SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[ X ] Annual Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
FOR THE FISCAL YEAR ENDED: JUNE 30, 2004
Or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from ________ to _________
COMMISSION FILE NO: 0-18833
CHESTER VALLEY BANCORP INC.
---------------------------
(Exact name of registrant as specified in its charter)
PENNSYLVANIA 23-2598554
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
100 E. Lancaster Ave., Downingtown PA 19335
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(Address of principal executive offices) (Zip Code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (610) 269-9700
Securities registered pursuant to Section 12(b) of the Act:
NOT APPLICABLE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $1.00 PAR VALUE PER SHARE
---------------------------------------
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to such filing
requirements for the past 90 days. YES X NO
----- -----
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendments to
this Form 10-K. X
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Indicate by check mark whether registrant is an accelerated filer as defined in
Exchange Act Rule 12b-2. YES X NO
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As of September 3, 2004, the aggregate value of the 4,878,515 shares of Common
Stock of the registrant which were issued and outstanding on such date,
excluding 464,122 shares held by all directors and officers of the registrant as
a group, was approximately $92.1 million. This figure is based on the closing
sales price of $20.86 per share of the registrant's Common Stock on September 3,
2004.
Number of shares of Common Stock outstanding as of September 3, 2004: 4,878,515
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Definitive Proxy Statement for the 2004 annual meeting of
shareholders are incorporated into Part III, Items 10-13 of this Form 10-K.
INDEX
PAGE
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PART I
Item 1. Business............................................................... 1
Item 2. Properties............................................................. 31
Item 3. Legal Proceedings...................................................... 33
Item 4. Submission of Matters to a Vote of Security Holders.................... 33
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters................................................................ 33
Item 6. Selected Financial Data................................................ 34
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.................................................. 35
Item 7A. Quantitative and Qualitative Disclosures About Market Risk............. 48
Item 8. Financial Statements and Supplementary Data............................ 50
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure............................................... 81
Item 9a. Controls and Procedures................................................ 81
PART III
Item 10. Directors and Executive Officers of the Registrant..................... 81
Item 11. Executive Compensation................................................. 81
Item 12. Security Ownership of Certain Beneficial Owners and Management......... 81
Item 13. Certain Relationships and Related Transactions......................... 81
PART IV
Item 14. Principal Accountants Fees and Services................................ 82
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K....... 83
Signatures ....................................................................... 85
FORWARD LOOKING STATEMENTS
In this Annual Report on Form 10-K (the "Form-10-K"), the Company has
included certain "forward looking statements", either express or implied, which
concern anticipated future operations of the Company. It is management's desire
to take advantage of the "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995. This statement is for the express purpose of
availing the Company of the protections of such safe harbor with respect to all
"forward looking statements" contained in this Form 10-K. The Company may have
used "forward looking statements" to describe certain of its future plans and
strategies including management's current expectations of the Company's future
financial results. Management's ability to predict results or the effect of
future plans and strategy involve certain risks, uncertainties, estimates, and
assumptions, which are subject to factors beyond the Company's control.
Consequently, the Company's actual results could differ materially from
management's expectations. Factors that could affect results include, but are
not limited to, interest rate trends, competition, the general economic climate
in Chester County, the mid-Atlantic region and the United States as a whole,
loan demand, loan delinquency rates and changes in asset quality, changes in
monetary and fiscal policies of the United States Government, changes in federal
and state regulation, changes in accounting policies and practices as may be
adopted by bank regulatory agencies and the Financial Accounting Standards Board
and other uncertainties described in the Company's filings with the Securities
and Exchange Commission (the "Commission"), including this Form 10-K. These
factors should be considered in evaluating the "forward looking statements", and
undue reliance should not be placed on such statements. The Company undertakes
no obligation to update or revise any forward-looking statements, whether
written or oral that may be made from time to time by or on the Company's
behalf.
PART I.
ITEM 1. BUSINESS
GENERAL
Chester Valley Bancorp Inc. (the "Holding Company") was incorporated in the
Commonwealth of Pennsylvania in August 1989. The business of the Holding Company
and its subsidiaries (collectively, the "Company") consists of the operations of
First Financial Bank ("First Financial" or the "Bank"), a Pennsylvania-chartered
commercial bank founded in 1922 as a savings association, and Philadelphia
Corporation for Investment Services ("PCIS"), a full-service investment advisory
and securities brokerage firm. Effective September 1, 2001, the Bank converted
to a Pennsylvania-chartered commercial bank from a Pennsylvania-chartered
savings association. As a consequence of such charter conversion, the Holding
Company became a bank holding company that has also been designated as a
financial holding company. Prior to such conversion, the Holding Company was a
unitary thrift holding company. The Bank provides a wide range of banking
services to individual and corporate customers through its twelve full-service
branch offices located in Chester County, Pennsylvania. The Bank provides
residential real estate, commercial real estate, commercial and consumer lending
services, which are primarily funded by retail and business deposits as well as
borrowings. PCIS is a registered broker/dealer in all 50 states and the District
of Columbia and it is also registered as an investment advisor with the
Commission. PCIS provides many additional services, including self-directed and
managed retirement accounts, safekeeping, daily sweep money market funds,
portfolio and estate valuations, life insurance and annuities, and margin
accounts, to individuals and smaller corporate accounts. PCIS' offices are
located in Wayne and Philadelphia, Pennsylvania.
References to the Company include its wholly owned subsidiaries, the Bank
and PCIS, unless the context of the reference indicates otherwise.
1
First Financial Bank's customer deposits are insured to the maximum extent
provided by law by the Federal Deposit Insurance Corporation ("FDIC") through
the Savings Association Insurance Fund ("SAIF"). The Bank is subject to
examination and comprehensive regulation by the FDIC and the Pennsylvania
Department of Banking ("Department"). Prior to the Bank's conversion to a
commercial bank, it was also subject to regulation and examination by the Office
of Thrift Supervision ("OTS"). It is a member of the Federal Home Loan Bank of
Pittsburgh ("FHLBP"), which is one of the 12 regional banks comprising the FHLB
System. The Bank is further subject to regulations of the Board of Governors of
the Federal Reserve System ("Federal Reserve Board") governing reserves to be
maintained against deposits and certain other matters. The Holding Company, as a
registered bank holding company, is subject to examination and regulation of the
Federal Reserve Board.
MARKET AREA AND COMPETITION
The Bank's primary market area includes Chester County and sections of the
four contiguous counties (Delaware, Montgomery, Berks, and Lancaster) in
Pennsylvania. Chester County, in which all of the Bank's offices are located,
continues to grow in terms of economic development and population growth. The
segment of the market served by the Company from a business perspective is
primarily industrially oriented and demographically is comprised of middle and
upper income households.
COMPETITION
First Financial encounters strong competition both in the attraction of
deposits and in the making of commercial, real estate and other loans. Its most
direct competition for deposits has historically come from commercial banks,
savings associations, savings banks and credit unions conducting business in its
primary market area. The Bank also encounters competition for deposits from
money market and other mutual funds, as well as corporate and government
securities and insurance companies. The principal methods used by the Bank to
attract deposit accounts include offering a variety of services, providing
convenient office locations with expanded banking hours and offering
extraordinary customer service and competitive interest rates. The Bank's
primary competition for commercial, real estate and other loans, comes from
other commercial banks, savings institutions, credit unions, mortgage banking
companies, insurance companies, and other lenders. First Financial competes
successfully for loans through competitive interest rates and maturities and
loan fees as well as providing quality service to borrowers and real estate
brokers.
PCIS is engaged in securities brokerage and asset management activities,
both of which are extremely competitive businesses. Competitors include all of
the member organizations of the New York Stock Exchange and other registered
securities exchanges, all members of the National Association of Securities
Dealers, Inc. (the "NASD"), commercial banks and savings associations, insurance
companies, investment companies, and financial consultants. PCIS competes
successfully against other firms through its' quality service, excellent
reputation, successful track record and competitive pricing.
EMPLOYEES
The Company had 171 full-time employees and 26 part-time employees as of
June 30, 2004. None of these employees are covered by a collective bargaining
agreement and the Company believes that it enjoys good relations with its
personnel.
2
LENDING ACTIVITIES
LOAN PORTFOLIO COMPOSITION
The Company's net loan portfolio (net of loans in process, deferred fees
and allowance for loan losses), including loans held for sale, totaled $395.7
million at June 30, 2004 representing approximately 61.6% of the Company's total
assets of $642.1 million at that date.
The following table presents information regarding the composition of the
Company's loan portfolio at the dates indicated.
AT JUNE 30,
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2004 2003 2002 2001 2000
----------------- ----------------- ----------------- ----------------- -----------------
% OF % OF % OF % OF % OF
TOTAL TOTAL TOTAL TOTAL TOTAL
AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS
----------------- ----------------- ----------------- ----------------- -----------------
(Dollars in Thousands)
Real estate loans:
Residential:
Single-family $ 70,126 16.4% $ 99,401 24.1% $ 127,072 32.4% $ 148,805 40.2% $ 167,451 46.8%
Multi-family 3,878 0.9% 2,596 0.6% 6,679 1.7% -- 0.0% -- 0.0%
Commercial 140,721 33.0% 122,207 29.6% 103,985 26.5% 82,890 22.4% 66,221 18.5%
Construction and land
acquisition(1) 48,860 11.4% 57,073 13.8% 48,470 12.3% 46,243 12.5% 42,372 11.8%
--------- ---- --------- ---- --------- ---- --------- ---- --------- ----
Total real estate loans 263,585 61.7% 281,277 68.1% 286,206 72.9% 277,938 75.1% 276,044 77.1%
Commercial business loans(2) 49,142 11.5% 43,059 10.4% 36,774 9.4% 27,653 7.4% 19,358 5.4%
Consumer loans(3) 114,787 26.8% 88,918 21.5% 69,538 17.7% 64,756 17.5% 62,433 17.5%
--------- ---- --------- ---- --------- ---- --------- ---- --------- ----
Total loans receivable 427,514 100.0% 413,254 100.0% 392,518 100.0% 370,347 100.0% 357,835 100.0%
Less:
Loans in process (25,549) (25,944) (22,833) (20,528) (20,908)
Allowance for loan losses (6,331) (5,415) (4,588) (4,264) (3,908)
Deferred loan fees (508) (933) (1,533) (1,592) (1,713)
--------- ---- --------- ---- --------- ---- --------- ---- ---------
Net loans receivable 395,126 380,962 363,564 343,963 331,306
Loans held for sale: single-family
residential mortgages 538 3,866 138 2,350 --
--------- ---- --------- ---- --------- ---- --------- ---- ---------
Net loans receivable and loans
held for sale $ 395,664 $ 384,828 $ 363,702 $ 346,313 $ 331,306
========= ========= ========= ========= =========
- ---------------
(1) Includes construction loans for both residential and commercial
real estate properties.
(2) Consists primarily of loans secured by accounts receivable, inventory,
equipment and general corporate assets.
(3) Consists primarily of home equity loans and lines of credit, home
improvement, automobile and other personal loans.
3
CONTRACTUAL MATURITIES
The following table sets forth the contractual principal repayments of the
total loan portfolio, including loans in process, of the Company as of June 30,
2004, by categories of loans. Loans are included in the period in which they
mature. Loans held for sale are not included.
PRINCIPAL REPAYMENTS
CONTRACTUALLY DUE IN YEAR(S) ENDED JUNE 30,
-------------------------------------------
(In Thousands)
TOTAL
OUTSTANDING
AT 2010
JUNE 30, 2006- AND
2004 2005 2009 THEREAFTER
----------- -------- -------- ----------
Real estate loans:
Residential $ 74,004 $ 10,789 $ 7,642 $ 55,573
Commercial 140,721 30,382 102,378 7,961
Construction and land acquisition 48,860 24,360 12,396 12,104
Commercial business loans 49,142 35,956 9,276 3,910
Consumer loans 114,787 32,408 9,587 72,792
-------- -------- -------- --------
TOTAL LOANS RECEIVABLE $427,514 $133,895 $141,279 $152,340
======== ======== ======== ========
The following table sets forth, as of June 30, 2004, the dollar amount of
all loans contractually due after June 30, 2005, which have fixed interest rates
and floating or adjustable rates.
CONTRACTUAL OBLIGATIONS
DUE AFTER JUNE 30, 2005
-------------------------------------
FLOATING/
FIXED ADJUSTABLE
RATES RATES TOTAL
-------------------------------------
(In Thousands)
Real estate loans:
Residential $ 54,512 $ 8,703 $ 63,215
Commercial 23,835 86,504 110,339
Construction and land acquisition 2,374 22,126 24,500
Commercial business loans 11,642 1,544 13,186
Consumer loans 81,667 712 82,379
-------------------------------------
TOTAL LOANS $174,030 $119,589 $293,619
=====================================
Contractual principal repayments of loans do not necessarily reflect the
actual term of the Company's loan portfolio. The average life of mortgage loans
is substantially less than their contractual terms because of loan prepayments
as well as the enforcement of due-on-sale clauses, which give the Company the
right to declare a loan immediately due and payable in the event, among other
things, that the borrower sells the real property subject to the mortgage and
the loan is not repaid. The average life of mortgage loans tends to increase,
however, when current mortgage loan rates substantially exceed rates on existing
mortgage loans and, conversely, decrease when rates on existing mortgage loans
substantially exceed current mortgage loan rates.
4
ORIGINATION, PURCHASE AND SALE OF LOANS
Commercial, multi-family residential real estate and consumer loans are
originated directly by the Bank through salaried loan officers. Salaried
employees originated single-family residential real estate loans during part of
fiscal 2002 but beginning in the second quarter of fiscal 2002, the Bank
outsourced much of this function to a third party. (In February 2004, the Bank
changed its third party processor to a Private Label platform, which provides
the Bank with better control of its customer base to handle the originations,
processing and sale of single-family residential real estate loans.)
Substantially all of the residential real estate loans originated by the Bank
using the third party processor are immediately sold and the Bank recognizes a
gain or loss on the sale.
Prior to changing its method of originating single-family residential loans
in 2002, the Bank had periodically identified certain loans as held for sale at
the time of origination. These loans consisted primarily of fixed-rate,
single-family residential mortgage loans. See "Loans Held for Sale" within Note
- - 1 of Notes to the Consolidated Financial Statements set forth at Item 8
hereof.
LOAN PRODUCTS
The Bank offers a broad array of loan products with competitive terms and
conditions to both individuals and to businesses. Prior to its' charter
conversion to a commercial bank, loan activity had been primarily focused on the
origination of mortgage loans collateralized by single-family residential
properties. However, in recent years, the Bank has substantially expanded its
involvement in commercial real estate and commercial business lending as part of
its strategic shift, which shift culminated in the Bank's conversion to a
commercial bank in September 2001. As a result of the changing composition of
the Bank's loan portfolio, loans secured by single-family properties have
declined as a percentage of the total loan portfolio from 46.8% at June 30, 2000
to 17.3% at June 30, 2004. Commercial real estate and commercial business loans
in the aggregate increased from 22.7% to 44.5% at the same dates, respectively.
The Bank has also continued to remain an active construction and land
acquisition loan originator, with such loans accounting for 11.4% of the Bank's
total loan portfolio as of June 30, 2004. In order to meet the wide-ranging
needs of its customers, the Bank has also marketed aggressively a variety of
consumer loans, including home equity loans and lines of credit.
Through its' outsourcing partnerships, the Bank originates residential real
estate loans secured by properties located primarily in southeastern
Pennsylvania. These loans are both fixed-rate and adjustable-rate loans with
amortization periods up to 30 years.
The Bank provides a wide range of commercial lending products. These
products include commercial business loans, commercial and multi-family real
estate construction, residential development and land acquisition loans.
Commercial real estate loans normally are secured by properties located in
Chester County or the four counties contiguous to it. The majority of such loans
bear adjustable interest rates with amortization terms of 20 years or less.
Commercial business loans are generally made to small and medium sized
companies located in the Bank's primary market area. While the Bank does on
occasion make unsecured commercial loans, generally these loans are on a secured
basis and are collateralized by accounts receivable, inventory, equipment,
and/or other general corporate assets of the borrowers. Commercial business
loans are originated with both fixed and adjustable rates with the adjustable
interest rates generally indexed to the national prime rate. These loans
typically carry terms from one to five years.
The Bank's consumer loans are primarily loans to individuals originated
through its branch network. The majority of its originations are home equity
term and credit lines secured by a first or second mortgage on the primary
residence of the borrower. Home equity credit lines are generally indexed to the
national prime rate, while home equity term loans generally bear fixed interest
rates and have terms of fifteen years or less. Home equity loans and lines of
credit aggregated $100.8 million or 23.6% of the total loan portfolio at June
30, 2004.
5
REGULATORY REQUIREMENTS AND UNDERWRITING POLICIES
Under the Financial Institutions Reform, Recovery, and Enforcement Act of
1989 ("FIRREA") and pursuant to the parity provisions of the Pennsylvania
Banking Code of 1965 ("Banking Code"), the aggregate loans that the Company may
make to any borrower and its affiliates is limited to 15% of unimpaired capital
for unsecured loans and 25% of capital for loans secured by readily marketable
collateral. At June 30, 2004, pursuant to such provisions, the Bank was
permitted to extend credit to any one borrower totaling $9.8 million. At June
30, 2004, the Bank's largest loan or group of loans to one borrower, including
related entities, aggregated $9.1 million, and is in conformity with the current
loans to one borrower regulations described above.
The Bank is currently permitted to lend up to 100% of the appraised value
of the real property securing a loan; however, if the amount of a single-family
residential first mortgage loan exceeds 90% of the appraised value, the Bank is
required by regulation to obtain private mortgage insurance on the portion of
the principal amount of the loan that exceeds 80% of the appraised value of the
security property. Pursuant to underwriting guidelines adopted by the Board of
Directors, private mortgage insurance is normally obtained on all residential
loans whose loan-to-value ratios exceed 80%. The Bank will generally lend up to
97% of the appraised value of one-to four-family owner-occupied residential
dwellings when the required private mortgage insurance is obtained. The Bank
generally originates loans of up to 80% of the appraised value of the properties
securing its commercial real estate and commercial business loans and 80% of the
appraised value upon completion or sale price, whichever is lower, for
construction loans. With respect to construction loans for owner-occupied
properties made in connection with the providing of the permanent financing, the
Bank will lend up to 90% of the appraised value when the required private
mortgage insurance is obtained.
LOAN FEE AND SERVICING INCOME
In addition to interest earned on loans, the Bank receives income
through servicing of loans and fees in connection with loan originations, loan
modifications, late payments, prepayments, repayments and changes of property
ownership and for miscellaneous services related to its loans. Income from these
activities varies from period to period with the volume and type of loans made.
At June 30, 2004, the Bank was servicing $9.9 million of loans for others, of
which $2.5 million consisted of whole loans sold by the Bank to Freddie Mac.
Loan origination fees and certain direct loan origination costs are
deferred and amortized over the life of the related loans as an adjustment to
the yield of such related loans. However, in the event the related loan is sold
or repaid prior to maturity, any deferred loan fees or costs remaining with
respect to such loan are taken into income.
NON-PERFORMING LOANS AND REAL ESTATE OWNED
If the delinquency on a mortgage loan exceeds 90 days and is not cured
through the Bank's normal collection procedures, or an acceptable arrangement is
not worked out with the borrower, the Bank will institute measures to remedy the
default, including commencing a foreclosure action or, in special circumstances,
accepting from the mortgagor a voluntary deed of the secured property in lieu of
foreclosure. However, under Pennsylvania law, a lender is prohibited from
accelerating the maturity of a residential mortgage loan, commencing any legal
action (including foreclosure proceedings) to collect on such loan, or taking
possession of any loan collateral until the lender has first provided the
delinquent borrower with at least 30 days prior written notice specifying the
nature of the delinquency and the borrower's right to correct such delinquency.
This provision of Pennsylvania law, as well as others, may delay for several
months the Bank's ability to foreclose upon residential loans secured by real
estate located in the Commonwealth of Pennsylvania. In addition, the uniform
Fannie Mae/Freddie Mac lending documents used by the Bank, as well as most other
residential lenders in Pennsylvania, require notice and a right to cure similar
to that provided under Pennsylvania law.
6
Non-accrual loans are loans on which the accrual of interest ceases when
the collection of principal or interest payments is determined to be doubtful by
management. It is the policy of the Bank to discontinue the accrual of interest
when principal or interest payments are delinquent 90 days or more (unless the
loan principal and interest are determined by management to be fully secured and
in the process of collection), or earlier, if the financial condition of the
borrower raises significant concern with regard to the ability of the borrower
to service the debt in accordance with the current loan term. Interest income is
not accrued until the financial condition and payment record of the borrower
once again demonstrate the ability to service the debt. When a loan is placed on
non-accrual status, previously accrued but unpaid interest is deducted from
interest income.
If foreclosure is successful, and the Bank acquires the real estate, which
is recorded as real estate owned ("REO") at the lower of carrying value or fair
value less disposal cost and any write-down resulting there from is charged to
the allowance for loan losses. Interest accrual ceases on the date of
acquisition and all costs incurred in maintaining the property from that date
forward are expensed. Costs incurred for the improvement or development of such
property are capitalized to the extent they do not exceed the property's fair
value. No loss reserves are maintained on REO and future write-downs for costs
beyond the fair value are expensed.
For purposes of applying the measurement criteria for impaired loans, the
Bank excludes large groups of smaller balance homogeneous loans, primarily
consisting of residential real estate loans and consumer loans as well as
commercial loans with balances of less than $100,000. For applicable loans, the
Bank evaluates the need for impairment recognition when a loan becomes
non-accrual or earlier if, based on management's assessment of the relevant
facts and circumstances, it is probable that the Bank will be unable to collect
all proceeds due according to the contractual terms of the loan agreement. At
June 30, 2004, the Bank had $4.0 million in impaired loans as compared to $3.2
million at June 30, 2003. The Bank's policy for the recognition of interest
income on impaired loans is the same as for non-accrual loans discussed above.
Impaired loans or a portion thereof are charged off when the Bank determines
that foreclosure is probable and the fair value less disposal costs of the
collateral is less than the recorded investment of the impaired loan.
The following table sets forth information regarding non-accrual loans and
REO held by the Bank at the dates indicated. The Bank did not have, at any of
the dates presented any (i) loans 90 days or more delinquent as to principal or
interest and on which interest is being accrued or (ii) loans classified as
restructured troubled debt.
7
AT JUNE 30,
----------------------------------------------
2004 2003 2002 2001 2000
----------------------------------------------
(Dollars in Thousands)
NON-ACCRUAL LOANS:
Residential real estate loans $ 591 $ 968 $ 858 $ 952 $ 735
Commercial and multi-family
residential real estate loans 2,900 3,092 -- -- --
Construction and land loans -- -- -- -- --
Commercial business loans 682 62 -- -- --
Consumer loans 37 65 86 220 207
------ ------ ------ ------ ------
Total non-accrual loans $4,210 $4,187 $ 944 $1,172 $ 942
====== ====== ====== ====== ======
Single commercial real estate loan 2,900 3,092 -- -- --
------ ------ ------ ------ ------
Total non-accrual loans less
single commercial real estate $1,310 $1,095 $ 944 $1,172 $ 942
loan(1)
====== ====== ====== ====== ======
Total non-accrual loans
to total assets 0.66% 0.72% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
Total non-accrual loans less
single commercial real estate
loan to total assets(1) 0.20% 0.19% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
Total REO 54 -- 40 -- --
------ ------ ------ ------ ------
Total non-accrual loans and REO
to total assets .66% .72% 0.17% 0.22% 0.19%
====== ====== ====== ====== ======
(1) We believe this non-GAAP disclosure is important as this particular
loan had been originated prior to the current management of the Bank
and we do not believe it is representative of the balance of the
portfolio.
At June 30, 2004, non-accrual real estate loans included 8 residential
mortgage loans aggregating $591,000, all secured by single-family residential
properties as well as a single commercial real estate loan in the amount of $2.9
million. The Loan had not been repaid in accordance with its original maturity
and has been extended by the Bank as the borrower attempts to work through its
financial difficulties. The Borrower has recently received a commitment from the
United States Department of Agriculture to guarantee a portion of the underlying
real estate project and is in the process of negotiating a refinance of the
project with an independent third party lender. Although the loan is current in
the payment of interest as it has been due, since its origination in 1998, and
the Bank has received interest prepaid through September 15, 2004, the loan was
placed on non-accrual as principal was not repaid in accordance with the
original stated maturity, as the borrower has encountered financial
difficulties, the underlying real estate is outside the Bank's primary lending
area and repayment is dependent upon factors not under the complete control of
the borrower. Additionally, June 30, 2004 non-accrual loans include two
commercial business loans aggregating $655,000 to a single borrower who has
encountered financial difficulties but has continued to maintain the loans in a
current status. Cash payments received are reducing the outstanding principal
balance on the loans.
8
The total amount of non-performing loans was $4.2 million, $4.2 million and
$944 thousand at June 30, 2004, 2003, and 2002, respectively. If these
non-performing loans had been current in accordance with their original terms
(or were not placed on non-accrual at the Bank's discretion) and had been
outstanding throughout the respective periods, the gross amount of interest
income for 2004, 2003, and 2002 that would have been recorded for these loans
would have been $734 thousand, $451 thousand, and $195 thousand, respectively.
Interest income on these non-performing loans included in income for 2004, 2003,
and 2002 amounted to $107 thousand, $353 thousand, and $114 thousand,
respectively.
ALLOWANCES FOR LOSSES ON LOANS AND CLASSIFIED LOANS
The allowance for loan losses is maintained at a level that represents
management's best estimate of known and inherent losses, which are probable and
reasonably determinable based upon an evaluation of the loan portfolio.
Homogeneous portfolios of loans, which include residential mortgage, home equity
and other consumer loans, are evaluated as a group. Commercial business loans
greater than $100,000, commercial mortgage and construction loans are evaluated
individually. Specific portions of the allowance are developed by analyzing
individual loans for adequacy of collateral, cash flow and other risks unique to
that particular loan. General portions of the allowance are developed by grading
individual loans in the commercial and construction portfolios and applying loss
factors by grade. The general portion of the allowance also includes loss
factors applied to the homogeneous portfolios as a group. The loss factors
applied to graded loans were developed based on the Company's loss history for
loans with similar attributes, local and national economic conditions, as well
as input from the Company's primary banking regulators. Loss factors are applied
to homogeneous loans based upon prior loss experience of the portfolio,
delinquency trends, local and national economic conditions and the volume of
non-performing loans. Although management believes it has used the best
information available to it in making such determinations, and that the present
allowance for loan losses is adequate, future adjustments to the allowance may
be necessary, and net income may be adversely affected if circumstances differ
substantially from the assumptions used in determining the level of the
allowance. In addition, various regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for losses
on loans. Such agencies may require the Bank to recognize additions to the
allowance based on their judgments about information available to them at the
time of their examination. The allowance is increased by the provision for loan
losses, which is charged to operations. Loan losses, other than those incurred
on loans held for sale, are charged directly against the allowance and
recoveries on previously charged-off loans are added to the allowance.
For purposes of applying the measurement criteria for impaired loans, the
Company excludes large groups of smaller balance homogeneous loans, primarily
consisting of residential real estate loans and consumer loans as well as
commercial business loans with balances of less than $100,000. For applicable
loans, the Company evaluates the need for impairment recognition when a loan
becomes non-accrual or earlier if, based on management's assessment of the
relevant facts and circumstances, it is probable that the Company will be unable
to collect all proceeds under the contractual terms of the loan agreement. At
June 30, 2004, the recorded investment in impaired loans was $4.0 million as
compared to $3.2 million at June 30, 2003. The increase is due primarily to the
above noted two commercial business loans to the single borrower. The Company's
policy for the recognition of interest income on impaired loans is the same as
for non-accrual loans. A portion of an impaired loan is charged off when the
Company determines that foreclosure is probable and the fair value of the
collateral is less than the recorded investment of the impaired loan.
At June 30, 2004, the Bank's allowance for loan losses was $6.3 million or
1.60% of total net loans receivable and 150.4% of total non-performing loans
compared to $5.4 million or 1.41% of net loans receivable and 129.3% of total
non-performing loans at June 30, 2003. The following table summarizes activity
in the Company's allowance for loan losses during the periods indicated.
9
AS OF JUNE 30,
-------------------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------- ------- -------
(In Thousands)
Allowance at beginning of period $ 5,415 $ 4,588 $ 4,264 $ 3,908 $ 3,651
Loans charged off against the allowance:
Residential real estate -- (7) (142) (29) (8)
Commercial business (29) -- -- -- (131)
Consumer (102) (69) (87) (75) (32)
-------- -------- -------- -------- --------
Total charge-offs (131) (76) (229) (104) (171)
Recoveries:
Residential real estate 5 -- -- 4 --
Commercial business -- -- -- 2 2
Consumer 26 24 6 9 6
-------- -------- -------- -------- --------
Total recoveries 31 24 6 15 8
Net charge-offs (100) (52) (223) (89) (163)
Provision for loan losses charged to
operating expenses 971 879 547 445 420
-------- -------- -------- -------- --------
Allowance acquired in Coatesville
branch acquisition 45 -- -- -- --
-------- -------- -------- -------- --------
Allowance at year end $ 6,331 $ 5,415 $ 4,588 $ 4,264 $ 3,908
======== ======== ======== ======== ========
Ratio of net charge-offs to
average loans outstanding 0.02% 0.01% 0.06% 0.03% 0.05%
======== ======== ======== ======== ========
Ratio of allowance to period-end
net loans 1.60% 1.41% 1.26% 1.23% 1.18%
======== ======== ======== ======== ========
10
The following table presents information regarding the Bank's total
allowance for losses on loans as well as the allocation of such amounts to the
various categories of the loan portfolio.
AT JUNE 30,
--------------------------------------------------------------------------------------------
2004 2003 2002 2001 2000
---------------- ---------------- ---------------- ---------------- ----------------
% OF % OF % OF % OF % OF
LOANS LOANS LOANS LOANS LOANS
TO TOTAL TO TOTAL TO TOTAL TO TOTAL TO TOTAL
AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS AMOUNT LOANS
----------------- ----------------- ---------------- ---------------- ----------------
(In Thousands)
Residential real estate loans $ 272 17.3% $ 372 24.7% $ 402 34.1% $ 537 40.2% $ 700 46.8%
Commercial real estate loans 2,830 33.0% 2,613 29.6% 1,707 26.5% 1,547 22.4% 1,553 18.5%
Construction and land loans 338 11.4% 380 13.8% 279 12.3% 200 12.5% 241 11.8%
Commercial business loans 1,825 11.5% 1,231 10.4% 1,450 9.4% 1,267 7.4% 632 5.4%
Consumer loans 1,066 26.8% 819 21.5% 750 17.7% 713 17.5% 782 17.5%
----------------- ----------------- ---------------- ---------------- -----------------
Total allowance for loan losses $ 6,331 100.0% $ 5,415 100.0% $ 4,588 100.0% $ 4,264 100.0% $ 3,908 100.0%
================= ================= ================= ================= =================
Total allowance for loan losses
to total non-performing loans 150.4% 129.3% 486.0% 363.8% 414.9%
======= ======= ======= ======= =======
Total allowance for loan losses
to total non-performing loans
less single commercial real
estate loan1 483.3% 495.0% 486.0% 363.8% 414.9%
======= ======= ======= ======= =======
Total non-performing loans $4,210 $4,187 $ 944 $ 1,172 $ 942
======= ======= ======= ======= =======
- -----------------------
(1)See Table on Page 8 for reconciliation.
11
The Company monitors the quality of its loans on a regular basis and
classifies them under a classification system that has three categories: (i)
substandard, (ii) doubtful and (iii) loss. A loan may fall within more than one
category and a portion of the asset may remain unclassified. The Company is
required to review the classification of its loans on a regular basis. In
addition, in connection with the examinations of First Financial by the FDIC and
the Department, the examiners have the authority to identify problem loans and,
if appropriate, classify them and/or require adjustments to the carrying value
of such assets.
Loans classified substandard are considered inadequately protected by the
current net worth and paying capacity of the obligor or the value of the
collateral pledged, if any. Loans so classified must have a well-defined
weakness or weaknesses. They are characterized by the distinct possibility that
the insured institution will sustain some loss if the deficiencies are not
corrected.
Loans classified doubtful are considered to have all the weaknesses
inherent in those classified substandard with the added characteristic that the
weaknesses make collection or liquidation in full, on the basis of currently
existing facts, conditions, and values, highly questionable and improbable.
Loans classified loss are considered uncollectable and of such little value
that their continuance as assets is not warranted. After charging off a loan,
the Company continues its efforts to obtain a recovery on the loan.
At June 30, 2004, the Company's classified loans, which consisted of loans
classified as substandard or doubtful, totaled $10.7 million as compared to
$15.3 million at June 30, 2003. Included in the loans classified substandard at
June 30, 2004 and June 30, 2003 were all loans 90 days past due, loans which are
less than 90 days delinquent but inadequately protected by the current paying
capacity of the borrower or of the collateral pledged, and loans which have a
well-defined weakness that may jeopardize the liquidation of the debt.
SECURITIES ACTIVITIES
Historically, interest and dividends on securities and interest-bearing
deposits have provided the Company with a significant source of revenue. At June
30, 2004, the Company's securities portfolio and interest-bearing deposits
aggregated $204.8 million or 31.9% of its total assets.
The Company divides its securities portfolio into three segments: (a) held
to maturity; (b) available for sale; and (c) trading. Securities in the held to
maturity category are accounted for at amortized cost. Trading securities are
accounted for at quoted market prices with changes in market values being
recorded as gain or loss in the statement of operations. All other securities
are included in the available for sale category and are accounted for at fair
value with unrealized gains or losses, net of taxes, being reflected as
adjustments to equity. At June 30, 2004, the Company had a net unrealized loss
on securities available for sale, net of taxes, of $2.0 million. The following
table sets forth the Company's securities portfolio and interest-earning
deposits at carrying value at the dates indicated.
12
AT JUNE 30,
------------------------------------------
2004 2003 2002
--------- --------- ---------
(Dollars in Thousands)
Interest-bearing deposits $ 15,352 $ 9,438 $ 29,163
Trading account securities(1) 8 10 16
Investment securities held to maturity:
U.S. Government and agency obligations 32,513 130 6,376
Municipal notes and bonds(2) 14,884 13,793 8,215
Mortgage-backed securities 3,366 8,520 16,725
Collateralized mortgage obligations 885 1,934 4,585
Debt securities 1,003 3,216 --
Other 6,733 5,797 5,279
--------- --------- ---------
Total investment securities held to maturity 59,384 33,390 41,180
AT JUNE 30,
------------------------------------------
2004 2003 2002
--------- --------- ---------
Investment securities available for sale:
U.S. Government and agency obligations 7,336 2,074 3,401
Municipal notes and bonds(2) 11,606 26,767 30,195
Mortgage-backed securities 40,934 31,672 24,696
Collateralized mortgage obligations 35,568 25,545 23,319
Equity securities 688 1,236 1,346
Debt securities 17,021 24,916 18,436
Asset-backed securities 13,040 -- --
Other 3,896 2,010 --
--------- --------- ---------
Total investment securities available for sale 130,089 114,220 101,393
--------- --------- ---------
Total securities and interest-bearing deposits $ 204,833 $ 157,058 $ 171,752
========= ========= =========
(1) The trading account securities are being maintained at PCIS, which is
a subsidiary of the Company.
(2) The income from municipal notes and bonds is generally non-taxable for
federal and state purposes.
The investment security portfolio is a significant tool in the Company's
management of its' interest rate risk as well as serving as a secondary source
for funding the liquidity needs of the Bank. In that regard, the Company
attempts to maximize income within the portfolio while minimizing interest rate
risk so that the portfolio is not subject to significant fluctuations in market
value.
Included in investment securities available for sale at June 30, 2004 are
three non-rated Pennsylvania Municipal Authority bonds that have been classified
as substandard. These securities were originally purchased at various times
during the period from June 1998 through June 2000. The aggregate book value of
the bonds, after write-downs of $955 thousand is $5.6 million. Two of the three
bonds with an aggregate book value of $4.9 million at June 30, 2004 are zero
coupon bonds with maturities extending up to 2034. Both bonds are secured by the
revenue streams of commercial office buildings, which are leased to various
agencies of the Commonwealth of Pennsylvania under long-term lease arrangements
with renewal options.
A third bond was issued by the Housing Authority of Chester County and has
a book balance of $720 thousand at June 30, 2004 and bears interest at rates
between 5.60% and 6.00% and matures in June 2019. This bond involves low-income
scattered housing in Chester County under a program of the Office of Housing and
Urban Development ("HUD"). HUD has committed to provide additional funds to
build additional houses, which would be donated to this bond issue. The
retirement of the bond issue is dependent upon proceeds from either the rental
or sale of the existing and additional houses. This bond is on non-accrual at
June 30, 2004.
13
These classified investments are closely monitored and fairly stated at
June 30, 2004 based on available information. There can be no assurance that
further subsequent adverse or positive developments may occur and thus could
result in further adjustments to the carrying value of these investments.
The amortized cost and estimated fair value of investment securities at
June 30, 2004, by contractual maturity, are shown below.
WEIGHTED
AMORTIZED ESTIMATED AVERAGE
COST FAIR VALUE YIELD
---------- ---------- --------
(Dollars in Thousands)
HELD TO MATURITY
Due in one year or less $ 1,003 $ 1,012 5.75%
Due after one year through five years 127 127 6.00%
Due after five years through ten years 22,094 21,325 4.17%
Due after ten years 29,427 28,582 4.88%
No stated maturity 6,733 6,733 1.50%
---------- ---------- -------
TOTAL HELD TO MATURITY $ 59,384 $ 57,779 4.25%
---------- ---------- -------
AVAILABLE FOR SALE
Due in one year or less $ 115 $ 116 3.53%
Due after one year through five years 6,701 6,570 4.69%
Due after five years through ten years 24,000 23,387 4.87%
Due after ten years 99,751 97,427 4.07%
No stated maturity 2,615 2,589 3.93%
---------- ---------- -------
TOTAL AVAILABLE FOR SALE $ 133,182 $ 130,089 4.24%
---------- ---------- -------
TOTAL INVESTMENT SECURITIES $ 192,566 $ 187,868 4.25%
========== ========== =======
The weighted average yield, based on amortized cost, is presented on a
taxable equivalent basis.
As of June 30, 2004, investments in the debt and/or equity securities of
any one issuer (excluding U.S. Government and federal agencies) did not exceed
10% of the Company's stockholders' equity.
SOURCES OF FUNDS
GENERAL
Deposits obtained through branch offices have traditionally been the
principal source of the Company's funds for use in lending and for other general
business purposes. The Company also derives funds from amortization and
prepayments of outstanding loans and investments and sales of loans. From time
to time, the Company also may borrow funds from the FHLBP and other sources.
Borrowings may be used to compensate for reductions in deposits or to support
expanded lending and investment activities.
14
DEPOSITS
The Company obtains deposits primarily from residents of Chester
County, and to a lesser extent Berks, Delaware, Lancaster and Montgomery
Counties, Pennsylvania. Currently, the principal methods used by First Financial
to attract deposit accounts include the offering of services and a wide variety
of accounts, competitive interest rates, and convenient office locations and
service hours. Other than during times of inverse or flat yield curves, the Bank
has adopted a pricing program for its certificate accounts which provides for
higher rates of interest on its longer term certificates in order to encourage
depositors to invest in certificates with longer maturities, thus reducing the
interest rate sensitivity of the Company's deposit portfolio. First Financial
also offers a tiered money market account that pays higher interest on higher
balances so as to maintain a relatively stable level of core deposits even when
its certificate accounts mature.
The Bank's current deposit products include non-interest-bearing accounts,
passbook/statement savings accounts, NOW checking accounts, money market deposit
accounts, certificates of deposit ranging in terms from 30 days to seven years
and certificates of deposit in denominations of $100,000 or more ("jumbo
certificates"). Included among these deposit products are individual retirement
account certificates ("IRA certificates") and Keogh accounts.
The following table shows the balances of the Company's deposits as of the
dates indicated:
AT JUNE 30,
-------------------------------------------------------------------------------
2004 2003 2002
------------------------- ------------------------- -------------------------
(Dollars in Thousands)
% OF % OF % OF
AMOUNT DEPOSITS AMOUNT DEPOSITS AMOUNT DEPOSITS
------------ ----------- ------------ ----------- ------------ -----------
Non-interest-bearing accounts $ 69,132 16.2% $ 59,906 15.0% $ 44,890 11.6%
NOW checking accounts 64,638 15.1% 61,828 15.4% 55,307 14.3%
Passbook/statementsavings
accounts 34,762 8.1% 31,107 7.8% 31,560 8.2%
Money market deposits accounts 151,204 35.5% 101,112 25.2% 65,411 17.0%
Certificates of deposit less than
$100,000 82,119 19.2% 99,003 24.7% 120,810 31.3%
Certificates of deposit with
$100,000 minimum balance 25,248 5.9% 47,630 11.9% 68,002 17.6%
------------ ----------- ------------ ----------- ------------ -----------
Total deposits $ 427,103 100.0% $ 400,586 100.0% $ 385,980 100.0%
============ =========== ============ =========== ============ ===========
The following table shows the balances of certificates of deposit with
balances of $100,000 or greater which mature during the periods indicated and
the balance at June 30, 2004.
BALANCES AT JUNE 30, 2004 MATURING
-----------------------------------------------------
(In Thousands)
AT Within Three Six to After
JUNE 30, Three to Six Twelve Twelve
2004 Months Months Months Months
-------- ------- ------- ------- -------
Certificates of deposit with $100,000
minimum balance $25,248 $ 3,586 $ 2,910 $ 8,690 $10,062
======== ======= ======= ======= =======
15
The following table presents the average balance by type of deposit and the
average rate paid by type of deposit for the periods indicated.
YEAR ENDED JUNE 30,
--------------------------------------------------------------------------
2004 2003 2002
---------------------- ----------------------- -----------------------
(Dollars in Thousands)
AVERAGE AVERAGE AVERAGE
AVERAGE RATE AVERAGE RATE AVERAGE RATE
BALANCE PAID BALANCE PAID BALANCE PAID
----------- --------- --------- ---------- --------- ---------
NOW Checking accounts $ 64,187 0.24% $ 56,928 0.53% $ 48,644 0.89%
Passbook/statement savings accounts 32,041 0.23% 30,527 0.66% 27,524 1.16%
Money market deposit accounts 125,035 1.30% 80,707 1.72% 63,651 2.25%
Certificates of deposit less
than $100,000 86,457 2.79% 114,221 3.51% 119,072 4.49%
Certificates of deposit with
$100,000 minimum balance 35,194 2.92% 65,617 3.15% 88,105 4.15%
First Financial's emphasis on core deposit growth (NOW, Savings and Money
Market) has resulted in it becoming less dependent on higher costing
certificates of deposit and the reduced threat of disintermediation (the flow of
funds away from savings institutions into direct investment vehicles such as
government and corporate securities). Like many financial institutions, First
Financial is susceptible to short-term fluctuations in deposit flows, as
customers have become more rate conscious and willing to move funds into
higher-yielding accounts. Thus, First Financials ability to attract and maintain
deposits, as well as its ability to control its cost of funds, will continue to
be affected by economic conditions, the interest rate environment as well as
competition from other financial institutions.
First Financial attempts to control the flow of deposits by pricing its
accounts to remain generally competitive with other financial institutions in
its primary market area, but does not necessarily seek to match the highest
rates paid by competing institutions.
First Financial's deposits are obtained primarily from persons who are
residents of Pennsylvania and, to a much lesser degree, from governmental
entities. First Financial does not advertise for deposits outside of
Pennsylvania nor has it to this point accepted brokered deposits. Management
believes that at June 30, 2004, an insignificant amount of First Financial's
deposits were held by non-residents of Pennsylvania.
BORROWINGS
First Financial may obtain advances from the FHLBP upon the security of the
common stock it owns in that bank, its investment security portfolio as well as
certain residential mortgage and other loans, provided they meet certain
standards established by the FHLBP. See "Regulation - Regulation of the Bank -
Federal Home Loan Bank System." Such advances are made pursuant to several
different credit programs, with differing interest rates and maturities. FHLBP
advances are generally available to meet withdrawals of deposit accounts, to
fund expansion of lending and investment activities, as well as to aid the Bank
in its asset and liability management. At June 30, 2004, the Company had $121.0
million in FHLBP advances outstanding. In addition, the Company has established
a line of credit with the FHLBP at June 30, 2004 in the amount of $10 million,
which is subject to certain conditions, including the holding of a predetermined
amount of FHLBP stock as collateral. At June 30, 2004, there was no balance
outstanding on the line of credit.
16
The following table presents certain information regarding short-term
borrowings (borrowings with a maturity of one year or less) for the periods
indicated:
YEAR ENDED JUNE 30,
------------------------------------------
2004 2003 2002
---------- ---------- ----------
(Dollars in Thousands)
SHORT-TERM BORROWINGS:
Balance outstanding at end of period $ 40,858 $ 29,458 $ 28,750
Weighted average interest rate at end of period 1.29% 0.96% 5.88%
Average balance outstanding 27,915 27,610 28,606
Maximum amount outstanding at any month-end
during the period 40,858 59,244 35,250
Weighted average interest rate during the period 1.15% 2.44% 5.63%
YIELDS EARNED AND RATES PAID
The largest components of the Company's total income and total expense are
interest income and interest expense. As a result, the Company's earnings are
dependent primarily upon net interest income, which is determined by the
Company's net interest rate spread (i.e., the difference between the yields
earned on interest-earning assets and the rates paid on interest-bearing
liabilities) and the relative amounts of interest-earning assets and
interest-bearing liabilities.
17
INTEREST INCOME AND INTEREST SPREAD ANALYSIS
The following table sets forth, for the periods indicated, information
regarding (1) the total dollar amount of interest income of the Company from
interest-earning assets and the resultant average yields; (2) the total dollar
amount of interest expense on interest-bearing liabilities and the resultant
average cost; (3) net interest income; (4) interest rate spread; and (5) net
interest-earning assets and their net yield. Average balances are determined on
a daily basis, which is representative of operations.
YEAR ENDED JUNE 30,
-------------------------------------------------------------------------------------------
2004 2003 2002
----------------------------- ------------------------------ ------------------------------
AVERAGE YIELD/ AVERAGE YIELD/ AVERAGE YIELD/
BALANCE(1) INTEREST(2) RATE(2 BALANCE(1) INTEREST(2) RATE(2) BALANCE(1) INTEREST(2) RATE(2)
---------- ----------- ------ ---------- ----------- ------- ---------- ----------- -------
(Dollars in Thousands)
Assets:
Loans and loans held for sale $ 403,030 $ 23,467 5.82% $ 377,027 $ 25,640 6.80% $ 359,725 $ 26,756 7.44%
Securities and other investments 170,762 7,084 4.15% 163,758 6,814 4.16% 156,800 8,520 5.43%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Total interest-earning assets 573,792 30,551 5.32% 540,785 32,454 6.00% 516,525 35,276 6.83%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Non-interest earning assets 36,712 43,285 31,436
--------- --------- ---------
Total assets $ 610,504 $ 584,070 $ 547,961
========= ========= =========
Liabilities and Stockholders'
Equity:
Deposits and repurchase agreements $ 379,434 $ 5,407 1.43% $ 380,434 $ 8,152 2.14% $ 369,600 $ 11,340 3.07%
FHLB advances and other
Borrowings 127,831 5,311 4.15% 108,426 5,740 5.30% 93,153 5,024 5.39%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Total interest-bearing liabilities 507,265 10,718 2.11% 488,860 13,892 2.84% 462,753 16,364 3.54%
--------- --------- ----- --------- --------- ----- --------- -------- -----
Non-interest-bearing liabilities 51,822 48,423 43,085
Stockholders' equity 51,417 46,787 42,123
--------- --------- ---------
Total liabilities and stockholders' $ 610,504 $ 584,070 $ 547,961
equity ========= ========= =========
Net interest income/interest
rate spread $ 19,833 3.21% $ 18,562 3.16% $ 18,912 3.29%
========= ===== ========= ===== ======== =====
Net interest-earning assets/net
yield on interest-earning assets $ 66,527 3.46% $ 51,925 3.43% $ 53,772 3.66%
========= ===== ========= ===== ========= =====
Ratio of average interest-earning
assets to interest-bearing
liabilities 113% 111% 112%
==== ==== ====
- ----------------
(1) Non-accruing loans are included in the average balance.
(2) The indicated interest and annual yield and rate are presented on a taxable
equivalent basis using the Federal marginal income tax rate of 34% adjusted
for the 20% interest expense disallowance (27.2%) for 2004, 2003, and 2002.
The following details the tax equivalent adjustments in the above table:
18
YEAR ENDED JUNE 30,
-------------------------------------------------------------------------------------------------------------
2004 2003 2002
----------------------------------- ---------------------------------- ------------------------------------
INTEREST TAX ADJUSTED INTEREST TAX ADJUSTED INTEREST TAX ADJUSTED
INCOME ADJUSTMENT INCOME INCOME ADJUSTMENT INCOME INCOME ADJUSTMENT INCOME
-------------------------------------------------------------------------------------------------------------
(Dollars in Thousands)
Loans $ 23,406 $ 61 $ 23,467 $ 25,560 $ 80 $ 25,640 $ 26,658 $ 98 $ 26,756
Investments 6,462 622 7,084 6,155 659 6,814 7,812 708 8,520
----------------------------------- ---------------------------------- ------------------------------------
Total $ 29,868 $ 683 $ 30,551 $ 31,715 $ 739 $ 32,454 $ 34,470 $ 806 $ 35,276
=================================== =================================== ===================================
RATE/VOLUME ANALYSIS
The following table presents certain information regarding changes in
interest income and interest expense of the Company for the periods indicated.
Interest income and the annual rate are calculated on a taxable equivalent basis
using the Federal marginal income tax rate of 34% adjusted for the 20% interest
expense disallowance (27.2%). For each category of interest-earning assets and
interest-bearing liabilities, information is provided with respect to changes
attributable to (1) changes in volume (change in volume multiplied by old rate),
(2) changes in rate (change in rate multiplied by old volume) and (3) changes in
rate/volume (change in rate multiplied by change in volume). The changes in
rate/volume are allocated to the change in volume variance and the change in the
rate variance on a pro rated basis.
2004 COMPARED TO 2003 2003 COMPARED TO 2002
INCREASE (DECREASE) DUE TO INCREASE (DECREASE) DUE TO
-------------------------------- -----------------------------------
VOLUME RATE TOTAL VOLUME RATE TOTAL
-------- --------- --------- ------- --------- ---------
(Dollars in Thousands)
Interest income on interest-
earning assets:
Loans and loans held for sale $ 1,689 $ (3,862) $ (2,173) $ 1,251 $ (2,367) $ (1,116)
Securities and other investments 286 (16) 270 363 (2,069) (1,706)
-------- --------- --------- -------- --------- ---------
Total interest income 1,975 (3,878) (1,903) 1,614 (4,436) (2,822)
-------- --------- --------- -------- --------- ---------
Interest expense on interest-bearing
liabilities:
Deposits and repurchase agreements (21) (2,724) (2,745) 325 (3,515) (3,190)
FHLB advances and other borrowings 933 (1,362) (429) 804 (86) 718
-------- --------- --------- -------- --------- ---------
Total interest expense 912 (4,086) (3,174) 1,129 (3,601) (2,472)
-------- --------- --------- -------- --------- ---------
Net change in net interest income $ 1,063 $ 208 $ 1,271 $ 485 $ (835) $ (350)
======== ========= ========= ======= ========= =========
19
RATIOS
The following table shows certain income and financial condition ratios for
the periods indicated. All averages are based on month-end balances, which are
representative of operations.
YEAR ENDED JUNE 30,
-------------------------------------
2004 2003 2002
---------- ---------- ----------
Return on average assets
(income divided by average
total assets) 1.03% 0.90% 1.02%
Return on average equity
(income divided by average equity) 12.27% 11.25% 13.24%
Equity-to-assets ratio
(average equity divided by
average assets) 8.42% 8.01% 7.69%
Dividend pay-out ratio 31.52% 34.13% 30.65%
SUBSIDIARIES OF FIRST FINANCIAL
The Bank operates (as a wholly owned subsidiary) D & S Service Corporation
("D & S Service"), which has participated in the development for sale of
residential properties, in particular condominium conversions, and also the
development of commercial properties in order for the Bank to expand its
facilities to accommodate its growth. All of such projects have either been
located in or within close proximity to the Bank's primary market area. D & S
Service operates two wholly owned subsidiaries: Wildman Projects and D & F
Projects, Inc. As of June 30, 2004, the Bank had invested $1.8 million in D & S
Service and its wholly owned subsidiaries. Additionally, the Bank has a second
subsidiary, First Financial Investments, from which the Bank conducts retail
investment service activities.
REGULATION
Set forth below is a brief description of certain laws and regulations that
relate to the regulation of the Company, the Bank and PCIS in effect as of June
30, 2004. The description of these laws and regulations, as well as descriptions
of laws and regulations contained elsewhere herein, do not purport to be
complete and is qualified in its entirety by reference to applicable laws and
regulations.
REGULATION OF THE HOLDING COMPANY
GENERAL
The Holding Company, as a bank holding company as a result of the
conversion effective September 1, 2001 of the Bank from a Pennsylvania chartered
thrift to a Pennsylvania-chartered commercial bank, is subject to regulation and
supervision by the Federal Reserve Board. Under the Bank Holding Company Act
("BHCA"), a bank holding company is required to file annually with the Federal
Reserve Board a report of its operations and, with its subsidiaries, is subject
to examination by the Federal Reserve Board.
20
ACTIVITIES AND OTHER LIMITATIONS
The BHCA generally prohibits a bank holding company from acquiring direct
or indirect ownership or control of more than 5% of the voting shares of any
bank, or increasing such ownership or control of any bank, without prior
approval of the Federal Reserve Board. The Federal Reserve Board generally may
approve an application by a bank holding company that is adequately capitalized
and adequately managed to acquire control of, or to acquire all or substantially
all of the assets of, a bank located in a state other than the home state of
such bank holding company, without regard to whether such transaction is
prohibited under the law of any state, provided, however, that the Federal
Reserve Board may not approve any such application that would have the effect of
permitting an out-of-state bank holding company to acquire a bank in a host
state that has not been in existence for any minimum period of time, not to
exceed five years, specified in the statutory law of the host state.
The BHCA also generally prohibits a bank holding company, with certain
exceptions, from acquiring more than 5% of the voting shares of any company that
is not a bank and from engaging in any business other than banking or managing
or controlling banks. Under the BHCA, the Federal Reserve Board is authorized to
approve the ownership of shares by a bank holding company in any company the
activities of which the Federal Reserve Board had determined, by regulation or
by order, to be so closely related to banking or to managing or controlling
banks as to be a proper incident thereto as of November 11, 2000, the day before
the date of enactment of the Gramm-Leach-Bliley Act, discussed below. In making
such determinations, the Federal Reserve Board is required to weigh the expected
benefit to the public, such as greater convenience, increased competition or
gains in efficiency, against the possible adverse effects, such as undue
concentration of resources, decreased or unfair competition, conflicts of
interest or unsound banking practices.
CAPITAL REQUIREMENTS
The Federal Reserve Board has issued risk-based and leverage capital
guidelines applicable to bank holding companies. In addition, the Federal
Reserve Board may from time to time require that a bank holding company maintain
capital above the minimum levels, whether because of its financial condition or
actual or anticipated growth. The Federal Reserve Board's risk-based guidelines
define a three-tier capital framework. Tier 1 capital consists of common and
qualifying preferred shareholders' equity, less certain intangibles and other
adjustments. Tier 2 capital consists of preferred stock not qualifying as Tier 1
capital, subordinated and other qualifying debt, and the allowance for credit
losses up to 1.25 percent of risk-weighted assets. Tier 3 capital includes
subordinated debt that is unsecured, fully paid, has an original maturity of a
least two years, is not redeemable before maturity without prior approval by the
Federal Reserve Board and includes a lock-in clause precluding payment of either
interest or principal if the payment would cause the issuing entity's risk-based
capital ratio to fall or remain below the required minimum. The sum of Tier 1
and Tier 2 capital less investments in unconsolidated subsidiaries represents
qualifying total capital, at least 50 percent of which must consist of Tier 1
capital. Risk-based capital ratios are calculated by dividing Tier 1 and total
capital by risk-weighted assets. Assets and off-balance sheet exposures are
assigned to one of four categories of risk-weights, based primarily on relative
credit risk. The minimum Tier 1 capital ratio is 4 percent and the minimum total
capital ratio is 8 percent. The leverage ratio is determined by dividing Tier 1
capital by adjusted average total assets. Although the stated minimum ratio is 3
percent, most banking organizations are required to maintain ratios of at least
100 to 200 basis points above 3 percent.
As of June 30, 2004, the Company's capital ratios exceeded applicable
requirements. See Note 13 of the Consolidated Financial Statements included in
Item 8 hereof.
AFFILIATED INSTITUTIONS
Under Federal Reserve Board policy, the Holding Company is expected to act
as a source of financial strength to the Bank and to commit resources to support
the Bank in circumstances when it might not do so absent such policy. The
Federal Reserve Board takes the position that in implementing this policy it may
require bank holding companies to provide such support when the holding company
otherwise would not consider itself able to do so.
21
A bank holding company is a legal entity separate and distinct from its
subsidiary bank. Normally, the major source of a holding company's revenue is
dividends a holding company receives from its subsidiary bank. The right of a
bank holding company to participate as a stockholder in any distribution of
assets of its subsidiary bank upon its liquidation or reorganization or
otherwise is subject to the prior claims of creditors of such subsidiary bank.
The subsidiary bank is subject to claims by creditors for long-term and
short-term debt obligations, including substantial obligations for federal funds
purchased and securities sold under repurchase agreements, as well as deposit
liabilities. Under FIRREA, in the event of a loss suffered by the FDIC in
connection with a banking subsidiary of a bank holding company (whether due to a
default or the provision of FDIC assistance), other banking subsidiaries of the
holding company could be assessed for such loss.
Federal laws limit the transfer of funds by a subsidiary bank to its
holding company in the form of loans or extensions of credit, investments or
purchases of assets. Transfers of this kind are limited to 10% of a bank's
capital and surplus with respect to each affiliate and to 20% in the aggregate,
and are also subject to certain collateral requirements. These transactions, as
well as other transactions between a subsidiary bank and its holding company,
also must be on terms substantially the same as, or at least as favorable as,
those prevailing at the time for comparable transactions with non-affiliated
companies or, in the absence of comparable transactions, on terms or under
circumstances, including credit standards, that would be offered to, or would
apply to, non-affiliated companies.
In January 2003, the FASB issued FASB Interpretation No. 46, "Consolidation
of Variable Interest Entities, an Interpretation of ARB No. 51" ("FIN 46"). FIN
46 provided a new framework for identifying variable interest entities ("VIEs")
and determining when a company should include the assets, liabilities,
non-controlling interests and results of activities of a VIE in its consolidated
financial statements. FIN 46 was effective immediately for VIEs created after
January 31, 2003 and was effective beginning in the third quarter of 2003 for
VIEs created prior to the issuance of the interpretation. The Company adopted
the provisions of FIN 46 with no material impact on its financial condition or
results of operations, earnings per share or cash flows. For information
regarding an ongoing evaluation of the effects of FIN 46 on the treatment of
capital securities issued by consolidated subsidiary trusts for regulatory
purposes, see "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Capital."
FINANCIAL MODERNIZATION
Effective November 12, 1999, the Gramm-Leach-Bliley Act, permits bank
holding companies to become financial holding companies and thereby affiliate
with securities firms and insurance companies and engage in other activities
that are financial in nature. A bank holding company may become a financial
holding company if its subsidiary bank is "well capitalized" and "well managed,"
as defined, and has at least a satisfactory rating under the Community
Reinvestment Act by filing a declaration that the bank holding company wishes to
become a financial holding company. No regulatory approval is required for a
financial holding company to acquire a company, other than a bank or savings
association, engaged in activities that are financial in nature or incidental to
activities that are financial in nature, as determined by the Federal Reserve
Board.
The Gramm-Leach-Bliley Act defines "financial in nature" to include
securities underwriting, dealing and market making; sponsoring mutual funds and
investment companies; insurance underwriting and agency; merchant banking
activities; and activities that the Federal Reserve Board has determined to be
closely related to banking. Subsidiary banks of a financial holding company must
continue to be well capitalized and well managed in order to continue to engage
in activities that are financial in nature without regulatory actions or
restrictions, which could include divestiture of the financial in nature
subsidiary or subsidiaries. In addition, a financial holding company or a bank
may not acquire a company that is engaged in activities that are financial in
nature unless each of the subsidiary banks of the financial holding company or
the bank has a Community Reinvestment Act rating of satisfactory or better.
22
In connection with the Holding Company's application to become a bank
holding company as a result of the conversion of the Bank to a
Pennsylvania-chartered commercial bank, the Company elected to become a
financial holding company.
STATE REGULATION
The Company is registered as a Pennsylvania financial institution holding
company under Pennsylvania law and as such is subject to regulation and
examination by the Superintendent of Banking of the Commonwealth of
Pennsylvania.
REGULATION OF PCIS
GENERAL
In the United States, a number of federal regulatory agencies are charged
with safeguarding the integrity of the securities and other financial markets
and with protecting the interest of customers participating in those markets.
The Commission is the federal agency that is primarily responsible for the
regulation of broker-dealers and investment advisers doing business in the
United States, and the Federal Reserve Board promulgates regulations applicable
to securities credit transactions involving broker-dealers and certain other
institutions in the Unites States. Much of the regulation of broker-dealers,
however, has been delegated to self-regulatory organizations ("SROs"),
principally the NASD (and its subsidiaries NASD Regulation, Inc. and the Nasdaq
Stock Market), and the national securities exchanges. These SROs, which are
subject to oversight by the Commission, adopt rules (which are subject to
approval by the Commission) that govern the industry, monitor daily activity and
conduct periodic examinations of member broker-dealers.
PCIS is also subject to the Uniting and Strengthening America by Providing
Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the
"USA Patriot Act'), signed into law on October 26, 2001. (See "Recent
Legislation") The USA Patriot Act requires financial institutions to adopt and
implement policies and procedures designed to prevent and defeat money
laundering. PCIS believes it is in compliance with the USA Patriot Act.
Securities firms are also subject to regulation by state securities
commissions in the states in which they are required to be registered. PCIS is
registered as a broker-dealer with the Commission and in all 50 states and in
the District of Columbia, and is a member of, and subject to regulation by, a
number of SROs, including the NASD.
As a result of federal and state registration and SRO memberships, PCIS is
subject to overlapping schemes of regulation that cover all aspects of its
securities business. Such regulations cover matters including capital
requirements, uses and safe-keeping of clients' funds, conduct of directors,
officers and employees, record-keeping and reporting requirements, supervisory
and organizational procedures intended to assure compliance with securities laws
and to prevent improper trading on material nonpublic information,
employee-related matters, including qualification and licensing of supervisory
and sales personnel, limitations on extensions of credit in securities
transactions, clearance and settlement procedures, requirements for the
registration, underwriting, sale and distribution of securities, and rules of
the SROs designed to promote high standards of commercial honor and just and
equitable principles of trade. A particular focus of the applicable regulations
concerns the relationship between broker-dealers and their customers. As a
result, the many aspects of the broker-dealer customer relationship are subject
to regulation including, in some instances, "suitability" determinations as to
certain customer transactions, limitations on the amounts that may be charged to
customers, timing of proprietary trading in relation to customers' trades and
disclosures to customers.
23
PCIS also is subject to "Risk Assessment Rules" imposed by the SEC which
require, among other things, that certain broker-dealers maintain and preserve
certain information, describe risk management policies and procedures and report
on the financial condition of certain affiliates whose financial and securities
activities are reasonably likely to have a material impact on the financial and
operational condition of the broker-dealers. Certain "Material Associated
Persons" (as defined in the Risk Assessment Rules) of the broker-dealers and the
activities conducted by such Material Associated Persons may also be subject to
regulation by the SEC.
PCIS is registered as an investment adviser with the SEC. As an investment
adviser registered with the SEC, it is subject to the requirements of
the Investment Advisers Act of 1940 and the SEC's regulations thereunder, as
well as certain state securities laws and regulations. Such requirements relate
to, among other things, limitations on the ability of an investment adviser to
charge performance-based or non-refundable fees to clients, record-keeping and
reporting requirements, disclosure requirements, limitations on principal
transactions between an adviser or its affiliates and advisory clients, as well
as general anti-fraud prohibitions. The state securities law requirements
applicable to registered investment advisers are in certain cases more
comprehensive than those imposed under the federal securities laws.
In the event of non-compliance with an applicable regulation, governmental
regulators and the NASD may institute administrative or judicial proceedings
that may result in censure, fine, civil penalties (including treble damages in
the case of insider trading violations), the issuance of cease-and-desist
orders, the deregistration or suspension of the non-compliant broker-dealer or
investment adviser, the suspension or disqualification of the broker-dealer's
officers or employees or other adverse consequences. The imposition of any such
penalties or orders on PCIS could have a material adverse effect on PCIS' (and
thus the Company's) operating results and financial condition.
NET CAPITAL REQUIREMENTS
As a broker-dealer registered with the SEC and as a member firm of the
NASD, PCIS is subject to the capital requirements of the SEC and the NASD. These
capital requirements specify minimum levels of capital that PCIS is required to
maintain and also limit the amount of leverage that each firm is able to obtain
in its respective business.
As of June 30, 2004, PCIS was required to maintain minimum net capital, in
accordance with SEC rules, of $250,000 and had total net capital of $977,000 or
$747,000 in excess of the minimum amount required. PCIS is required to maintain
a net capital ratio, in accordance with SEC rules, not to exceed 15 to 1. At
June 30, 2004, PCIS' net capital ratio was .25 to 1.
A failure of a broker-dealer to maintain its minimum required net capital
or net capital ratio would require it to cease executing customer transactions
until it came back into compliance, and could cause it to lose its NASD
membership, its registration with the SEC or require its liquidation. Further,
the decline in a broker-dealer's net capital below certain "early warning
levels," even though above minimum net capital requirements, could cause
material adverse consequences to the broker-dealer.
PCIS is a member of the Securities Investor Protection Corporation
("SIPC"), which is a non-profit corporation that was created by the United
States Congress under the Securities Protection Act of 1970. SIPC protects
customers of member broker-dealers against losses caused by the financial
failure of the broker-dealer but not against a change in the market value of
securities in customers' accounts at the broker-dealer. In the event of the
inability of a member broker-dealer to satisfy the claims of its customers in
the event of its failure, the SIPC's funds are available to satisfy the
remaining claims up to maximum of $500,000 per customer, including up to
$100,000 on claims for cash. In addition, PCIS' clearing broker carries private
insurance that provides similar coverage up to $25 million per customer.
24
REGULATION OF THE BANK
GENERAL
As a Pennsylvania-chartered commercial bank, the Bank is subject to
regulation and examination by the FDIC, which insures the deposits of the Bank
to the maximum extent permitted by law, certain requirements established by the
Federal Reserve Board and by the Pennsylvania Department of Banking. The federal
laws and regulations which are applicable to state-chartered banks regulate,
among other things, the scope of their business, their investments, their
reserves against deposits, the timing of the availability of deposited funds and
the nature and amount of and collateral for loans. Prior to the Bank's
conversion from a state-chartered savings association to a commercial bank, it
was subject also to regulation and examination by the Office of Thrift
Supervision.
CAPITAL REQUIREMENTS
The Bank is subject to regulatory capital requirements of the FDIC, which
are substantially comparable to the regulatory capital requirements of the
Federal Reserve Board applicable to the Holding Company, as discussed above. At
June 30, 2004, the Bank's regulatory capital substantially exceeded applicable
requirement. See Note 13 to the Consolidated Financial Statements included in
Item 8 hereof.
PROMPT CORRECTIVE ACTION
Section 38 of the Federal Deposit Insurance Act ("FDIA") provides the
federal banking regulators with broad power to take "prompt corrective action"
to resolve the problems of undercapitalized institutions. The extent of the
regulators' powers depends on whether the institution in question is "well
capitalized," "adequately capitalized," "undercapitalized," "significantly
undercapitalized" or "critically undercapitalized." Under regulations adopted by
the federal banking regulators, an institution shall be deemed to be (i) "well
capitalized" if it has total risk-based capital ratio of 10.0% or more, has a
Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital
ratio of 5.0% or more and is not subject to specified requirements to meet and
maintain a specific capital level for any capital measure; (ii) "adequately
capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier
I risk-based capital ratio of 4.0% or more a Tier I leverage capital ratio of
4.0% or more (3.0% under certain circumstances) and does not meet the definition
of "well capitalized"; (iii) "undercapitalized" if it has a total risk-based
capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is
less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0%
under certain circumstances), (iv) "significantly undercapitalized" if it has a
total risk-based capital ratio that is less than 6.0%, a Tier I risk-based
capital ratio that is less than 3.0% or a Tier I leverage capital ratio that is
less than 3.0%, and (v) "critically undercapitalized" if it has a ratio of
tangible equity to total assets that is equal to or less than 2.0%. The
regulations also provide that a federal banking regulator may, after notice and
an opportunity for a hearing, reclassify a "well capitalized" institution as
"adequately capitalized" and may require an "adequately capitalized" institution
or an "undercapitalized" institution to comply with supervisory actions as if it
were in the next lower category if the institution is in an unsafe or unsound
condition or engaging in an unsafe or unsound practice. The federal banking
regulator may not, however, reclassify a "significantly undercapitalized"
institution as "critically undercapitalized."
At June 30, 2004, the Bank's capital levels qualified it as a "well
capitalized" institution under applicable laws and regulations.
FDIC INSURANCE PREMIUMS
The Bank is a member of the Savings Association Insurance Fund ("SAIF")
administered by the FDIC rather than the Bank Insurance Fund ("BIF") since it
was formerly a savings association.
25
As an FDIC-insured institution, the Bank is required to pay deposit
insurance premiums to the FDIC. Effective January 1, 1997, the assessment
schedule for both BIF and SAIF ranges from 0 basis points (subject to a $2,000
annual minimum) to 27 basis points of the balance of insured deposits. In
addition, both BIF-insured institutions and SAIF-insured institutions are
assessed amounts in order for a federally chartered Financing Corporation to
make payments on it bonds. These assessments will continue until the Financing
Corporation bonds mature in 2019.
BROKERED DEPOSITS
The Federal Deposit Insurance Act ("FDIA") restricts the use of brokered
deposits by certain depository institutions. Under the FDIA and applicable
regulations, (i) a "well capitalized insured depository institution" may solicit
and accept, renew or roll over any brokered deposit without restriction, (ii) an
"adequately capitalized insured depository institution" may not accept, renew or
roll over any brokered deposit unless it has applied for and been granted a
waiver of this prohibition by the FDIC and (iii) an "undercapitalized insured
depository institution" may not (s) accept, renew or roll over any brokered
deposit or (y) solicit deposits by offering an effective yield that exceeds by
more than 75 basis points the prevailing effective yields on insured deposits of
comparable maturity in such institution's normal market area or in the market
area in which such deposits are being solicited. The term "undercapitalized
insured depository institution" is defined to mean any insured depository
institution that fails to meet the minimum regulatory capital requirement
prescribed by its appropriate federal banking agency. The FDIC may, on a
case-by-case basis and upon application by an adequately capitalized insured
depository institution, waive the restriction on brokered deposits upon a
finding that the acceptance of brokered deposits does not constitute an unsafe
or unsound practice with respect to such institution. At June 30, 2004, the Bank
did not have any brokered deposits.
COMMUNITY INVESTMENT AND CONSUMER PROTECTION LAWS
In connection with its lending activities, the Bank is subject to a variety
of federal laws designed to protect borrowers and promote lending to various
sectors of the economy and population. Included among these are the Federal Home
Mortgage Disclosure Act, Real Estate Settlement Procedures Act, Truth-in-Lending
Act, Equal Credit Opportunity Act, Fair Credit Reporting Act and Community
Reinvestment Act ("CRA"). In order to better direct and monitor the Bank's CRA
efforts, a committee of the Board of Directors specific to Community
Reinvestment was formed during the current fiscal year.
The CRA requires insured institutions to define the communities that they
serve, identify the credit needs of those communities and adopt and implement a
"Community Reinvestment Act Statement" pursuant to which they offer credit
products and take other actions that respond to the credit needs of the
community. The responsible federal banking regulator must conduct regular CRA
examinations of insured financial institutions and assign to them a CRA rating
of "outstanding," "satisfactory," "needs improvement" or "unsatisfactory." In
last CRA rating of the Bank dated August 26, 2002, the Bank was rated
"Satisfactory".
LIMITATIONS ON DIVIDENDS
The Holding Company is a legal entity separate and distinct from its
banking and other subsidiaries. The Holding Company's principal source of funds
is cash dividends from its subsidiaries, including the Bank. Banking regulations
impose minimum capital and other regulatory restrictions on the Holding Company
and the Bank, affecting both entities ability to pay dividends. For a more
detailed discussion see "Regulation of the Company - Capital Requirements",
"Regulation of the Bank - Capital Requirements" and Note 13 to the Consolidated
Financial Statements.
26
MISCELLANEOUS
Federal laws strictly limit the ability of banks to engage in transactions
with their affiliates, including their bank holding companies. Such transactions
between a subsidiary bank and its parent company or the non-bank subsidiaries of
the bank holding company are limited to 10% of a bank subsidiary's capital and
surplus and, with respect to such parent company and all such non-bank
subsidiaries, to an aggregate of 20% of the bank subsidiary's capital and
surplus. Further, loans and extensions of credit generally are required to be
secured by eligible collateral in specified amounts. Federal law also requires
that all transactions between a bank and its affiliates be on terms as favorable
to the bank as transactions with non-affiliates.
REGULATORY ENFORCEMENT AUTHORITY
The enforcement powers available to federal banking regulators are
substantial and include, among other things, the ability to assess civil money
penalties, to issue cease-and-desist or removal orders and to initiate
injunctive actions against banking organizations and institution-affiliated
parties, as defined. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with regulatory authorities.
FEDERAL HOME LOAN BANK SYSTEM
The Bank is a member of the FHLBP, which is one of 12 regional FHLBs that
administer the home financing credit function of savings associations and
commercial banks. Each FHLB serves as a source of liquidity for its members
within its assigned region. It is funded primarily from proceeds derived from
the sale of consolidated obligations of the FHLB System. It makes loans to
members (i.e., advances) in accordance with policies and procedures established
by its Board of Directors. As of June 30, 2004, the Bank's advances from the
FHLBP amounted to $121.0 million.
As a member, the Bank is required to purchase and maintain stock in the
FHLBP in an amount equal to the greater of 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year or 5% of total advances. At June 30, 2004, the Bank
had $6.7 million in FHLB stock, which was in compliance with this requirement.
RECENT LEGISLATION
THE USA PATRIOT ACT
In response to the events of September 11, 2001, President George W. Bush
signed into law the Uniting and Strengthening America by Providing Appropriate
Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA
PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal
government new powers to address terrorist threats through enhanced domestic
security measures, expanded surveillance powers, increased information sharing,
and broadened anti-money laundering requirements. By way of amendments to the
Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to
encourage information sharing among bank regulatory agencies and law enforcement
bodies. Further, certain provisions of Title III impose affirmative obligations
on a broad range of financial institutions, including banks, thrifts, brokers,
dealers, credit unions, money transfer agents and parties registered under the
Commodity Exchange Act. Among other requirements, Title III of the USA PATRIOT
Act imposes the following requirements with respect to financial institutions:
(a) Pursuant to Section 352, all financial institutions must establish
anti-money laundering programs that include, at minimum:
(1) internal policies, procedures, and controls,
(2) specific designation of an anti-money laundering compliance
officer,
(3) ongoing employee training programs, and
27
(4) an independent audit function to test the anti-money laundering
program. Rules promulgated under Section 352 were required to be
adopted by April 24, 2002
(b) Section 326 authorizes the Secretary of the Department of Treasury, in
conjunction with other bank regulators, to issue regulations by
October 26, 2002 that provide for minimum standards with respect to
customer identification at the time new accounts are opened.
(c) Section 312 requires financial institutions that establish, maintain,
administer, or manage private banking accounts or correspondent
accounts in the United States for non-United States persons or their
representatives (including foreign individuals visiting the United
States) to establish appropriate, specific, and, where necessary,
enhanced due diligence policies, procedures, and controls designed to
detect and report money laundering. Rules promulgated under Section
312 were due by April 24, 2002, to be effective by July 23, 2002.
(d) Effective December 25, 2001, financial institutions are prohibited
from establishing, maintaining, administering or managing
correspondent accounts for foreign shell banks (foreign banks that do
not have a physical presence in any country), and will be subject to
certain record-keeping obligations with respect to correspondent
accounts of foreign banks.
(e) Bank regulators are directed to consider a holding company's
effectiveness in combating money laundering when ruling on Federal
Reserve Act and Bank Merger Act applications.
SARBANES-OXLEY ACT OF 2002
On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of
2002 implementing legislative reforms intended to address corporate and
accounting fraud. In addition to the establishment of a new accounting oversight
board which will enforce auditing, quality control and independence standards
and will be funded by fees from all publicly traded companies, the bill
restricts provision of both auditing and consulting services by accounting
firms. To ensure auditor independence, any non-audit services being provided to
an audit client will require pre-approval by the company's audit committee
members. In addition, the audit partners must be rotated. The bill requires
chief executive officers and chief financial officers, or their equivalent, to
certify to the accuracy of periodic reports filed with the SEC, subject to civil
and criminal penalties if they knowingly or willfully violate this certification
requirement. In addition, under the Act, counsel will be required to report
evidence of a material violation of the securities laws or a breach of fiduciary
duty by a company to its chief executive officer or its chief legal officer,
and, if such officer does not appropriately respond, to report such evidence to
the audit committee or other similar committee of the board of directors or the
board itself.
Longer prison terms will also be applied to corporate executives who
violate federal securities laws, the period during which certain types of suits
can be brought against a company or its officers has been extended, and bonuses
issued to top executives prior to restatement of a company's financial
statements are now subject to disgorgement if such restatement was due to
corporate misconduct. Executives are also prohibited from insider trading during
retirement plan "blackout" periods, and loans to company executives are
restricted. In addition, a provision directs that civil penalties levied by the
SEC as a result of any judicial or administrative action under the Act be
deposited to a fund for the benefit of harmed investors. The Federal Accounts
for Investor Restitution ("FAIR") provision also requires the SEC to develop
methods of improving collection rates. The legislation accelerates the time
frame for disclosures by public companies, as they must immediately disclose any
material changes in their financial condition or operations. Directors and
executive officers must also provide information for most changes in ownership
in a company's securities within two business days of the change.
28
The Act also increases the oversight of, and codifies certain requirements
relating to audit committees of public companies and how they interact with the
company's "registered public accounting firm" ("RPAF"). Audit Committee members
must be independent and are barred from accepting consulting, advisory or other
compensatory fees from the issuer. In addition, companies must disclose whether
at least one member of the committee is a "financial expert" (as such term is
defined by the SEC) and if not, why not. Under the Act, a RPAF is prohibited
from performing statutorily mandated audit services for a company if such
company's chief executive officer, chief financial officer, comptroller, chief
accounting officer or any person serving in equivalent positions has been
employed by such firm and provided services in the audit of such company within
one year of the filing of the Company's prior year Form 10-K. The Act also
prohibits any officer or director of a company or any other person acting under
their direction from taking any action to fraudulently influence, coerce,
manipulate or mislead any independent public or certified accountant engaged in
the audit of the company's financial statements for the purpose of rendering the
financial statement's materially misleading. The Act also requires the SEC to
prescribe rules requiring inclu