interest-bearing liabilities, as well as a slight increase in loan yield. Contributing to the growth in net interest income during 1998 was the decline in cost of funds, as reflected in the lower amount of interest expense in 1998 despite an increase in average total deposits. Net interest income for 1997 was $29,860,866 as compared to $23,696,206 in 1996, an increase of 26.0%. This increase was due primarily to a $61,212,715 increase in average interest-earning assets during 1997 as compared to 1996, offset by a $53,509,868 increase in average interest bearing liabilities during the same period to fund such growth. At the same time, the Company's net interest margin increased in 1997 to 6.21% from 5.65% in 1996. This increase in net interest margin reflects the Company's focus on commercial and commercial real estate loans, which generally have shorter terms and are priced based upon the prime rate offered by New York banks as reported in The Wall Street Journal. The Company's loan yields were thus enhanced by the 25 basis point prime rate increase in the first quarter of 1997. Commercial and commercial real estate loans comprised, in the aggregate, 51.3% of the Company's gross loan portfolio at December 31, 1997. Offsetting the growth in interest income during 1997 was the related increase in interest expense arising primarily from the 12.7% increase in 1997 in the Company's average deposit base. Average Balances, Interest Rates and Yields. Net interest income is affected by (i) the difference between yields earned on interest-earning assets and rates paid on interest-bearing liabilities ("interest rate spread") and (ii) the relative amounts of interest-earning assets and interest-bearing liabilities. The Company's interest rate spread is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. When the total of interest-earning assets (that is, when yields earned exceed rates paid) approximates or exceeds the total of interest-bearing liabilities, any positive interest rate spread will generate net interest income. Another indication of an institution's net interest income is its "net yield on interest-earning assets," which is net interest income divided by average interest-earning assets. 5 6 The following table sets forth certain information relating to the Company's consolidated average interest-earning assets and interest-bearing liabilities and reflects the average yield on assets and average cost of liabilities for the periods indicated. Such yields and costs are derived by dividing income or expense by the average daily balance of assets or liabilities, respectively, for the periods presented. During the periods indicated, non-accruing loans, if any, are included in the net loan category. 1998 ---------------------------------- Average Revenue/ Yield/ Balance Expense Rate ------- ------- ---- INTEREST-EARNING ASSETS: Loans(1) - -------- Commercial ................$235,166,862 $21,002,417 8.93% Installment - net(2)....... 207,718,394 23,064,331 11.10% Fees on loans ............. 3,754,124 ------------ ----------- Total loans (including fees)........$442,885,256 $47,820,872 10.80% Investment securities(3) - ------------------------ Taxable ...................$ 29,326,409 $ 1,865,083 6.36% Tax exempt(4) ............. 6,250,730 282,161 4.51% ------------ ----------- Total investment Securities ............$ 35,577,139 $ 2,147,244 6.04% Other short-term Investments ............. 14,808,885 824,340 5.57% ------------ ----------- Total interest- earning assets ........$493,271,280 $50,792,456 10.30% ------------ ----------- NON-INTEREST-EARNING ASSETS: Cash and due from Banks ...................$ 17,855,077 Premises and Equipment ............... 9,968,183 Other, less allowance for loan losses ......... 5,346,239 ------------ Total non-interest- earning assets..........$ 33,169,499 ------------ Total average assets......$526,440,779 ============ 1997 -------------------------------------- Average Revenue/ Yield/ Balance Expense Rate ------- ------- ---- INTEREST-EARNING ASSETS: Loans(1) - -------- Commercial ................$240,601,635 $21,476,951 8.93% Installment - net(2)....... 190,304,270 22,024,965 11.57% Fees on loans ............. 2,502,460 ----------- ----------- Total loans (including fees)........$430,905,905 $46,004,376 10.68% Investment securities(3) - ------------------------ Taxable ...................$ 38,079,718 $ 2,467,835 6.48% Tax exempt(4) ............. 9,210,719 403,507 4.38% ----------- ---------- Total investment Securities ............$ 47,290,437 $ 2,871,342 6.07% Other short-term Investments ............. 2,409,152 129,080 5.36% ----------- ----------- Total interest- earning assets ........$480,605,494 $49,004,798 10.20% ----------- ----------- NON-INTEREST-EARNING ASSETS: Cash and due from Banks ...................$ 17,589,326 Premises and Equipment ............... 9,355,616 Other, less allowance for loan losses ......... 5,945,568 ------------ Total non-interest- earning assets..........$ 32,890,510 ------------ Total average assets......$513,496,004 ============ 1996 ----------------------------------------- Average Revenue/ Yield/ Balance Expense Rate ------- ------- ---- INTEREST-EARNING ASSETS: Loans(1) - -------- Commercial ................ $173,178,149 $14,967,334 8.64% Installment - net(2)....... 174,667,162 19,022,302 10.89% Fees on loans ............. 1,395,467 ------------ ----------- Total loans (including fees)........ $347,845,311 $35,385,103 10.17% Investment securities(3) - ------------------------ Taxable ................... $ 51,687,569 $ 3,125,592 6.05% Tax exempt(4) ............. 10,953,312 496,705 4.53% ------------ ----------- Total investment Securities ............ $ 62,640,881 $ 3,622,297 5.78% Other short-term Investments ............. 8,906,587 513,326 5.76% ------------ ----------- Total interest- earning assets ........ $419,392,779 $39,520,726 9.42% ------------ ----------- NON-INTEREST-EARNING ASSETS: Cash and due from Banks ................... $ 15,979,895 Premises and Equipment ............... 9,379,752 Other, less allowance for loan losses ......... 8,457,324 ------------ Total non-interest- earning assets.......... $ 33,816,971 ------------ Total average assets...... $453,209,750 ============ - --------------------------------------------- (1) Average loan balances include nonaccrual loans. Interest income collected on nonaccrual loans has been included. (2) Installment loans are stated net of unearned income. (3) The average balance of and the related yield associated with securities available for sale are based on the cost of such securities. (4) Tax exempt income has not been adjusted to tax-equivalent basis. 6 7 1998 1997 1996 ----------------------------------- --------------------------------- ----------------------------------- Average Revenue/ Yield/ Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate ------- ------- ---- ------- ------- ---- ----------- ------- ------ INTEREST-BEARING LIABILITIES: Deposits Savings, NOW accounts, and money markets.... $160,775,161 $ 3,849,723 2.39% $150,088,946 $ 3,930,293 2.62% $150,877,450 $ 3,536,624 2.34% Time deposits...... 255,872,184 13,975,781 5.46% 253,840,096 13,947,656 5.49% 207,440,687 11,641,179 5.61% ----------- ---------- ----------- ---------- ----------- ---------- Total deposits......$416,647,345 $ 17,825,503 4.28% $403,929,042 $ 17,877,949 4.43% $358,318,137 $15,177,803 4.24% Securities sold Under repurchase Agreement and Short-term Borrowings............ 2,943,827 115,784 3.93% 4,949,115 236,553 4.78% 4,931,307 227,613 4.62% Debt ................. 8,503,098 630,861 7.42% 16,147,018 1,029,430 6.38% 8,265,863 19,104 5.07% --------- ------- ---------- --------- --------- ------ Total interest- Bearing Liabilities........ $428,094,270 $ 18,572,148 4.34% $425,025,175 $ 19,143,932 4.50% $371,515,307 $15,824,520 4.26% ----------- ---------- ----------- ---------- ----------- ---------- NON-INTEREST-BEARING LIABILITIES: Demand deposits.....$ 39,821,855 $ 33,540,018 $ 30,945,475 Other liabilities... 6,033,556 5,904,610 5,680,694 ------------ ------------ ------------ Total liabilities...$ 45,855,411 $ 39,444,628 $ 36,626,169 Stockholders' equity. 52,491,098 49,026,201 45,068,274 ------------ ------------ ------------ Total liabilities and Stockholders' equity.$526,440,779 $513,496,004 $453,209,750 ============ ============ =========== Net interest income.. $ 32,220,308 $ 29,860,866 $23,696,206 ============ ============ ========== MARGIN ANALYSIS: Interest rate spread.... 5.96% 5.70% 5.16% ===== ===== ===== Net yield on Interest-earning assets (net interest margin)............... 6.53% 6.21% 5.65% ===== ===== ===== 7 8 Rate/Volume Analysis. The following table analyzes net interest income in terms of changes in the volume of interest-earning assets and interest-bearing liabilities and changes in yields and rates. The table reflects the extent to which changes in the interest income and interest expense are attributable to changes in volume (changes in volume multiplied by prior year rate) and changes in rate (changes in rate multiplied by prior year volume). Changes attributable to the combined impact of volume and rate have been separately identified. 1998 vs. 1997 1997 vs. 1996 --------------------------------------- ------------------------------------------ Rate/ Total Rate/ Total Volume Rate Volume Change Volume Rate Volume Change ------ ---- ------ ------ ------ ------ ------ ------ INTEREST INCOME: Loans net of unearned income $ 1,278 $ 523 $ 15 $ 1,816 $ 8,449 $ 1,752 $ 418 $10,619 Investment securities: Taxable ................... (567) (46) 11 (602) (823) 224 (59) (658) Tax exempt ................ (130) 12 (4) (122) (79) (17) 3 (93) Other short-term investments 664 5 26 695 (374) (36) 26 (384) ------- ------- ------- ------- ------- ------- -------- ------- Total interest income ..... 1,245 494 48 1,787 7,173 1,923 388 9,484 ------- ------- ------- ------- ------- ------- -------- ------- INTEREST EXPENSE: Savings, NOW accounts, and Money market accounts . 280 (336) (24) (80) (18) 414 (2) 394 Time deposits ............ 111 (83) (1) 27 2,603 (243) (54) 2,306 Short-term borrowings .... (96) (42) 17 (121) 1 8 -- 9 Debt ..................... (487) 169 (80) (398) 399 108 103 610 ------- ------- ------- ------- ------- ------- -------- ------- Total interest expense ... (192) (292) (88) (572) 2,985 287 47 3,319 ------- ------- ------- ------- ------- ------- -------- ------- Net interest income ......... $ 1,437 $ 786 $ 136 $ 2,359 $ 4,188 $ 1,636 $ 341 $ 6,165 ======= ======= ======= ======= ======= ======= ======== ======= At December 31, 1998, loans outstanding, net of unearned income and allowance for loan losses, were $466.7 million compared to $441.4 million at 1997 year end. The increase is primarily due to the Company's increased emphasis during fourth quarter 1998 on loan growth through implementation of a more-competitive commercial loan rate structure and the hiring of a senior commercial lender from a regional bank who brought new and significant seasoned lending relationships to the Bank and an experienced commercial lending staff. Average outstanding loans, net of unearned interest, for 1998 were $442.9 million, an increase of 2.78% from the 1997 average of $430.9 million. The average outstanding loans for 1996 were $347.8 million. The growth in average loans for the past three years can be attributed to the Company's continuing market expansion into surrounding counties through the Company's branch network and to the development of its other financing businesses and indirect financing. During 1998, the Company continued its expansion with a new branch in Cocke County and new offices in the consumer finance subsidiary. The marginal increase in interest income can be attributed to the decrease in the prime rate during the latter part of 1998. During 1997, increases in the prime rate were reflected in the slight increase in overall loan yields in 1997 compared to 1996. During 1996, the prime rate was generally constant at 8.25%. Average investment securities for 1998 were $35.6 million, compared to $47.3 million in 1997, and $62.6 million in 1996. In 1998, the average yield on investments was 6.04%, essentially the same as the 6.07% yield in 1997 and an increase from the 5.78% yield in 1996. This is reflective of the Company's substantial proportion of adjustable-rate securities comprising its investment portfolio and the reduction in the prime rate during the latter part of 1998. Income provided by the investment portfolio in 1998 was $2,147,244 as compared to $2,871,342 in 1997, and $3,662,297 in 1996. The decline in the average balance of investment securities from 1997 to 1998 was the result of funding the loan growth experienced by the Company during 1998. PROVISION FOR LOAN LOSSES. The Company's provision for loan losses decreased $2,536,195, or 42.6%, to $3,417,010 in 1998 from $5,953,205 in 1997. The decrease in the provision for loan losses is 8 9 primarily attributable to a reduction in problem loans associated with Superior Financial in prior years and management's assessment of the reduced risk profile in its existing portfolio. The ratio of loans 30 days or more past due to total gross loans for consumer loans originated by Superior Financial decreased from 7.61% at December 31, 1996 to 5.12% at December 31, 1997 and to 2.58% at December 31, 1998. Management of the Company believes that these past due and nonperforming loans originated by its consumer finance subsidiary reflect the risk inherent in this type of business. However, management also believes this risk is also offset by the net benefits attributable to operation of the finance company, including a higher net yield on these types of loans, market penetration and diversification of the Company's activities into non-traditional lending areas. To further manage its credit risk on loans, the Company maintains a "watch list" of loans that, although currently performing, have characteristics that require closer supervision by management. At December 31, 1998, the Company had identified $11.2 million in loans that were placed on its "watch list." The Company's provision for loan losses in 1997 increased by $2,980,012 or 100.23%, to $5,953,205 in 1997 from $2,973,193 in 1996. This increase reflects the Company's more aggressive identification of potential problem loans and the inclusion of the risks associated with such loans in the determination of the Company's allowance for losses. In addition, the increase reflected management's assessment of the risk of loss in its loan portfolio, as indicated by its increasing amount of charge-offs. In 1997, the Company's net charge-offs increased $3.4 million or 456% to $4.1 million from $737,000 in 1996. The Company's net charge-offs to average loans outstanding increased in 1997 to 0.95% from 0.21% in 1996, a 352% growth that exceeded the growth in the Company's average loans outstanding during the same period. These charge-offs were primarily attributable to consumer loans originated by Superior Financial during the period 1994 through 1997 and both secured and unsecured loans. The Company's provision for loan losses in 1996 increased by $1,549,541 or 108.8%, to $2,973,193 in 1996 from $1,423,656 in 1995. This increase reflected the Company's more aggressive identification of potential problem loans and the inclusion of the risks associated with such loans in the determination of the Company's allowance for losses. In addition, the provision reflected the perceived risk associated with commercial loans originated by the Company which have higher individual balances and are more susceptible to delinquency than mortgage installment and installment real estate loans. This approach is consistent with the Company's concurrent imposition during 1995 of stricter loan underwriting standards. From 1995 to 1996, nonperforming assets increased $0.2 million, or 9.5%, from $2.1 million in 1995 to $2.3 million in 1996. NON-INTEREST INCOME. Income that is not related to interest-earning assets, consisting primarily of service charges, commissions and fees, has become more important as increases in levels of interest-bearing deposits and other liabilities make it more difficult to maintain interest rate spreads. Total non-interest income for 1998 was $4,555,489 as compared to $3,921,116 in 1997 and $3,410,780 in 1996. The largest components of non-interest income are service charges, commissions and fees, which totaled $3,742,053 in 1998, $3,168,699 in 1997 and $2,593,594 in 1996. The increase from 1997 to 1998 reflects management's continued focus on the generation of fee income and additional fee income generated by the subsidiaries of Greene County Bank. NON-INTEREST EXPENSE. Control of non-interest expense also is an important aspect in managing net income. Non-interest expense includes, among others, personnel, occupancy, and other expenses such as data processing, printing and supplies, legal and professional fees, postage and Federal Deposit Insurance Corporation assessments. Total non-interest expense was $20,461,962 in 1998, compared to $17,008,839 in 1997 and $14,799,910 in 1996. 9 10 Personnel costs are the primary element of the Company's non-interest expenses. In 1998, salaries and benefits represented $11,458,768 or 56.0% of total non-interest expenses. This was an increase of $1,933,566 or 20.3% over 1997's total of $9,525,202. Personnel costs for 1997 increased $1,631,567 or 20.7% over 1996's total of $7,893,635. These increases were due to opening a new branch requiring increased staff levels and increased employee benefit costs, including health insurance and retirement benefit costs. Overall, the number of full-time equivalent employees at December 31, 1998 was 307 versus 268 at December 31, 1997, an increase of 14.6%. Occupancy and furniture and equipment expense exhibited the same upward trend during the past three years as did personnel costs due to essentially the same reasons referenced above. At December 31, 1998, the Company had 35 branches compared to 29 branches at December 31, 1997. Assessments by the FDIC increased from $6,187 in 1996 to $54,989 in 1997 and increased to $65,414 in 1998. These premiums, representing a percentage of deposit base, and based upon deposit levels at period ends, have been consistently reduced and essentially eliminated for well-capitalized banks such as those owned by the Company, although premiums are still being assessed for repayment of debt incurred by the federal government in connection with the deposit insurance fund (i.e., the "FICO bonds"). For 1999, the FDIC premiums (including assessments for the FICO bonds) are calculated at 1.176 basis points on the assessable deposit base. The Company's premiums for 1999 are estimated to be $55,000 assuming the same deposit base at December 31, 1998. Other expenses increased $1,307,247, or 27.0%, from 1997 to 1998 representing primarily the Company's new bank branch, which required additional advertising, postage, telephone and other expenses, as well as increased expenses related to new programs for customer product delivery. The increase from 1996 to 1997 was $85,012, or 1.8%. CHANGES IN FINANCIAL CONDITION Total assets at December 31, 1998 were $568.2 million, an increase of $34.1 million, or 6.4%, over 1997's year end total assets of $534.1 million. Average assets for 1998 were $526.4 million, an increase of $12.9 million or 2.5% over 1997 average assets of $513.5 million. This increase was the result of loan growth, funded by increases in average deposits and, to a lesser extent, by FHLB advances. Return on average assets was 1.56% in 1998, as compared to 1.33% in 1997 and 1.32% in 1996. Earning assets consist of loans, investment securities and short-term investments that earn interest. Average earning assets during 1998 were $493.3 million, an increase of 2.6% from an average of $480.6 million in 1997. Non-performing loans include non-accrual and classified loans. The Company has a policy of placing loans 90 days delinquent in non-accrual status and charging them off at 120 days past due. Other loans past due that are well secured and in the process of collection continue to be carried on the Company's balance sheet. For further information, see Note 1 of the Notes to Consolidated Financial Statements. The Company has aggressive collection practices in which senior management is significantly and directly involved. The Company maintains an investment portfolio to provide liquidity and earnings. Investments at year end 1998 with an amortized cost of $30.2 million had a market value of $30.3 million. At year end 1997, investments with an amortized cost of $41.3 million had a market value of $41.5 million. This decline in investments in 1998 reflects the Company's continuing shift of funds to higher-yielding commercial and consumer lending. 10 11 The Company's deposits were $459.2 million at December 31, 1998. This represents a decrease of $2.5 million, or 0.5%, from the $461.7 million of deposits at December 31, 1997. The decrease is primarily the result of a reduction in certificates of deposit in late 1998 due to the Company's policy of funding increased loan demand via lower-cost vehicles such as borrowing from the Federal Home Loan Bank of Cincinnati. Although year-end balances of deposits declined in 1998 as compared to 1997, the Company's average deposit balances increased during 1998. In 1998, demand deposit balances increased 3.8% from 1997. Demand deposit balances were approximately $37.1 million and $35.7 million at December 31, 1998 and 1997, respectively. Average interest-bearing deposits increased $12.7 million, or 3.1%, in 1998. In 1997, average interest-bearing deposits increased $45.6 million or 12.7% over 1996. These increases in deposits are reflective of the Company's aggressive efforts to attract new deposit customers for the purpose of funding various lending programs. The Company's continued ability to fund its loan and overall asset growth remains dependent upon the availability of deposit market share in the Company's existing market of East Tennessee. As of June 30, 1998, approximately 64.7% of the deposit base of East Tennessee was controlled primarily by five commercial banks, one savings bank and one credit union and, as of September 1998, the total deposit base of Tennessee commercial banks had a weighted average rate of 4.79%. Management of the Company does not anticipate further significant growth in its deposit base unless it either offers interest rates well above its prevailing weighted average rate of 4.28% or it acquires deposits from other financial institutions. During 1998, the premiums charged in Tennessee by selling financial institutions for deposit accounts ranged from 6.7% to 37.8%. If the Company takes action to increase its deposit base by offering above-market interest rates or by acquiring deposits from other financial institutions and thereby increases its overall cost of deposits, its net interest income could be adversely affected if it is unable to correspondingly increase the rates it charges on its loans. Interest paid on deposits in 1998 totaled $17,825,503 reflecting a 4.28% cost on average interest-bearing deposits of $416.6 million. In 1997, interest of $17,877,949 was paid at a cost of 4.43% on average deposits of $403.9 million. In 1996, interest of $15,177,803 was paid at a cost of 4.24% on average deposits of $358.3 million. INTEREST RATE SENSITIVITY Deregulation of interest rates and more volatile short-term, interest-bearing deposits have created a need for shorter maturities of earning assets. An increasing percentage of commercial and installment loans are being made with variable rates or shorter maturities to increase liquidity and interest rate sensitivity. The difference between interest-sensitive asset repricing and interest-sensitive liability repricing within time periods is referred to as the interest rate sensitivity gap. Gaps are identified as either positive (interest sensitive assets in excess of interest sensitive liabilities) or negative (interest sensitive liabilities in excess of interest sensitive assets). The Company currently believes it is slightly asset sensitive. The Company considers certain demand and time deposits as having longer maturities than what may be considered typical for the industry and, thus, its liabilities are not as sensitive to changes in interest rates. On December 31, 1998, the Company had a positive cumulative one-year gap position of $76.7 million, indicating that while $350.9 million in assets were repricing, only $274.2 million in liabilities would reprice in the same time frame. 11 12 The following table reflects the Company's interest rate gap position at December 31, 1998 based upon repricing dates rather than maturity dates. This table represents a static point in time and does not consider other variables such as changing relationships or interest rate levels. ------------------------------------------------------------- Expected Maturity Date ------------------------------------------------------------- 1999 2000 2001 2002 ---- ---- ---- ---- (Dollars in Thousands) INTEREST-EARNING ASSETS: Loans, net of allowance for loan losses................. $ 300,323 $ 66,221 $ 47,731 $ 24,329 Average interest rate....... 8.81% 9.44% 9.25% 9.05% Investment securities........... $ 26,299 $ 1,948 $ 830 $ 759 Average interest rate...... 5.56% 4.83% 5.37% 4.60% Federal funds sold.............. $ 24,300 -- -- -- Average interest rate....... 4.75% -- -- -- ---------- ---------- ---------- ---------- Total interest-earning Assets...................... $ 350,922 $ 68,169 $ 48,561 $ 25,088 ---------- ---------- ---------- ---------- INTEREST-BEARING LIABILITIES(1): Savings and time deposits....... $ 205,176 $ 53,661 $ 16,549 $ 6,716 Average interest rate....... 5.02% 4.79% 4.01% 3.51% Money market and Transaction accounts........ $ 34,984 $ 19,578 $ 19,578 $ 14,756 Average interest rate....... 1.86% 1.79% 1.79% 1.66% Debt and other borrowed money(2)........................ $ 31,667 $ 87 $ 87 $ 187 Average interest rate....... 5.15% 5.94% 5.94% 7.04% Securities sold under agreement to repurchase...... $ 2,416 $ -- $ -- $ -- Average interest rate........ 4.00% -- -- -- ---------- ---------- ---------- ---------- Total interest-bearing liabilities..................... $ 274,243 $ 73,326 $ 36,214 $ 21,659 ========== ========== ========== ========== Interest sensitivity gap............ $ 76,679 $ (5,157) $ 12,347 $ 3,429 ========== ========== ========== ========== Cumulative interest Sensitive gap..................... $ 76,679 $ 71,522 $ 83,869 $ 87,298 ========== ========== ========== ========== Interest sensitive gap to Total assets...................... 13.49% -0.91% 2.17% 0.60% ========== ========== ========== ========== Cumulative interest Sensitive gap to total assets..... 13.49% 12.58% 14.75% 15.36% ========== ========== ========== ========== --------------------------------------------------------------- Expected Maturity Date --------------------------------------------------------------- 2003 Thereafter Total Fair Value ---- ---------- ----- ---------- (Dollars in Thousands) INTEREST-EARNING ASSETS: Loans, net of allowance for loan losses................. 12,118 $ 15,939 $ 466,661 $ 467,522 Average interest rate....... 8.67% 8.64% 8.95% Investment securities........... 103 $ 408 $ 30,347 $ 30,347 Average interest rate...... 4.69% 4.28% 5.47% Federal funds sold.............. -- -- $ 24,300 $ 24,300 Average interest rate....... -- -- 4.75% ---------- ---------- ---------- ---------- Total interest-earning Assets...................... $ 12,221 $ 16,347 $ 521,308 $ 522,169 ---------- ---------- ---------- ---------- INTEREST-BEARING LIABILITIES(1): Savings and time deposits....... $ 5,689 $ 9,512 $ 297,303 $ 294,227 Average interest rate....... 2.75% 2.25% 4.76% Money market and Transaction accounts........ $ 14,756 $ 21,174 $ 124,826 $ 112,175 Average interest rate....... 1.66% 1.51% 1.73% Debt and other borrowed money(2)........................ $ 219 $ 4,380 $ 36,627 $ 36,610 Average interest rate....... 7.15% 6.97% 5.19% Securities sold under agreement to repurchase..... $ -- $ -- $ 2,416 $ 2,416 Average interest rate....... -- -- 4.00% ---------- ---------- ---------- ---------- Total interest-bearing liabilities..................... $ 20,664 $ 35,066 $ 461,172 $ 450,228 ========== ========== ========== ========== Interest sensitivity gap............ $ (8,443) $ (18,719) $ 60,136 $ 71,941 ========== ========== ========== ========== Cumulative interest Sensitive gap..................... $ 78,855 $ 60,136 $ 60,136 $ 71,941 ========== ========== ========== ========== Interest sensitive gap to Total assets...................... -1.49% -3.29% 10.58% 12.65% ========== ========== ========== ========== Cumulative interest Sensitive gap to total assets..... 13.87% 10.58% 10.58% 12.65% ========== ========== ========== ========== (1) The Company has presented substantial balances of deposits as non-rate sensitive and/or not repricing within one year. (2) For further information regarding fair value of debt instruments, see Note 18 of Notes to Consolidated Financial Statements. Accounts also include a note payable to a related party. See Note 5 of Notes to Consolidated Financial Statements. The above table reflects a positive cumulative gap position in all maturity classifications. This is the result of core deposits being used to fund shorter term interest earning assets, such as loans and investment securities. A positive cumulative gap position implies that interest earning assets (loans and investments) will reprice at a faster rate than interest-bearing liabilities (deposits). In a rising rate environment, this position will generally have a positive effect on earnings, while in a falling rate environment this position will generally have a negative effect on earnings. Other factors, however, including the speed at which assets and liabilities reprice in response to changes in market rates and the interplay of competitive factors, can also influence the overall impact on net income of changes in interest rates. Management believes that a rapid, significant and prolonged increase or decrease in rates could have a substantial adverse impact on the Company's net interest margin. 12 13 INFLATION The effect of inflation on financial institutions differs from its impact on other types of businesses. Since assets and liabilities of banks are primarily monetary in nature, they are more affected by changes in interest rates than by the rate of inflation. Inflation generates increased credit demand and fluctuation in interest rates. Although credit demand and interest rates are not directly tied to inflation, each can significantly impact net interest income. As in any business or industry, expenses such as salaries, equipment, occupancy, and other operating expenses also are subject to the upward pressures created by inflation. Since the rate of inflation has been stable during the last several years, the impact of inflation on the earnings of the Company has been insignificant. EFFECT OF NEW ACCOUNTING STANDARDS In June 1997, the FASB issued SFAS No. 130, "Reporting of Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a complete set of financial statements. This statement also requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Reclassification of financial statements for earlier periods for comparative purposes is required. Adoption of this new standard did not have a material effect on the Company's financial condition or the results of its operations. The Company adopted SFAS No. 130 on January 1, 1998. In June, 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting by public companies of operating segments in annual financial statements and requires that those enterprises also report selected information about operating segments in interim financial reports issued to shareholders. This statement also establishes standards for related disclosures about products and services, geographic areas, and major customers. This statement requires the reporting of financial and descriptive information about an enterprise's reportable operating segments. This statement is effective for periods beginning after December 15, 1997. In the initial year of application, comparative information for earlier years must be restated. The disclosure impact of SFAS No. 131 is described in Note 20 of the Consolidated Financial Statements. The Company adopted SFAS No. 131 on December 31, 1998. During February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." The statement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans. Restatement of disclosures for earlier periods for comparative purposes is required. The disclosure impact of SFAS No. 132 is described in Note 11 of the financial statements. The Company adopted SFAS No. 132 on December 31, 1998. In June, 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." The statement established 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. 13 14 SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. A company may also implement the statement as of the beginning of any fiscal quarter after issuance (that is, fiscal quarters beginning June 16, 1998 and thereafter). SFAS No. 133 cannot be applied retroactively. SFAS No. 133 must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired or substantively modified after December 31, 1997 (and, at the Company's election, before January 1, 1998). The Company has not yet quantified the impacts of adopting SFAS No. 133 on its financial statements and has not determined the timing or method of its adoption of SFAS No. 133. However, the statement could increase volatility in earnings and other comprehensive income. The FASB has issued SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise." The statement requires that an entity engaged in mortgage banking activities classify any resulting mortgage-backed securities or other retained interests based on its ability and intent to sell or hold these investments. The statement is effective for 1999 for the Company; however, management does not expect this pronouncement to have a significant impact on the Company's financial position. YEAR 2000 The Year 2000 issue is the result of computer programs being written using two digits rather than four to define the applicable year. The Company's computer equipment and software and devices with imbedded technology that are time-sensitive may recognize a date using "00" as the year 1900 rather than the year 2000 and thereafter. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions and/or invoices or engage in similar normal business activities. The Company has been actively involved in Year 2000 ("Y2K") issues and has assessed its state of readiness by evaluating its information technology ("IT") and non-IT systems. IT systems commonly include data processing, accounting, telephone/PBX systems, etc. Examples of non-IT systems are alarm systems, fax machines and other miscellaneous systems. With respect to its mission critical IT systems, the Company estimates that its Y2K identification, assessment, remediation and testing efforts are substantially complete. Test results have been reviewed by the Company's internal auditing coordinator in conjunction with financial industry consultants. During 1999, further testing will be carried out in order to ensure that all systems are working properly. The Company has assessed its Y2K status in regard to non-IT systems and has determined that no material risk exists. The Company has also verbally communicated with its significant vendors in order to determine the extent to which interfaces with such entities are vulnerable to Y2K issues and whether the products and services purchased from such entities are Y2K compliant. The Company has received either verbal or written assurance from these vendors that they expect to address all their significant Y2K issues on a timely basis. Further, the Company has conducted telephonic Y2K evaluations with significant depositors and/or borrowers and has evaluated the responses as part of its Y2K assessment. With respect to significant depositors, the Company does not anticipate any material Y2K issues. The Company has assessed the results of its evaluation regarding significant borrowers and such results are reflected in its allowance for loan losses for the year ended December 31, 1998. The Company also began in June 1998 incorporating the Y2K issue in its underwriting process as it relates to significant borrowers, and has begun communicating the Y2K issue to its checking account base via statement fliers. Further, the Company has been conducting Y2K awareness seminars with its customer base beginning in January 1999. 14 15 The Company believes that the cost of its Y2K identification, assessment, remediation and testing efforts will not exceed $200,000 in terms of incremental cash outflows. The Company spent approximately $150,000 as of March 26, 1999 and expects to spend an additional $50,000 on such efforts. The source of these funds can be provided from cash flows from operations of the Company. The Company anticipates that the most likely worst case scenario will be a combination of several borrowers experiencing short term Y2K cash flow problems and a pre-Y2K increased cash demand from its overall customer base. The Company does not consider a computer system failure as likely because of the extensive pre-Y2K preparation by the Company. The other commonly discussed failure is a collapse of the power grid, which the Company considers unlikely in view of the reports made by the various power companies in the newspapers with respect to their Y2K readiness. If the Company has borrowers that experience Y2K cash flow problems, they will be dealt with in the same routine manner in which normal cash flow interruptions by borrowers are handled; however, the Company does not anticipate any material Y2K failure of borrowers due to the Company's ongoing review process. Any Y2K increase in cash demand will be funded by the Company's normal currency ordering procedures. The Company's Y2K coordinator will continue to review the status of the Company's Y2K readiness and report his findings to the Board of Directors. 15 16 Report of Independent Accountants To the Board of Directors Greene County Bancshares, Inc. In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, shareholders' equity and of cash flows present fairly, in all material respects, the financial position of Greene County Bancshares, Inc. and its subsidiaries at December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which 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, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. PricewaterhouseCoopers LLP Knoxville, Tennessee January 29, 1999 16 17 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1998 AND 1997 1998 1997 ASSETS Cash and due from banks $ 19,591,814 $ 20,687,367 Securities available-for-sale (Note 3) 26,726,813 33,851,953 Securities held-to-maturity - approximate market value of $3,619,748 and $7,637,774 in 1998 and 1997, respectively (Note 3) 3,619,992 7,627,126 Federal funds sold 24,300,000 5,500,000 Loans, net (Notes 4 and 5) 466,661,145 441,389,766 Premises and equipment, net (Note 6) 11,715,143 9,803,199 Accrued interest receivable 3,901,795 4,377,481 Deferred income taxes (Note 12) 2,648,178 2,447,858 Cash surrender value of life insurance contracts 4,136,062 3,904,675 Other assets 4,878,583 4,512,276 ---------------- ---------------- Total assets $ 568,179,525 $ 534,101,701 ================ ================ The accompanying notes are an integral part of these consolidated financial statements. 17 18 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1998 AND 1997 LIABILITIES AND SHAREHOLDERS' EQUITY Deposits (Note 7): Noninterest bearing demand deposits $ 37,053,958 $ 35,708,317 Interest bearing accounts: NOW 12,883,063 81,936,674 Money market transaction 111,966,713 30,228,480 Savings 47,526,285 46,800,738 Certificates of deposit $100,000 and over 52,022,269 61,002,308 Other certificates of deposit 197,731,072 206,052,041 ----------------- ----------------- Total deposits 459,183,360 461,728,558 ----------------- ----------------- Federal funds purchased 4,800,000 - Securities sold under agreements to repurchase 2,416,000 1,414,000 Accrued interest and other liabilities 9,767,259 5,359,563 Related party notes payable (Note 5) 2,511,418 2,561,418 Long-term debt (Note 8) 34,115,690 12,925,302 ----------------- ----------------- Total liabilities 512,793,727 483,988,841 ----------------- ----------------- Commitments and contingencies (Notes 9, 11, 13, 14 and 17) Shareholders' equity (Note 10): Common stock, par value $10, authorized 5,000,000 shares; issued and outstanding 1,357,198 and 1,354,500 shares in 1998 and 1997, respectively 13,571,980 13,545,000 Paid-in capital 4,172,180 4,052,656 Retained earnings 37,421,151 32,332,574 Accumulated other comprehensive income, net of income tax expense of $57,820 and $60,469 in 1998 and 1997, respectively 220,487 182,630 ----------------- ----------------- Total shareholders' equity 55,385,798 50,112,860 ----------------- ----------------- $ 568,179,525 $ 534,101,701 ================= ================= The accompanying notes are an integral part of these consolidated financial statements. (continued) 18 19 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF INCOME YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 Interest income: Loans $ 47,820,872 $ 46,004,376 $ 35,385,103 Securities available-for-sale 1,684,453 2,342,170 3,111,304 Securities held-to-maturity 462,791 529,172 510,993 Federal funds sold 824,340 129,080 513,326 -------------- -------------- -------------- Total interest income 50,792,456 49,004,798 39,520,726 Interest expense: Deposit accounts 17,825,503 17,877,949 15,177,803 Securities sold under agreements to repurchase 115,784 236,553 227,613 Related party notes payable 197,557 249,829 160,718 Long-term debt 433,304 779,601 258,386 -------------- -------------- -------------- Total interest expense 18,572,148 19,143,932 15,824,520 -------------- -------------- -------------- Net interest income 32,220,308 29,860,866 23,696,206 Provision for loan losses (3,417,010) (5,953,205) (2,973,193) -------------- -------------- -------------- Net interest income after provision for loan losses 28,803,298 23,907,661 20,723,013 Noninterest income: Service charges, commissions and fees 3,742,053 3,168,699 2,593,594 Net realized gains on calls of available-for-sale securities - 1,982 - Gain on sale of branch - 191,261 - Other income 813,436 559,174 817,186 -------------- -------------- -------------- Total noninterest income 4,555,489 3,921,116 3,410,780 -------------- -------------- -------------- Noninterest expense: Salaries and benefits 11,458,768 9,525,202 7,893,635 Occupancy expenses 1,413,988 1,219,125 1,057,418 Furniture and equipment expense 1,373,130 1,354,745 1,315,721 (Gain) loss on other real estate owned (5,310) 6,053 (240,252) Net realized losses on sales of available-for-sale securities - - 3,488 Federal insurance premiums 65,414 54,989 6,187 Other expenses 6,155,972 4,848,725 4,763,713 -------------- -------------- -------------- Total noninterest expense 20,461,962 17,008,839 14,799,910 -------------- -------------- -------------- Income before income taxes 12,896,825 10,819,938 9,333,883 Income tax expense: State 604,699 670,691 515,065 Federal 4,085,707 3,319,073 2,855,556 -------------- -------------- -------------- Total income tax expense 4,690,406 3,989,764 3,370,621 -------------- -------------- -------------- Net income $ 8,206,419 $ 6,830,174 $ 5,963,262 ============== ============== ============== Per share of common stock: Net income, basic $ 6.05 $ 5.04 $ 4.43 ============== ============== ============== Net income, assuming dilution $ 6.02 $ 5.03 $ 4.43 ============== ============== ============== The accompanying notes are an integral part of these consolidated financial statements. 19 20 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 Net income $ 8,206,419 $ 6,830,174 $ 5,963,262 Other comprehensive income, net of tax: Tax benefit from exercise of stock options 43,344 - 82,804 Unrealized gains (losses) on securities (5,487) 155,289 (291,923) ------------- ------------- ------------- Other comprehensive income 37,857 155,289 (209,119) ------------- ------------- ------------- Comprehensive income $ 8,244,276 $ 6,985,463 $ 5,754,143 ============= ============= ============= The accompanying notes are an integral part of these consolidated financial statements. 20 21 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 ACCUMULATED OTHER COMMON PAID-IN RETAINED COMPREHENSIVE STOCK CAPITAL EARNINGS INCOME TOTAL ----- ------- -------- ------ ----- December 31, 1995 $ 4,424,440 $ 2,914,724 $ 33,498,636 $ 236,460 $ 41,074,260 Net income - - 5,963,262 - 5,963,262 Other comprehensive loss, net of tax Unrealized loss on securities - - - (291,923) (291,923) Tax benefit from exercise of nonincentive stock options - - - 82,804 82,804 Dividends paid ($1.72 per share) - - (2,328,858) - (2,328,858) Issuance of 27,123 shares 90,410 1,135,381 - - 1,225,791 ------------- ------------- -------------- ------------ -------------- December 31, 1996 4,514,850 4,050,105 37,133,040 27,341 45,725,336 Net income - 6,830,174 - 6,830,174 Other comprehensive income, net of tax Unrealized gain on securities - - - 155,289 155,289 Dividends paid ($1.92 per share) - - (2,600,640) - (2,600,640) Issuance of 45 shares 150 2,551 - - 2,701 Three-for-one stock split 9,030,000 - (9,030,000) - - ------------- ------------- -------------- ------------ -------------- December 31, 1997 13,545,000 4,052,656 32,332,574 182,630 50,112,860 Net income - - 8,206,419 - 8,206,419 Other comprehensive loss, net of tax Unrealized loss on securities - - - (5,487) (5,487) Tax benefit from exercise of nonincentive stock options - - - 43,344 43,344 Dividends paid ($2.30 per share) - - (3,117,842) - (3,117,842) Issuance of 2,698 shares 26,980 119,524 - - 146,504 ------------- ------------- -------------- ------------ -------------- December 31, 1998 $ 13,571,980 $ 4,172,180 $ 37,421,151 $ 220,487 $ 55,385,798 ============= ============= ============== ============ ============== The accompanying notes are an integral part of these consolidated financial statements. 21 22 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 Net cash provided by operating activities: Net income $ 8,206,419 $ 6,830,174 $ 5,963,262 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 3,417,010 5,953,205 2,973,193 Provision for depreciation and amortization 993,523 1,146,564 1,096,120 Amortization of investment security premiums, net of accretion 314,599 420,829 515,996 Net realized (gains) losses on available-for-sale securities - (1,982) 3,488 Gain on sale of fixed assets (5,030) - - (Gain) loss on other real estate owned (5,310) 6,053 (240,252) Gain on sale of branch - (191,261) - Deferred income tax benefit (200,320) (573,157) (677,653) Increase in cash surrender value of life insurance contracts (231,387) (154,003) (170,472) Change in accrued income and other assets 437,319 (1,033,423) 1,238,459 Change in accrued interest and other liabilities 4,929,375 555,121 (1,047,045) ------------ ------------ ------------- Net cash provided by operating activities 17,856,198 12,958,120 9,655,096 ------------ ------------ ------------- Cash flows from investing activities: Acquisition of bank, net of acquired cash - - 1,022,043 Purchases of available-for-sale securities (1,950,832) (578,184) (14,766,578) Proceeds from sales of available-for-sale securities - - 2,000,000 Proceeds from maturities of available-for-sale securities 8,770,371 9,510,288 36,488,422 Purchases of securities held-to-maturity (75,000) - (6,815,907) Proceeds from maturities of securities held-to-maturity 4,065,000 1,800,000 6,748,835 Net originations of loans (30,247,073) (66,708,497) (76,092,935) Proceeds from sales of other real estate owned 544,369 347,370 337,605 Proceeds from sale of fixed assets 34,267 - - Fixed asset additions (2,718,705) (1,048,526) (1,845,545) Decrease (increase) in federal funds sold (18,800,000) (5,500,000) 23,800,000 Cash transferred in sale of branch - (988,302) - ------------ ------------ ------------- Net cash used by investing activities (40,377,603) (63,165,851) (29,124,060) ------------ ------------ ------------- The accompanying notes are an integral part of these consolidated financial statements. (continued) 22 23 GREENE COUNTY BANCSHARES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS, CONTINUED YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 1998 1997 1996 Cash flows from financing activities: Net increase in demand deposits, NOW, money market and savings accounts 14,755,810 5,259,522 11,056,917 Net increase (decrease) in certificates of deposit (17,301,008) 49,078,207 9,708,911 Increase in federal funds purchased 4,800,000 - - Increase (decrease) in securities sold under agreements to repurchase 1,002,000 (1,858,000) (1,512,000) Payments on related party notes payable (50,000) (50,000) (50,000) Payments on long-term debt (2,309,612) (19,769,657) (19,781,151) Borrowings of long-term debt 23,500,000 19,500,637 29,500,000 Proceeds from issuance and sale of common stock 146,504 2,701 484,366 Cash dividends paid (3,117,842) (2,600,640) (2,328,858) --------------- --------------- --------------- Net cash provided by financing activities 21,425,852 49,562,770 27,078,185 --------------- --------------- --------------- Net increase (decrease) in cash and cash equivalents (1,095,553) (644,961) 7,609,221 Cash and cash equivalents at beginning of year 20,687,367 21,332,328 13,723,107 --------------- --------------- --------------- $ 19,591,814 $ 20,687,367 $ 21,332,328 =============== =============== =============== The accompanying notes are an integral part of these consolidated financial statements. 23 24 GREENE COUNTY BANCSHARES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES: The accounting policies of Greene County Bancshares, Inc. (the Corporation) and subsidiary conform to generally accepted accounting principles and to general practices of the banking industry. The following is a summary of the more significant policies. Certain reclassifications have been made in the 1997 and 1996 consolidated financial statements and accompanying notes to conform with the 1998 presentation. PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of Greene County Bancshares, Inc. and its wholly-owned subsidiary, Greene County Bank (the Bank). The Corporation's other wholly-owned subsidiary, Premier Bank of East Tennessee, combined with the Bank in October 1998. Superior Financial Services, Inc. and GCB Acceptance Corp., Inc., consumer finance companies, are wholly owned subsidiaries of Greene County Bank. Superior Mortgage, Inc., a mortgage company and Fairway Title Co., Inc., a title company, are also wholly owned subsidiaries of Greene County Bank. All material intercompany balances and transactions have been eliminated in consolidation. CASH AND DUE FROM BANKS - For purposes of reporting cash flows, cash and due from banks include cash on hand, cash items in the process of collection and amounts due from banks with a maturity of less than three months. The Bank is required to maintain certain daily reserve balances on hand in accordance with Federal Reserve Board requirements. The average reserve balance maintained in accordance with such requirements was approximately $1,197,000 and $6,331,000 for the years ended December 31, 1998 and 1997, respectively. INVESTMENT SECURITIES - Investments in certain debt and equity securities are classified as either Held- to-Maturity (reported at amortized cost), Trading (reported at fair value with unrealized gains and losses included in earnings), or Available-for-Sale (reported at fair value with unrealized gains and losses excluded from earnings and reported as a separate component of comprehensive income). Premiums and discounts on investment securities are recognized in interest income on a method which approximates the level yield method over the period to maturity. Gains and losses from sales of investment securities are recognized at the time of sale based upon specific identification of the security sold. LOANS - Loans are stated at principal amounts outstanding, reduced by unearned income and an allowance for loan losses. Interest income on installment loans is recognized in a manner that approximates the level yield method when related to the principal amount outstanding. Interest on other loans is calculated using the simple interest method on the principal amount outstanding. 24 25 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED: Management assesses the adequacy of the allowance for loan losses by considering a combination of regulatory and credit risk criteria. The entire loan portfolio is graded and potential loss factors are assigned accordingly. The potential loss factors for impaired loans are assigned based on regulatory guidelines. The regulatory criteria are set forth in the Interagency Policy Statement on the Allowance for Loan and Lease Losses. The potential loss factors associated with unimpaired loans are based on historical net loss experience and management's review of trends within the portfolio and related industries. Generally, all loans within the portfolio are assigned a level of risk at inception. Thereafter, loans are reviewed on an ongoing basis, with commercial loans receiving more frequent review. The review includes loan payment and collateral status, borrowers' financial data and borrowers' internal operating factors such as cash flows, operating income, liquidity, leverage and loan documentation, and any significant change can result in an increase or decrease in the loan's assigned risk grade. Aggregate dollar volume by risk grade is monitored on an ongoing basis. Any changes of risk grades for consumer loans are usually based solely upon payment performance. Generally, the Bank maintains only a general loan loss allowance. This allowance is increased or decreased based upon management's assessment of the overall risk of its loan portfolio. Occasionally, a portion of the allowance may be allocated to a specific loan to reflect unusual circumstances associated with that loan. Management reviews certain key indicators on a monthly basis as well as year-end loss results. This review process provides a degree of objective measurement that is used in conjunction with periodic internal evaluations. To the extent that this process yields differences between estimated and actual observed losses, adjustments are made to provisions and/or the level of the allowance. Increases and decreases in the allowance for loan losses due to changes in the measurement of the impaired loans are included in the provision for loan losses. Loans continue to be classified as impaired unless they are brought fully current and the collection of scheduled interest and principal is considered probable. The Bank uses several factors in determining if a loan is impaired under Statement of Financial Accounting Standards (SFAS) No. 114. The internal asset classification procedures include a thorough review of significant loans and lending relationships and include the accumulation of related data. This data includes loan payment and collateral status, borrowers' financial data and borrowers' operating factors such as cash flows, operating income, liquidity, leverage and loan documentation, and any significant changes. A loan is considered impaired, based on current information and events, if it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Uncollateralized loans are measured for impairment based on the present value of expected future cash flows discounted at the historical effective interest rate, while all collateral-dependent loans are measured for impairment based on the fair value of the collateral. 25 26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED: At December 31, 1998 and 1997, the recorded investment in loans for which impairment has been recognized was approximately $7,345,000 and $2,570,000, respectively, and these loans had a corresponding valuation allowance of $1,079,000 and $358,000, respectively. The impaired loans at December 31, 1998 and 1997, were measured for impairment using the fair value of the collateral as all of these loans were collateral dependent. For the years ended December 31, 1998 and 1997, the average recorded investment in impaired loans was approximately $4,961,000 and $5,100,000, respectively. When a loan or portion of a loan is determined to be uncollectible, the portion deemed uncollectible is charged against the allowance and subsequent recoveries, if any, are credited to the allowance. Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days, unless such loans are well-secured and in the process of collection. If a loan or a portion of a loan is classified as doubtful or is partially charged off, the loan is generally classified as nonaccrual. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt. Loans may be returned to accrual status when all principal and interest amounts contractually due (including arrearages) are reasonably assured of repayment within an acceptable period of time, and there is a sustained period of repayment performance (generally a minimum of six months) by the borrower, in accordance with the contractual terms of interest and principal. While a loan is classified as nonaccrual and the future collectibility of the recorded loan balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding, except in the case of loans with scheduled amortizations where the payment is generally applied to the oldest payment due. When the future collectibility of the recorded loan balance is expected, interest income may be recognized on a cash basis. In the case where a nonaccrual loan had been partially charged off, recognition of interest on a cash basis is limited to that which would have been recognized on the recorded loan balance at the contractual interest rate. Receipts in excess of that amount are recorded as recoveries to the allowance for loan losses until prior charge-offs have been fully recovered. PREMISES AND EQUIPMENT - Premises and equipment are stated at cost less accumulated depreciation and amortization computed principally on the straight-line method based on the estimated useful lives of the respective assets. Leasehold improvements are stated at cost adjusted for accumulated amortization computed on a straight-line method over the shorter of the estimated useful life of the assets or the term of the lease. 26 27 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED OTHER REAL ESTATE OWNED - Other real estate owned represents real estate acquired through foreclosure or repossession and is initially recorded at the lower of cost (principal balance and any accrued interest of the former loan plus costs of obtaining title and possession) or fair value minus estimated costs to sell. Initial writedowns are charged against the allowance for loan losses. Initial costs relating to the development and improvement of the property are capitalized and considered in determining the fair value of the property, whereas those costs relating to holding the property are expensed. Valuations are periodically performed by management and if the carrying value of a property exceeds its net realizable value, the property is written down by a charge against income. OTHER ASSETS - Included in other assets are core deposit intangibles and goodwill which arose from the acquisition of Premier Bancshares in 1996. Management periodically evaluates the net realizability of the carrying amount of such assets. These assets will be amortized on a straight-line basis over their estimated useful lives of ten years. INCOME TAXES - The Corporation files a consolidated federal income tax return. There are two components of the income tax provision; current and deferred. Current income tax provisions approximate taxes to be paid or refunded for the applicable period. Balance sheet amounts of deferred taxes are recognized on the temporary differences between the bases of assets and liabilities as measured by tax laws and their bases as reported in the financial statements. Deferred tax expense or benefit is then recognized for the change in deferred tax liabilities or assets between periods. Recognition of deferred tax assets is based on management's belief that it is more likely than not that the tax benefit associated with certain temporary differences and tax credits will be realized in that sufficient taxes have been paid in prior years to provide for such realization. RETIREMENT BENEFITS - The Corporation has established two defined contribution plans, the cost of which is charged to current operations. Additionally, the Corporation has established certain supplemental deferred compensation plans which are funded through insurance policies as described in Note 11. STOCK-BASED COMPENSATION - On January 1, 1996, the Corporation adopted Statement of Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS 123). As permitted by SFAS 123, the Corporation has chosen to apply APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations in accounting for its Plans. The pro forma disclosures of the impact of SFAS 123 is described in Note 10 of the financial statements. NET INCOME PER SHARE OF COMMON STOCK - The Corporation follows Statement of Financial Accounting Standards No. 128, Earnings Per Share, which requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. 27 28 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, CONTINUED: COMPREHENSIVE INCOME - On January 1, 1998, the Corporation adopted Statement of Accounting Standards No. 130, Reporting of Comprehensive Income, which establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a complete set of financial statements. This statement also requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. Reclassification of financial statements for earlier periods for comparative purposes is required. Adoption of this new standard did not have a material effect on the Corporation's financial condition or the results of its operations. SEGMENT REPORTING - On December 31, 1998, the Corporation adopted Statement of Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, which establishes standards for reporting by public companies of operating segments in annual financial statements and requires that those enterprises also report selected information about operating segments in interim financial reports issued to shareholders. This statement also establishes standards for related disclosures about products. This statement requires the reporting of financial and descriptive information about an enterprise's reportable operating segments. The segment disclosures of SFAS 131 are described in Note 20 of the financial statements. DEFERRED COMPENSATION - On December 31, 1998, the Corporation adopted Statement of Accounting Standards No. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits. The statement revises employers' disclosures about pension and other postretirement benefit plans. It does not change the measurement or recognition of those plans. Restatement of disclosures for earlier periods for comparative purposes is required. The disclosure impact of SFAS 132 is described in Note 11 of the financial statements. STOCK SPLIT - On September 5, 1997, the Corporation announced a 3-for-1 stock split effected in the form of a 200% stock dividend, payable on October 3, 1997, to shareholders of record as of September 19, 1997. All references to the outstanding number of shares and earnings/dividends per share have been restated to reflect the split. SIGNIFICANT ESTIMATES - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The most significant estimate impacting the financial statements of the Corporation is the allowance for loan losses. Actual results could differ from these estimates. 28 29 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 2. ACQUISITION: On January 1, 1996, the Corporation acquired 100% of the stock of Premier Bancshares, Inc. (Premier), a one-bank holding company for Premier Bank of East Tennessee, Niota, Tennessee (Premier Bank). As of the acquisition date, Premier had assets of approximately $24.2 million, deposits of approximately $22.0 million, debt and other liabilities of approximately $.5 million, and capital of approximately $1.7 million. The purchase price of Premier was $3,140,000, consisting of cash of $708,582 and the Corporation's promissory notes to the sellers in the aggregate principal amount of $2,431,418, plus $230,000 for noncompete agreements with the sellers. The transaction was accounted for as a purchase, resulting in the recording of a core deposit intangible of approximately $1.1 million, goodwill of approximately $1.3 million, and an increase to deferred tax and other liabilities of approximately $.4 million. Amortization of the intangibles was approximately $216,000 in 1998 and 1997, respectively. Prior to March 31, 1996, the Corporation merged Premier into the Corporation since Premier had no assets other than the stock of Premier Bank. This transaction resulted in the Corporation owning 100% of the stock of Premier Bank. On October 16, 1998, the Corporation consolidated the operations of Premier Bank into the operations of the Bank. As a result, Premier Bank is no longer an active entity. 29 30 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 3. SECURITIES: At December 31, 1998 and 1997, securities have been classified in the consolidated financial statements according to management's intent. The carrying amount of securities and their approximate market values at December 31, 1998 and 1997, were as follows: 1998 - ---- GROSS GROSS GROSS APPROXIMATE AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUE Available-for-sale: U.S. treasury securities and obligations of U.S. government corporations and agencies $ 22,286,787 $ 247,880 $ 114,194 $ 22,420,473 Obligations of state and political subdivisions 1,094,267 18,473 - 1,112,740 Federal Home Loan Bank stock 3,193,600 - - 3,193,600 ------------- ---------- ---------- ------------- $ 26,574,654 $ 266,353 $ 114,194 $ 26,726,813 ============= ========== ========== ============= Held-to-maturity: Obligations of state and political subdivisions $ 3,619,992 $ 59,143 $ 59,387 $ 3,619,748 ============= ========== ========== ============= 1997 - ---- GROSS GROSS GROSS APPROXIMATE AMORTIZED UNREALIZED UNREALIZED MARKET COST GAINS LOSSES VALUE Available-for-sale: U.S. treasury securities and obligations of U.S. government corporations and agencies $ 30,132,241 $ 317,549 $ 165,945 $ 30,283,845 Obligations of state and political subdivisions 1,144,316 9,541 849 1,153,008 Federal Home Loan Bank stock 2,415,100 - - 2,415,100 ------------- ---------- ---------- ------------- $ 33,691,657 $ 327,090 $ 166,794 $ 33,851,953 ============= ========== ========== ============= Held-to-maturity: Obligations of state and political subsivisions $ 7,627,126 $ 43,507 $ 32,859 $ 7,637,774 ============= ========== ========== ============= 30 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 3. SECURITIES, CONTINUED: Interest income from securities for the years ended December 31, 1998, 1997 and 1996, consist of: 1998 1997 1996 U.S. treasury securities $ 139,297 $ 165,720 $ 421,236 Obligations of other U.S. government corporations and agencies 1,545,155 2,105,423 2,622,980 Obligations of states and political subdivisions 282,161 387,097 479,174 Other securities 180,631 213,102 98,907 ----------- ----------- ----------- $ 2,147,244 $ 2,871,342 $ 3,622,297 =========== =========== =========== Gross realized gains and losses on all sales of securities for the years ended December 31, 1998, 1997 and 1996, are as follows: 1998 1997 1996 Gross realized gains: Available-for-sale $ - $ 1,982 $ - ========== ========== ========== Gross realized losses: Available-for-sale $ - $ - $ 3,488 ========== ========== ========== Debt securities at December 31, 1998, will mature on the following schedule: AVAILABLE-FOR-SALE HELD-TO-MATURITY ------------------ ---------------- APPROXIMATE APPROXIMATE BOOK MARKET BOOK MARKET VALUE VALUE VALUE VALUE Due in one year or less $ 7,174,242 $ 7,185,293 $ 395,326 $ 397,601 Due after one year through five years 1,991,375 2,022,623 2,824,666 2,881,534 Due after five years through ten years 5,816,366 5,860,695 - - Due after ten years 11,592,671 11,658,202 400,000 340,613 ------------ ------------ ----------- ----------- $ 26,574,654 $ 26,726,813 $ 3,619,992 $ 3,619,748 ============ ============ =========== =========== Investment securities with book and market values of $8,238,621 and $8,256,203 at December 31, 1998, respectively and $4,918,255 and $4,953,389 at December 31, 1997, respectively, were pledged to secure public and trust deposits and for other purposes as required or permitted by law. 31 32 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 4. LOANS: Major classifications of loans at December 31, 1998 and 1997, are summarized as follows: 1998 1997 Commercial $ 121,294,075 $ 108,985,440 Commercial real estate 115,203,849 125,357,908 Mortgage installment 153,159,913 146,226,882 Installment consumer 80,147,158 72,751,994 Other loans 17,102,345 3,154,342 ------------- ------------- 486,907,340 456,476,566 Less: Unearned income (9,993,687) (5,932,977) Allowance for loan losses (10,252,508) (9,153,823) $ 466,661,145 $ 441,389,766 ============= ============= At December 31, 1998 and 1997, loans on which the accrual of interest had been discontinued totaled $4,159,303 and $2,264,634, respectively. Unrecorded interest income on these loans aggregated approximately $260,554, $112,300 and $169,100 for 1998, 1997 and 1996, respectively. Loans-in-process at December 31, 1998 and 1997 totaled $13,302,325 and $921,754, respectively. A summary of activity in the allowance for loan losses for the years ended December 31, 1998, 1997 and 1996, was as follows: 1998 1997 1996 Balance at beginning of year $ 9,153,823 $ 7,330,676 $ 4,654,234 Balances acquired in acquisition of Premier Bank - - 440,000 Provision for loan losses 3,417,010 5,953,205 2,973,193 Recoveries 915,893 1,012,092 888,249 ------------ ------------ ------------ 13,486,726 14,295,973 8,955,676 Loans charged to allowance (3,234,218) (5,142,150) (1,625,000) ------------ ------------ ------------ $ 10,252,508 $ 9,153,823 $ 7,330,676 ============ ============ ============ 32 33 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 5. RELATED PARTY TRANSACTIONS: Certain officers, employees and directors and/or companies in which they have ten percent or more beneficial ownership were indebted to the Bank as indicated below. In the opinion of management, all such loans were made in the ordinary course of business on the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated borrowers and did not involve more than the normal risk of collectibility. Balance, December 31, 1996 $ 11,388,251 Additions 2,711,499 Reductions (3,849,713) ------------ Balance, December 31, 1997 10,250,037 Additions 1,841,500 Reductions (1,820,008) ------------ Balances, December 31, 1998 $ 10,271,529 ============ In addition to the above, the Bank provides financing for purchasers of automotive and other transportation equipment from dealerships in which a director has more than a ten percent beneficial interest. Loans originated through these dealerships aggregated $1,739,085 during 1998 and $1,583,653 for 1997. Such financing is represented by installment notes that are the obligations of the purchasers and are primarily collateralized by the equipment. Some of these notes, totaling $65,198 and $8,868 at December 31, 1998 and 1997, respectively, are secondarily collateralized by dealer finance reserves and also provide for recourse against the dealerships to further protect the Banks against potential losses. As described in Note 2, the acquisition of Premier Bank generated promissory notes to the sellers and noncompete agreements with the sellers, a related party. These notes can be summarized as follows at December 31, 1998: Noncompete agreement, payable in yearly principal installments through January 2000 $ 80,000 8% note, interest payments due quarterly, principal payments January 15, 2003 through January 15, 2008 231,418 8% note, interest payments due quarterly, principal payments January 15, 2002 through January 15, 2008 2,200,000 ----------- $ 2,511,418 =========== 33 34 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 5. RELATED PARTY TRANSACTIONS, CONTINUED: Scheduled principal maturities of notes payable as of December 31, 1998, are: 1999 $ 40,000 2000 40,000 2001 - 2002 100,000 2003 131,418 Thereafter 2,200,000 ----------- $ 2,511,418 =========== 6. PREMISES AND EQUIPMENT: Premises and equipment at December 31, 1998 and 1997, was comprised of the following: 1998 1997 Land $ 1,892,120 $ 1,763,220 Banking quarters 7,720,215 6,951,635 Leasehold improvements 1,515,708 1,195,989 Furniture and fixtures 6,061,456 5,356,170 Construction in progress 899,082 117,352 Automobiles 361,257 378,996 ------------- ------------ 18,449,838 15,763,362 Less accumulated deprecition and amortization (6,734,695) (5,960,163) ------------- ------------ $ 11,715,143 $ 9,803,199 ============= ============ 7. DEPOSITS: The components of interest expense on deposits for the years ended December 31, 1998, 1997 and 1996, were: 1998 1997 1996 Interest bearing accounts: NOW $ 1,054,950 $ 1,556,528 $ 1,400,414 Money market transaction 1,584,073 1,132,337 950,906 Savings 1,210,700 1,241,428 1,185,304 Certificates of deposit $100,000 and over 3,070,421 3,093,701 2,080,723 Other certificates of deposit 10,905,359 10,853,955 9,560,456 ------------- ------------- ------------- $ 17,825,503 $ 17,877,949 $ 15,177,803 ============= ============= ============= 34 35 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 7. DEPOSITS, CONTINUED: During the year ended December 31, 1998, the Bank purchased software that allowed the Bank to re-class deposits held in the NOW accounts to the Money Market transaction account. The purpose of transferring funds from the NOW account to the Money Market transaction account is to reduce or eliminate the Bank's reserve requirement at the Federal Reserve. The Bank transferred approximately $74,000,000 to the Money Market transaction account in 1998. 8. LONG-TERM DEBT: The Bank has long-term debt arrangements with the Federal Home Loan Bank of Cincinnati (FHLB) to provide funding for the origination of fixed rate mortgages. This debt is collateralized by the Bank's blanket pledge of mortgage loans aggregating approximately $88,710,000 and stock of the Federal Home Loan Bank. Long-term debt at December 31, 1998 and 1997, was summarized as follows: 1998 1997 5.82% note, repaid February 15, 1998 $ - $ 4,000,000 5.88% note, repaid May 20, 1998 - 4,000,000 5.81% note, repaid December 2, 1998 - 2,000,000 5.65% note, payable in monthly installments of $21,854 through July 1, 2003 1,039,901 1,253,257 6.35% note, payable in monthly installments of $7,368 through September 1, 2013 842,357 878,824 6.10% note, payable in monthly installments of $8,493 through July 1, 2008 733,432 793,221 4.38% note, interest payments due monthly, principal due November 18, 2008 2,500,000 - 4.74% note, interest payments due monthly, principal due November 20, 2008 3,000,000 - 4.64% note, interest payments due monthly, principal due December 11, 2003 2,000,000 - 4.56% note, interest payments due monthly, principal due December 8, 2008 2,000,000 - 4.23% note, interest payments due monthly, principal due December 15, 2008 2,000,000 - 5.50% note, interest payments due monthly, principal due January 4, 1999 20,000,000 - ------------- ------------- $ 34,115,690 $ 12,925,302 ============= ============= 35 36 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 8. LONG-TERM DEBT, CONTINUED: Scheduled principal maturities of long-term debt outstanding as of December 31, 1998, are: 1999 $20,303,605 2000 321,755 2001 340,993 2002 361,383 2003 2,249,693 Thereafter 10,538,261 ----------- $34,115,690 =========== At December 31, 1998, the Corporation maintained three unused federal funds lines of credit totaling $20,000,000 with interest at the federal funds buy rate at three correspondent banks. The Corporation also maintains an unused line of credit of $20,000,000 with the Federal Home Loan Bank of Cincinnati with the option of selecting a variable rate of interest for up to 90 days. The line of credit will expire on September 5, 1999. The Bank also maintains a $25,000,000 letter of credit with the FHLB, which is used to pledge the Corporation's public deposits with the state collateral pool, at a quoted one-year variable interest rate which will expire December 16, 1999. 9. LEASES: The Corporation leases certain banking facilities and equipment under long-term operating lease agreements, which generally contain renewal options for periods ranging from 5 to 30 years, and require the payment of certain additional costs (generally maintenance and insurance). Future minimum lease payments for these noncancelable operating leases, with a term in excess of one year, at December 31, 1998 for each of the years in the five year period ending December 31, 2001, and thereafter were as follows: 1999 $ 169,074 2000 61,491 2001 15,138 2002 - 2003 - Thereafter - --------- $ 245,703 ========= The total rental expense for operating leases was $396,982, $164,506 and $305,618 for the years ended December 31, 1998, 1997 and 1996, respectively. 36 37 10. STOCK OPTIONS: On January 6, 1989, the Corporation established a stock option plan, whereby a certain key executive was granted options to purchase 300 shares per year of the Corporation's stock at one and one-half times book value at each year end. The number of options granted per year was increased to 600 as a result of a 1991 stock split, and 1,800 as a result of a 1997 stock split. The options are fully vested upon grant, expire ten years from the date of grant and are cancelled if the key executive voluntarily resigns his employment or is terminated for cause. Compensation expense recognized by the Corporation in connection with these options was $93,100, $82,800 and $30,000 for the years ended December 31, 1998, 1997 and 1996, respectively. During 1993, the Corporation granted certain other key executives stock option awards to purchase shares of the Corporation's stock. Shares under this plan are to be awarded at market price at the date of grant. In 1998, 1997 and 1996, the Corporation granted additional stock options to certain key executives to purchase 6,000, 5,540 and 4,980 shares at $115, $100 and $71.67 per share, respectively. If a key executive is a ten percent or greater stockholder at the time of exercise, the option price is increased by ten percent. The options granted in 1993 and 1994 are nonincentive stock options and are fully vested. The options granted in 1995 and subsequent years are incentive stock options and vest at the rate of twenty percent per year and expire ten years from the date of grant. 37 38 10. STOCK OPTIONS, CONTINUED: A summary of the status of the Corporation's Plans as of December 31, 1998, 1997 and 1996, and changes during the years ended on those dates is presented below: 1998 - ---- KEY EXECUTIVE OTHER KEY EXECUTIVES TOTAL ------------- -------------------- ------------- WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE EXERCISE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE Outstanding at beginning of year 3,600 $ 53.07 19,298 $ 72.19 22,898 $ 69.19 Granted 1,800 61.21 6,000 115.00 7,800 102.59 Exercised - - (2,698) 54.30 (2,698) 54.30 Forfeited - - (1,877) 80.63 (1,877) 80.63 -------- --------- --------- --------- --------- --------- Outstanding at end of year 5,400 $ 55.78 20,723 $ 86.15 26,123 $ 79.87 ======== ========= ========= ========= ========= ========= Options exercisable at year end 5,400 $ 55.78 7,785 $ 68.19 13,185 $ 63.11 ======== ========= ========= ========= ========= ========= Fair value of each option granted during the year $51.50 $17.42 ====== ====== 1997 - ---- Outstanding at beginning of year 1,800 $ 50.64 13,803 $ 60.99 15,603 $ 59.80 Granted 1,800 55.50 5,540 100.00 7,340 89.09 Exercised - - (45) 60.00 (45) 60.00 -------- --------- --------- --------- --------- --------- Outstanding at end of year 3,600 $ 53.07 19,298 $ 72.19 22,898 $ 69.19 ======== ========= ========= ========= ========= ========= Options exercisable at year end 3,600 $ 53.07 7,434 $ 55.63 11,034 $ 54.79 ======== ========= ========= ========= ========= ========= Fair value of each option granted during the year $46.99 $19.20 ====== ====== 38 39 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 10. STOCK OPTIONS, CONTINUED: 1996 ---- KEY EXECUTIVE OTHER KEY EXECUTIVE TOTAL ------------- --------------------- ------------------------ WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE Outstanding at beginning of year 11,244 $ 38.27 9,900 $ 54.44 21,144 $ 45.84 Granted 1,800 50.64 4,980 71.67 6,780 66.07 Exercised (11,244) 38.27 (1,077) 50.19 (12,321) 39.31 -------- ------- -------- -------- --------- -------- Outstanding at end of year 1,800 $ 50.64 13,803 $ 60.99 15,603 $ 59.80 ======== ======= ======== ======== ========= ======== Options exercisable at year end 1,800 $ 50.64 5,703 $ 52.21 7,503 $ 51.83 ======== ======= ======== ======== ========= ======== Fair value of each option granted during the year $26.72 $13.97 ====== ====== The following table summarizes information about the Plans' stock options at December 31, 1998: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------- ------------------- NUMBER WEIGHTED-AVERAGE NUMBER WEIGHTED RANGE OF OUTSTANDING REMAINING EXERCISABLE AVERAGE EXERCISE PRICES AT 12/31/98 CONTRACTUAL LIFE AT 12/31/98 EXERCISE PRICE *$50.64 - $61.21 5,400 9.0 5,400 $ 55.78 $48.33 - $71.67 9,969 7.0 6,136 $ 58.44 $100.00 - $115.00 10,754 9.6 1,649 $ 106.99 *Compensation for the key executive. Had compensation cost for the Corporation's Plans been determined based on the fair value at the grant dates for awards under the Plans consistent with the method of SFAS 123, the Corporation's net income and net income per share would have been reduced to the pro forma amounts indicated below: 1998 1997 1996 -------------------------- --------------------------- --------------------------- AS AS AS REPORTED PRO FORMA REPORTED PRO FORMA REPORTED PRO FORMA Net income $ 8,206,419 $ 8,151,888 $ 6,830,174 $ 6,775,830 $ 5,963,262 $ 5,924,579 Net income per share $ 6.05 $ 6.01 $ 5.04 $ 5.00 $ 4.43 $ 4.40 Net income per share, assuming dilution $ 6.02 $ 5.98 $ 5.03 $ 4.99 $ 4.43 $ 4.40 39 40 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 10. STOCK OPTIONS, CONTINUED: The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996, respectively: dividend growth rate of 15%, 12% and 12%; expected volatility of 9.8%, 10.38% and 7.75%: risk-free interest rates of 5%, 5.5% and 6.6%; and expected lives of 7 years, 7 years and 7 years. 11. PROFIT SHARING AND DEFERRED COMPENSATION: The Corporation has a contributory profit-sharing plan covering certain employees with one year or more of service. Participating employees have the option to contribute from three to ten percent of their monthly salary to the Plan. Effective January 1, 1998, the Corporation amended the profit-sharing plan to provide for a 2% company contribution. The Corporation contributed $80,600 in 1998. The Corporation made no contributions to this plan for the years ended December 31, 1997 and 1996. The Corporation also has a contributory money purchase plan covering certain employees with one year or more of service. While the employees do not contribute to the plan, the Corporation makes contributions. Effective January 1, 1998, the Corporation amended the money purchase plan to provide for a contribution in the amount of 13% of each eligible participant's gross earnings, less bonuses and vacations, actually paid or received. In the prior years the Corporation made contributions in an amount equal to 15% of each eligible participant's gross earnings, less bonuses and vacations, actually paid or received. The contributions by the Corporation for the money purchase plan were $539,400, $571,569 and $505,031 for 1998, 1997 and 1996, respectively. The Bank has established supplemental benefit plans for selected officers and directors. These plans are nonqualified and therefore, in general, a participant's or beneficiary's claim to benefits is as a general creditor. Directors of the Corporation and the Bank also have the right to participate in a deferred compensation plan which permits the directors to defer director compensation and earn a guaranteed interest rate on such deferred amounts. Compensation costs associated with the plan are charged to operations. Included in accrued interest and other liabilities in the consolidated financial statements is $1,033,053 and $938,323 at December 31, 1998 and 1997, respectively, related to the above supplemental benefit plans. To fund these plans, the Corporation purchased single premium universal life insurance contracts on the lives of the related directors and officers. The cash surrender value of such contracts is included in the consolidated balance sheets. If all of the assumptions regarding mortality, interest rates, policy dividends, and other factors are realized, the Corporation will ultimately realize its full investment in such contracts. 40 41 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 12. INCOME TAXES: The components of income tax expense for the years ended December 31, 1998, 1997 and 1996, were: 1998 1997 1996 Current income taxes: Federal $ 4,211,321 $ 3,831,898 $ 3,461,877 State 679,405 731,023 586,397 ----------- ----------- ----------- 4,890,726 4,562,921 4,048,274 Deferred income tax benefit (200,320) (573,157) (677,653) ----------- ----------- ----------- $ 4,690,406 $ 3,989,764 $ 3,370,621 =========== =========== =========== A reconciliation of expected federal tax expense based on the federal statutory rate of 34 percent to consolidated tax expense for the years ended December 31, 1998, 1997 and 1996, was as follows: 1998 1997 1996 Tax at statutory rates $ 4,384,921 $ 3,678,779 $ 3,173,520 Tax increases (decreases) attributable to: Tax exempt interest (121,401) (131,613) (180,099) State income tax less federal tax benefit 399,101 482,475 387,022 Interest expense disallowed 34,757 38,813 20,040 Dividends (32,770) (27,797) (11,551) Option compensation 31,650 28,152 10,200 Goodwill amortization 68,226 36,031 35,785 Cash surrender value earnings (71,505) (66,718) (58,557) Other (2,573) (48,358) (5,739) ------------ ------------ ------------ $ 4,690,406 $ 3,989,764 $ 3,370,621 ============ ============ ============ The significant components of the Corporation's deferred tax assets and liabilities at December 31, 1998 and 1997, were as follows: 1998 1997 Deferred tax assets: Allowance for loan losses and other real estate owned $ 3,652,946 $ 3,162,045 Deferred compensation 376,719 355,992 ------------ ------------ Gross deferred tax assets 4,029,665 3,518,037 ------------ ------------ Deferred tax liabilities: Depreciation 604,198 533,785 Unrealized appreciation on available-for-sale securities 57,820 60,469 Core deposit intangible 292,670 334,481 FHLB stock 210,085 141,444 Other 216,714 - ------------ ------------ Gross deferred tax liabilities 1,381,487 1,070,179 ------------ ------------ Net deferred tax asset $ 2,648,178 $ 2,447,858 ============ ============ 41 42 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 13. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK: The Bank is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in consolidated balance sheets. 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 notional amount of those instruments. The Bank uses the same credit policies in making these commitments and conditional obligations as it does for on-balance-sheet instruments. 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 many commitments expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer's credit worthiness on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Bank upon extension of credit is based on management's credit evaluation of the borrower. Collateral held varies but may include marketable securities, trade accounts receivable, property, plant, and equipment and/or income-producing commercial properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Most of the Bank's business activities are with customers located within the state of Tennessee for residential, consumer and commercial loans. A majority of the loans are secured by residential or commercial real estate or other personal property. The loans are expected to be repaid from cash flow or proceeds from the sale of selected assets of the borrowers. Outstanding standby letters of credit as of December 31, 1998 and 1997 amounted to $4,901,888 and $1,931,888, respectively. Outstanding commitments to lend at fixed rates were $17,244,863 and $1,608,807 and at variable rates were $6,088,328 and $3,423,217 at December 31, 1998 and 1997, respectively. Undisbursed advances on customer lines of credit were $58,284,854 and $61,141,551 at December 31, 1998 and 1997, respectively. The amount available for borrowing under inventory collateralized loans was $4,307,270 at December 31, 1998 and $3,970,495 at December 31, 1997. The Bank does not anticipate any losses as a result of these transactions that would be unusual in relation to its historical levels of loan losses on its recorded loan portfolio. 42 43 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 14. CAPITAL REQUIREMENTS AND DIVIDEND RESTRICTIONS: The Corporation and the 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 financial statements of the Corporation and the Bank. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involves quantitative measures of the assets, liabilities, and certain off-balance-sheet items of the Corporation and the Bank as calculated under regulatory accounting practices. The capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the table below) 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 total consolidated assets (as defined). Management believes, as of December 31, 1998 and 1997, that the Corporation and the Bank met all capital adequacy requirements to which they were subject. The Corporation and the Bank are well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Corporation and the Bank must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table. 43 44 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 14. CAPITAL REQUIREMENTS AND DIVIDEND RESTRICTIONS, CONTINUED: REGULATORY TO BE WELL REQUIREMENTS CAPITALIZED UNDER FOR CAPITAL PROMPT CORRECTIVE ACTUAL ADEQUACY PURPOSES ACTION PROVISIONS ------ ----------------- ----------------- AMOUNT RATIO AMOUNT RATIO AMOUNT RATIO ------ ----- ------ ----- ------ ----- As of December 31, 1998: Total Capital (to Risk Weighted Assets): Consolidated 58,868,000 13.02% 36,182,960 >8% 45,228,700 >10% - - Greene County Bank 60,368,000 13.35% 36,184,160 >8% 45,230,200 >10% - - Premier Bank* - 0.00% - 0% - 0% Tier I Capital (to Risk Weighted Assets): Consolidated 53,158,000 11.75% 18,091,480 >4% 27,137,220 >6% - - Greene County Bank 54,657,000 12.08% 18,092,080 >4% 27,138,120 >6% - - Premier Bank* - 0.00% - 0% - 0% Tier I Capital (to Average Assets): Consolidated 53,158,000 9.86% 21,570,320 >4% 26,962,900 >5% - - Greene County Bank 54,657,000 10.16% 21,524,840 >4% 26,906,050 >5% - - Premier Bank* - 0.00% - 0% - 0% As of December 31, 1997: Total Capital (to Risk Weighted Assets): Consolidated $ 53,035,000 12.33% $ 34,408,000 >8% $ 43,010,000 >10% - - Greene County Bank 51,457,000 12.87% 31,981,840 >8% 39,977,300 >10% - - Premier Bank 3,217,000 11.14% 2,310,320 >8% 2,887,900 >10% - - Tier I Capital (to Risk Weighted Assets): Consolidated 47,612,000 11.07% 17,204,000 >4% 25,806,000 >6% - - Greene County Bank 46,415,000 11.61% 15,990,920 >4% 23,986,380 >6% - - Premier Bank 2,854,000 9.88% 1,155,160 >4% 1,732,740 >6% - - Tier I Capital (to Average Assets): Consolidated 47,612,000 9.30% 20,481,840 >4% 25,602,300 >5% - - Greene County Bank 46,415,000 9.80% 18,939,440 >4% 23,674,300 >5% - - Premier Bank 2,854,000 7.67% 1,487,560 >4% 1,859,450 >5% - - * Combined with Greene County Bank in 1998 44 45 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 14. CAPITAL REQUIREMENTS AND DIVIDEND RESTRICTIONS, CONTINUED: The Corporation's principal source of funds is dividends received from the Bank. Under applicable banking laws, the Bank may only pay dividends from retained earnings and only to the extent that the remaining balance of retained earnings is at least equal to the capital stock amounts of the Bank. As a practical matter, dividend payments by the Bank to the Corporation would be limited by the necessity to maintain appropriate amounts for capital adequacy purposes under federal banking regulations. 15. ADDITIONAL CASH FLOW INFORMATION: Income taxes paid during the years ended December 31, 1998, 1997 and 1996 amounted to $4,523,019, $4,460,000 and $5,273,919, respectively. Interest expense paid in cash during the years 1998, 1997 and 1996 amounted to $18,845,800, $18,970,895 and $15,632,435, respectively. Significant noncash transactions for the years ended December 31, 1998, 1997 and 1996, were as follows: 1998 1997 1996 Financed sales of other real estate owned $ - $ 147,128 $ 59,750 Foreclosed loans transferred to OREO 1,558,684 784,769 380,587 Assets acquired/generated through bank purchase: Investments - - 6,750,643 Loans, net - - 14,638,794 Property, plant and equipment, net - - 567,992 Other assets - - 450,034 Intangibles - - 2,159,966 Liabilities assumed/generated through bank purchase: Deposits - - 22,005,281 Accrued interest and other liabilities - - 546,483 Notes payable - - 2,431,418 Noncompete payable - - 230,000 Deferred tax liability - - 376,290 45 46 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 16. PARENT COMPANY FINANCIAL INFORMATION: Condensed financial information for Greene County Bancshares, Inc. (parent company only) is as follows: CONDENSED BALANCE SHEETS DECEMBER 31, ------------ 1998 1997 ASSETS Cash $ 928,198 $ 983,385 Investments in subsidiary 55,371,639 50,043,024 Cash surrender value of life insurance contracts 202,963 193,524 Other assets 2,039,019 2,066,220 ------------ ------------ $ 58,541,819 $ 53,286,153 ============ ============ LIABILITIES Deferred income taxes $ 210,068 $ 302,980 Related party notes payable 2,511,418 2,561,418 Other liabilities 434,535 308,895 ------------ ------------ 3,156,021 3,173,293 ------------ ------------ SHAREHOLDERS' EQUITY Common stock 13,571,980 13,545,000 Paid-in capital 4,172,180 4,052,656 Retained earnings 37,421,151 32,332,574 Net unrealized depreciation on available-for-sale securities, net of income tax expense (benefit) of $57,820 and $60,469 in 1998 and 1997, respectively 220,487 182,630 ------------ ------------ Total shareholders' equity 55,385,798 50,112,860 ------------ ------------ Total liabilities and shareholders' equity $ 58,541,819 $ 53,286,153 ============ ============ 46 47 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 16. PARENT COMPANY FINANCIAL INFORMATION, CONTINUED: CONDENSED STATEMENTS OF EARNINGS YEARS ENDED DECEMBER 31, ------------------------ 1998 1997 1996 Revenue: Equity in undistributed earnings of subsidiary $ 5,334,099 $ 3,902,503 $ 3,862,086 Dividends from subsidiaries 3,355,057 3,347,855 3,022,100 Other income 147,130 126,212 107,871 ----------- ----------- ----------- Total revenue 8,836,286 7,376,570 6,992,057 Related party interest expense 197,557 247,215 160,718 Other expense 745,050 556,784 524,547 ----------- ----------- ----------- Income before income taxes 7,893,679 6,572,571 6,306,792 Income tax expense (benefit) (312,740) (257,603) 343,530 ----------- ----------- ----------- Net income $ 8,206,419 $ 6,830,174 $ 5,963,262 =========== =========== =========== 47 48 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 16. PARENT COMPANY FINANCIAL INFORMATION, CONTINUED: CONDENSED STATEMENTS OF CASH FLOWS 1998 1997 1996 Cash flows from operating activities: Net income $ 8,206,419 $ 6,830,174 $ 5,963,262 Adjustments to reconcile net income to net cash provided by operating activities: Equity in undistributed earnings of subsidiary (5,334,099) (3,902,503) (3,862,086) Depreciation and amortization 215,999 215,999 232,855 Change in other assets (281,713) (71,344) 537,500 Change in other liabilities 125,640 (30,959) (22,236) ----------- ----------- ----------- Net cash provided by operating activities 2,932,246 3,041,367 2,849,295 ----------- ----------- ----------- Cash flows from investing activities: Acquisition of bank - - (708,582) Increase in cash surrender value of life insurance contracts (9,439) (9,416) (6,128) ----------- ----------- ----------- Net cash used by investing activities (9,439) (9,416) (714,710) ----------- ----------- ----------- Cash flows from financing activities: Capital contributed to subsidiary - (500,000) - Proceeds from issuance and sale of common stock 189,848 2,701 484,366 Repayments of related party debt (50,000) (50,000) (50,000) Repayments of debt - - (327,239) Dividends paid (3,117,842) (2,600,640) (2,328,858) ----------- ----------- ----------- Net cash used by financing activities (2,977,994) (3,147,939) (2,221,731) ----------- ----------- ----------- Net decrease in cash (55,187) (115,988) (87,146) Cash at beginning of year 983,385 1,099,373 1,186,519 ----------- ----------- ----------- Cash at end of year $ 928,198 $ 983,385 $ 1,099,373 =========== =========== =========== 48 49 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 17. COMMITMENTS AND CONTINGENCIES: The Corporation is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Corporation's consolidated financial position, results of operations, or cash flows. 18. FAIR VALUES OF FINANCIAL INSTRUMENTS: The following information is presented as required by Statement of Financial Accounting Standards No. 107, Disclosures About Fair Value of Financial Instruments. For financial instruments not described below, generally short term financial instruments, book value approximates fair value. The following methods and assumptions were used to estimate the fair value of each class of financial instruments: SECURITIES AND INTEREST BEARING DEPOSITS - Fair values of securities and interest bearing deposits are based on quoted market prices. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. FEDERAL FUNDS SOLD - Fair values of federal funds sold are based on quoted market prices. LOANS, NET - The fair value for loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. DEPOSITS - The fair value of demand deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of certificates of deposit is estimated by discounting the future cash flows using the current rate offered for similar deposits with the same remaining maturities. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE - Fair values of securities sold under agreements to repurchase are based on quoted market prices. 49 50 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 18. FAIR VALUES OF FINANCIAL INSTRUMENTS, CONTINUED: The estimated fair values of the Corporation's financial instruments at December 31, 1998 and 1997, were as follows (rounded to the nearest thousand): 1998 1997 ---- ---- CARRYING FAIR CARRYING FAIR VALUE VALUE VALUE VALUE ----- ----- ----- ----- Financial assets: Securities $ 30,347,000 $ 30,347,000 $ 41,479,000 $ 41,490,000 Federal funds sold 24,300,000 24,300,000 5,500,000 5,500,000 Loans, net 466,661,000 467,521,000 441,390,000 438,824,000 Financial liabilities: Deposits $ 459,183,000 $ 442,375,000 $ 461,729,000 $ 444,939,000 Securities sold under agreements to repurchase 2,416,000 2,416,000 1,414,000 1,414,000 Federal funds purchased 4,800,000 4,800,000 - - Long-term debt 34,116,000 34,145,000 12,925,000 12,917,000 Related party notes payable 2,511,000 2,465,000 2,561,000 2,561,000 The Corporation believes that the fair value of commitments to extend credit and standby letters of credit approximate the stated amounts at December 31, 1998 and 1997. 19. EARNINGS PER SHARE OF COMMON STOCK: Basic earnings per share of common stock is computed by dividing net income available for common shareholders by the weighted average number of common shares outstanding. Diluted earnings per share is computed by dividing adjusted net income by the weighted average number of common shares and assumed conversions of dilutive securities outstanding during each year. Stock options are regarded as dilutive securities. Dilutive securities are computed using the treasury stock method. 50 51 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 19. EARNINGS PER SHARE OF COMMON STOCK, CONTINUED: The following is a reconciliation of the numerators and denominators used in the basic and diluted earnings per share computations for the years ended December 31, 1998, 1997 and 1996: 1998 1997 1996 ---- ---- ---- INCOME SHARES INCOME SHARES INCOME SHARES ----------- ------------- ----------- ------------- ----------- ------------ (NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR) BASIC EPS Income available to common shareholders $ 8,206,419 1,355,498 $ 6,830,174 1,354,498 $ 5,963,262 1,344,852 EFFECT OF DILUTIVE SECURITIES Stock options outstanding - 7,782 - 4,109 - 2,664 ----------- ----------- ----------- ----------- ----------- ----------- DILUTED EPS Income available to common shareholders plus assumed conversions $ 8,206,419 1,363,280 $ 6,830,174 1,358,607 $ 5,963,262 1,347,516 =========== =========== =========== =========== =========== =========== 20. SEGMENT INFORMATION: The Bank's principal business consists of attracting deposits from the general public and investing those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial real estate loans, consumer loans and single-family mortgage loans. The Bank has four wholly-owned subsidiaries; a consumer finance business, a mortgage banking operation, a subprime automobile lending operation and a title insurance business. These subsidiaries have been disclosed below in the other column as they do not meet quantitative threshold on an individual basis. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. Intersegment revenues and expenses are accounted for as if they were to third parties at current market prices. The reportable segments are strategic business units that offer different products and services. They are managed separately because each requires different marketing strategies. 51 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS, CONTINUED 20. SEGMENT INFORMATION, CONTINUED: 1998 BANK OTHER ELILMINATIONS TOTAL Interest income $ 45,035,584 $ 8,424,664 $ (2,667,792) $ 50,792,456 Interest expense 18,374,592 2,865,348 (2,667,792) 18,572,148 ------------- ------------- -------------- ------------- Net interest income $ 26,660,992 $ 5,559,316 $ - $ 32,220,308 ============= ============= ============== ============= Provision for loan losses $ 1,468,533 $ 1,948,477 $ - $ 3,417,010 Noninterest income 3,871,232 1,571,161 (886,904) 4,555,489 Noninterest expense 15,757,712 4,978,006 (273,756) 20,461,962 Income tax expense 4,616,824 73,582 - 4,690,406 ------------- ------------- -------------- ------------- Segment net income $ 8,689,155 $ 130,412 $ (613,148) $ 8,206,419 ============= ============= ============== ============= Segment assets $ 567,732,386 $ 100,471,188 $ (100,024,049) $ 568,179,525 ============= ============= ============== ============= 1997 Interest income $ 45,095,525 $ 5,477,748 $ (1,568,475) $ 49,004,798 Interest expense 18,962,133 1,750,274 (1,568,475) 19,143,932 ------------- ------------- -------------- ------------- Net interest income $ 26,133,392 $ 3,727,474 $ - $ 29,860,866 ============= ============= ============== ============= Provision for loan losses 2,816,227 3,136,978 - 5,953,205 Noninterest income 2,439,416 966,171 515,529 3,921,116 Noninterest expense 13,795,797 3,471,074 (258,032) 17,008,839 Income tax expense 4,712,409 (722,645) - 3,989,764 ------------- ------------- -------------- ------------- Segment net income $ 7,248,376 $ 1,191,763 $ 773,561 $ 6,830,174 ============= ============= ============== ============= Segment assets $ 532,305,851 $ 76,545,128 $ (74,749,278) $ 534,010,701 ============= ============= ============== ============= 1996 Interest income $ 38,096,534 $ 2,124,082 $ (699,890) $ 39,520,726 Interest expense 15,693,015 831,395 (699,890) 15,824,520 ------------- ------------- -------------- ------------- Net interest income $ 22,403,519 $ 1,292,687 $ - $ 23,696,206 ============= ============= ============== ============= Provision for loan losses $ 2,353,500 $ 619,693 $ - $ 2,973,193 Noninterest income 3,484,299 427,657 (501,176) 3,410,780 Noninterest expense 13,733,290 1,424,878 (358,258) 14,799,910 Income tax expense 2,913,354 457,267 - 3,370,621 ------------- ------------- -------------- ------------- Segment net income $ 6,887,674 $ (781,494) $ (142,918) $ 5,963,262 ============= ============= ============== ============= Segment assets $ 475,417,557 $ 57,421,739 $ (54,790,990) $ 478,048,306 ============= ============= ============== ============= 52 53 MARKET AND DIVIDEND INFORMATION There currently are 1,357,948 shares of Common Stock outstanding and approximately 1,650 holders of record of the Common Stock. There is no established public trading market in which shares of the Common Stock are regularly traded, nor are there any uniformly quoted prices for shares of the Common Stock. The following table sets forth certain information known to management as to the prices at the end of each quarter for the Common Stock and cash dividends declared per share of Common Stock for the calendar quarters indicated. Sales Price at Dividends Declared Quarter-End Per Share (2) ----------- ------------- FISCAL 1997: First quarter $ 76.67(1) $ 0.416(1) Second quarter 76.67(1) 0.417(1) Third quarter 83.33(1) 0.417(1) Fourth quarter 100.00 0.670 ---------- $ 1.920 ========== FISCAL 1998: First quarter $ 110.00 $ 0.500 Second quarter 110.00 0.500 Third quarter 115.00 0.500 Fourth quarter 115.00 0.800 ---------- $ 2.300 ========== - ------------------- (1) The sales price and dividend information has been restated to reflect the effect of the Company's 3-for-1 stock split effected as a stock dividend in October 1997. (2) For information regarding restrictions on the payment of dividends by the Bank to the Company, see "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Liquidity and Capital Resources" in this Annual Report. See also Note 14 of Notes to Consolidated Financial Statements. 53