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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-Q
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|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2006
OR
| | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
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Commission file number 000-23777
PENSECO FINANCIAL SERVICES CORPORATION
Incorporated pursuant to the laws of Pennsylvania
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Internal Revenue Service -- Employer Identification No. 23-2939222
150 North Washington Avenue, Scranton, Pennsylvania 18503-1848
(570) 346-7741
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Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No | |
Indicate by checkmark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer | | Accelerated filer |X| Non-accelerated filer | |
Indicate by checkmark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).
Yes | | No |X|
The total number of shares of the registrant's Common Stock, $0.01 par value,
outstanding on April 28, 2006 was 2,148,000.
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PENSECO FINANCIAL SERVICES CORPORATION
Page
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Part I -- FINANCIAL INFORMATION
Item 1. Financial Statements - Consolidated
Balance Sheets:
March 31, 2006.........................................3
December 31, 2005......................................3
Statements of Income:
Three Months Ended March 31, 2006......................4
Three Months Ended March 31, 2005......................4
Statements of Cash Flows:
Three Months Ended March 31, 2006......................5
Three Months Ended March 31, 2005......................5
Notes to Financial Statements..............................6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................13
Item 3. Quantitative and Qualitative Disclosures About Market Risk....21
Item 4. Controls and Procedures.......................................21
Part II -- OTHER INFORMATION
Item 1. Legal Proceedings.............................................22
Item 1A. Risk Factors..................................................22
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds...24
Item 3. Defaults Upon Senior Securities...............................24
Item 4. Submission of Matters to a Vote of Security Holders...........24
Item 5. Other Information.............................................24
Item 6. Exhibits......................................................24
Signatures...............................................................24
Certifications...........................................................25
PART I. FINANCIAL INFORMATION, Item 1 -- Financial Statements
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED BALANCE SHEETS
(unaudited)
(in thousands, except per share amounts)
March 31, December 31,
2006 2005
--------------- ---------------
ASSETS
Cash and due from banks $ 10,799 $ 11,310
Interest bearing balances with banks 433 263
Federal funds sold - -
--------------- ---------------
Cash and Cash Equivalents 11,232 11,573
Investment securities:
Available-for-sale, at fair value 129,961 147,942
Held-to-maturity (fair value of $80,003
and $83,130, respectively) 79,900 82,015
--------------- ---------------
Total Investment Securities
209,861 229,957
Loans, net of unearned income 329,495 321,362
Less: Allowance for loan losses 3,900 3,800
--------------- ---------------
Loans, Net 325,595 317,562
Bank premises and equipment 9,420 9,453
Other real estate owned 2 91
Accrued interest receivable 3,257 3,473
Other assets 4,809 3,579
--------------- ---------------
Total Assets $ 564,176 $ 575,688
=============== ===============
LIABILITIES
Deposits:
Non-interest bearing $ 89,481 $ 91,713
Interest bearing 307,781 306,154
--------------- ---------------
Total Deposits 397,262 397,867
Other borrowed funds:
Repurchase agreements 16,905 30,414
Short-term borrowings 8,475 4,626
Long-term borrowings 73,045 75,401
Accrued interest payable 1,322 1,261
Other liabilities 2,645 2,320
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Total Liabilities 499,654 511,889
--------------- ---------------
STOCKHOLDERS' EQUITY
Common stock ($ .01 par value, 15,000,000 shares
authorized, 2,148,000 shares issued and outstanding) 21 21
Surplus 10,819 10,819
Retained earnings 54,429 53,607
Accumulated other comprehensive income (747) (648)
--------------- ---------------
Total Stockholders' Equity 64,522 63,799
--------------- ---------------
Total Liabilities and Stockholders' Equity $ 564,176 $ 575,688
=============== ===============
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(in thousands, except per share amounts)
Three Months Ended Three Months Ended
March 31, 2006 March 31, 2005
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INTEREST INCOME
Interest and fees on loans $ 5,515 $ 4,151
Interest and dividends on investments:
U.S. Treasury securities and U.S. Agency obligations 1,512 1,710
States & political subdivisions 625 694
Other securities 58 35
Interest on Federal funds sold - 23
Interest on balances with banks 9 37
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Total Interest Income 7,719 6,650
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INTEREST EXPENSE
Interest on time deposits of $100,000 or more 219 162
Interest on other deposits 1,426 901
Interest on other borrowed funds 903 890
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Total Interest Expense 2,548 1,953
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Net Interest Income 5,171 4,697
Provision for loan losses 127 122
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Net Interest Income After Provision for Loan Losses 5,044 4,575
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OTHER INCOME
Trust department income 354 353
Service charges on deposit accounts 189 224
Merchant transaction income 1,108 1,356
Other fee income 255 273
Other operating income 132 153
Realized (losses) gains on securities, net - (13)
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Total Other Income 2,038 2,346
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OTHER EXPENSES
Salaries and employee benefits 2,440 2,293
Expense of premises and fixed assets 652 675
Merchant transaction expenses 852 1,080
Other operating expenses 1,179 1,358
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Total Other Expenses 5,123 5,406
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Income before income taxes 1,959 1,515
Applicable income taxes 385 269
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Net Income 1,574 1,246
Other comprehensive income, net of taxes:
Unrealized securities (losses) gains (99) (697)
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Comprehensive Income $ 1,475 $ 549
================== ==================
Earnings per Common Share
(Based on 2,148,000 shares outstanding) $ 0.73 $ 0.58
Cash Dividends Declared Per Common Share $ 0.35 $ 0.33
PENSECO FINANCIAL SERVICES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(in thousands)
Three Months Ended Three Months Ended
March 31, 2006 March 31, 2005
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OPERATING ACTIVITIES
Net Income $ 1,574 $ 1,246
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 160 188
Provision for loan losses 127 122
Deferred income tax provision (benefit) 31 7
Amortization of securities, (net of accretion) 165 372
Net realized losses (gains) on securities - 13
Loss (gain) on other real estate - 10
Decrease (increase) in interest receivable 216 462
(Increase) decrease in other assets (1,480) (810)
Increase (decrease) in income taxes payable 217 262
Increase (decrease) in interest payable 61 44
Increase (decrease) in other liabilities 77 132
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Net cash provided by operating activities 1,148 2,048
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INVESTING ACTIVITIES
Purchase of investment securities available-for-sale (1,038) (33)
Proceeds from sales and maturities of investment securities
available-for-sale 16,219 15,757
Purchase of investment securities to be held-to-maturity - -
Proceeds from repayments of investment securities available-for-sale 2,907 4,068
Proceeds from repayments of investment securities held-to-maturity 1,994 3,115
Net loans (originated) repaid (8,162) (11,384)
Proceeds from other real estate 91 11
Investment in premises and equipment (127) (53)
----------------- ------------------
Net cash provided (used) by investing activities 11,884 11,481
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FINANCING ACTIVITIES
Net (decrease) increase in demand and savings deposits (779) (3,940)
Net proceeds (payments) on time deposits 174 321
Increase (decrease) in federal funds purchased - -
(Decrease) increase in repurchase agreements (13,509) 5,074
Net increase (decrease) in short-term borrowings 3,849 (127)
Repayments of long-term borrowings (2,356) (2,275)
Cash dividends paid (752) (709)
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Net cash provided (used) by financing activities (13,373) (1,656)
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Net (decrease) increase in cash and cash equivalents (341) 11,873
Cash and cash equivalents at January 1 11,573 8,297
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Cash and cash equivalents at March 31 $ 11,232 $ 20,170
================== ==================
The Company paid interest and income taxes of $2,487 and $0 and $1,909 and $284,
for the three month periods ended March 31, 2006 and 2005, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the Quarter Ended March 31, 2006
(unaudited)
These Notes to Financial Statements reflect events subsequent to December 31,
2005, the date of the most recent Report of Independent Registered Public
Accounting Firm, through the date of this Quarterly Report on Form 10-Q for the
quarter ended March 31, 2006. These Notes to Financial Statements should be read
in conjunction with Financial Information and Other Information required to be
furnished as part of this Report, in particular, (1) Management's Discussion and
Analysis of Financial Condition and Results of Operations for the three months
ended March 31, 2006 and March 31, 2005, with respect to the Company's net
interest income, capital requirements and liquidity, (2) Part II, Item 6,
Exhibits and (3) the Company's Annual Report - Form 10-K for the year ended
December 31, 2005, incorporated herein by reference.
FORWARD LOOKING INFORMATION
This Form 10-Q contains forward-looking informational statements, in addition to
the historical financial information required by the Securities and Exchange
Commission. There are certain risks and uncertainties associated with these
forward-looking statements which could cause actual results to differ materially
from those stated herein. Such differences are discussed in the section entitled
"Management Discussion and Analysis of Financial Condition and Results of
Operations". These forward-looking statements reflect management's analysis as
of this point in time. Readers should review the other documents the Company
periodically files with the Securities and Exchange Commission in order to keep
apprised of any material changes. The company undertakes no obligation to
publicly release the results of any revisions to those forward-looking
statements that may be made to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.
NOTE 1 -- Principles of Consolidation
Penseco Financial Services Corporation (Company) is a financial holding company,
incorporated under the laws of Pennsylvania. It is the parent company of Penn
Security Bank and Trust Company (Bank), a Pennsylvania state chartered bank.
Intercompany transactions have been eliminated in preparing the consolidated
financial statements.
The accounting policies of the Company conform with accounting principles
generally accepted in the United States of America and with general practices
within the banking industry.
NOTE 2 -- Basis of Presentation
The unaudited consolidated financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial information.
In the opinion of management, all adjustments that are of a normal recurring
nature and are considered necessary for a fair presentation have been included.
They are not, however, necessarily indicative of the results of consolidated
operations for a full year.
All information is presented in thousands of dollars, except per share amounts.
For further information, refer to the consolidated financial statements and
accompanying notes included in the Company's Annual Report - Form 10-K for the
year ended December 31, 2005.
NOTE 3 -- Use of 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 date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change
relate to the determination of the allowance for losses on loans and the
valuation of real estate acquired in connection with foreclosures or in
satisfaction of loans. In connection with the determination of the allowances
for losses on loans and foreclosed real estate, management obtains independent
appraisals for significant properties.
NOTE 4 -- Investment Securities
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is done based on
management's estimate of the lives of the securities, adjusted, when necessary,
for advanced prepayments in excess of those estimates.
Realized gains and losses on the sale of securities available-for-sale are
determined using the specific identification method and are reported as a
separate component of other income in the Statements of Income. Unrealized gains
and losses are included as a separate item in computing comprehensive income.
The amortized cost and fair value of investment securities at March 31, 2006 and
December 31, 2005 are as follows:
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
March 31, 2006 Cost Gains Losses Value
- --------------------------------------------------------------------------------
U.S. Agency securities $ 59,856 $ - $ 303 $ 59,553
Mortgage-backed securities 41,451 - 349 41,102
States & political
subdivisions 20,701 646 - 21,347
- --------------------------------------------------------------------------------
Total Debt Securities 122,008 646 652 122,002
Equity securities 7,553 449 43 7,959
- --------------------------------------------------------------------------------
Total Available-for-Sale $ 129,561 $ 1,095 $ 695 $ 129,961
- --------------------------------------------------------------------------------
AVAILABLE-FOR-SALE
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2005 Cost Gains Losses Value
- --------------------------------------------------------------------------------
U.S. Agency securities $ 74,852 $ - $ 308 $ 74,544
Mortgage-backed securities 44,408 - 407 44,001
States & political subdivisions 20,698 937 - 21,635
- --------------------------------------------------------------------------------
Total Debt Securities 139,958 937 715 140,180
Equity securities 7,433 402 73 7,762
- --------------------------------------------------------------------------------
Total Available-for-Sale $ 147,391 $ 1,339 $ 788 $ 147,942
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HELD-TO-MATURITY
Gross Gross
Amortized Unrealized Unrealized Fair
March 31, 2006 Cost Gains Losses Value
- --------------------------------------------------------------------------------
Mortgage-backed securities $ 50,648 $ 2 $ 1,890 $ 48,760
States & political subdivisions 29,252 1,991 - 31,243
- --------------------------------------------------------------------------------
Total Held-to-Maturity $ 79,900 $ 1,993 $ 1,890 $ 80,003
================================================================================
HELD-TO-MATURITY
Gross Gross
Amortized Unrealized Unrealized Fair
December 31, 2005 Cost Gains Losses Value
- --------------------------------------------------------------------------------
Mortgage-backed securities $ 52,763 $ 3 $ 1,274 $ 51,492
States & political subdivisions 29,252 2,386 - 31,638
- --------------------------------------------------------------------------------
Total Held-to-Maturity $ 82,015 $ 2,389 $ 1,274 $ 83,130
================================================================================
The amortized cost and fair value of debt securities at March 31, 2006 by
contractual maturity are shown below. Expected maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties.
March 31, 2006 Available-for-Sale Held-to-Maturity
- --------------------------------------------------------------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
- --------------------------------------------------------------------------------
Due in one year or less:
U.S. Agency securities $ 59,856 $ 59,553 $ - $ -
After one year through
five years:
U.S. Agency securities - - 241 261
After ten years:
States & political
subdivisions 20,701 21,347 29,011 30,982
- --------------------------------------------------------------------------------
Subtotal 80,557 80,900 29,252 31,243
Mortgage-backed securities 41,451 41,102 50,648 48,760
- --------------------------------------------------------------------------------
Total Debt Securities $ 122,008 $ 122,002 $ 79,900 $ 80,003
================================================================================
The gross fair value and unrealized losses of the Company's investments,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at March 31, 2006 and
December 31, 2005 are as follows:
Less than twelve months Twelve months or more Totals
----------------------- ----------------------- ----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
March 31, 2006 Value Losses Value Losses Value Losses
- ------------------------------------------------------------------------------------------------------------
U.S. Agency securities $ 34,667 $ 161 $ 24,886 $ 142 $ 59,553 $ 303
Mortgage-backed securities 8,087 119 81,404 2,120 89,491 2,239
States & political subdivisions - - - - - -
Equities 728 38 342 5 1,070 43
- ------------------------------------------------------------------------------------------------------------
Total $ 43,482 $ 318 $ 106,632 $ 2,267 $ 150,114 $ 2,585
============================================================================================================
The table above at March 31, 2006, includes fourteen (14) securities that have
unrealized losses for less than twelve months and twelve (12) securities that
have been in an unrealized loss position for twelve or more months.
Less than twelve months Twelve months or more Totals
----------------------- ----------------------- ----------------------
Fair Unrealized Fair Unrealized Fair Unrealized
December 31, 2005 Value Losses Value Losses Value Losses
- ------------------------------------------------------------------------------------------------------------
U.S. Agency securities $ 39,870 $ 227 $ 34,674 $ 81 $ 74,544 $ 308
Mortgage-backed securities 8,598 104 86,501 1,577 95,099 1,681
States & political subdivisions - - - - - -
Equities 1,298 73 - - 1,298 73
- ------------------------------------------------------------------------------------------------------------
Total $ 49,766 $ 404 $ 121,175 $ 1,658 $ 170,941 $ 2,062
============================================================================================================
U.S. Agency Securities
The unrealized losses on the Company's investments in these obligations were
caused by recent interest rate increases. The contractual terms of these
investments do not permit the issuer to settle the securities at a price less
than the par value of the investment. Because the Company has the ability to
hold these investments until a recovery of fair value, which may be maturity,
the Company does not consider these investments to be other-than-temporarily
impaired at March 31, 2006.
Mortgage-Backed Securities
The unrealized losses on the Company's investment in mortgage-backed securities
were caused by recent interest rate increases, along with the unamortized
premium. The bank amortizes the premium to expected maturity and adjusts for
unusual prepayments. The contractual cash flows of these investments are
guaranteed by an agency of the U.S. government. Accordingly, it is expected that
these securities would not be settled at a price less than the amortized cost of
the Company's investment. Because the decline in market value is attributable to
changes in interest rates and not credit quality and because the Company has the
ability to hold these investments until a recovery of fair value, which may be
maturity, the Company does not consider these investments to be
other-than-temporarily impaired at March 31, 2006.
Marketable Equity Securities
The unrealized losses on the Company's investment in marketable equity
securities were caused primarily by recent interest rate increases and other
market conditions. The Company's investments in marketable equity securities
consist primarily of investments in common stock of companies in the financial
services industry. Because the Company has the ability and intent to hold these
investments for a reasonable period of time sufficient for a forecasted recovery
of fair value, the Company does not consider these investments to be
other-than-temporarily impaired at March 31, 2006.
NOTE 5 -- Loan Portfolio
Details regarding the Company's loan portfolio:
March 31, December 31,
As Of: 2006 2005
- --------------------------------------------------------------------------------
Real estate - construction and land development $ 13,244 $ 13,132
Real estate mortgages 242,605 227,853
Commercial 31,908 42,894
Credit card and related plans 3,008 3,152
Installment and all other loans 29,358 26,293
Obligations of states & political subdivisions 9,372 8,038
- --------------------------------------------------------------------------------
Loans, net of unearned income 329,495 321,362
Less: Allowance for loan losses 3,900 3,800
- --------------------------------------------------------------------------------
Loans, net $ 325,595 $ 317,562
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NOTE 6 -- Loan Servicing
The Company generally retains the right to service mortgage loans sold to
others. The cost allocated to the mortgage servicing rights retained has been
recognized as a separate asset and is being amortized in proportion to and over
the period of estimated net servicing income.
Mortgage servicing rights are evaluated for impairment based on the fair value
of those rights. Fair values are estimated using discounted cash flows based on
current market rates of interest and current expected future prepayment rates.
For purposes of measuring impairment, the rights must be stratified by one or
more predominant risk characteristics of the underlying loans. The Company
stratifies its capitalized mortgage servicing rights based on the product type,
interest rate and term of the underlying loans. The amount of impairment
recognized is the amount, if any, by which the amortized cost of the rights for
each stratum exceed the fair value.
NOTE 7 -- Long-Term Debt
During 2003, the Bank borrowed $100,000 from the Federal Home Loan Bank, in four
loans with various maturity dates, to finance the purchase of a mortgaged-backed
security.
The loans are secured by a general collateral pledge of the Company.
A summary of the long-term debt at March 31, 2006 is as follows:
Note payable, due in monthly installments of $161, including
principal and interest at a fixed rate of 2.73%, maturing March, 2008. $ 3,748
Note payable, due in monthly installments of $253, including
principal and interest at a fixed rate of 3.22%, maturing March, 2010. 11,377
Note payable, due in monthly installments of $430, including
principal and interest at a fixed rate of 3.74%, maturing March, 2013. 31,740
Note payable, due in monthly installments of $186, including
principal and interest at a fixed rate of 4.69%, maturing March, 2023. 26,180
-------
Total long-term debt $73,045
=======
The Company has agreed to maintain sufficient qualifying collateral to fully
secure the above borrowings.
Aggregate maturities of long-term debt at March 31, 2006 are as follows:
March 31, Principal
--------- ---------
2007 $ 9,631
2008 9,974
2009 8,377
2010 8,692
2011 5,938
Thereafter 30,433
---------
$ 73,045
=========
NOTE 8 -- Employee Benefit Plans
The Company provides a defined benefit pension plan for eligible employees.
The components of the net periodic benefit costs are as follows:
Pension Benefits Other Benefits
---------------- ----------------
Three months ended March 31, 2006 2005 2006 2005
- ----------------------------------------------------------------------------
Service cost $ 109 $ 104 $ 1 $ 2
Interest cost 167 168 4 4
Expected return on plan assets (223) (189) - -
Amortization of prior service cost 2 - 2 2
Amortization of net loss (gain) 41 27 - -
- ----------------------------------------------------------------------------
Net periodic pension cost $ 96 $ 110 $ 7 $ 8
============================================================================
Contributions
- -------------
The Company previously disclosed in its financial statements for the year ended
December 31, 2005, that it expected to contribute $246 to its pension plan and
$13 to its postretirement plan for 2006. As of April 15, 2006, $62 has been
contributed to the pension plan for 2006. The Company previously disclosed that
it contributed an additional $1,005 during the first quarter of 2006 to the
Company's pension plan. The pension and postretirement contribution estimates
have not changed since December 31, 2005. Readers should refer to the Annual
Report on Form 10K for further details on the Company's defined benefit pension
plan.
NOTE 9 -- Regulatory Matters
The Company 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 Company and the Bank's Consolidated Financial Statements.
Under capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Company and the Bank must meet specific capital
guidelines that involve quantitative measures of their assets, liabilities, and
certain off-balance sheet items as calculated under regulatory accounting
practices. The Company and the Bank's 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 Company and the Bank to maintain minimum amounts and ratios (set
forth in the Capital Adequacy table on the following page) of Tier I and Total
Capital to risk-weighted assets and of Tier I Capital to average assets
(Leverage ratio). The table also presents the Company's actual capital amounts
and ratios. The Bank's actual capital amounts and ratios are substantially
identical to the Company's. Management believes, as of March 31, 2006, that the
Company and the Bank meet all capital adequacy requirements to which they are
subject.
As of March 31, 2006, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Company as "well capitalized" under
the regulatory framework for prompt corrective action. To be categorized as
"well capitalized", the Company must maintain minimum Tier I Capital, Total
Capital and Leverage ratios as set forth in the Capital Adequacy table. There
are no conditions or events since that notification that management believes
have changed the Company's categorization by the FDIC.
The Company and Bank are also subject to minimum capital levels, which could
limit the payment of dividends, although the Company and Bank currently have
capital levels which are in excess of minimum capital level ratios required.
The Pennsylvania Banking Code restricts capital funds available for payment of
dividends to the Retained Earnings of the Bank. Accordingly, at March 31, 2006,
the balances in the Capital Stock and Surplus accounts totalling $10,840 are
unavailable for dividends.
In addition, the Bank is subject to restrictions imposed by Federal law on
certain transactions with the Company's affiliates. These transactions include
extensions of credit, purchases of or investments in stock issued by the
affiliate, purchases of assets subject to certain exceptions, acceptance of
securities issued by an affiliate as collateral for loans, and the issuance of
guarantees, acceptances, and letters of credit on behalf of affiliates. These
restrictions prevent the Company's affiliates from borrowing from the Bank
unless the loans are secured by obligations of designated amounts. Further, the
aggregate of such transactions by the Bank with a single affiliate is limited in
amount to 10 percent of the Bank's Capital Stock and Surplus, and the aggregate
of such transactions with all affiliates is limited to 20 percent of the Bank's
Capital Stock and Surplus. The Federal Reserve System has interpreted "Capital
Stock and Surplus" to include undivided profits.
Actual Regulatory Requirements
- ---------------------------------------------- --------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
As of March 31, 2006 Amount Ratio Amount Ratio Amount Ratio
- ----------------------------------------------------------------------------------------------
Total Capital
(to Risk Weighted Assets) $ 68,885 19.09% > $ 28,870 > 8.0% > $ 36,088 > 10.0%
- - - -
Tier 1 Capital
(to Risk Weighted Assets) $ 64,985 18.01% > $ 14,435 > 4.0% > $ 21,653 > 6.0%
- - - -
Tier 1 Capital
(to Average Assets) $ 64,985 11.48% > $ * > * > $ 28,298 > 5.0%
- - - -
*3.0% ($16,979), 4.0% ($22,638) or 5.0% ($28,298) depending on the bank's CAMELS
Rating and other regulatory risk factors.
Actual Regulatory Requirements
- ---------------------------------------------- --------------------------------------------
For Capital To Be
Adequacy Purposes "Well Capitalized"
As of December 31, 2005 Amount Ratio Amount Ratio Amount Ratio
- ----------------------------------------------------------------------------------------------
Total Capital
(to Risk Weighted Assets) $ 67,933 18.62% > $ 29,188 > 8.0% > $ 36,486 > 10.0%
- - - -
Tier 1 Capital
(to Risk Weighted Assets) $ 64,133 17.58% > $ 14,594 > 4.0% > $ 21,892 > 6.0%
- - - -
Tier 1 Capital
(to Average Assets) $ 64,133 11.28% > * > * > $ 28,415 > 5.0%
- - - -
*3.0% ($17,049), 4.0% ($22,732) or 5.0% ($28,415) depending on the bank's CAMELS
Rating and other regulatory risk factors.
PART 1. FINANCIAL INFORMATION, Item 2 --
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following commentary provides an overview of the financial condition and
significant changes in the results of operations of Penseco Financial Services
Corporation and its subsidiary, Penn Security Bank and Trust Company, for the
three months ended March 31, 2006 and March 31, 2005. Throughout this review,
the subsidiary of Penseco Financial Services Corporation, Penn Security Bank and
Trust Company, is referred to as the "Company". All intercompany accounts and
transactions have been eliminated in preparing the consolidated financial
statements. All information is presented in thousands of dollars, except as
indicated.
Critical Accounting Policies
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 date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Provision (allowance) for possible loan losses - The provision for loan losses
is based on past loan loss experience, management's evaluation of the potential
loss in the current loan portfolio under current economic conditions and such
other factors as, in management's best judgment, deserve current recognition in
estimating loan losses. The annual provision for loan losses charged to
operating expense is that amount which is sufficient to bring the balance of the
allowance for possible loan losses to an adequate level to absorb anticipated
losses.
Actuarial assumptions associated with pension, post-retirement and other
employee benefit plans - These assumptions include discount rate, rate of future
compensation increases and expected return on plan assets.
Provision for income taxes - Management believes that the assumptions and
judgments used to record tax related assets or liabilities have been
appropriate.
Fair value of certain investment securities - Fair value of investment
securities are based on quoted market prices.
Loan servicing rights - Mortgage servicing rights are evaluated for impairment
based on the fair value of those rights. Fair values are estimated using
discounted cash flows based on current market rates of interest and current
expected future prepayment rates. For purposes of measuring impairment, the
rights must be stratified by one or more predominant risk characteristics of the
underlying loans. The Company stratifies its capitalized mortgage servicing
rights based on the product type, interest rate and term of the underlying
loans. The amount of impairment recognized is the amount, if any, by which the
amortized cost of the rights for each stratum exceed the fair value.
Premium amortization - The amortization of premiums on mortgage-backed
securities is done based on management's estimate of the lives of the
securities, adjusted, when necessary, for advanced prepayments in excess of
those estimates.
Executive Summary
Penseco Financial Services Corporation reported an increase in net income of
$328 or 26.3% for the three months ended March 31, 2006 to $1,574 or $.73 per
share compared with $1,246 or $.58 per share from the year ago period. Net
interest income after provision for loan losses increased $469 or 10.3%, to
$5,044 for three months ended March 31, 2006 compared to $4,575 for the same
quarter of 2005. Partly, the increase resulted from higher interest on loans due
to net loan growth of $37.9 million since March 31, 2005, including $8.0 million
from December 31, 2005. Other income decreased $308 or 13.1% for the three
months ended March 31, 2006 to $2,038 compared with $2,346 for the three months
ended March 31, 2005. Total other expenses decreased $283 or 5.2% to $5,123 for
the first quarter 2006, compared with $5,406 for the same period of 2005.
Net Interest Income and Net Interest Margin
Net interest income, the largest contributor to the Company's earnings, is
defined as the difference between interest income on assets and the cost of
funds supporting those assets. Average earning assets are composed primarily of
loans and investments while deposits, short-term and long-term borrowings
represent interest-bearing liabilities.
Variations in the volume and mix of these assets and liabilities, as well as
changes in the yields earned and rates paid, are determinants of changes in net
interest income.
Net interest income after provision for loan losses increased $469 or 10.3% to
$5,044 for the three months ended March 31, 2006 compared to $4,575 for the
three months ended March 31, 2005. The average yield on earning assets increased
85 basis points, largely due to volume increases and increase in interest rates.
Also, there was an increase of $37.9 million in average loans from the
comparable period of 2005.
The net interest margin represents the Company's net yield on its average
earning assets and is calculated as net interest income divided by average
earning assets. In the three months ended March 31, 2006, net interest margin
was 3.80% increasing 39 basis points from 3.41% in the same period of 2005.
Total average earning assets and average interest bearing funds decreased in the
three months ended March 31, 2006 as compared to 2005. Average earning assets
decreased $7.3 million or 1.3%, from $551.7 million in 2005 to $544.4 million in
2006 and average interest bearing funds decreased $10.5 million, or 2.5%, from
$422.6 million to $412.1 million for the same period, mainly due to lower
savings and money market accounts, as well as, reductions in repurchase
agreements and long-term borrowings. As a percentage of average assets, earning
assets decreased to 96.2% for the three months ended March 31, 2006 from 96.6%
for the year ago period.
Changes in the mix of both earning assets and funding sources also impacted net
interest income in the three months ended March 31, 2006 and 2005. Average loans
as a percentage of average earning assets increased from 51.9% in 2005 to 59.5%
in 2006, due in part to the increase of new residential mortgages as well as
commercial loans secured by real estate; average investments decreased $34.7
million from 46.1% to 40.3% of earning assets. Average short-term investments,
federal funds sold and interest bearing balances with banks decreased $10.5
million to $.8 million from $11.3 million. Average time deposits increased $7.1
million or 6.4%, average short-term borrowings increased $5.6 million, average
long-term borrowings decreased $9.2 million, and repurchase agreements decreased
$4.8 million.
Shifts in the interest rate environment and competitive factors affected the
rates paid for funds as well as the yields earned on assets. The investment
securities tax equivalent yield increased 17 basis points from 4.40% in the
three months ended March 31, 2005 to 4.57% for 2006. Average loan yields
increased 101 basis points, from 5.80% in the three months ended March 31, 2005
to 6.81% in 2006.
The average time deposit costs increased 94 basis points from 2.56% in 2005 to
3.50% in 2006, along with money market accounts increasing 120 basis points from
1.11% in 2005 to 2.31% in 2006. Also, short-term borrowings increased 361 basis
points from 1.66% in 2005 to 5.27% in 2006.
The most significant change in net interest income has been the growth in our
average loan portfolio of $37.9 million mostly in commercial and real estate
loans which will have a significant positive impact on our net interest margin.
Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates
and Interest Differential
The table below presents average balances, interest income on a fully taxable
equivalent basis and interest expense, as well as average rates earned and paid
on the Company's major asset and liability items for the three months ended
March 31, 2006 and March 31, 2005.
- ----------------------------------------------------------------------------------------------------------
March 31, 2006 March 31, 2005
ASSETS Average Revenue/ Yield/ Average Revenue/ Yield/
Balance Expense Rate Balance Expense Rate
- ----------------------------------------------------------------------------------------------------------
Investment Securities
Available-for-sale:
U.S. Treasury securities $ - $ - - $ 5,077 $ 83 6.54%
U.S. Agency obligations 109,229 947 3.47% 118,480 918 3.10%
States & political
subdivisions 21,635 235 6.58% 31,430 298 5.75%
Federal Home Loan Bank stock 4,848 28 2.31% 5,166 31 2.40%
Other 3,063 30 3.92% 662 4 2.42%
Held-to-maturity:
U.S. Agency obligations 51,561 565 4.38% 64,190 709 4.42%
States & political
subdivisions 29,252 390 8.08% 29,249 396 8.21%
Loans, net of unearned income:
Real estate mortgages 242,160 4,189 6.92% 206,930 3,020 5.84%
Commercial 42,577 579 5.44% 42,899 616 5.74%
Consumer and other 39,300 747 7.60% 36,352 515 5.67%
Federal funds sold - - - 4,008 23 2.30%
Interest on balances with banks 757 9 4.76% 7,264 37 2.04%
- ----------------------------------------------------------------------------------------------------------
Total Earning Assets/Total Interest Income 544,382 $ 7,719 5.67% 551,707 $ 6,650 4.82%
- ----------------------------------------------------------------------------------------------------------
Cash and due from banks 9,189 7,891
Bank premises and equipment 9,571 9,179
Accrued interest receivable 3,022 2,834
Other assets 3,582 2,967
Less: Allowance for loan losses 3,790 3,594
- ----------------------------------------------------------------------------------------------------------
Total Assets $ 565,956 $ 570,984
- ----------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Demand-Interest bearing $ 31,707 $ 52 0.66% $ 31,219 $ 33 0.42%
Savings 75,056 64 0.34% 80,099 69 0.34%
Money markets 86,781 501 2.31% 91,457 253 1.11%
Time - Over $100 28,437 219 3.08% 24,143 162 2.68%
Time - Other 89,162 809 3.63% 86,370 546 2.53%
Federal funds purchased - - - - - -
Repurchase agreements 20,638 91 1.76% 25,407 76 1.20%
Short-term borrowings 6,144 81 5.27% 482 2 1.66%
Long-term borrowings 74,194 731 3.94% 83,397 812 3.89%
- ----------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities/
Total Interest Expense 412,119 $ 2,548 2.47% 422,574 $ 1,953 1.85%
- ----------------------------------------------------------------------------------------------------------
Demand - Non-interest bearing 87,002 84,131
All other liabilities 2,179 1,473
Stockholders' equity 64,656 62,806
- ----------------------------------------------------------------------------------------------------------
Total Liabilities and
Stockholders' Equity $ 565,956 $ 570,984
- ----------------------------------------------------------------------------------------------------------
Interest Spread 3.20% 2.97%
- ----------------------------------------------------------------------------------------------------------
Net Interest Income $ 5,171 $ 4,697
- ----------------------------------------------------------------------------------------------------------
FINANCIAL RATIOS
Net interest margin 3.80% 3.41%
Return on average assets 1.11% 0.87%
Return on average equity 9.74% 7.94%
Average equity to average assets 11.42% 11.00%
Dividend payout ratio 47.95% 56.90%
- ----------------------------------------------------------------------------------------------------------
Investments
The Company's investment portfolio consists primarily of two functions: To
provide liquidity and to contribute to earnings. To provide liquidity the
Company may invest in short-term securities such as Federal funds sold, interest
bearing deposits with banks, U.S. Treasury securities and U.S. Agency securities
all with maturities of one year or less. These funds are invested short-term to
ensure the availability of funds to meet customer demand for credit needs. The
Company enhances interest income by securing long-term investments within its
investment portfolio, by means of U.S. Treasury securities, U.S. Agency
securities, municipal securities and mortgage-backed securities generally with
maturities greater than one year.
Investments in securities are classified in two categories and accounted for as
follows:
Securities Held-to-Maturity Bonds, notes, debentures and mortgage-backed
securities for which the Company has the positive intent and ability to hold to
maturity are reported at cost, adjusted for amortization of premiums and
accretion of discounts computed on the straight-line basis, which approximates
the interest method, over the remaining period to maturity.
Securities Available-for-Sale Bonds, notes, debentures, mortgage-backed
securities and certain equity securities not classified as securities to be held
to maturity are carried at fair value with unrealized holding gains and losses,
net of tax, reported as a net amount in a separate component of stockholders'
equity until realized.
The amortization of premiums on mortgage-backed securities is determined based
on management's estimate of the lives of the securities, adjusted, when
necessary, for advanced prepayments in excess of those estimates.
Gains and losses on the sale of securities available-for-sale are determined
using the specific identification method and are reported as a separate
component of other income in the Statements of Income.
Deposits
The Company is largely dependent on its core deposit base to fund operations.
Management has competitively priced its deposit products in checking, savings,
money market and time deposits to provide a stable source of funding.
As the economy shows strength and improves, migration of some deposits may
return to the equity markets as consumers become more prone to increased yields.
Historically, such changes in the Company's deposit base have been minimal.
Provision for Loan Losses
The provision for loan losses represents management's determination of the
amount necessary to bring the allowance for loan losses to a level that
management considers adequate to reflect the risk of future losses inherent in
the Company's loan portfolio. The process of determining the adequacy of the
allowance is necessarily judgmental and subject to changes in external
conditions. The allowance for loan losses reflects management's judgment as to
the level considered appropriate to absorb such losses based upon a review of
many factors, including historical loss experience, adverse situations that may
affect the borrower's ability to repay (including the timing of future
payments), economic conditions and trends, loan portfolio volume and mix, loan
performance trends, the value and adequacy of collateral, and the Company's
internal credit review process. Accordingly, there can be no assurance that
existing levels of the allowance will ultimately prove adequate to cover actual
loan losses. The quarterly provision for loan losses charged to operating
expense is that amount which is sufficient to bring the balance of the allowance
for possible loan losses to an adequate level to absorb anticipated losses.
Based on this ongoing evaluation, management determines the provision necessary
to maintain an appropriate allowance.
For the three months ended March 31, 2006, the provision for loan losses
increased to $127 from $122 in the three months ended March 31, 2005. Loans
charged off totaled $29 and recoveries were $2 for the three months ended March
31, 2006. In the same period of 2005, loans charged off were $24 and recoveries
were $2. At March 31, 2006 the allowance for loan losses was set at $3,900 or
1.18% of loans based upon the bank's analysis, compared to $3,700 or 1.27% of
loans at March 31, 2005.
Other Income
The following table sets forth information by category of other income for the
Company for three months ended March 31, 2006 and March 31, 2005, respectively:
March 31, March 31,
Three Months Ended: 2006 2005
- ----------------------------------------------------------------------------
Trust department income $ 354 $ 353
Service charges on deposit accounts 189 224
Merchant transaction income 1,108 1,356
Other fee income 255 273
Other operating income 132 153
Realized (losses) gains on securities, net - (13)
- ----------------------------------------------------------------------------
Total Other Income $ 2,038 $ 2,346
============================================================================
Other income decreased $308 or 13.1% to $2,038 for the three months ended March
31, 2006 compared with $2,346 for the similar period of 2005. Merchant
transaction income decreased $248 or 18.3% due to lower transaction volume.
Service charge on deposit accounts decreased $35 or 15.6% while other fee income
fell $18 or 6.6% as accommodations were made to our customers during the
computer conversion that took place during the quarter. Other operating income
decreased $21 or 13.7%, mainly because March 31, 2005 included the recovery of a
previously written off cash item.
Other Expenses
The following table sets forth information by category of other expenses for the
Company for the three months ended March 31, 2006 and March 31, 2005,
respectively:
March 31, March 31,
Three Months Ended: 2006 2005
- ----------------------------------------------------------------------------
Salaries and employee benefits $ 2,440 $ 2,293
Expense of premises and fixed assets 652 675
Merchant transaction expenses 852 1,080
Other operating expenses 1,179 1,358
- ----------------------------------------------------------------------------
Total Other Expenses $ 5,123 $ 5,406
============================================================================
Total other expenses decreased $283 or 5.2% to $5,123 for the first quarter
ended March 31, 2006 compared with $5,406 for the same period of 2005. Salaries
and employee benefits increased $147 or 6.4%, mainly due to additional wages
related to a computer conversion during the first quarter. Merchant transaction
expense decreased by $228 or 21.1% due to lower transaction volume. Other
operating expenses decreased $179 or 13.2%, from decreased professional fees and
general operating expenses.
Applicable income taxes increased $116 or 43.1% due to higher income along with
lower tax-free income.
Loan Portfolio
Details regarding the Company's loan portfolio:
March 31, December 31,
As Of: 2006 2005
- --------------------------------------------------------------------------------
Real estate - construction and land development $ 13,244 $ 13,132
Real estate mortgages 242,605 227,853
Commercial 31,908 42,894
Credit card and related plans 3,008 3,152
Installment and all other loans 29,358 26,293
Obligations of states & political subdivisions 9,372 8,038
- --------------------------------------------------------------------------------
Loans, net of unearned income 329,495 321,362
Less: Allowance for loan losses 3,900 3,800
- --------------------------------------------------------------------------------
Loans, net $ 325,595 $ 317,562
================================================================================
Loan Quality
The lending activities of the Company are guided by the comprehensive lending
policy established by the Board of Directors. Loans must meet criteria which
include consideration of the character, capacity and capital of the borrower,
collateral provided for the loan, and prevailing economic conditions.
Regardless of credit standards, there is risk of loss inherent in every loan
portfolio. The allowance for loan losses is an amount that management believes
will be adequate to absorb possible losses on existing loans that may become
uncollectible, based on evaluations of the collectibility of the loans. The
evaluations take into consideration such factors as change in the nature and
volume of the loan portfolio, overall portfolio quality, review of specific
problem loans, industry experience, collateral value and current economic
conditions that may affect the borrower's ability to pay. Management believes
that the allowance for loan losses is adequate. While management uses available
information to recognize losses on loans, future additions to the allowance may
be necessary based on changes in economic conditions. In addition, various
regulatory agencies, as an integral part of their examination process,
periodically review the Company's allowance for loan losses. Such agencies may
require the Company to recognize additions to the allowance based on their
judgment of information available to them at the time of their examination.
The allowance for loan losses is increased by periodic charges against earnings
as a provision for loan losses, and decreased periodically by charge-offs of
loans (or parts of loans) management has determined to be uncollectible, net of
actual recoveries on loans previously charged-off.
Non-Performing Assets
Non-performing assets consist of non-accrual loans, loans past due 90 days or
more and still accruing interest and other real estate owned. The following
table sets forth information regarding non-performing assets as of the dates
indicated:
March 31, December 31, March 31,
As Of: 2006 2005 2005
- ---------------------------------------------------------------------------------------
Non-accrual loans $ 1,443 $ 1,627 $ 1,534
Loans past due 90 days or more and accruing:
Guaranteed student loans 349 152 268
Credit card loans 12 21 4
- ---------------------------------------------------------------------------------------
Total non-performing loans 1,804 1,800 1,806
Other real estate owned 2 91 334
- ---------------------------------------------------------------------------------------
Total non-performing assets $ 1,806 $ 1,891 $ 2,140
=======================================================================================
Loans are generally placed on a non-accrual status when principal or interest is
past due 90 days or when payment in full is not anticipated. When a loan is
placed on non-accrual status, all interest previously accrued but not collected
is charged against current income. Loans are returned to accrual status when
past due interest is collected and the collection of principal is probable.
Loans on which the accrual of interest has been discontinued or reduced amounted
to $1,443 and $1,534 at March 31, 2006 and March 31, 2005, respectively. If
interest on those loans had been accrued, such income would have been $45 and
$208 for the three months ended March 31, 2006 and March 31, 2005, respectively.
Interest income on those loans, which is recorded only when received, amounted
to $1 and $0 for March 31, 2006 and March 31, 2005, respectively. There are no
commitments to lend additional funds to individuals whose loans are in
non-accrual status.
The management process for evaluating the adequacy of the allowance for loan
losses includes reviewing each month's loan committee reports which list all
loans that do not meet certain internally developed criteria as to collateral
adequacy, payment performance, economic conditions and overall credit risk.
These reports also address the current status and actions in process on each
listed loan. From this information, adjustments are made to the allowance for
loan losses. Such adjustments include both specific loss allocation amounts and
general provisions by loan category based on present and past collection
experience, nature and volume of the loan portfolio, overall quality, and
current economic conditions that may affect the borrower's ability to pay. As of
March 31, 2006 there
are no significant loans as to which management has serious doubt about their
collectibility other than what is included above.
At March 31, 2006 and December 31, 2005, the Company did not have any loans
specifically classified as impaired.
Most of the Company's lending activity is with customers located in the
Company's geographic market area and repayment thereof is affected by economic
conditions in this market area.
Loan Loss Experience
The following tables present the Company's loan loss experience during the
periods indicated:
March 31, March 31,
Three Months Ended: 2006 2005
- -------------------------------------------------------------------------
Balance at beginning of period $ 3,800 $ 3,600
Charge-offs:
Real estate mortgages - 10
Commercial and all others 23 -
Credit card and related plans 6 7
Installment loans - 7
- -------------------------------------------------------------------------
Total charge-offs 29 24
- -------------------------------------------------------------------------
Recoveries:
Real estate mortgages - -
Commercial and all others - -
Credit card and related plans 2 1
Installment loans - 1
- -------------------------------------------------------------------------
Total recoveries 2 2
- -------------------------------------------------------------------------
Net charge-offs (recoveries) 27 22
- -------------------------------------------------------------------------
Provision charged to operations 127 122
- -------------------------------------------------------------------------
Balance at End of Period $ 3,900 $ 3,700
=========================================================================
Ratio of net charge-offs (recoveries)
to average loans outstanding 0.008% 0.008%
=========================================================================
Management believes the allowance for loan losses is considered adequate based
on its methodology. The allowance for loan losses, as a percentage of total
loans, stands at 1.18% at March 31, 2006 and 1.27% at March 31, 2005.
The allowance for loan losses is allocated as follows:
As Of: March 31, 2006 December 31, 2005 March 31, 2005
- ---------------------------------------------------------------------------------------------
Amount %* Amount %* Amount %*
- ---------------------------------------------------------------------------------------------
Real estate mortgages $ 1,200 78% $ 1,200 75% $ 1,100 72%
Commercial and all others 2,225 12% 2,190 16% 2,170 15%
Credit card and related plans 225 1% 185 1% 180 1%
Personal installment loans 250 9% 225 8% 250 12%
- ---------------------------------------------------------------------------------------------
Total $ 3,900 100% $ 3,800 100% $ 3,700 100%
=============================================================================================
* Percent of loans in each category to total loans
Liquidity
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
The Company remains in a highly liquid condition both in the short and long
term. Sources of liquidity include the Company's U.S. Agency bond portfolios,
additional deposits, earnings, overnight loans to and from other companies
(Federal Funds) and lines of credit at the Federal Reserve Bank and the Federal
Home Loan Bank. The Company is not a party to any commitments, guarantees or
obligations that could materially affect its liquidity.
The Company offers collateralized repurchase agreements, that have a one day
maturity, as an alternative deposit option for its customers. The Company also
has long-term debt outstanding to the FHLB, which was used to purchase a Freddie
Mac pool of residential mortgages, as described earlier in this report. The
Company maintains a collateralized maximum borrowing capacity of $194,628 with
the Federal Home Loan Bank of Pittsburgh.
Commitments and Contingent Liabilities
In the normal course of business, there are outstanding commitments and
contingent liabilities, created under prevailing terms and collateral
requirements such as commitments to extend credit, financial guarantees and
letters of credit, which are not reflected in the accompanying Financial
Statements. The Company does not anticipate any losses as a result of these
transactions. These instruments involve, to varying degrees, elements of credit
and interest rate risk in excess of the amount recognized in the Balance Sheets.
The contract or notional amounts of those instruments reflect the extent of
involvement the Company has in particular classes of financial 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 expiration dates of one year or less or other termination clauses
and may require payment of a fee. Since many of the commitments are expected to
expire without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.
Standby letters of credit are conditional commitments issued 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.
Related Parties
The Company does not have any material transactions involving related persons or
entities, other than traditional banking transactions, which are made on the
same terms and conditions as those prevailing at the time for comparable
transactions with unrelated parties. The Bank has issued standby letters of
credit for the accounts of related parties in the amount of $6,545.
Capital Resources
A strong capital position is important to the continued profitability of the
Company and promotes depositor and investor confidence. The Company's capital
provides a basis for future growth and expansion and also provides additional
protection against unexpected losses.
Additional sources of capital would come from retained earnings from the
operations of the Company and from the sale of additional common stock.
Management has no plans to offer additional common stock at this time.
The Company's total risk-based capital ratio was 19.09% at March 31, 2006. The
Company's risk-based capital ratio is more than the 10.00% ratio that Federal
regulators use as the "well capitalized" threshold. This is the current criteria
which the FDIC uses in determining the lowest insurance rate for deposit
insurance. The Company's risk-based capital ratio is more than double the 8.00%
limit, which determines whether a company is "adequately capitalized". Under
these rules, the Company could significantly increase its assets and still
comply with these capital requirements without the necessity of increasing its
equity capital.
PART 1. FINANCIAL INFORMATION, Item 3 --
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company currently does not enter into derivative financial instruments,
which include futures, forwards, interest rate swaps, option contracts and other
financial instruments with similar characteristics. However, the Company is
party to traditional financial instruments with off-balance sheet risk in the
normal course of business to meet the financing needs of its customers. These
financial instruments include commitments to extend credit, financial guarantees
and letters of credit. These traditional instruments involve to varying degrees,
elements of credit and interest rate risk in excess of the amount recognized in
the Consolidated Balance Sheets. 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. Standby letters of credit
are conditional commitments issued to guarantee the performance of a customer to
a third party up to a stipulated amount and with specified terms and conditions.
Commitments to extend credit and standby letters of credit are not recorded as
an asset or liability by the Company until the instrument is exercised. The
Company's exposure to market risk is reviewed on a regular basis by the
Asset/Liability Committee. Interest rate risk is the potential of economic
losses due to future interest rate changes. These economic losses can be
reflected as a loss of future net interest income and/or a loss of current fair
market values. The objective is to measure the effect on net interest income and
to adjust the balance sheet to minimize the inherent risk while at the same time
maximizing income. Management realizes certain risks are inherent and that the
goal is to identify and minimize the risks. Tools used by management include the
standard GAP report and an interest rate shock simulation report. The Company
has no market risk sensitive instruments held for trading purposes. It appears
the Company's market risk is reasonable at this time.
PART 1. FINANCIAL INFORMATION, Item 4 --
CONTROLS AND PROCEDURES
Under the supervision and with the participation of our management, including
our Chief Executive Officer and Controller, we conducted an evaluation of our
disclosure controls and procedures, as such term is defined under Rule 13a-15(e)
under the Securities Exchange Act of 1934. Based upon this evaluation, our Chief
Executive Officer and our Controller concluded that our disclosure controls and
procedures were effective as of the end of the period covered by this quarterly
report.
The Company continually assesses the adequacy of its internal control over
financial reporting and enhances its controls in response to internal control
assessments, and internal and external audit and regulatory recommendations. The
Company installed new computer software encompassing most core banking
applications during the quarter ended, March 31, 2006. When fully implemented
the new software will provide for enhanced internal controls over financial
reporting.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate due to changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
PART II. OTHER INFORMATION
Item 1 -- Legal Proceedings
None.
Item 1A -- Risk Factors
RISKS RELATED TO OUR BUSINESS
Credit Risk
Changes in the credit quality of our loan portfolio may impact the level of our
allowance for loan losses.
We make various judgments about the collectibility of our loans, including the
creditworthiness of our borrowers and the value of the real estate and other
assets serving as collateral for our loans. In determining the amount of the
allowance for loan losses, we review our loans and our loan loss and delinquency
experience, and we evaluate economic conditions. If our judgments are incorrect,
our allowance for loan losses may not be sufficient to cover future losses,
which will result in additions to our allowance through increased provisions for
loan losses. In addition, bank regulators periodically review our allowance for
loan losses and may require us to increase our provision for loan losses or
recognize further loan charge-offs. Increased provisions for loan losses would
increase our expenses and reduce our profits.
Nonetheless, to the best of management's knowledge, there are also no particular
risk elements in the local economy that put a group or category of loans at
increased risk. Also the Company is not dependent upon a single customer, or a
few customers, the loss of one or more of which would have a material adverse
effect on its operations. The operations and earnings of the Corporation are
also not materially affected by seasonal changes.
Market Risk
Changes in interest rates could affect our investment values and net interest
income.
At March 31, 2006, the Company owned approximately $130.0 million of marketable
securities available for sale. These securities are carried at fair value on the
consolidated balance sheet. Unrealized gains or losses on these securities, that
is, the difference between the fair value and the amortized cost of these
securities, is reflected in stockholders' equity, net of deferred taxes. As of
March 31, 2006, the Company's available for sale marketable securities portfolio
had a net unrealized gain, net of taxes, of $264. The fair value of the
Company's available for sale marketable securities is subject to interest rate
change, which would not affect recorded earnings, but would increase or decrease
comprehensive income and stockholders' equity.
The principal component of the Company's earnings is net interest income, which
is the difference between interest and fees earned on interest-earning assets
and interest paid on deposits and other borrowings. The most significant impact
on net interest income between periods is derived from the interaction of
changes in the volume of and rates earned or paid on interest-earning assets and
interest-bearing liabilities. The volume of earning dollars in loans and
investments, compared to the volume of interest-bearing liabilities represented
by deposits and borrowings, combined with the spread, produces the changes in
net interest income between periods.
The Company continually monitors the relationship of its interest rate sensitive
assets and liabilities through its Asset/Liability Committee.
Strong competition within our market could affect our profits and growth.
The Bank operates in a competitive environment in which it must share its market
with many local independent banks as well as several banks which are affiliates
or branches of very large regional holding companies. The Bank encounters
competition from diversified financial institutions, ranging in size from small
banks to the nationwide banks operating in its region. The competition includes
commercial banks, savings and loan associations, credit unions, other lending
institutions and mortgage originators.
The principal competitive factors among the Company's competitors can be grouped
into two categories: pricing and services. In the Company's primary service
area, interest rates on deposits, especially time deposits, and interest rates
and fees charged to customers on loans are very competitive. From a service
perspective, the Bank competes in areas such as convenience of location, types
of services, service costs and banking hours.
Compliance
We operate in a highly regulated environment and may be affected by changes in
laws and regulations.
The Company is registered as a financial holding company under the Bank Holding
Company Act of 1956, as amended, and, as such, is subject to supervision and
regulation by the Board of Governors of the Federal Reserve System ("FRB"). The
Company is required to file quarterly reports of its operations with the FRB.
As a financial holding company, the Company is permitted to engage in
banking-related activities as authorized by the Federal Reserve Board, directly
or through subsidiaries or by acquiring companies already established in such
activities subject to the FRB regulations relating to those activities.
Our banking subsidiary, Penn Security Bank and Trust Company, as a Pennsylvania
state-chartered financial institution, is subject to supervision, regulation and
examination by the Commonwealth of Pennsylvania Department of Banking and by the
Federal Deposit Insurance Corporation (the "FDIC"), which insures the Bank's
deposits to the maximum extent permitted by law.
Operational Risk
The Company needs to continually attract and retain qualified personnel for its
operations.
High quality customer service, as well as efficient and profitable operations,
are dependent on the Company's ability to attract and retain qualified
individuals for key positions within the organization. As of March 31, 2006, the
Company employed 182 full-time equivalent employees. The employees of the
Company are not represented by any collective bargaining group. Management of
the Company considers relations with its employees to be good.
Our operations could be affected if we do not have access to modern and reliable
technology.
The Company operates in a highly-automated environment, wherein almost all
transactions are processed by computer software to produce results. To remain
competitive, the Company must continually evaluate the adequacy of its data
processing capabilities and make revisions as needed.
The Company regularly tests its ability to restore data capabilities in the
event of a natural disaster, sustained power failure or other inability to
utilize its primary systems.
Liquidity Risk
Increased needs for disbursement of funds on loans and deposits can affect our
liquidity.
The objective of liquidity management is to maintain a balance between sources
and uses of funds in such a way that the cash requirements of customers for
loans and deposit withdrawals are met in the most economical manner. Management
monitors its liquidity position continuously in relation to trends of loans and
deposits for short-term as well as long-term requirements. Liquid assets are
monitored on a daily basis to assure maximum utilization. Management also
manages its liquidity requirements by maintaining an adequate level of readily
marketable assets and access to short-term funding sources. Management does not
foresee any adverse trends in liquidity.
Our future pension plan costs and contributions could be unfavorably impacted by
the factors that are used in the actuarial calculations.
Our costs of providing non-contributory defined benefit pension plans are
dependent upon a number of factors, such as the rates of return on plan assets,
discount rates, the level of interest rates used to measure the required minimum
funding levels of the plans, future government regulation and our required or
voluntary contributions made to the plans. While the Company complies with the
minimum funding requirements under the Employee Retirement Income Security Act
of 1974, our pension plan obligations exceeded the value of plan assets by
approximately $1.0 million as of December 31, 2005. An additional contribution
of this amount was made to the Pension Plan in 2006 to resolve the unfunded
liability. Without sustained growth in the pension investments over time to
increase the value of our plan assets and depending upon the other factors
impacting our costs as listed above, we could be required to fund our plans with
higher amounts of cash than are anticipated by our actuaries. Such cash
increased funding obligations could have a material impact on our liquidity by
reducing our cash flows.
Item 2 -- Unregistered Sales of Equity Securities and Use of Proceeds
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
31 Certifications required under Section 302 of the Sarbanes-Oxley Act of 2002
32 Certifications required under Section 906 of the Sarbanes-Oxley Act of 2002
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.
PENSECO FINANCIAL SERVICES CORPORATION
By /s/ CRAIG W. BEST
------------------------------
Craig W. Best
President and CEO
Dated: May 5, 2006
By /s/ PATRICK SCANLON
------------------------------
Patrick Scanlon
Controller
Dated: May 5, 2006