1 SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 or the quarterly period ended September 30, 1999 or ------------------ [ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. For the transition period from __________________ to ___________________ Commission File No. 0-17222 WARREN BANCORP, INC. (Exact Name of registrant as specified in the charter) MASSACHUSETTS 04-3024165 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 10 MAIN STREET, PEABODY, MASSACHUSETTS 01960 (Address of principal executive offices) (Zip Code) (978) 531-7400 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such report(s), and (2) has been subject to such filing requirement for the past 90 days. Yes [x] No [ ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at November 8, 1999 - --------------------------------------- ------------------------------- Common Stock, par value $.10 per share 7,327,771 2 WARREN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ ASSETS Cash and due from banks (non-interest bearing) $ 7,038 $ 7,497 Money market funds and overnight investments 13,434 4,542 --------- --------- Cash and cash equivalents 20,472 12,039 Investment and mortgage-backed securities available for sale (amortized cost of $79,352 at September 30, 1999 and $102,055 at December 31, 1998) 79,823 103,294 Other investments (fair value of $7,034 at September 30, 1999 and $6,784 at December 31, 1998) 6,794 6,544 Loans held for sale 989 1,192 Loans 280,071 266,475 Allowance for loan losses (4,204) (4,023) --------- --------- Net loans 275,867 262,452 Banking premises and equipment, net 5,083 5,004 Accrued interest receivable 2,410 2,803 Real estate acquired by foreclosure 72 1,450 Other assets 2,278 2,287 --------- --------- Total assets $ 386,994 $ 390,521 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Deposits $ 348,027 $ 347,012 Borrowed funds 7,854 7,674 Escrow deposits of borrowers 1,132 1,065 Accrued interest payable 494 589 Accrued expenses and other liabilities 1,414 804 --------- --------- Total liabilities 358,921 357,144 --------- --------- Stockholders' equity: Preferred stock, $.10 par value; Authorized - 10,000,000 shares; Issued and outstanding - none -- -- Common stock, $.10 par value; Authorized - 20,000,000 shares; Issued - 8,094,414 shares at September 30, 1999 and December 31, 1998 Outstanding - 7,326,811 shares at September 30, 1999 and 7,826,691 shares at December 31, 1998 809 809 Additional paid-in capital 35,624 35,710 Retained earnings 4,490 4,516 Treasury stock, at cost, 767,603 shares at September 30, 1999 and 267,723 shares at December 31, 1998 (6,357) (1,913) --------- --------- 34,566 39,122 Unrealized gain on securities available for sale, net of income taxes 301 799 --------- --------- Total stockholders' equity 34,867 39,921 --------- --------- Total liabilities and stockholders' equity $ 393,788 $ 397,065 ========= ========= See accompanying notes to consolidated financial statements. 3 WARREN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, -------------------- -------------------- 1999 1998 1999 1998 ---- ---- ---- ---- (Dollars in thousands, except per-share data) Interest and dividend income: Interest on loans $ 5,713 $ 5,642 $ 16,825 $ 16,788 Interest and dividends on investments 1,213 1,279 3,764 3,739 Interest on mortgage-backed securities 271 423 885 1,397 ------- ------- -------- -------- Total interest and dividend income 7,197 7,344 21,474 21,924 ------- ------- -------- -------- Interest expense: Interest on deposits 2,865 3,023 8,542 8,789 Interest on borrowed funds 84 70 235 154 ------- ------- -------- -------- Total interest expense 2,949 3,093 8,777 8,943 ------- ------- -------- -------- Net interest income 4,248 4,251 12,697 12,981 Provision for (recovery of) loan losses 36 (22) 69 (90) ------- ------- -------- -------- Net interest income after provision for or recovery of loan losses 4,212 4,273 12,628 13,071 ------- ------- -------- -------- Non-interest income: Customer service fees 240 209 700 635 Gains on sales of investment securities, net 17 -- 17 188 Gains on sales of mortgage loans 43 112 196 243 Other 1 9 (16) 12 ------- ------- -------- -------- Total non-interest income 301 330 897 1,078 ------- ------- -------- -------- Income before non-interest expense and income taxes 4,513 4,603 13,525 14,149 ------- ------- -------- -------- Non-interest expense: Salaries and employee benefits 1,702 1,513 4,793 4,403 Office occupancy and equipment 262 291 796 892 Professional services 56 53 169 144 Marketing 35 62 140 189 Real estate operations (68) 14 (78) 40 Outside data processing expense 120 135 354 385 Other 464 415 1,320 1,277 ------- ------- -------- -------- Subtotal operating expenses 2,571 2,483 7,494 7,330 Expenses for formation of Warren Real Estate Investment Corporation 87 -- 87 -- ------- ------- -------- -------- Total non-interest expenses 2,658 2,483 7,581 7,330 ------- ------- -------- -------- Income before income taxes 1,855 2,120 5,944 6,819 Income tax expense 593 725 2,028 2,327 ------- ------- -------- -------- Net income $ 1,262 $ 1,395 $ 3,916 $ 4,492 ======= ======= ======== ======== Basic earnings per share $ 0.17 $ 0.18 $ 0.53 $ 0.58 ======= ======= ======== ======== Diluted earnings per share $ 0.17 $ 0.17 $ 0.51 $ 0.55 ======= ======= ======== ======== See accompanying notes to consolidated financial statements. 4 WARREN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS NINE MONTHS ENDED SEPTEMBER 30, ------------------------------- 1999 1998 -------- -------- (In thousands) Cash flows from operating activities: Net Income $ 3,916 $ 4,492 Adjustments to reconcile net income to net cash provided by operating activities: Provision for (recovery of) loan losses 69 (90) Depreciation and amortization 369 461 Deferred income tax expense 69 238 Amortization of premiums and discounts 487 259 (Gains) on sales of investment securities (17) (188) (Gains) on sales of mortgage loans (196) (243) (Gains) on sale of real estate acquired by foreclosure (30) (17) (Increase) decrease in loans held for sale 203 (499) (Increase) decrease in accrued interest receivable 393 (147) (Increase) decrease in other assets 209 (44) (Decrease) in accrued interest payable (95) (231) Increase in other liabilities and escrow deposits 690 373 -------- -------- Net cash provided by operating activities 6,067 4,364 -------- -------- Cash flows from investing activities: Purchase of investment securities (11,560) (36,945) Proceeds from sales of investment securities available for sale 17 2,525 Proceeds from maturities of investment securities 28,663 28,122 Proceeds from payments of mortgage-backed securities 4,864 7,435 Proceeds from sales of real estate acquired by foreclosure 91 547 Net (increase) in loans (11,971) (16,169) Purchases of premises and equipment (448) (611) -------- -------- Net cash provided by (used in) investing activities 9,656 (15,096) -------- -------- Cash flows from financing activities: Net increase in deposits 1,015 8,138 Proceeds from Federal Home Loan Bank advances -- 2,000 Net increase in other borrowed funds 180 1,876 Dividends paid (3,942) (4,959) Purchase of treasury stock (4,634) -- Stock options exercised 91 1,018 -------- -------- Net cash provided by (used in) financing activities (7,290) 8,073 -------- -------- Net increase (decrease) in cash and cash equivalents 8,433 (2,659) Cash and cash equivalents at beginning of period 12,039 13,479 -------- -------- Cash and cash equivalents at end of period $ 20,472 $ 10,820 -------- -------- Cash paid during the period for: Interest $ 8,872 $ 9,214 Income taxes $ 1,580 $ 2,243 See accompanying notes to consolidated financial statements. 5 WARREN BANCORP, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1999 ACCUMULATED ADDITIONAL OTHER COMPREHENSIVE COMMON PAID-IN RETAINED COMPREHENSIVE TREASURY INCOME STOCK CAPITAL EARNINGS INCOME STOCK TOTAL ------------- ------ ---------- -------- ------------- -------- ------ (Dollars in thousands) Balance at December 31, 1997 $780 $34,724 $4,282 $1,416 ($1,174) $40,028 Comprehensive income: Net income ....................................... $4,492 - - 4,492 - - 4,492 Other comprehensive income (loss): Unrealized loss on securities available for sale, net of taxes ....................... (88) Less: Reclassification adjustment for securities gains, net tax expense of $63, included in net income ....................... 125 ------ ' Total other comprehensive (loss) .......... 37 - - - 37 - 37 ------ Comprehensive income ............................... $4,529 ====== Tax benefit of stock options exercised ............. - 77 - - - 77 Dividends paid ..................................... - - (4,959) - - (4,959) Issuance of 272,545 common shares for exercise of options .......................... 29 916 - - 73 1,018 ---- ------- ------ ------ ------- ------- Balance at September 30, 1998 ........................ 809 35,717 3,815 1,453 (1,101) 40,693 Comprehensive income: Net income ....................................... $1,412 - - 1,412 - - 1,412 Other comprehensive income (loss): Unrealized loss on securities available for sale, net of taxes ....................... (651) Less: Reclassification adjustment for securities gains, net tax expense of $3, included in net income ....................... (3) ------ Total other comprehensive income .......... (654) - - - (654) - (654) ------ Comprehensive income ............................... $ 758 ====== Purchase of treasury stock (102,523 shares) ....... - - - - (928) (928) Tax benefit of stock options exercised ............. - 29 - - - 29 Dividends paid ..................................... - - (711) - - (711) Issuance of 13,675 shares for exercise of options ....................................... - (36) - - 116 80 ---- ------- ------ ------ ------- ------- Balance at December 31, 1998 .......................... 809 35,710 4,516 799 (1,913) 39,921 Comprehensive income: Net income ....................................... $3,916 - - 3,916 - - 3,916 Other comprehensive income (loss): Unrealized loss on securities available for sale, net of taxes ....................... (498) Less: Reclassification adjustment for securities gains, net tax expense of $0, included in net income ....................... - ------ ' Total other comprehensive (loss) .......... (498) - - - (498) - (498) ------ Comprehensive income ............................... $3,418 ====== Tax benefit of stock options exercised ............. - 13 - - - 13 Dividends paid ..................................... - - (3,942) - - (3,942) Purchase of treasury stock (523,400 shares) ....... - - - - (4,634) (4,634) Issuance of 23,520 shares for exercise of options ....................................... - (99) - - 190 91 ---- ------- ------ ------ ------- ------- Balance at September 30, 1999 ........................ $809 $35,624 $4,490 $ 301 ($6,357) $34,867 ==== ======= ====== ====== ======= ======= See accompanying notes to consolidated financial statements 6 WARREN BANCORP, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS BASIS OF PRESENTATION The consolidated financial statements of Warren Bancorp, Inc. (the "Corporation") presented herein should be read in conjunction with the consolidated financial statements of the Corporation as of and for the year ended December 31, 1998. The accompanying consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to those rules and regulations, but the Corporation believes that the disclosures are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments necessary for a fair presentation of the results for the interim periods presented. Certain amounts have been reclassified to conform with the 1999 presentation. EARNINGS PER SHARE The components of basic and diluted EPS for the quarters and nine months ended September 30, 1999 and 1998 are as follows: QUARTER ENDED SEPTEMBER 30, ------------------------------------------------------------------------------------- NET INCOME WEIGHTED AVERAGE SHARES NET INCOME PER SHARE ------------------------------------------------------------------------------------- 1999 1998 1999 1998 1999 1998 ------------------------------------------------------------------------------------- (In thousands, except per-share data) Basic EPS $1,262 $1,395 7,324 7,909 $0.17 $0.18 Effect of dilutive stock options -- -- 214 276 -- (0.01) ------ ------ ----- ----- ----- ----- Dilutive EPS $1,262 $1,395 7,538 8,185 $0.17 $0.17 ====== ====== ===== ===== ===== ===== NINE MONTHS ENDED SEPTEMBER 30, -------------------------------------------------------------------------------------- NET INCOME WEIGHTED AVERAGE SHARES NET INCOME PER SHARE -------------------------------------------------------------------------------------- 1999 1998 1999 1998 1999 1998 -------------------------------------------------------------------------------------- (In thousands, except per-share data) Basic EPS $3,916 $4,492 7,449 7,802 $0.53 $0.58 Effect of dilutive stock options -- -- 199 370 (0.02) (0.03) ------ ------ ----- ----- ----- ----- Dilutive EPS $3,916 $4,492 7,648 8,172 $0.51 $0.55 ====== ====== ===== ===== ===== ===== 1 7 BUSINESS SEGMENTS For internal reporting, planning and business purposes, the Corporation segments its operations into distinct business groups. An individual business group's profit contribution to the Corporation as a whole is determined based upon the Corporation's profitability reporting system which assigns capital and other balance sheet items and income statement items to each of the business groups. This segmentation mirrors the Corporation's organizational structure. Management accounting policies are in place for assigning revenues and expenses that are not directly incurred by the business groups, such as overhead, the results of asset allocations, and transfer revenues and expenses. Accordingly, the Corporation's business-segment operating results will differ with other similar information published by other financial institutions. In addition, management accounting concepts are periodically refined and results may change to reflect these refinements. The Corporation follows the provisions of Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting operating segments of a business enterprise. The new rules establish revised standards for public companies relating to the reporting of financial and descriptive information about their operating segments in financial statements. Operating segments are components of an enterprise which are evaluated regularly by the chief operating decision maker in deciding how to allocate resources and in assessing performance. The Corporation's chief operating decision maker is the President and Chief Executive Officer of the Corporation. The adoption of SFAS No. 131 had no effect on the Corporation's primary financial statements, but did result in the disclosure of segment information contained herein. The Corporation has identified its reportable operating business segments as the Corporate Banking Business and the Personal Banking Business. A description of each reportable business segment is discussed below: CORPORATE BANKING The Corporate Banking Business provides services to business customers in the Corporation's market area. These services include, but are not limited to, commercial real estate and construction loans, asset-based financing and cash management/deposit services. It services all loans in its business. PERSONAL BANKING The Personal Banking Business provides services to consumers in the Corporation's market area through its branch and ATM network. These services include, but are not limited to, home equity loans, installment loans, safe deposit boxes and an array of deposit services. This business purchases adjustable-rate mortgage loans from another business group and services all loans in its business. Non-reportable operating segments of the Corporation's operations that do not meet the qualitative and quantitative thresholds requiring disclosure are included in the Other category in the disclosure of business segments below. Revenues in these segments consist mainly of interest income on investments and gains on sales of mortgage loans and securities. 2 8 Specific reportable segment information as of and for the quarters and nine-month periods ended September 30, 1999 and 1998 is as follows (in thousands): QUARTER ENDED SEPTEMBER 30, 1999 CORPORATE PERSONAL WARREN BANCORP BANKING BANKING OTHER ELIMINATIONS CONSOLIDATED - --------------------------------------------------------------------------------------------------------------- Interest income-external $4,832 $2,341 $ 24 -- $7,197 Interest income-internal -- 2,310 7 $(2,317) -- Fee and other income 24 218 59 -- 301 Net income 1,011 629 (378) -- 1,262 QUARTER ENDED SEPTEMBER 30, 1998 CORPORATE PERSONAL WARREN BANCORP BANKING BANKING OTHER ELIMINATIONS CONSOLIDATED - ------------------------------------------------------------------------------------------------------------ Interest income-external $4,631 $2,571 $142 -- $7,344 Interest income-internal -- 2,045 29 $(2,074) -- Fee and other income 26 185 119 -- 330 Net income 952 405 38 -- 1,395 NINE MONTH PERIOD ENDED SEPTEMBER 30, 1999 CORPORATE PERSONAL WARREN BANCORP BANKING BANKING OTHER ELIMINATIONS CONSOLIDATED - -------------------------------------------------------------------------------------------------------------- Interest income-external $14,066 $7,262 $ 146 -- $21,474 Interest income-internal -- 6,629 27 $(6,656) -- Fee and other income 123 590 184 -- 897 Net income 3,051 1,904 (1,039) -- 3,916 NINE MONTH PERIOD ENDED SEPTEMBER 30, 1998 CORPORATE PERSONAL WARREN BANCORP BANKING BANKING OTHER ELIMINATIONS CONSOLIDATED - -------------------------------------------------------------------------------------------------------------- Interest income-external $13,363 $8,175 $386 -- $21,924 Interest income-internal -- 6,362 39 $(6,401) -- Fee and other income 88 558 432 -- 1,078 Net income 2,846 1,634 12 -- 4,492 3 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this Form 10-Q constitute "forward-looking statements" as that term is defined under the Private Securities Litigation Reform Act of 1995. The words "believe," "expect," "anticipate," "intend," "estimate," "plan," "assume" and other similar expressions which are predictions of or indicate future events and trends and which do not relate to historical matters identify forward-looking statements. Reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which are in some cases beyond the control of the Corporation and may cause the actual results, performance or achievements of the Corporation to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements. Certain factors that might cause such differences include, but are not limited to, the following: interest rates may increase, adversely affecting the ability of borrowers to repay adjustable-rate loans and the Corporation's earnings and income which derive in significant part from loans to borrowers; unemployment in the Corporation's market area may increase, adversely affecting the ability of individual borrowers to repay loans; property values may decline, adversely affecting the ability of borrowers to repay loans and the value of real estate securing repayment of loans; failure to realize the expected tax benefits from the newly formed Warren Real Estate Investment Corporation and higher-than-expected expenses related to its formation; and general economic and market conditions in the Corporation's market area may decline, adversely affecting the ability of borrowers to repay loans, the value of real estate securing repayment of loans and the Corporation's ability to make profitable loans. Any of the above may also result in lower interest income, increased loan losses, additional charge-offs and writedowns and higher operating expenses. The section entitled "Year 2000" also contains forward-looking statements. Anticipated expenses or delays in dealing with year-2000 issues by the Corporation, its suppliers and borrowers could result in material differences between the forward-looking statements and actual results. These and other factors that might cause differences between actual and anticipated results, performance and achievements are discussed in greater detail in this Form 10-Q. GENERAL Warren Bancorp, Inc.'s operating results for the three and nine months ended September 30, 1999 (the "1999 quarter" and "1999 period") reflect the operations of its only subsidiary, Warren Five Cents Savings Bank (the "Bank"). The Bank, which is wholly owned by the Corporation, operates as a community bank and is in the business of making individual and commercial loans to customers in its market area. The Corporation recorded a decreased profit for the 1999 period as compared to the nine months ended September 30, 1998 (the "1998 period") primarily due to decreased spreads due to a highly competitive commercial lending environment, lower levels of stockholders' equity, which caries no interest expense, in the 1999 quarter as compared to the 1998 quarter due to the stock buyback program in 1999, and lower yields on assets in the 1999 quarter than in the 1998 quarter as general interest rates began to fall in the 1998 quarter and have increased during 1999 only back to levels at the beginning of the 1998 quarter. When general interest rates decrease, the yield on the Bank's total assets will typically decrease more than its cost of funds. This is mainly because certain sources of funds, namely demand deposits and stockholders' equity, do not bear interest, and other sources of funds at already low interest rates may not have their rates reduced at the same rate as the Bank's assets. Further reductions in general interest rates may reduce the Bank's rate spread and net yield on average earning assets. Real estate acquired by foreclosure decreased to $72,000 at September 30, 1999 from $1.5 million at December 31, 1998. The decrease was mainly due to the sale of a parcel of land that the Corporation had held in its Real Estate Owned portfolio since 1991. This property had a book value of $1.2 million. The Bank financed a portion of the sales price for the buyer, and the resulting performing loan is reflected on the balance sheet at September 30, 1999. Nonperforming loans increased to $1.3 million at September 30, 1999 from $638,000 at December 31, 1998. Management continues to monitor these nonperforming asset portfolios closely. If conditions in the Massachusetts' real estate market become unstable and values deteriorate, the amount of nonaccrual loans and real estate acquired through foreclosure would be expected to increase, resulting in lower interest income and increased loan losses, 4 10 which could require additional loan loss provisions to be charged to operating income. Moreover, real estate acquired through foreclosure may give rise to additional charge-offs and writedowns and higher expenses for property taxes and other carrying costs. On January 20, 1999, the Board of Directors authorized a new common stock repurchase program which allows the repurchase of shares up to approximately 5% of the 7,721,000 shares outstanding on that date. As of September 30, 1999, the Corporation had repurchased approximately 400,000 shares. On April 22, 1999 the Corporation adopted a new Shareholder Rights Plan (the "Plan") which replaced its recently expired Plan. The Plan is designed to enhance the Corporation's ability to protect shareholder interests and to ensure that shareholders receive fair treatment in the event any coercive takeover attempt of the Corporation is made in the future, and is intended to provide the Corporation with sufficient time to consider any and all alternatives to such action. The Plan was not adopted in response to any takeover attempt, and the Corporation is not aware of any such attempt. In connection with the adoption of the Plan, the Board of Directors (the "Board") declared a dividend distribution of one preferred stock purchase right for each outstanding share of common stock to shareholders of record as of April 22, 1999. Initially, these rights will not be exercisable and will trade with the shares of The Corporation's common stock. Under the Plan, the rights generally become exercisable if a person becomes an "acquiring person" by acquiring 15% or more of the common stock of the Corporation, if a person who owns 10% or more of the common stock of the Corporation is determined to be an "adverse person" by the Board of Directors, or if a person commences a tender offer that would results in that person owning 15% or more of the common stock of the Corporation. In the event that a person becomes an "acquiring person" or is declared an "adverse person" by the Board, each holder of a right (other than the acquiring person or the adverse person) would be entitled to acquire such number of shares of preferred stock which are equivalent to the Corporation's common stock having a value of twice the exercise price of the right. If the Corporation is acquired in a merger or other business combination transaction after any such event, each holder of a right would then be entitled to purchase, at the then-current exercise price, shares of the acquiring company's common stock having a value of twice the exercise price of the right. ASSET/LIABILITY MANAGEMENT A primary objective of the Corporation's asset/liability management policy is to manage interest-rate risk over time to achieve a prudent level of net interest income in changing interest-rate environments. Management's strategies are intended to be responsive to changes in interest rates and to recognize market demands for particular types of deposit and loan products. These strategies are overseen by an internal Asset/Liability Management Committee and by the Bank's Board of Directors, and the risks are managed with techniques such as simulation analysis, which measures the effect on net interest income of possible changes in interest rates, and "gap" analysis, using models similar to the one shown on the following page. The Corporation uses simulation analysis to measure exposure of net interest income to changes in interest rates over a one-year period. This period is measured because the Corporation is most vulnerable to changes in short-term (one year and under) rates. Simulation analysis involves projecting future interest income and expense under various rate scenarios. The Corporation's policy on interest-rate risk specifies that if short-term interest rates were to shift immediately up or down 100 basis points, estimated net interest income for the next 12 months should decline by less than 13%. This policy remained in effect during the period, and in management's opinion there were no material changes in interest rate risk since December 31, 1998, the date as of which the simulation analysis was performed. Certain shortcomings are inherent in a simulation analysis. Estimates of customer behavior to changing interest rates may differ significantly from actual. Areas of these estimates include loan prepayment speeds, shifting between adjustable-rate and fixed-rate loans, and activity within different categories of deposit products. Also, the ability of some borrowers to repay their adjustable-rate loans may decrease in the event of interest-rate increases. The following table summarizes the Corporation's interest-rate sensitivity position as of September 30, 1999. Assets and liabilities are classified as interest-rate sensitive if they have a remaining term to maturity of 0-12 months, or are subject to interest-rate adjustments within those time periods. Adjustable-rate loans and mortgage-backed securities are shown as if the entire balance came due on the repricing date. 5 11 Nonaccruing loans are not included in this analysis due to their status as non-earning assets. Estimates of fixed-rate loan and fixed-rate mortgage-backed security amortization and prepayments are included with rate sensitive assets. The following types of deposit accounts are assumed to have effective maturities as follows based on their past retention characteristics: NOW accounts-up to five years; cash manager and passbook plus accounts-up to six months; and regular savings accounts-up to greater than five years. None of these assets is considered a trading asset. INTEREST-RATE SENSITIVITY POSITION SEPTEMBER 30, 1999 ----------------------------------------------------------------------- 0-3 3-6 6-12 1-5 OVER 5 MONTHS MONTHS MONTHS YEARS YEARS ------ ------ ------ ----- ------ (Dollars in Thousands) INTEREST SENSITIVE ASSETS: Investment securities ......................... $ 35,166 $ 9,697 $ 9,204 $ 28,706 $ -- Loans held for sale ........................... 989 -- -- -- -- Adjustable-rate loans ......................... 89,918 10,821 33,155 96,051 6,736 Fixed-rate loans .............................. 6,018 1,195 2,439 26,437 6,044 Mortgage-backed securities .................... 1,957 2,579 6,036 3,362 1,186 -------- -------- -------- -------- ------- Total interest sensitive assets ............ 134,048 24,292 50,834 154,556 13,966 -------- -------- -------- -------- ------- INTEREST SENSITIVE LIABILITIES: Cash manager and passbook plus accounts ..................................... 17,707 17,706 -- -- -- Time deposits ................................. 23,822 28,547 52,118 54,266 -- Other deposits (a) ............................ 10,493 10,493 22,363 83,974 10,046 Borrowings .................................... 5,183 -- -- 33 2,638 -------- -------- -------- -------- ------- Total interest sensitive liabilities ....... 57,205 56,746 74,481 138,273 12,684 -------- -------- -------- -------- ------- Excess (deficiency) of interest sensitive assets over interest sensitive liabilities .................................. $ 76,843 $(32,454) $(23,647) $ 16,283 $ 1,282 ======== ======== ======== ======== ======= Excess of cumulative interest sensitive assets over cumu- lative interest sensitive liabilities ........ $ 76,843 $ 44,389 $ 20,742 $ 37,025 $38,307 ======== ======== ======== ======== ======= Cumulative interest sensitive assets as a percentage of cumulative interest sensitive liabilities ............... 234.3% 139.0% 111.0% 111.3% 111.3% ======== ======== ======== ======== ======= Cumulative excess as a percentage of total assets ................... 19.5% 11.3% 5.3% 9.4% 9.7% ======== ======== ======== ======== ======= - ---------- (a) Other deposits consist of regular savings and N.O.W. accounts. 6 12 Interest-rate sensitivity statistics are static measures that do not necessarily take into consideration external factors which might affect the sensitivity of assets and liabilities and consequently cannot be used alone to predict the operating results of a financial institution in a changing environment. However, these measurements do reflect major trends and thus the Corporation's sensitivity to interest rates changes over time. LIQUIDITY The Bank seeks to ensure sufficient liquidity is available to meet cash requirements while earning a return on liquid assets. The Bank uses its liquidity primarily to fund loan and investment commitments, to supplement deposit flows and to meet operating expenses. The primary sources of liquidity are interest and amortization from loans, mortgage-backed securities and investments, sales and maturities of investments, loan sales, deposits and Federal Home Loan Bank of Boston ("FHLBB") advances, which include a $15 million overnight line of credit. The Bank also has access to the Federal Reserve Bank's discount window and may borrow from the Depositors Insurance Fund Liquidity Fund. During the 1999 period, the Bank did not use the Federal Reserve Bank discount window and did not borrow from the Depositors Insurance Fund Liquidity Fund. The Bank also uses the longer term borrowings facilities within its total available credit line with the FHLBB. Advances from the FHLBB, none of which were from the overnight facility, were $2,671,000 at September 30, 1999. During 1999, the primary sources of liquidity for the Bank were $18.3 million in loan sales, proceeds from maturities of investment securities of $28.7 million and proceeds from paydowns of mortgage-backed securities of $4.9 million. Primary uses of funds were $102.8 million in residential, commercial real estate and commercial loan originations and $11.6 million to purchase investment securities. At September 30, 1999, the Bank had $13.4 million in overnight investments. From time to time, the Bank has obtained time deposits in denominations of $100,000 and over. The following table summarizes maturities of time deposits of $100,000 or more outstanding at September 30, 1999: Within One Year (IN THOUSANDS) --------------- Less than 3 months................................... $ 3,971 3 to 6 months........................................ 5,008 6 to 12 months....................................... 10,291 ------- 19,270 More than 12 months.................................. 8,623 ------- $27,893 ======= The primary source of liquidity for Warren Bancorp, Inc. (the bank holding company) is dividends from the Bank. The primary uses of this liquidity are dividends paid and stock repurchases. CAPITAL ADEQUACY Total stockholders' equity at September 30, 1999 was $34.9 million, a decrease of $5.0 million from $39.9 million at December 31, 1998. This decrease was primarily the result of a $4.4 million increase in treasury stock due to the Corporation's stock repurchase program and $3.9 million of dividends paid to shareholders. Included in stockholders' equity at September 30, 1999 is an unrealized gain on securities available for sale, which increased stockholders' equity, of $301,000 as compared to an unrealized gain at December 31, 1998 of $799,000. Future interest-rate increases could reduce the fair value of these securities and reduce stockholders' equity. As a percentage of total assets, stockholders' equity was 8.85% at September 30, 1999 compared to 10.05% at December 31, 1998. At September 30, 1999, neither the Federal Reserve Board ("FRB") nor the FDIC permitted the unrealized gain or loss to be used in their calculation of Tier I capital. 7 13 The FRB's leverage capital-to-assets guidelines require the strongest and most highly rated bank holding companies to maintain at least a 3.00% ratio of Tier I capital to average consolidated assets. All other bank holding companies are required to maintain at least 4.00% to 5.00%, depending on how the FRB evaluates their condition. The FRB may require a higher capital ratio. At September 30, 1999, the FRB leverage capital ratio was 8.79% compared to 10.10% at December 31, 1998. The FDIC's leverage capital-to-assets ratio guidelines are substantially similar to those adopted by the FRB and described above. At September 30, 1999, the Bank's leverage capital ratio, under FDIC guidelines, was 8.44% compared to 9.20% at December 31, 1998. The FRB and the FDIC have also imposed risk-based capital requirements on the Corporation and the Bank, respectively, which give different risk weightings to assets and to off-balance sheet assets such as loan commitments and loans sold with recourse. Both the FRB and FDIC guidelines require the Corporation and the Bank to have an 8.00% risk-based capital ratio. The Corporation's and the Bank's risk-based capital ratios were 11.45% and 11.04%, respectively, at September 30, 1999 compared to 12.71% and 11.68% at December 31, 1998, thus exceeding their risk-based capital requirements. As of September 30, 1999, the Bank's total risk-based capital ratio, Tier I risk-based capital ratio and leverage capital ratio were 11.04%, 9.80%, and 8.44%, respectively. Based on these capital ratios, the Bank is considered to be "well capitalized." YEAR 2000 The statements in the following section are "Year-2000 readiness disclosure" within the meaning of the Year 2000 Information and Readiness Disclosure Act of 1998. The year-2000 issue is the result of systems run by computer (personal computers, telephone systems, electric utilities, etc.) being date sensitive. Older computer hardware and associated software applications are based on two-digit years which will either recognize the year 2000 as 1900 or not at all. To remedy this situation these date-sensitive systems must be reprogrammed or replaced to recognize the year 2000. The Corporation has developed comprehensive plans to evaluate, test, and ensure that its computer systems and key service providers are year-2000 compliant and to date has met the timetable established to complete this effort. As part of the Corporation's contract with its outside data processing service provider, the data service provider will ensure year-2000 compliance of the core banking systems that it provides to the Corporation. All costs related to this aspect of the year-2000 effort are the responsibility of the provider. The provider, which services over 600 banks in the United States, has completed remediation efforts and testing. The first phase of testing began in November, 1998 with two separate teams made up of the Corporation's employees inputting and validating data. Another testing phase began in February, 1999. The provider met its schedule and testing by the Corporation's employees has produced satisfactory results. Test plans for systems not provided by the data service provider are also complete. As these systems were identified, test scripts were developed on an individual basis. The testing phase began on October 16, 1998 and was completed by May 31, 1999 as scheduled. Test results on these systems were also found to be satisfactory. Included in its 1998 business plan, the Corporation upgraded all of its personal computers and associated software, all of which were year-2000 certified upon purchase. This upgrade is now complete. The Corporation has contacted its commercial borrowers by personal contact and questionnaires to monitor their preparedness and has also notified deposit customers by mail of the Corporation's year-2000 efforts. Additional customer contact is taking place in 1999 that includes direct mailing, a web page and a dedicated telephone line specifically for year-2000 issues. A list of significant third party vendors (telephone systems, electric utilities, security systems, etc.) has been developed and monitoring of their year-2000 preparedness continues. A contingency plan has been developed in the event that the Corporation's third party vendors do not remediate their own year-2000 issues. At the present time the Corporation has not received any indication from its vendors that they will not be year-2000 compliant. The ability of third parties, including the Corporation's borrowers, with whom the Corporation transacts business to adequately address their year- 8 14 2000 issues is outside of the Corporation's control. Due to this uncertainty, the failure of such third parties of the Corporation to adequately address their own year-2000 issues could have a material adverse effect on the Corporation's financial condition and results of operations. These adverse effects could be the result of but not limited to borrowers failing to repay loans, loss of business opportunities due to a failure to properly transact business and loss of customers to competition due to customer-service failure. This uncertainty cannot be quantified at this time. The Corporation has updated hardware and its associated software as part of its normal ongoing operations, and the hardware and software upgrades were a necessary result of that plan and have not been accelerated due to the year-2000 issue. The use of internal resources for the year-2000 effort has not delayed normal workflow or other projects from being completed. Management estimates that out-of-pocket costs related to year-2000 issues will be less than $50,000. These costs will not be material to the financial condition or results of operations of the Corporation. FINANCIAL CONDITION The Corporation's total assets decreased to $393.8 million at September 30, 1999 from $397.1 million at December 31, 1998. Decreases occurred in residential mortgages and investments available for sale and were partially offset by increases in commercial, commercial real estate, commercial construction loans and overnight investments. INVESTMENTS AND MORTGAGE-BACKED SECURITIES Investments, consisting of investment securities and mortgage-backed securities available for sale, and other investments, decreased to $86.6 million at September 30, 1999 from $109.8 million at December 31, 1998. A majority of this decrease was from the maturity of corporate notes. The proceeds from the maturity of these investments were used principally to fund loans, repurchase the Corporation's common stock and increase overnight investments to provide liquidity to address certain year-2000 issues as part of the Corporation's year-2000 contingency plan. Mortgage-backed securities decreased to $15.3 million at September 30, 1999 from $20.4 million at December 31, 1998 due to principal paydowns. Future increases in interest rates could reduce the value of these investments. 9 15 INVESTMENTS AT SEPTEMBER 30, 1999 ARE AS FOLLOWS: GROSS GROSS AMORTIZED UNREALIZED UNREALIZED FAIR COST GAINS LOSSES VALUE -------- ---------- ---------- ------- (IN THOUSANDS) AVAILABLE-FOR-SALE Fixed income mutual funds .................. $28,706 $ 90 $ (132) $28,664 FNMA mortgage-backed securities ............ 10,475 282 (2) 10,755 GNMA mortgage-backed securities ............ 4,645 -- (129) 4,516 U.S. Government and related obligations ............................... 3,010 -- (9) 3,001 Corporate notes ............................ 25,205 -- (56) 25,149 Preferred stock ............................ 7,311 427 -- 7,738 ------- ------ ------- ------- 79,352 799 (328) 79,823 ------- ------ ------- ------- OTHER Foreign government bonds and notes .................................... 1,000 -- -- 1,000 Stock in Federal Home Loan Bank of Boston ................................ 4,110 -- -- 4,110 Stock in Depositors Insurance Fund Liquidity Fund ........................... 108 -- -- 108 Stock in Savings Bank Life Insurance Company of Massachusetts ................. 1,576 240 -- 1,816 ------- ------ -------- ------- 6,794 240 -- 7,034 ------- ------ -------- ------- $86,146 $1,039 $ (328) $86,857 ======= ====== ======== ======= LOANS AND LOANS HELD FOR SALE Loans and loans held for sale increased by $13.4 million during the 1999 period to $281.1 million at September 30, 1999. This increase is the result of increases in commercial real estate, commercial construction and commercial loans. Due to the lower level of interest rates experienced in the fourth quarter of 1998 and in the first half of the 1999 period as compared to the first half of the 1998 period, the adjustable-rate residential loan portfolio has decreased since December 31, 1998 by $1.2 million due to refinancing into fixed-rate loans. Since June 30, 1999 these prepayments have slowed and the balance of the adjustable-rate residential loan portfolio has stabilized. Commercial real estate, commercial construction and commercial loans typically earn higher yields than residential mortgage loans, but usually carry higher risk due to loan size. The following table sets forth the classification of the Corporation's loans as of September 30, 1999 and December 31, 1998 (in thousands): SEPTEMBER 30, 1999 DECEMBER 31, 1998 ------------------ ----------------- Residential mortgages.............. $ 42,822 $ 45,658 Commercial real estate............. 167,435 163,154 Commercial construction ........... 16,755 13,620 Commercial loans................... 31,147 23,726 Consumer loans..................... 21,912 20,317 -------- -------- $280,091 $266,475 ======== ======== Residential mortgage loan originations during the 1999 period were $30.8 million compared to $32.7 million in the 1998 period. The Corporation originated $19.4 million in fixed-rate loans during the 1999 period compared to $27.3 million during the 1998 period. Adjustable-rate loans totaling $11.4 million were 10 16 originated during the 1999 period compared to $5.4 million during the 1998 period. The Corporation sold loans totaling $18.3 million during the 1999 period compared to $17.2 million sold in the 1998 period. At September 30, 1999, the Corporation held $989,000 of fixed-rate residential mortgage loans for sale compared to $1.2 million at December 31, 1998. CREDIT QUALITY IMPAIRED AND NONPERFORMING LOANS Loans are deemed by the Corporation to be impaired when, based on current information and events, it is probable that the Corporation will be unable to collect all amounts due according to the contractual terms of the original loan agreement. Generally, nonaccruing loans are deemed impaired. Large groups of homogeneous loans, such as smaller balance residential mortgage and consumer installment loans are collectively evaluated for impairment. Typically, the minimum delay in receiving payments according to the contractual terms of the loan that can occur before a loan is considered impaired is ninety days. Impaired loans are analyzed and categorized by level of credit risk and collectibility in order to determine their related allowance for loan losses. At September 30, 1999 there were two loans considered impaired and accruing totaling $188,000 compared to four loans considered impaired and accruing totaling $710,000 at December 31, 1998. Loans past due 90 days or more, or past due less than 90 days but in nonaccrual status were $1,257,000 at September 30, 1999 compared to $638,000 at December 31, 1998. Included in nonperforming loans are six loans considered impaired and nonaccruing in the amount of $1,257,000 at September 30, 1999. There were no loans considered impaired and nonaccruing at December 31, 1998. Accrual of interest on loans is discontinued either when a reasonable doubt exists as to that the full, timely collection of principal or interest or when the loans become contractually past due by ninety days or more, unless they are adequately secured and are in the process of collection. When a loan is placed on nonaccrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on such loans is recognized to the extent that cash is received and where the ultimate collection of principal and interest is probable. Following collection procedures, the Corporation generally institutes appropriate action to foreclose the property or acquire it by deed in lieu of foreclosure. 11 17 The table below details nonperforming loans at: SEPTEMBER 30, 1999 DECEMBER 31, 1998 ------------------ ----------------- (DOLLARS IN THOUSANDS) Accruing loans 90 days or more in arrears ....... $ -- $163 Nonaccrual loans ................................ 1,257 475 ------ ---- Total nonperforming loans ....................... $1,257 $638 ====== ==== Percentage of nonperforming loans to: Total loans ..................................... 0.45% 0.24% ====== ==== Total assets .................................... 0.32% 0.16% ====== ==== REAL ESTATE ACQUIRED BY FORECLOSURE Real estate acquired by foreclosure totaled $72,000 at September 30, 1999 and $1.5 million at December 31, 1998. Real estate acquired by foreclosure is reflected at the lower of the carrying value of the loans or the net carrying value of the property less estimated cost of disposition. These properties consist mainly of land. If conditions become unstable in the Massachusetts real estate market, losses and writedowns could occur as the Corporation reduces the book value of real estate to reflect likely realizable values. In summary, nonperforming assets are as follows (in thousands): SEPTEMBER 30, 1999 DECEMBER 31, 1998 ------------------ ----------------- Nonperforming loans............................. $1,257 $ 638 Real estate acquired by foreclosure............. 72 1,450 ------ ------ Total nonperforming assets...................... $1,329 $2,088 ====== ====== Total nonperforming assets as a percentage of total assets................... 0.33% 0.52% 12 18 ALLOWANCE FOR LOAN LOSSES The following table presents the activity in the allowance for loan losses for the nine months ended September 30, 1999 and September 30, 1998 (dollars in thousands): 1999 1998 ---- ---- Balance at beginning of period .................................... $ 4,023 $ 4,066 ------- ------- Losses charged to the allowance: Residential mortgage .......................................... 12 -- Commercial mortgage and construction .......................... -- -- Commercial loans .............................................. -- -- Consumer loans ................................................ 44 63 ------- ------- 56 63 ------- ------- Loan recoveries: Residential mortgage .......................................... 23 10 Commercial mortgage and construction .......................... 80 62 Commercial loans .............................................. 42 21 Consumer loans ................................................ 23 17 ------- ------- 168 110 ------- ------- Net recoveries .................................................... (112) (47) ------- ------- Provision for (recovery of) loan losses (credited) to income ...... 69 (90) ------- ------- Balance at end of period .......................................... $ 4,204 $ 4,023 ======= ======= Allowance to total loans at end of period ......................... 1.50% 1.56% ======= ======= Allowance to nonperforming loans at end of period ................. 334.4% 367.4% ======= ======= Allocation of ending balance: Residential mortgage .......................................... $ 423 $ 626 Commercial mortgage and construction .......................... 3,118 2,932 Commercial loans .............................................. 455 264 Consumer loans ................................................ 208 201 ------- ------- $ 4,204 $ 4,023 ======= ======= Notwithstanding the foregoing allocations, the entire allowance for loan losses is available to absorb charge-offs in any category of loans. Loan losses are charged against the allowance when management believes that the collectibility of the loan principal is doubtful. Balances in the allowance for loan losses are determined on a periodic basis by management and the Loan Committee of the Board of Directors with assistance from an independent credit review consulting firm. Loan loss allocations are based on the conditions of each loan, whether performing or non-performing, including collectibility, collateral adequacy and the general condition of the borrowers, economic conditions, delinquency statistics, market area activity, the risk factors associated with each of the various loan categories and the borrower's adherence to the original terms of the loan. Individual loans, including loans considered impaired, are analyzed and categorized by level of credit risk and collectibility. In determining the allowance, management uses specific estimated losses on certain problem loans, loss factors determined for each category of credit risk using historical charge-off statistics and factors that consider economic condition and trends. The associated provision for loan losses is the amount required to bring the allowance for loan losses to the balance considered necessary by management at the end of the period after accounting for the effect of loan charge-offs (which decrease the allowance) and loan-loss recoveries (which increase the allowance). The allowance for loan losses included above attributable to $1.4 million of impaired loans, of which $188,000 is measured using the present value method and $1,257,000 using the fair value method, is $193,000. 13 19 The required allowance for loan losses could increase in future periods if the condition of the loan portfolio deteriorates or if the balance of the portfolio increases. Such an increase in the allowance could require additional provisions for loan losses to be charged to income. LEGAL AND OFF-BALANCE SHEET RISKS Various legal claims arise from time to time in the course of business of the Corporation and its subsidiaries. At September 30, 1999, there were no legal claims against the Corporation or its subsidiaries. The Corporation is party to financial instruments with off-balance sheet risk in the normal course of business to meet the financial needs of its customers and to reduce its own exposure to fluctuations of interest rates. These financial instruments include commitments to originate loans, unused lines of credit, standby letters of credit, recourse arrangements on sold assets and forward commitments to sell loans. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. OTHER ASSETS Included in other assets at September 30, 1999 and December 31, 1998 are $1.6 million and $1.4 million, respectively, of deferred income taxes receivable. Also included in other assets at December 31, 1998 was a current income tax receivable of $139,000. LIABILITIES Deposits increased to $348.0 million at September 30, 1999 from $347.0 million at December 31, 1998. This increase took place primarily in time and money market deposits and was partially offset by decreases in NOW and demand deposit accounts. Federal Home Loan Bank of Boston advances were $2,671,000 at September 30, 1999 and December 31, 1998. Securities sold under agreement to repurchase were $5.2 million at September 30, 1999 and $5.0 million at December 31, 1998. 14 20 RESULTS OF OPERATIONS - FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THE THREE MONTHS ENDED SEPTEMBER 30, 1998 GENERAL The Corporation recorded a profit for the 1999 quarter of $1.3 million compared to a profit for the 1998 quarter of $1.4 million. The decrease in the 1999 quarter profit is primarily due to decreased spreads due to a highly competitive commercial lending environment and generally lower yield on assets during the 1999 quarter as compared to during the 1998 quarter as general interest rates began to fall in the 1998 quarter and have increased during 1999 only back to levels at the beginning of the 1998 quarter. The Corporation also had lower levels of stockholders' equity, which carries no interest expense, in the 1999 third quarter than in the 1998 quarter due to the stock buyback program in 1999. Income before taxes was $1.9 million in the 1999 quarter compared to $2.1 million in the 1998 quarter. Net interest income for the 1999 and 1998 quarters was $4.2 million and $4.3 million, respectively. The weighted average interest rate spread for the 1999 quarter was 4.34% compared to 4.47% for the 1998 quarter. The net yield on average earning assets was 4.51% for the 1999 quarter and 4.70% for the 1998 quarter. The return on average assets and the return on average stockholders' equity were 1.28% and 14.66%, respectively, for the 1999 quarter compared to 1.47% and 13.97%, respectively, for the 1998 quarter. INTEREST AND DIVIDEND INCOME Total interest and dividend income decreased to $7.2 million for the 1999 quarter from $7.3 million for the 1998 quarter. Interest on loans increased to $5.7 million for the 1999 quarter from $5.6 million for the 1998 quarter. The average loan yield decreased to 8.33% for the 1999 quarter from 8.91% for the 1998 quarter while average loans outstanding increased during the 1999 quarter as compared to the 1998 quarter. Interest and dividends on investments was $1.2 and $1.3 million for the 1999 and 1998 quarters, respectively. An increase in the average amount of investments held during the 1999 quarter was offset by a decrease in the average yield on investments to 5.54% for the 1999 quarter from 5.94% for the 1998 quarter. Mortgage-backed securities income decreased to $271,000 in the 1999 quarter from $423,000 in the 1998 quarter primarily due to a decrease in the average amount of mortgage-backed securities due to paydowns and a decrease in the average yield to 6.87% for the 1999 quarter compared to 7.17% in the 1998 quarter. INTEREST EXPENSE Interest on deposits decreased to $2.9 million for the 1999 quarter from $3.0 for the 1998 quarter. The average cost of deposits decreased to 3.26% for the 1999 quarter from 3.61% for the 1998 quarter. Interest on borrowed funds and escrow deposits of borrowers increased to $84,000 from $70,000 for the 1999 and 1998 quarters, respectively. This increase is primarily related to an increase in borrowed funds in the form of customer repurchase agreements. The average cost of borrowings was 3.66% for the 1999 quarter and 3.84% for the 1998 quarter. NON-INTEREST INCOME Total non-interest income for the 1999 quarter was $301,000 compared to $330,000 for the 1998 quarter. The gain from the sale of mortgage loans was $43,000 in the 1999 quarter compared to $112,000 in the 1998 quarter. The gain from the sale of investment securities was $17,000 for the 1999 quarter. There were no sales of investment securities in the 1998 quarter. NON-INTEREST EXPENSE Total non-interest expense increased to $2.7 million in the 1999 quarter from $2.5 million in the 1998 quarter. Salary and employee benefits increased to $1.7 million in the 1999 quarter from $1.5 million in the 1998 quarter due to increases in salaries mainly from Bankwide salary increases and increased staffing in the Corporate Banking and Residential Mortgage Origination Businesses as the Corporation continues to expand these businesses. Real estate operations expense was a credit of $68,000 in the 1999 quarter compared to an expense of $14,000 in the 1998 quarter due to the reimbursement of expenses incurred in prior years. During the 1999 quarter the Corporation formed Warren Real Estate Investment Corporation, a real estate investment trust, and incurred $87,000 in formation expenses. During the 1999 fourth quarter the Corporation expects 15 21 to incur additional formation expenses of approximately $100,000. Due to the formation of Warren Real Estate Investment Corporation, the Corporation saved approximately $53,000 in taxes in the 1999 quarter and expects to save another $55,000 in the fourth quarter of 1999. The Corporation anticipates tax savings of over $200,000 per year in subsequent years from the operation of Warren Real Estate Investment Corporation, subject to its level of pre-tax earnings. INCOME TAX EXPENSE Income tax expense for the 1999 quarter decreased to $593,000 from $725,000 for the 1998 quarter due to lower pretax income and due to the formation of Warren Real Estate Investment Corporation, a real estate investment trust, which reduced the Corporation's income tax expense by approximately $53,000 in the 1999 quarter. See "Non-Interest Expense" above for further discussion of Warren Real Estate Investment Corporation. 16 22 RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 1998 GENERAL The Corporation recorded a profit for the 1999 period of $3.9 million compared to a profit for the 1998 quarter of $4.5 million. The decrease in the 1999 period profit is primarily due to decreased spreads due to a highly competitive commercial lending environment and generally lower interest rates during the 1999 period as compared to the 1998 period as well as lower levels of capital, which carries no interest expense, in the 1999 period than in the 1998 period due to the stock buyback program in 1999. Income before taxes was $5.9 million in the 1999 period compared to $6.8 million in the 1998 period. Net interest income for the 1999 and 1998 periods were $12.7 million and $13.0 million, respectively. The weighted average interest rate spread for the 1999 period was 4.30% compared to 4.63% for the 1998 period. The net yield on average earning assets was 4.54% for the 1999 period and 4.88% for the 1998 period. The return on average assets and the return on average stockholders' equity were 1.34% and 14.48%, respectively, for the 1999 period compared to 1.60% and 14.83%, respectively, for the 1998 period. INTEREST AND DIVIDEND INCOME Total interest and dividend income decreased to $21.5 million for the 1999 period from $21.9 million for the 1998 period. Interest on loans remained $16.8 million for the 1999 and 1998 periods. Average loans outstanding increased during the 1999 period while the average loan yield decreased to 8.34% for the 1999 period compared to 9.10% for the 1998 period. Interest and dividends on investments was $3.8 and $3.7 million for the 1999 and 1998 periods, respectively. This increase is attributed to an increase in the average amount of investments held during the 1999 period partially offset by a decrease in the average yield to 5.62% for the 1999 period from 6.01% for the 1998 period. Mortgage-backed securities income decreased to $885,000 in the 1999 period from $1,397,000 in the 1998 period primarily due to a decrease in the average amount of mortgage-backed securities held due to paydowns and a decrease in the average yield to 6.84% for the 1999 period compared to 7.16% in the 1998 period. INTEREST EXPENSE Interest on deposits decreased to $8.5 million for the 1999 period from $8.8 million for the 1998 period. This decrease was related to a decrease in the average cost of deposits to 3.31% for the 1999 period from 3.52% for the 1998 period despite an increase in average total deposits outstanding. Interest on borrowed funds and escrow deposits of borrowers increased to $235,000 in the 1999 period from $154,000 for the 1998 period. This increase is primarily related to an increase in borrowed funds in the form of customer repurchase agreements and the average cost of borrowings increasing to 3.62% for the 1999 period from 3.49% for the 1998 period. NON-INTEREST INCOME Total non-interest income for the 1999 period was $897,000 compared to $1,078,000 for the 1998 period. The gain from the sale of mortgage loans was $196,000 in the 1999 period compared to $243,000 in the 1998 period. Gains from the sale of investment securities for the 1999 period were $17,000 compared to $188,000 in the 1998 period. NON-INTEREST EXPENSE Total non-interest expense was $7.6 million in the 1999 period and $7.3 million in the 1998 period. Salary and employee benefits were $4.8 million in the 1999 period and $4.4 million for the 1998 period, respectively. This increase is mainly due to an increase in the staffing of the Corporate Banking and Residential Mortgage Origination Businesses as the Corporation continues to expand these businesses, and Bankwide salary increases. Real estate operations expense was a credit of $78,000 in the 1999 period compared to an expense of $40,000 in the 1998 period due to the reimbursement of expenses incurred in prior years. During the 1999 period the Corporation formed Warren Real Estate Investment Corporation, a 17 23 real estate investment trust, and incurred $87,000 in formation expenses. During the 1999 fourth quarter the Corporation expects to incur additional formation expenses of approximately $100,000. INCOME TAX EXPENSE Income tax expense for the 1999 period was $2.0 million compared to $2.3 million for the 1998 period. This decrease is due to the decrease in pretax income in the 1999 period and due to the formation of Warren Real Estate Investment Corporation, a real estate investment trust which has reduced the Corporation's income tax expense by approximately $53,000 in the 1999 period. See "Non-Interest Expense" in "Results of Operations - For the Three Months Ended September 30, 1999 Compared to the Three Months Ended September 30, 1998" above for further discussion of Warren Real Estate Investment Corporation. 18 24 WARREN BANCORP, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS 27.1 Financial Data Schedule - 1999 19 25 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. WARREN BANCORP, INC. DATE: November 10, 1999 By: /s/ John R. Putney ------------------------------------------ John R. Putney President and Chief Executive Officer DATE: November 10, 1999 By: /s/ Paul M. Peduto ------------------------------------------ Paul M. Peduto Treasurer (Principal Financial Officer and Principal Accounting Officer) 20