MANAGEMENT’S
DISCUSSION A
N
D ANALYSIS OF FINANCIAL
CONDITION
AND
RESULTS OF OPERATIONS
September
30, 2007
The
following is management’s discussion and analysis of the significant changes in
the consolidated financial condition, results of operations, capital resources
and liquidity presented in the accompanying unaudited consolidated financial
statements for the Company. This discussion should be read in
conjunction with the preceding consolidated financial statements and related
footnotes, as well as, the Company's December 31, 2006 Annual Report on Form
10-K. Current performance does not guarantee and may not be
indicative of similar performance in the future.
In
addition to historical information, this quarterly report on Form 10-Q contains
forward-looking statements. The forward-looking statements contained in this
report are subject to certain risks, assumptions and
uncertainties. Because of the possibility of change in the underlying
assumptions, actual results could differ materially from those projected in
the
forward-looking statements. Additional factors that might cause
actual results to differ materially from those expressed in the forward-looking
statements include, but are not limited to:
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operating,
legal and regulatory risks,
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economic,
political and competitive forces affecting the Company’s services,
and
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the
risk that management’s analyses of these risks could be incorrect and/or
that the strategies developed to address them could be
unsuccessful.
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The
Company’s forward-looking statements are relevant only as of the date on which
the statements are made. By making forward-looking statements, the
Company assumes no duty to update them to reflect new, changing or unanticipated
events or circumstances. Readers should carefully review the risk
factors described in other periodic reports and public documents that the
Company files from time to time with the Securities and Exchange
Commission.
CRITICAL
ACCOUNTING POLICIES
Disclosure
of the Company’s significant
accounting policies is included in Note 1 to the consolidated financial
statements of the Company’s Annual Report on Form 10-K for the year ended
December 31, 2006. Some of these policies are particularly sensitive
requiring significant judgments, estimates and assumptions to be made by
management. Additional information is contained on pages 15, 18 and
19 herein of this report for the provision and allowance for loan
losses.
OVERVIEW
Net
income for the nine months ended September 30, 2007 was $2,401,000 as compared
with net income of $2,579,000 for the nine months ended September 30,
2006. The $178,000, or 6.9% decrease in earnings is attributable to a
decline in net interest income and an increase in other non-interest expenses
due to incurring merger related expenses. On a basic and dilutive
earnings per share basis, net income per share for the nine months ended
September 30, 2007 was $0.38 per share as compared with $0.41 per share for
the
same period in 2006.
Net
income as a percentage of average assets on an annualized basis, also known
as
return on average assets, decreased to 0.73% for the first nine months of 2007
from 0.84% for the first nine months of 2006 as a result of asset growth of
3.40% since the end of the third quarter of 2006 to the end of the third quarter
of 2007. Net income as a percentage of total average stockholders’
equity on an annualized basis, also known as return on average equity, was
12.69% and 15.21% for the first nine months of 2007 and 2006,
respectively. The decrease in both ratios is also attributable to the
decline in net income.
During
the first nine months of 2007, the Company’s assets increased $966,000, or 0.2%,
to $440,418,000 as of September 30, 2007 as compared with $439,452,000 as of
December 31, 2006. The
increase
in assets since the 2006 year end is attributable to loan growth of $14,566,000,
or 4.5%, which was offset by declines of $10,163,000 in overnight federal funds
sold and $5,431,000 in securities available for sale. The decline in
federal funds sold was due to funding loan growth and paying off maturing
other borrowed funds. The decline in securities available
for sale was attributable to scheduled investment maturities and
amortization. The Company’s prime funding sources included deposits,
which increased $132,000, or 0.04% from the 2006 year end and securities sold
under agreements to repurchase, which grew $4,911,000, or 72.8%. The
growth in total deposits and securities sold under agreements to repurchase
during the first nine months of 2007 was 6.3% higher than their growth during
the same period in 2006 as a result of the Bank’s continued focus to offer
attractive products at competitive interest rates.
RESULTS
OF OPERATIONS
Net
Interest Income
For
the three months ended September
30, 2007, total interest income increased $340,000, or 5.1%, to $6,505,000
as
compared with $6,165,000 for the three months ended September 30,
2006. This increase is due to loan growth, which is the Company’s
highest yielding asset, and increased yields on total interest earning
assets.
Total
interest expense increased by
$372,000, or 13.4%, to $3,152,000 for the three months ended September 30,
2007
from $2,780,000 for the three months ended September 30,
2006. This increase is attributable to deposit growth, higher
volume of securities sold under agreements to repurchase and the increased
costs
associated with attracting and maintaining deposits and securities sold under
agreements to repurchase during a period of interest rate
uncertainties.
Net
interest income decreased by
$32,000, or 1.0%, to $3,353,000 for the three months ended September 30, 2007
from $3,385,000 for the three months ended September 30, 2006.
For
the nine months ended September 30,
2007, total interest income increased $1,833,000, or 10.5%, to $19,282,000,
as
compared with $17,449,000 for the nine months ended September 30,
2006. This increase was attributable to a higher yield from interest
earning assets, which increased to 6.46% (on a fully tax equivalent basis)
for
the first nine months of 2007 from 6.30% (on a fully tax equivalent basis)
for
the first nine months of 2006. In addition, average interest-earning
assets increased 8.3% to $415,073,000 for the first nine months of 2007, from
$383,423,000 for the same period in 2006. The growth in average
interest-earning assets was primarily attributable to an increase in loans
and
an increase in the level of overnight federal funds
sold.
Total
interest expense increased by $1,959,000, or 26.3%, to $9,395,000 for the nine
months ended September 30 2007, from $7,436,000 for the nine months ended
September 30, 2006. This increase was attributable to growth in
average interest bearing liabilities, which increased $55,935,000, or 16.4%
in
comparing September 30, 2007 with September 30, 2006. In addition,
the need to increase interest rates to maintain and attract deposits affected
cost of funds, which increased to 3.16% for the nine months ended September
30,
2007 from 2.91% for the same period in 2006.
The
resulting net interest income
decreased by $126,000, or 1.3%, to $9,887,000 for the nine months ended
September 30, 2007 from $10,013,000 for the nine months ended September 30,
2006. The increase in total interest income was more than offset by
an increase in interest expense, which contributed to net interest margin
compression as competitive deposit pricing increased funding costs faster then
earning asset yields grew. The increase in cost of funds was due to
an increase in the interest rates paid on deposits as a means of ensuring that
the Bank remained competitive in its market. Increased interest rates
not only resulted in deposit growth but effected a change within the composition
of the Bank’s deposits, where there was a shifting of funds being invested into
deposit products with higher interest rates, such as certificates of
deposit. Securities sold under agreements to repurchase also
increased when comparing 2007 with 2006. While the cost associated
with deposits has increased since last year, deposits were and continue to
be a
more cost effective source of funding asset growth as compared with other types
of funding sources, such as borrowings, which the Bank has made efforts to
reduce. This strategy has allowed management to better control
funding costs and minimize significant compression to its net interest spread
and margin. For
the
first
nine months of 2007, the net interest spread (on a fully tax equivalent basis)
decreased 9 basis points to 3.30% from 3.39% for the first nine months in 2006,
while the net interest margin (on a fully tax equivalent basis) decreased 27
basis points to 3.44% for the nine-month period ending September 30, 2007 from
3.71% for the nine-month period ending September 30, 2006. However,
the success of the Bank’s efforts to manage this compression is evidenced by the
increase in the net interest margin for the third quarter of 2007, which was
3.46% as compared with the net interest margin of 3.42% for the second quarter
of 2007 and 3.43% for the first quarter of 2007.
Provision
for Loan Losses
Provisions
for loan losses are charged
to operations in order to maintain the allowance for loan losses at a level
management considers adequate to absorb credit losses inherent in the loan
portfolio. Management assesses the allowance for loan losses on a
quarterly basis and makes provisions for loan losses in order to maintain the
adequacy of the allowance.
The
provision for loan losses was
$135,000 for the three months ended September 30, 2007 compared with $90,000
for
the three months ended September 30, 2006. The increase in this
quarter’s provision was due to the Bank’s charge-off of $33,000 in credit card
balances, which was completed as part of the Bank’s sale of the credit card
portfolio. This compares with $5,000 in credit card balances that the
Bank charged-off during the third quarter of 2006.
For
the nine months ended September 30,
2007, the provision for loan losses was $270,000, a decrease of $29,000 compared
with $299,000 for the nine months ended September 30, 2006. The
decrease in the provision is attributable to management’s ongoing efforts to
ensure the high quality of the loan portfolio as represented by the level of
non-performing assets and loans subject to review or regulatory
classification.
The
allowance for loans losses
represented 1.01% of total loans at September 30, 2007, compared with 1.01%
as
of December 31, 2006 and 1.03% as of September 30, 2006. Management
performs ongoing assessments of the loan loss reserve in relation to loan
portfolio growth, changes in the loan portfolio’s composition, credit exposure
to individual borrowers, overall trends in the loan portfolio and other relevant
factors. Based upon these factors, management believes that as of
September 30, 2007, the reserve is reasonable and sufficient to support the
increased loan growth in light of the strong asset quality as supported by
the
ratios reflected in the Asset Quality Ratios table on page 19.
Other
Income
For
the three months ended September
30, 2007, other income of $579,000 decreased $20,000, or 3.3%, from $599,000
for
the three months ended September 30, 2006. Contributing to this
decrease was a $13,000 decline in customer service fees, a decline of $14,000
in
income associated with the sale of other real estate owned since no such
transaction occurred in 2007 and a $10,000 decline in other
income. This was offset by increases of $5,000 in fee income from
mortgage banking activities and a $12,000 increase associated with an increase
in the cash surrender value of the Bank’s investment in life
insurance.
Other
income for the nine months ended September 30, 2007 increased $10,000, or 0.6%,
to $1,819,000 from $1,809,000 for the nine months ended September 30,
2006. This increase was attributable to a $26,000 increase in income
from mortgage banking activities and a $34,000 increase in income from the
investment in life insurance. These increases were offset by a
$16,000 decline in customer service fees, a decrease of $20,000 in other income
and a decline of $14,000 in income from the sale of other real estate owned
transactions for which there were none in 2007.
Other
Expenses
Other
expenses, which include salary,
occupancy, equipment and all other expenses incidental to the operation of
the
Company, increased to $3,002,000 for the third quarter of 2007 from $2,773,000
for the third quarter of 2006. The $229,000, or 8.3%, increase is not
only due to the Company’s continued
growth,
but is mostly attributable to expenses associated with the proposed merger
with
Harleysville National Corporation.
Salaries
and employee benefit expenses,
which make up the largest component of other expenses, decreased $27,000, or
1.8%, to $1,469,000 for the third quarter of 2007 from $1,496,000 for the third
quarter in 2006. The decrease is the result of not replacing
employees who left the Company’s employment.
Occupancy
expenses increased $10,000,
or 3.6%, to $289,000 for the three months ended September 30, 2007 from $279,000
for the three months ended September 30, 2006. The increase is due to
the costs associated with normal expenses incurred to maintain all of the
Company’s branch and office locations.
Equipment
expense decreased $1,000, or
0.5%, to $217,000 for the three months ended September 30, 2007 from $218,000
for the three months ended September 30, 2006. This decrease is due
to management’s efforts to control operating expenses.
Other
operating expenses during the
third quarter of 2007 increased $247,000, or 31.70%, to $1,027,000 from $780,000
during the third quarter of 2006. The increase is primarily
associated with incurring $296,000 in expenses during the third quarter of
2007
relating to the pending merger.
Other
expenses increased to $8,624,000
for the nine months ended September 30, 2007 from $8,293,000 for the nine months
ended September 30, 2006. The $331,000, or 4.0%, increase is due to
the merger related expenses the total of which was partially offset by the
Company’s ongoing efforts to manage overall efficiencies, particularly in light
of the compression of its net interest spread and margin.
For
the
first nine months of 2007, salaries and employee benefit expenses decreased
$49,000, or 1.1%, to $4,401,000 from $4,450,000 for the first nine months of
2006. The decrease is attributable to attrition, where certain staff
positions have not been replaced when employees have left the Bank.
Occupancy
expenses increased $49,000,
or 5.8%, to $891,000 as of September 30, 2007 from $842,000 as of September
30,
2006. The increase was attributable to a rise in normal occupancy
costs.
Equipment
expense decreased $16,000, or
2.4%, to $639,000 for the nine months ended September 30, 2007 from $655,000
for
the nine months ended September 30, 2006. This decrease was the
result of a reduction in expenses associated with the normal depreciation of
fixed assets. In addition, because facilities expansion has slowed as
compared with the prior year, there has not been a need to purchase additional
fixed assets to equip any new facilities.
Other
operating expenses increased $347,000, or 14.8%, to $2,693,000 for the nine
months ended September 30, 2007 from $2,346,000 for the nine months ended
September 30, 2006. This increase was attributable to $555,000 in
merger related expenses that were incurred during the first nine months of
2007. The Company’s ongoing efforts to improve efficiencies through
the elimination or reduction of other operating expenses were a benefit that
mitigated the full impact of the total merger expenses.
Effective
January 1, 2007, The Federal Deposit Insurance Corporation (“FDIC”) created a
new risk framework comprised of four risk categories and established assessment
rates to coincide with each category. Assessment rates for Risk
Category I financial institutions, which includes East Penn Bank, range from
5
to 7 basis points. The FDIC also approved a one-time assessment
credit for banks that were in existence on December 31, 1996 and paid a deposit
insurance assessment prior to that date. Management believes that the
one-time credit will more than offset the new FDIC assessment cost for
2007. It anticipates that the credit will be depleted by the first
quarter of 2008. Accordingly, the Company will begin to recognize the
FDIC assessment cost at that time.
Income
Taxes
Income
tax expense was $84,000 for the
three months ended September 30, 2007, a decrease of
$137,000,
or 62.0%, compared with $221,000 for the three months ended September 30,
2006. The decline in the tax expense was attributable to a decline of
$326,000, or 29.1%, in net income before taxes in the third quarter of 2007
as
compared with 2006 in addition to an increased level of tax exempt
income. The decline is also attributable to a change in the expected
effective tax rate between the second and third quarters of 2007.
For
the
nine months ended September 30, 2007, the tax provision was $411,000 compared
with $651,000 for the nine months ended September 30, 2006. The
decrease of $240,000, or 36.9%, was due to a reduction in the Company’s
effective tax rate to 15% at September 30, 2007 from 20% at September 30,
2006. The reduction in the Company’s effective tax rate was the
result of a larger proportion of the Company’s income being derived from
tax-exempt interest and Bank owned life insurance. The effective tax
rate continues to be less than the statutory Federal tax rate of
34%. The difference between the statutory and effective tax rates
primarily reflects the tax-exempt status of interest income earned from
obligations of state and political subdivisions and the increase in the
cash surrender value of bank owned life insurance.
Net
Income
Net
income for the three months ended
September 30, 2007 was $711,000, a decrease of $189,000, or 21.0%, compared
with
$900,000 for the three months ended September 30, 2006. The decrease
in net income is the result of a decrease of $32,000 in net interest income,
a
decrease of $20,000 in other income, an increase of $45,000 in the provision
for
loan losses and an increase of $229,000 in other expenses. Offsetting
this was a decrease of $137,000 in the income tax
provision. The decrease in the level of net income impacted
basic and diluted earnings per share which were $0.11 per share for the three
months ended September 30, 2007 as compared with $0.14 per share for the three
months ended September 30, 2006.
Net
income for the nine months ended
September 30, 2007 was $2,401,000, a decrease of $178,000, or 6.9%, compared
with $2,579,000 for the nine months ended September 30, 2006. The
decrease in net income was attributable to a decrease of $126,000 in net
interest income and an increase of $331,000 in other expenses offset by an
increase of $10,000 in other income, a decline of $29,000 in the provision
for
loan losses and a decrease of $240,000 in the provision for income
taxes. Basic and diluted earnings per share for the nine months ended
September 30, 2007 were $0.38 per share as compared with $0.41 per share for
the
same period in 2006.
FINANCIAL
CONDITION
Securities
The
Company’s securities portfolio is
comprised of securities that not only provide interest income, including
tax-exempt income, but also provide a source of liquidity, diversify the earning
assets portfolio, allow for the management of risk and tax liability, and
provide collateral for repurchase agreements and public fund
deposits. Policies are in place to address various aspects of
managing the portfolio, including but not limited to, concentrations, liquidity,
credit quality, interest rate sensitivity and regulatory
guidelines. Adherence to these policies is monitored by the Company’s
Asset/Liability Committee on a monthly basis.
As
of
September 30, 2007, all of the securities in the portfolio were classified
as
available for sale, with new purchases placed in this
category. Securities in the available for sale category are accounted
for at fair value with unrealized appreciation or depreciation, net of tax,
reported as a separate component of stockholders’ equity. The Company
periodically evaluates the securities portfolio to determine if any decline
in
the fair values of securities are other than temporary. If such a
decline was deemed to be other than temporary, the Company would write down
the
security to its fair value through a charge to current period
operations. As of September 30, 2007, there were no securities in the
portfolio whose values were deemed to be other than temporarily
impaired. At the time when the Company had securities categorized as
held to maturity, they were accounted for at amortized cost. The
Company invests in securities for the cash flow and yields they produce and
not
to profit from trading. The Company holds no trading securities in
its
portfolio,
and the securities portfolio contained no high risk securities or derivatives
as
of September 30, 2007.
The
securities portfolio at September
30, 2007 was $64,961,000, compared to $70,392,000 at December 31, 2006, a
decrease of $5,431,000, or 7.7%. The decrease is the result of
principal repayments, the proceeds of which were reinvested in the funding
of
loans. The carrying value of the available for sale portion of the
portfolio at September 30, 2007 includes an unrealized loss of ($1,102,000)
(reflected as an accumulated other comprehensive loss of ($727,000) in
stockholders’ equity, net of a deferred income tax asset of
$375,000). This compares with an unrealized loss at December 31, 2006
of ($1,231,000) (reflected as an accumulated other comprehensive loss of
($812,000) in stockholders’ equity, net of a deferred income tax asset
of $419,000).
Loans
The
loan
portfolio comprises the major component of the Company’s earning assets and
generally is the highest yielding asset category. Gross loans
receivable, net of unearned fees and origination costs, increased $14,566,000,
or 4.5%, to $337,366,000 at September 30, 2007 from $322,800,000 at December
31,
2006. In comparing the third quarter of 2007 with the third quarter
of 2006, gross loans increased $22,226,000, or 7.1%. Gross loans
represented 90.5% of total deposits at September 30, 2007 as compared with
86.6%
at December 31, 2006. Loan growth continued to be significant in
commercial lending, consisting of commercial real estate and commercial and
industrial loans with a specific focus on municipal/tax-free
loans. Outstanding retail loans have grown as well, although to a
lesser extent than commercial loans. While residential mortgage
lending remains active, it is not as robust as it was in prior years when
mortgage interest rates were lower than they are now. The Bank
selectively sells mortgage loans into the secondary market in order to
effectively manage long-term interest rate risk.
Credit
Risk and Loan Quality
The
Company continues to be vigilant in its efforts to minimize credit
risk. The Bank’s written lending policy requires underwriting, loan
documentation and credit analysis standards to be met prior to the approval
and
funding of a loan. In accordance with that policy, the internal loan
review process monitors the loan portfolio on an ongoing basis. The
Credit Administration area prepares an analysis of the allowance for loan losses
on a quarterly basis, which is then submitted to the Board of Directors for
its
assessment as to the adequacy of the allowance.
The
allowance for loan losses at September 30, 2007 and December 31, 2006 was
$3,409,000 and $3,258,000, respectively, compared to $3,235,000 at September
30,
2006. Although less of a provision for loan losses was recorded
during the first nine months of 2007 as compared with the same period in 2006,
there was an increase in the total allowance since the provision exceeded net
charge-offs. The allowance increased in consideration of the growth
in the loan portfolio and the shift in the loan mix, where there has been
continued growth in commercial loans, which generally carry a higher level
of
credit risk. At September 30, 2007, the allowance for loan losses
represented 1.01%
of the gross loan portfolio, compared
with 1.01% at December 31, 2006. This compares to 1.01% at September
30, 2006. At September 30, 2007, in consideration of the strong asset
quality, management believes that the allowance for loan loss reserve is at
an
acceptable level given current economic conditions, interest rates and the
composition of the loan portfolio.
The
following table details the activity, which occurred in the allowance for loan
losses over the first nine months of 2007 and 2006.
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Analysis
of Allowance for Loan Losses
(Dollars
in thousands)
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Nine
Months Ended
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|
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9/30/2007
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|
|
9/30/2006
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Balance,
beginning of year
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|
$
|
3,258
|
|
|
$
|
3,072
|
|
|
Provision
charged to operating expense
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|
|
270
|
|
|
|
299
|
|
|
Charge-offs:
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
(26
|
)
|
|
|
-
|
|
|
Real estate
|
|
|
(45
|
)
|
|
|
(90
|
)
|
|
Consumer
|
|
|
(129
|
)
|
|
|
(70
|
)
|
|
Total charge-offs
|
|
|
(200
|
)
|
|
|
(160
|
)
|
|
|
|
|
|
|
|
|
|
|
|
Recoveries:
|
|
|
|
|
|
|
|
|
|
Commercial
|
|
|
-
|
|
|
|
3
|
|
|
Real estate
|
|
|
65
|
|
|
|
1
|
|
|
Consumer
|
|
|
16
|
|
|
|
20
|
|
|
Total recoveries
|
|
|
81
|
|
|
|
24
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
(charge-offs) recoveries
|
|
|
(119
|
)
|
|
|
(136
|
)
|
|
|
|
$
|
3,409
|
|
|
$
|
3,235
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
(charge-offs) recoveries to average net loans
|
|
|
(0.04
|
%)
|
|
|
(0.06
|
%)
|
|
|
|
|
|
|
|
|
|
|
|
Note:
Bank’s loan portfolio is entirely domestic
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|
|
|
|
|
|
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The
Bank’s lending policy is executed
through the assignment of tiered loan limit authorities to individual officers
of the Bank, the Officer’s Loan Committee, the Board Loan Committee and the
Board of Directors. Although the Bank maintains sound credit
policies, certain loans may deteriorate for a variety of reasons. The
Bank’s policy is to place all loans on a non-accrual status upon becoming 90
days delinquent in their payments, unless there is a documented and reasonable
expectation of the collection of the delinquent amount. Loans are
reviewed monthly as to their status, and on a quarterly basis, a Watch List
of
potentially troubled loans is prepared and presented to the Board of
Directors. Management is not aware of any materially potential loan
problems that have not been disclosed in this report.
The
following table summarizes pertinent asset quality ratios at September 30,
2007
and December 31, 2006.
|
|
|
|
|
|
|
|
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Asset
Quality Ratios
|
|
9/30/07
|
|
|
12/31/06
|
|
|
Non-accrual
loans
(1)
/Total loans
|
|
|
0.32
|
%
|
|
|
0.13
|
%
|
|
Non-performing
assets
(1)
/Total
loans
|
|
|
0.39
|
%
|
|
|
0.13
|
%
|
|
Net
charge-offs/Average loans
|
|
|
0.04
|
%
|
|
|
0.07
|
%
|
|
Allowance/Total
loans
(2)
|
|
|
1.01
|
%
|
|
|
1.01
|
%
|
|
Allowance/Non-accrual loans
(1)
|
|
|
318.90
|
%
|
|
|
759.44
|
%
|
|
Allowance/Non-performing
loans
(1)
|
|
|
261.23
|
%
|
|
|
752.42
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
-
Non-performing assets of $1,305,000 as of September 30, 2007
and $433,000 as of December 31, 2006 include non-accrual loans of
$1,069,000 at September 30, 2007 and $429,000 at December 31,
2006. The increase in non-performing assets at September 30,
2007 is attributable to the addition of one secured commercial credit
to
non-accrual loans.
|
|
|
(2)
- Net charge-offs are on an annual
basis.
|
The Company had no other real estate owned as acquired through foreclosure
as of
September 30, 2007 and December 31, 2006.
Loan
concentrations are considered to exist when the total amount of loans to any
one
or a multiple number of borrowers engaged in similar activities or having
similar characteristics exceeds 10% of loans
outstanding
in any one category. The majority of the Bank’s lending is made
within its primary market area, which includes Emmaus and other adjacent
communities in Lehigh County, Pennsylvania. Two portfolio segments
represent possible concentrations: commercial real estate and consumer loans
secured by residential real estate. While the Bank does not have a
concentration of credit risk with any single borrower, repayments on loans
in
these portfolios can be negatively influenced by decreases in real estate
values. Management mitigates this risk through stringent underwriting
policies and procedures.
Bank
Owned Life Insurance
During
2000, the Bank invested
$4,500,000 in Bank Owned Life Insurance (“BOLI”) for a chosen group of
employees, namely officers. In 2001, the Bank made a subsequent BOLI
investment, resulting in a total investment of $6,000,000. Under the
terms of the BOLI, the Bank is the owner and beneficiary of the
policies. Earnings from the BOLI are recognized as other
income. The BOLI is profitable from the appreciation of the cash
surrender values of the pool of insurance, and provides a tax advantage to
the
Company. This profitability is used to offset a portion of current
and future employee benefit costs and a Nonqualified Supplemental Executive
Retirement Plan for the Company’s Chief Executive Officer.
The
Company had $8,025,000 and
$7,788,000 in BOLI as of September 30, 2007 and December 31, 2006,
respectively. Although the BOLI is an asset that may be liquidated,
it is the Company’s intention to hold this pool of insurance because it provides
tax-exempt income that lowers the Company’s tax liability, while enhancing its
overall capital position.
Investment
in Bank
On
September 23, 2003, the Company purchased 141,300 shares of common stock
outstanding for $1,413,000 in a
de novo
bank, named Berkshire Bank,
located in Wyomissing, Berks County, Pennsylvania. On October 22,
2003, the Company purchased an additional 12,123 shares of common stock for
$121,000, which resulted in increasing the Company’s investment to $1,534,000,
or 18.3%, of Berkshire Bank’s outstanding common stock as of December 31,
2003. The aggregate ownership percentage of the Company and its
directors and officers as dictated within the terms of the Stock Subscription
and Purchase Agreement between the Company and Berkshire Bank was
19.9%.
During
2004, Berkshire Bank announced a 5-for-4 stock split, effected in the form
of a
25% stock dividend, payable July 22, 2004, which resulted in the Company
receiving an additional 38,355 shares. On September 1, 2004,
Berkshire Bank commenced a three-phase common stock offering effective through
March 31, 2005. In order to maintain its level of investment in
Berkshire Bank, the Company purchased an additional 57,119 shares. On
July 21, 2005, Berkshire Bank announced the payment of a 5-for-4 stock split,
effected in the form of a 25% stock dividend, payable August 19, 2005, which
resulted in an additional 62,224 shares.
Pursuant
to a Plan of Reorganization and a Plan of Merger (the “Plan”) that was approved
by Berkshire Bank’s shareholders on April 18, 2006, a holding company named
Berkshire Bancorp, Inc. was formed and was effective September 1,
2006. As part of the reorganization, Berkshire Bank became a wholly
owned banking subsidiary of Berkshire Bancorp, Inc. The Plan further
provided for the one-for-one exchange of shares of common stock of Berkshire
Bank for shares of common stock of Berkshire Bancorp, Inc. In
accordance with its equivalent 19.9% ownership, the Company exchanged
one-for-one the common stock shares of Berkshire Bank for the common stock
shares of Berkshire Bancorp, Inc.
Berkshire
Bancorp, Inc. announced a 5-for-4 stock split effected in the form of a stock
dividend as of the record date of September 14, 2006, which resulted in the
issuance of 77,780 additional shares of common stock. On November 9,
2006, the Company purchased 256 additional shares at $10 per share in order
to
maintain its 19.9% aggregate ownership level. This occurred because
Berkshire Bancorp, Inc. issued additional stock as a result of the exercise
of
options by its officers.
Effective
March 22, 2007, Berkshire Bancorp, Inc. initiated a two-phase stock offering
that ended August 31, 2007. On August 31, 2007, the Company
subscribed to purchase 45,614 shares at $10 per share under this stock
offering. The transaction settled on September 4, 2007. As
part of this offering, the Company
also
received one five-year non-detachable common stock purchase warrant for each
share purchased. On September 27, 2007, the Company
purchased 256 additional shares at $10 per share as a result of the exercise
of
options by Berkshire Bancorp’s officers. At September 30, 2007, the
Company’s total investment in Berkshire Bancorp, Inc. was $2,608,000,
represented by 435,027 shares, resulting in a 19.9 % aggregate ownership in
consideration of the combined ownership of the Company, its directors and its
officers.
While
the
Company is considered to be a passive investor, it regards this to be a viable
investment. The investment is carried at cost and is included in the
other assets category on the consolidated balance sheet. The Company
uses the best information that is available to assess the reasonableness of
the
value of this asset. The financial condition of Berkshire Bancorp,
Inc. and the stability of its stock price have proven to be reliable valuation
sources. No indicators of impairment were noted as part of the
Company’s latest evaluation.
Deposits
Deposits
are the major source of the Company’s funds for lending and investment
purposes. Total deposits at September 30, 2007 were $372,763,000, an
increase of $132,000, or 0.04%, from total deposits of $372,631,000 at December
31, 2006. There was a shift in the deposit composition where
non-interest bearing deposits decreased $2,041,000 since the 2006 year end
while
interest bearing deposits increased $2,173,000. This impacted the
cost of deposits, which increased to 3.36% as of September 30, 2007 from 2.86%
as of December 31, 2006 and 3.01% as of September 30, 2006.
Securities
Sold under Agreements to Repurchase
Securities
sold under agreements to repurchase increased $4,911,000, or 72.8%, to
$11,660,000 at September 30, 2007 from $6,749,000 at December 31,
2006. The increase was attributable to rate-driven customers who
found that they could earn a higher rate of interest on this product as compared
with deposits. Securities sold under agreements to repurchase
generally mature in one business day and roll over under a continuing
contract.
Short-Term
Borrowings
There
were no short-term borrowings in the form of overnight federal funds purchased
as of September 30, 2007 and December 31, 2006. The Bank has a
$5,000,000 federal funds line of credit with its main correspondent bank,
Atlantic Central Bankers Bank, Camp Hill, Pennsylvania (“ACBB”) as well as a
short-term/overnight line of credit of $35 million with the Federal Home Loan
Bank of Pittsburgh (“FHLB”), which is part of its overall maximum borrowing
capacity of $136,344,000.
Long-Term
Debt and Borrowing Capacity
There
were $19 million outstanding in
fixed rate term loans with the FHLB at September 30, 2007, a reduction of $5
million from the $24 million that was outstanding at December 31,
2006. The $19 million borrowing is comprised of the following fixed
rate borrowings (dollars in thousands):
|
Maturity
|
|
Amount
|
|
|
Rate
|
|
|
|
|
|
|
|
|
|
|
November
28, 2007
|
|
$
|
7,000
|
|
|
|
3.43
|
%
|
|
May
5, 2008
|
|
|
5,000
|
|
|
|
4.03
|
%
|
|
November
28, 2008
|
|
|
7,000
|
|
|
|
3.78
|
%
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
19,000
|
|
|
3.72
|
%
weighted average
|
The
Bank
has generally used long-term borrowings to fund growth. This strategy
has helped the Bank to manage its cost of funds by allowing it to lock into
fixed rates, at a time when interest rates were at their historic lowest
levels.
The
Bank
has a total maximum borrowing capacity for both short and long-term borrowings
of approximately $136,344,000 with the FHLB, out of which $19 million represents
fixed rate term loans that were outstanding at September 30, 2007, and resulted
in an unused borrowing capacity of $117,344,000.
Mandatory
Redeemable Capital and Junior Subordinated Debentures
As
of
September 30, 2007, the Company had $8,248,000 outstanding in junior
subordinated debentures, which were issued on July 31, 2003 to investors as
capital trust pass-through securities by East Penn Statutory Trust I (“Trust”),
a Connecticut statutory business trust and non-consolidated wholly owned
subsidiary of the Company. The securities have a fixed rate of 6.80%
through September 17, 2008. The capital securities are redeemable by
the Company on or after September 17, 2008, at par, or earlier, if the deduction
of related interest for federal income taxes is prohibited, classification
as
Tier I Capital is no longer allowed, or certain other contingencies
arise. The capital securities must be redeemed upon final maturity of
the subordinated debentures on September 17, 2033. Proceeds totaling
$4.3 million were contributed to the capital at the Bank. The
remaining proceeds in the amount of $3.9 million were used to invest in
Berkshire Bank, a
de
novo bank, the repurchase of the Company’s common
stock and other business purposes. The Company chose to utilize the
multi-issuer trust preferred alternative, which proved to be a less expensive
and more flexible source of regulatory capital.
Asset/Liability
Management
Interest
rate risk is the exposure of a
Bank’s current and future earnings and capital arising from adverse movements in
interest rates. An interest sensitive asset or liability is one
that experiences changes in cash flows as a direct result of changes in market
interest rates. The management of interest rate risk involves
analyzing the maturity and repricing of interest sensitive assets and
liabilities at specific points in time. The imbalance between
interest sensitive assets and liabilities is commonly referred to as the
interest rate gap. The interest rate gap is one way of assessing the
risk inherent in the existing balance sheet as it relates to potential changes
in net interest income.
The
guidelines of the Company’s interest rate risk policy seek to limit the exposure
to changes in interest rates that affect the underlying economic value of assets
and liabilities, earnings and capital. The Company manages its
balance sheet with the intent of maximizing net interest income, while
maintaining an acceptable level of risk to minimize the impact that changing
interest rates may have on its net income and changes in the economic value
of
its equity. The overall interest rate risk position and strategies
for the management of interest rate risk are reviewed by senior management
and
the Asset/ Liability Committee (“ALCO”) of the Board of Directors on an ongoing
basis. The Company utilizes a variety of methodologies and resources
to measure its interest rate risk. It also has the ability to effect
strategies to manage interest rate risk, which include, but are not limited
to,
selling newly originated residential mortgage loans, controlling the volume
mix
of fixed/variable rate commercial loans and securities, increasing/decreasing
deposits via interest rate changes, borrowing from the FHLB, and buying/selling
securities. Adjustments to the mix of interest sensitive assets and
liabilities are made periodically in an effort to give the Company dependable
and steady growth in net interest income, while at the same time, managing
the
related risks.
Liquidity
Liquidity
refers to the Company’s
ability to generate adequate amounts of cash to meet financial obligations
to
its customers and shareholders in order to fund loans, to respond to deposit
outflows and to cover operating expenses. Maintaining a level of
liquid funds through asset/liability management seeks to ensure that these
needs
are met at a reasonable cost. Liquidity is essential to compensate
for fluctuations in the balance sheet and provide funds for growth and normal
operating expenditures. Sources of funds include scheduled
amortization of loans, loan prepayments, scheduled maturities of investments,
and cash flows from mortgage-backed securities. Liquidity needs may
also be met by converting assets into cash or obtaining sources of additional
funding, whether through deposit growth or borrowings under lines of credit
with
correspondent banks.
Liquidity
from asset categories is
provided through cash, amounts due from banks, interest-bearing deposits with
banks and federal funds sold, which were $14,753,000 at September 30, 2007,
compared to
$22,954,000
at December 31, 2006. This decrease was due to a decline in overnight
federal funds sold, a portion of which were used to fund loan
growth. Additional asset liquidity sources include principal and
interest payments from securities in the Company’s investment portfolio and cash
flows from its amortizing loan portfolio. Longer-term liquidity needs
may be met by selling securities available for sale, selling loans or raising
additional capital. At September 30, 2007, there was $27,290,000 in
liquid securities as compared with $45,328,000 at December 31,
2006. Liquid securities decreased $18,038,000 since year-end as a
result of the need to pledge additional securities to collateralize the increase
in securities sold under agreements to repurchase and public fund
deposits.
Liability
liquidity sources include
attracting deposits at competitive rates. Deposits at September 30,
2007 were $372,763,000, compared to $372,631,000 at December 31,
2006. In addition, the Bank has available lines of credit with its
main correspondent banks, ACBB, for $5,000,000 and the FHLB for $136,344,000,
both of which are reliable sources for short and long-term funds.
The
Company’s consolidated financial
statements do not reflect various off-balance sheet commitments that are made
in
the normal course of business, which may involve some liquidity
risk. Off-balance sheet arrangements are discussed in detail
below.
Management
is of the opinion that its liquidity position, at September 30, 2007, is
adequate to respond to fluctuations “on” and “off” the balance
sheet. In addition, management knows of no trends, demands,
commitments, events or uncertainties that may result in, or that are reasonably
likely to result in the Company’s inability to meet anticipated or unexpected
liquidity needs.
Contractual
Obligations
The
Company has various financial obligations that may require future cash
payments. These obligations include the payment of liabilities
recorded on the consolidated balance sheet as well as contractual obligations
for purchase commitments and operating leases. The following table
represents the Company’s contractual obligations, by type, that are fixed and
determined at September 30, 2007.
|
|
|
CONTRACTUAL
OBLIGATIONS
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September
30, 2007
|
|
|
|
|
Less
Than
|
|
|
|
|
|
|
|
|
Over
|
|
|
|
|
|
|
|
1
Year
|
|
|
1
– 3 Years
|
|
|
3
– 5 Years
|
|
|
5
Years
|
|
|
Total
|
|
|
|
|
(in
thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Time
deposits
|
|
$
|
139,241
|
|
|
$
|
50,431
|
|
|
$
|
1,209
|
|
|
$
|
159
|
|
|
$
|
191,040
|
|
|
Long-term
debt
|
|
|
12,000
|
|
|
|
7,000
|
|
|
|
-
|
|
|
|
-
|
|
|
|
19,000
|
|
|
Junior
subordinated
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
debentures
|
|
|
-
|
|
|
|
8,248
|
|
|
|
-
|
|
|
|
-
|
|
|
|
8,248
|
|
|
Nonqualified
supplemental
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
executive
retirement plan
|
|
|
108
|
|
|
|
91
|
|
|
|
68
|
|
|
|
198
|
|
|
|
465
|
|
|
Premises
commitments
|
|
|
850
|
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
850
|
|
|
Operating
leases
|
|
|
250
|
|
|
|
455
|
|
|
|
388
|
|
|
|
727
|
|
|
|
1,820
|
|
|
Total
|
|
$
|
160,697
|
|
|
$
|
57,977
|
|
|
$
|
1,665
|
|
|
$
|
1,084
|
|
|
$
|
221,423
|
|
Off-Balance
Sheet Arrangements
The
Company’s consolidated financial statements do not reflect various off-balance
sheet arrangements that are made in the normal course of
business. These commitments consist mainly of loans approved but not
yet funded, unused lines of credit and letters of credit made in accordance
with
the same standards as on-balance sheet instruments. Unused
commitments at September 30, 2007 were $105,140,000, which consisted of
$62,897,000 in unfunded commitments to existing loans, $24,484,000 to grant
new
loans, $11,560,000 in unused lines for overdraft privilege and $6,199,000 in
letters of credit. Because these instruments have fixed maturity
dates, and because many of them will expire without being drawn upon, they
do
not present a liquidity risk to the Company. Management
believes that any amounts
actually
drawn upon can be funded in the normal course of operations. The
Company has no investment in or financial relationship with any unconsolidated
entities that are reasonably likely to have a material effect on liquidity
or
the availability of capital resources.
Capital
The
following table presents the risk-based and leverage capital amounts and ratios
at September 30, 2007 for the Company and the Bank.
|
|
|
|
|
|
For
Capital Adequacy
Purposes
|
|
|
To
be Well Capitalized
under
Prompt
Corrective
Action
Provisions
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars
in Thousands)
|
|
|
As
of September 30, 2007:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
capital (to risk-weighted
assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Company
|
|
$
|
38,489
|
|
|
|
10.9
|
%
|
|
$
|
³
28,386
|
|
|
|
³
8.0
|
%
|
|
N/A
|
|
|
N/A
|
%
|
|
Bank
|
|
|
35,016
|
|
|
|
10.0
|
|
|
|
³
28,120
|
|
|
|
³
8.0
|
|
|
$
|
³
35,150
|
|
|
|
³
10.0
|
|
|
Tier
1 capital (to risk-weighted
assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Company
|
|
|
35,080
|
|
|
|
9.9
|
|
|
|
³
14,193
|
|
|
|
³
4.0
|
|
|
N/A
|
|
|
N/A
|
|
|
Bank
|
|
|
31,607
|
|
|
|
9.0
|
|
|
|
³
14,060
|
|
|
|
³
4.0
|
|
|
|
³
21,090
|
|
|
|
³
6.0
|
|
|
Tier
1 capital (to average
assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Company
|
|
|
35,080
|
|
|
|
7.9
|
|
|
|
³
17,732
|
|
|
|
³
4.0
|
|
|
N/A
|
|
|
N/A
|
|
|
Bank
|
|
|
31,607
|
|
|
|
7.2
|
|
|
|
³
17,608
|
|
|
|
³
4.0
|
|
|
|
³
22,010
|
|
|
|
³
5.0
|
|
The
capital ratios presented continue to remain at levels, which are considered
to
be “well-capitalized” as defined by regulatory guidelines, with the exception of
the Bank’s total risk based capital. The amount of the Bank’s total
risk based capital at September 30, 2007 was $35,016,000, which is $134,000
lower than the $35,150,000 which is the amount the Bank needed in order to
be
considered well-capitalized in this category. The decline in the
Bank’s retained earnings as a result of incurring merger related expenses
impacted the Bank’s risk based capital causing it to be lower than the well
capitalized level.
Banking
laws and regulations limit the amount of cash dividends that may be paid without
prior approval from the Company’s regulatory agencies. In abidance
with such requirements, on January 18, 2007, the Board of Directors authorized
and declared a semi-annual cash dividend for 2007 in the amount of $0.12 per
share, payable on February 28, 2007 to all shareholders of record as of February
2, 2007. On July 19, 2007, the Board of Directors authorized and
declared a cash dividend for the second half of 2007 for $0.12 per share of
common stock, payable on August 31, 2007 to all shareholders of record as of
August 10, 2007.
Restrictions
under Section 202e of the Pennsylvania Banking Code of 1965 are placed on the
size of a Bank’s investment in fixed assets as a percentage of
equity. Presently, the Bank exceeds the allowable limit of 25% of
equity, as defined by the Pennsylvania Department of Banking. The
Bank’s fixed assets as a percentage of equity decreased to 34.01% at September
30, 2007 as compared with 40.16% at September 30, 2006. The drop in
the ratio was due to there not being any major purchases as well as the decline
in the balance of total fixed assets, which decreased as a result of normal
depreciation. Further impacting the decline in this ratio was the
increase in total equity from the retention of earnings. Since this
ratio exceeds the allowable limit, the Bank generally contacts the Department
of
Banking to obtain the Department’s approval before acquiring a fixed asset that
is of a material dollar amount. Compliance with the allowable fixed
asset limit of this section of the Banking Code is expected to occur through
normal depreciation adjustments and retention of earnings.
Item
3.