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.
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 the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K [x].
The Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2)
AGGREGATE MARKET VALUE OF THE VOTING COMMON STOCK HELD BY NONAFFILIATES OF THE REGISTRANT EQUALS $51,419,439, AS OF JUNE 28, 2002, BASED ON A MARKET PRICE OF $36.00. THE NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AS OF MARCH 14, 2003, EQUALS 1,824,829.
Excerpts from the Registrant’s 2002 Annual Report to Shareholders are incorporated herein by reference in response to Part II. The Registrant’s definitive Proxy Statement to be used in connection with the 2003 Annual Meeting of Shareholders is incorporated herein by reference in partial response to Part III.
Contents
Business 3
Properties 4
Legal Proceedings 5
Submission of Matters to a Vote of Security Holders 6
Market for the Company's Common Equity and
Related Stockholder Matters 7
Select Financial Data 7
Mangements's Discussion and Analysis
of Financial Condition and Results of Operations 8
Financial Statement and Supplementary Data 9
Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure 48
Directors and Executive Officers of the Company 87
Executive Compensation 87
Security Ownership of Certain Beneficial Owners and Management 88
Certain Relationships and Related Transactions 88
Controls and Procedures 88
Exhibits, Financial Statement Schedules and Reports on Form 8-K 90
Signatures 92
Certificatons 94
Exhibit Index 97
Fidelity D&D Bancorp, Inc (the Company) was incorporated in the Commonwealth of Pennsylvania, on August 10, 1999, whose wholly owned state chartered commercial bank is The Fidelity Deposit and Discount Bank (the Bank) and is headquartered at Blakely and Drinker Streets in Dunmore, Pennsylvania. Financial holding company status was elected effective June 27, 2001.
The Bank has offered a full range of traditional banking services since it commenced operations in 1903. The Bank has a trust department and also provides alternative financial products. The service area is comprised of the Borough of Dunmore and the surrounding communities in Lackawanna and Luzerne counties.
A complete list of services provided by the Bank is detailed in the section entitled "Products & Services" contained herein.
The Bank is one of two financial institutions headquartered in Dunmore, Pennsylvania. Sources of competition come from:
There are no concentrations of loans that, if lost, would have a materially adverse effect on the business of the Bank. The Bank’s loan portfolio does not have a material concentration within a single industry or group of related industries that are vulnerable to the risk of a near-term severe impact.
On December 31, 2002, the Company had 176 full-time equivalent employees, including officers and part-time employees.
The Company is subject to the regulations of:
The Bank is subject to the regulations of:
Accounting policies and procedures are designed to comply with accounting principles, generally accepted in the United States of America (GAAP).
Applicable regulations relate to, among other things:
The Bank is examined by the Pennsylvania Department of Banking and the Federal Deposit Insurance Corporation on an alternate year basis. The last examination was conducted by the Pennsylvania Department of Banking as of September 30, 2002.
The Company’s internet address is www.the-fidelity.com. The Company currently does not make available the Annual Report on Form 10-K, quarterly reports or Form 10-Q and current reports or Form 8-K through the website. The Company is in the process of constructing space within the website to accommodate this information in the future. The anticipated completion date to make these reports available is June 2003. In the meantime, these reports will be provided without charge in either electronic or paper format upon request.
ITEM 2: PROPERTIESThe Company and the Bank are headquartered at the Main Branch on the corner of Blakely and Drinker Streets in Dunmore, Pennsylvania. The main office is a full-service banking center including a walk-up teller window, drive-thru windows and two twenty-four hour automated teller machines (ATMs). Administrative, Loan, Trust, Personal Investment, operational departments and customer service areas are also located in this building. There is space available for future use. The main office complex is free of any encumbrances.
The Green Ridge Branch, the first Scranton facility, operates from leased space in the Green Ridge Shopping Center in Scranton, Pennsylvania. This branch is a full-service office with a twenty-four hour ATM.
A second Scranton Branch is in a leased facility located at 139 Wyoming Avenue, Scranton, Pennsylvania. This office has a walk-up window and provides full-service banking to the downtown Scranton area.
The Abington Branch is located on the Morgan Highway in Clarks Summit, Pennsylvania. The building from which the branch operates is leased. This office provides full-service financial products, including a twenty-four
hour ATM and drive-thru windows. This office provides convenience to our customers located throughout the greater Abington area.
There is also a banking facility limited to serve employees and patients of the Clarks Summit State Hospital which is located within the hospital facility in Clarks Summit, Pennsylvania. The office is leased from the hospital under a lease for service provided agreement.
The Keystone Industrial Park Branch (KIP) is located in Dunmore, Pennsylvania. This office provides full-service banking with drive-thru windows and a twenty-four hour ATM. KIP is free of encumbrances.
The Pittston Branch is located in Bruno’s Supermarket 403 Kennedy Boulevard, Pittston, Pennsylvania. The space in the supermarket is leased. This office provides full-service banking including a twenty-four hour ATM. This location provides convenient service at extended hours to the Bank’s clientele in Luzerne County, Pennsylvania.
The Financial Center Branch is located at 338 North Washington Avenue in Scranton, Pennsylvania. This office provides full-service banking, including a twenty-four hour ATM. Executive and Operational offices are located in this building. A portion of the third floor is currently leased to a non-related entity. The Company owns the property free of encumbrance. The Company also owns, free of encumbrance, an adjacent building, which is leased to a non-related entity.
The Moosic Branch is located at 4010 Birney Avenue, Moosic, Pennsylvania. The branch operates from leased space. This office provides full-service banking, including a twenty-four hour ATM and drive-thru windows. The branch’s location provides the necessary link between the Lackawanna and Luzerne County branch office networks.
The West Pittston Branch is located in the Insalaco Shopping Center at 801 Wyoming Avenue, West Pittston, Pennsylvania. The branch operates from leased space. This office provides full-service, including a twenty-four hour ATM, to the Luzerne County area.
The Peckville Branch is located at 1598 Main Street, Peckville, Pennsylvania. The branch operates from leased space. This office provides full-service banking, including a twenty-four hour ATM and drive-thru windows.
The Bank’s branch coverage in Luzerne County includes a leased space known as the Kingston Branch, located at 247 Wyoming Avenue, Kingston, Pennsylvania. This office provides full-service financial products, including a twenty-four hour ATM and drive-thru windows.
On July 17, 2002, the Bank opened a new location in Lackawanna County. The Eynon Branch is located on Route 6 Business Eynon, Pennsylvania. The branch operates from leased space. This office provides full-service financial products, including a twenty-four hour ATM and drive-thru windows.
The Bank contracted space during 2002 for free standing twenty-four hour ATMs located at:
None of the lessors of the properties leased by the Bank are affiliated with the Company or the Bank.
The Bank owns a commercial facility located at 116 – 118 N. Blakely Street Dunmore, Pennsylvania. The facility is currently leased by a non-related entity. The property is held for possible future expansion.
All foreclosed properties are listed for sale. Foreclosed properties are recorded on the Company’s balance sheet at the lower of cost or fair value.
Repossessed assets consist of vehicles financed by the Company. Subsequent to the loan or lease, the borrower or lessee defaulted on their contract and the Company repossessed the unit. Repossessed assets are sold through either a private or public sale and any deficiency balance from the sale of the asset is charged to the Allowance for Loan and Lease Losses.
Terminated leases are vehicles that were lease financed by the Company and contractual terms fulfilled. As per the lease agreement, the vehicles are returned to the Company and recorded on the books at the residual value. Vehicles are subsequently sold at public auction. Any difference between residual value and auction price is submitted to the Company’s residual insurance carrier for payment. After receipt of residual insurance proceeds, any remaining deficiency balance is charged against current earnings.
ITEM 3: LEGAL PROCEEDINGSOn July 1, 2002, the Bank was served with a civil complaint that was filed in the Court of Common Pleas of Lackawanna County, Pennsylvania, on June 28, 2002. Scaccia Construction Company, the plaintiff, based upon multiple causes of action, demands approximately $250,000 in connection with certain environmental remediation activities. The activities were purportedly performed prior to the opening of the Bank’s new Eynon branch. On July 22, 2002, the Bank filed preliminary objections to the complaint. The preliminary objections were decided on November 26, 2002, and the Bank filed its answer and new matter raising various legal defenses. Formal discovery has commenced and depositions are scheduled through May 2003. The Bank intends to vigorously defend this action.
The nature of the Company’s business generates some litigation involving matters arising in the ordinary course of business. However, in the opinion of the Company after consulting with legal counsel, no other legal proceedings are pending, which, if determined adversely to the Company or the Bank, would have a material effect the Company’s undivided profits or financial condition. No other legal proceedings are pending other than ordinary routine litigation incident to the business of the Company and the Bank. In addition, to management’s knowledge, no governmental authorities have initiated or contemplated any material legal actions against the Company or the Bank.
Shareholders requesting information about the Company’s common stock may contact Michael F. Marranca, Chairman of the Board and President or Joseph J. Earyes, Executive Vice President and Chief Executive Officer. Requests may be mailed to:
The common stock of the Company is traded on the over-the-counter bulletin board under the symbol FDBC.
The following table lists the quarterly cash dividends paid and the range of bid and asked prices for the Company’s common stock. Such over-the-counter prices do not include retail mark-ups, markdowns, or commissions.
2002 2001
Prices Dividends Prices Dividends
High Low Paid High Low Paid
1st Quarter $37.50 $36.50 $.20 $37.375 $36.00 $.1875
2nd Quarter $37.50 $37.00 $.21 $37.00 $35.50 $.20
3rd Quarter $39.50 $37.25 $.21 $37.00 $35.90 $.20
4th Quarter $38.50 $37.40 $.22 $37.75 $36.40 $.20
The Company expects to continue paying similar dividends in the future. However, future dividends are dependent on earnings, the capital needs of the Company and other factors. Prior to the formation of the Company, the Bank paid dividends on a quarterly basis for over thirty years. Dividends are determined and declared by the Board of Directors. For a further discussion of regulatory capital requirements see Note 14 “Regulatory Matters”, contained within the Notes to Consolidated Financial Statements.
The Company had approximately 1,450 shareholders at March 14, 2003 and approximately 1,446 at December 31, 2002. The number of shareholders is the actual number of individual shareholders of record. Security depositories are considered as individual shareholders for the purpose of determining the approximate number of shareholders.
The Company has established a dividend reinvestment plan for its shareholders. The plan is designed to make the Company’s stock more available to our shareholders and to raise additional capital for future needs.
ITEM 6: SELECTED FINANCIAL DATA
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Balance Sheet Data:
- -------------------
Total assets $577,989,236 $569,029,838 $491,077,054 $446,569,505 $348,069,896
Total investment securities 149,549,607 153,973,988 119,756,391 109,262,221 78,607,860
Net loans 354,262,050 353,976,324 333,600,975 296,193,518 235,430,079
Loans available-for-sale 28,715,355 16,150,020 9,953,958 4,895,124 8,527,076
Total deposits 413,788,176 407,778,728 339,310,328 294,366,985 239,734,390
Total borrowings: 114,213,014 117,480,988 111,024,721 117,554,046 71,657,299
Total shareholders' equity 45,234,433 40,172,230 37,215,063 31,841,549 33,745,541
Operating Data for the year end:
- --------------------------------
Total interest income $ 34,567,393 $ 36,379,689 $ 35,085,780 $ 28,541,051 $ 23,443,709
Total interest expense (17,882,440) (20,853,631) (21,468,230) (15,375,799) (12,308,632)
------------ ------------ ------------ ------------ ------------
Net interest income 16,684,953 15,526,058 13,617,550 13,165,252 11,135,077
Provision for loan losses (1,664,000) (2,474,637) (1,158,260) (530,000) (646,000)
----------- ----------- ----------- ------------ ------------
Net interest income after provision for
loan losses 15,020,953 13,051,421 12,459,290 12,635,252 10,489,077
Other income 3,302,749 3,701,578 3,005,218 2,227,787 1,902,734
Other operating expense (12,751,174) (11,998,997) (11,699,489) (10,170,458) (7,609,162)
------------- ------------- ------------- ------------- -------------
Income before provision for income taxes 5,572,528 4,754,002 3,765,019 4,692,581 4,782,649
Provision for income taxes (1,526,355) (905,866) (558,391) (894,888) (1,246,760)
------------- ------------- ------------- ------------- -------------
Net Income $4,046,173 $3,848,136 $3,182,628 $3,797,693 $3,535,889
============ ============ ============ ============ ============
Per Share Data:
- ---------------
Net income per share - basic* $ 2.23 $ 2.12 $ 1.76 $ 2.12 $ 2.08
Net income per share - diluted* $ 2.22 $ 2.12 $ 1.76 $ 2.12 $ 2.08
Dividends declared $ 1,526,371 $1,426,097 $1,366,075 $1,344,141 $ 1,200,409
Dividends per share $ 0.84 $ 0.79 $ 0.76 $ 0.75 $ 0.70
Book Value per share $ 24.86 $ 22.08 $ 20.60 $ 17.68 $ 18.88
Weighted average number of shares
Outstanding** 1,817,430 1,811,391 1,803,674 1,792,232 1,697,108
Number of shares outstanding at year
end** 1,819,376 1,819,168 1,806,274 1,800,784 1,787,294
Ratios:
- -------
Return on average assets 0.70% 0.72% 0.67% 0.94% 1.13%
Return on average equity 9.47% 9.64% 9.54% 11.42% 11.78%
Net Interest Margin 3.10% 3.17% 3.14% 3.55% 3.82%
Efficiency Ratio 63.42% 62.42% 67.66% 63.23% 57.24%
Expense Ratio 2.20% 2.25% 2.46% 2.50% 2.43%
Allowance for loan losses to total
loans 1.02% 1.01% 0.95% 1.05% 1.23%
Dividend payout ratio 37.72% 37.06% 42.92% 35.39% 33.95%
Equity to assets 7.83% 7.06% 7.58% 7.13% 9.70%
Equity to deposits 10.93% 9.85% 10.97% 10.82% 14.08%
* Based on weighted average shares and adjusted for the stock exchange in 2000.
**Based on actual shares outstanding and adjusted for the stock exchange in 2000.
Besides historical information, this Form 10-K contains forward-looking statements. Forward-looking statements are subject to uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Important factors that might cause differences include, but are not limited to, those discussed in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. We caution readers not to place undue reliance on these forward-looking statements. The forward-looking statements reflect management’s analysis only as of December 31, 2002. The Company undertakes no obligation to update these forward-looking statements to reflect circumstances that arise after December 31, 2002. Readers should carefully review the risk factors described in other documents the Company files with the Securities and Exchange Commission. Such documents include Reports on Form 10-Q and current Reports on Form 8-K.
Forward-looking statements by their nature are subject to assumptions, risks and uncertainties. For a variety of reasons, actual results could differ materially from those contained or implied by the forward-looking statements:
The presentation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect many of the reported amounts and disclosures. Actual results could differ from these estimates.
A material estimate that is particularly susceptible to significant change relates to the determination of the allowance for loan losses. Management believes that the allowance for loan losses at December 31, 2002 is adequate and reasonable. Given the very subjective nature of identifying and valuing loan losses, it is likely that well-informed individuals could make different assumptions, and could, therefore calculate a materially different allowance value. While management uses available information to recognize losses on loans, changes in economic conditions may necessitate revisions in future years. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company’s allowance for loan losses. Such agencies may require the Company to recognize adjustments to the allowance based on their judgments of information available to them at the time of their examination.
Another material estimate is the calculation of fair values of the Company’s investment securities. The Company receives estimated fair values of investment securities from an independent valuation service. In developing these fair values, the valuation service uses estimates of cash flows, based on historical performance of similar instruments in similar interest rate environments. Based on experience, management is aware that estimated fair values of investment securities tend to vary among valuation services. Accordingly, when selling investment securities, management typically obtains price quotes from more than one source. As described in Notes 1 and 3 of the consolidated financial statements, the large majority of the Company’s investment securities are classified as available-for-sale. Available-for-sale securities are carried at fair value on the consolidated balance sheet, with unrealized gains and losses, net of income tax reported separately within shareholders’ equity through accumulated and other comprehensive income.
The fair value of residential mortgage loans classified as available-for-sale is obtained from the Federal National Mortgage Association (Fannie Mae). The fair value of SBA loans classified as available-for-sale is obtained from an outside pricing source. The market to which the Bank sells mortgage and other loans is restricted and price quotes from other sources are not typically obtained. Further discussion on the accounting treatment of available-for-sale loans is in the section entitled “Loans-available-for sale”, contained within Management’s Discussion and Analysis.
All significant accounting policies are contained in Note 1 “Nature of Operations and Summary of Significant Accounting Policies”, contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.
The following discussion and analysis presents the significant changes in the results of operations and financial condition of the Company and its wholly-owned subsidiary, the Bank. This discussion should be read in conjunction with the consolidated financial statements and notes included in this report.
The following table is a comparison of condensed balance sheet accounts and percentage to total assets at December 31, 2002, 2001 and 2000;
(Thousands of Dollars)
2002 2001 2000
Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ -------
Assets:
Cash and due from banks $ 18,763 3.25% $ 19,845 3.49% $ 5,503 1.12%
Interest bearing deposits with
Financial institutions 7,456 1.29 5,800 1.02 3,277 0.67
Investment securities 149,550 25.87 153,974 27.06 119,756 24.39
Net loans 354,262 61.29 353,976 62.21 333,601 67.93
Loans Available-for-sale 28,715 4.97 16,150 2.84 9,954 2.03
Accrued interest receivable 2,347 0.41 3,268 0.57 3,546 0.72
Bank premises and equipment 12,735 2.20 11,514 2.02 11,391 2.32
Foreclosed assets held for sale 437 0.08 688 0.12 353 0.07
Other assets 3,724 0.64 3,815 0.67 3,696 0.75
--------- ------ --------- ------- -------- -------
Total assets $ 577,989 100.00% $ 569,030 100.00% $491,077 100.00%
========= ======== ========= ======== ======== =======
Liabilities:
Deposits, non-interest bearing $ 61,151 10.58% $ 53,302 9.37% $ 47,185 9.61%
Certificates of deposit of $100,000
or more 129,487 22.40 132,680 23.32 94,718 19.29
Other interest-bearing deposits 223,150 38.61 221,797 38.98 197,407 40.20
Short-term borrowings 51,213 8.86 54,481 9.57 48,025 9.78
Other borrowed funds 63,000 10.90 63,000 11.07 63,000 12.82
Accrued interest payable and other
Liabilities 4,754 0.82 3,598 0.63 3,527 0.72
--------- ------ --------- ------- -------- -------
Total liabilities 532,755 92.17 528,858 92.94 453,862 92.42
Shareholders' equity 45,234 7.83 40,172 7.06 37,215 7.58
--------- ------ --------- ------- -------- -------
Total liabilities and shareholders'
Equity $ 577,989 100.00% $ 569,030 100.00% $491,077 100.00%
========= ======= ========= ======== ======== =======
Dollar Percent
December 31, 2002 December 31, 2001 change change
Noninterest-bearing deposits
Personal $ 22,956,626 $ 22,333,970 $ 622,656 2.79%
Non-personal 24,877,991 23,622,034 1,255,957 5.32%
Public fund 4,039,547 2,872,126 1,167,420 40.65%
Bank checks 9,277,301 4,473,474 4,803,827 107.38%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 61,151,465 $ 53,301,605 $ 7,849,860 14.73%
==================================================================================================================================
Certificates of deposit
of $100,000 or more
Personal $ 79,169,750 $ 61,521,341 $ 17,648,409 28.69%
Non-personal 23,571,462 23,391,143 180,318 0.77%
Public fund 21,111,991 42,578,923 (21,466,933) -50.42%
IRA's 5,633,296 5,188,588 444,708 8.57%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 129,486,498 $ 132,679,995 $ (3,193,497) -2.41%
==================================================================================================================================
Other interest-bearing deposits
CD's less than $100,000:
Personal $ 95,302,987 $ 98,038,828 $ (2,735,841) -2.79%
Non-personal 11,054,526 25,035,720 (13,981,194) -55.84%
Public fund 633,489 833,561 (200,072) -24.00%
IRA's 20,358,968 20,535,149 (176,181) -0.86%
- ----------------------------------------------------------------------------------------------------------------------------------
sub total 127,349,970 144,443,257 (17,093,288) -11.83%
NOW acounts 40,719,446 36,012,247 4,707,199 13.07%
Money market deposits 16,561,358 7,411,972 9,149,386 123.44%
Savings and clubs 38,519,440 33,929,652 4,589,788 13.53%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 223,150,213 $ 221,797,128 $ 1,353,085 0.61%
==================================================================================================================================
Total deposits
Noninterest-bearing deposits $ 61,151,465 $ 53,301,605 $ 7,849,860 14.73%
Interest-bearing deposits 352,636,711 354,477,123 (1,840,412) -0.52%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 413,788,176 $ 407,778,728 $ 6,009,448 1.47%
==================================================================================================================================
Public funds
Noninterest-bearing $ 4,039,547 $ 2,872,126 $ 1,167,420 40.65%
Certificates of deposit 21,745,480 43,412,484 (21,667,004) -49.91%
NOW acounts 10,299,948 6,868,500 3,431,448 49.96%
Money market deposits 8,923,912 442,860 8,481,051 1915.06%
Savings and clubs 2,806,208 1,413,952 1,392,257 98.47%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 47,815,094 $ 55,009,922 $ (7,194,828) -13.08%
==================================================================================================================================
Internet deposits
Noninterest-bearing $ 907 $ 102,942 $ (102,035) -99.12%
Interest-bearing 11,139,780 26,345,696 (15,205,916) -57.72%
- ----------------------------------------------------------------------------------------------------------------------------------
Total $ 11,140,687 $ 26,448,638 $ (15,307,951) -57.88%
==================================================================================================================================
Total assets $ 577,989,236 $ 569,029,838
Total deposits to total assets 71.59% 71.66%
Internet deposits to total deposits 2.69% 6.49%
Public funds to total deposits 11.56% 13.49%
Public funds to total assets 8.27% 9.67%
Due to the prevailing economic conditions in 2002, many investors moved monies from mutual funds into insured financial institutions. The Bank experienced growth in non-interest bearing deposits and short term interest-bearing accounts. As interest rates declined, these liquid accounts were preferred over fixed rate certificates of deposit (CDs). The liquidity aspect of these accounts allows depositors to transfer funds into fixed term CDs, when interest rates begin to rise.
Among the reasons cited by depositors as to why they selected the Bank are:
Part of the non-interest bearing deposits (DDA) growth is attributed to recent branch expansion. For example, DDA balances at the new Kingston and Peckville offices had a combined $3,900,000 at December 31, 2002, compared to $2,452,000 at December 31, 2001. DDA balances at the Eynon office, which opened in July 2002, were $82,000 at December 31, 2002.
Non-personal and Public Fund DDA balances grew $2,423,000 or 9.15% during 2002. Increased commercial lending relationships contributed to the growth in commercial deposits, as also did the successful marketing of commercial deposit products.
Commercial products include:
During 2002, the Bank instituted several programs, including the following to attract demand deposit accounts.
The Fidelity Check Card Campaign was designed to issue check cards to new and existing depositors. With the ease of purchasing goods and services with check cards, the Bank provides depositors an incentive to increase balances carried in their accounts. During the campaign, maintenance charges were waived for one year for any card issued.
Fidelity’s All-American Checking Campaign was initiated to attract personal and small business checking accounts. Incentives included no minimum balance requirements and the first order of 50 checks free.
The Visa Business Check Card Campaign targeted new business check cards and demand deposit accounts.
The Bank also offered discounts on home equity loan fees and first year free safe deposit box rentals for customers who had their payments directly charged to a demand deposit account.
Commercial borrowers were encouraged to have their operating and payroll accounts at the Bank.
Although personal CDs increased $14,913,000 during 2002, an overall slight decline in interest-bearing deposits was caused by a large reduction in Public Fund CDs towards year end and withdrawals of non-personal deposits in the second half of 2002.
While much of the decline in Public Fund CDs was necessitated by cash requirements of the Public entities, approximately $8,481,000 was transferred into money market accounts for liquidity purposes. The transfer of Public funds into money market accounts comprises 81.95% of the growth in this product. The Bank anticipates that it will recapture much of the overall decrease in Public Fund deposits during 2003.
The maturity distribution of CDs $100,000 or more at December 31, 2002 is as follows:
3 Months 3 - 6 6 - 12 Over
or less Months Months 12 months Total
------- ------ ------ --------- -----
$24,462,673 $8,861,488 $45,995,624 $50,166,713 $129,486,498
The over 12 months maturity distribution of CDs represents 12.12% of total deposits at December 31, 2002. The Bank believes this category provides a stable source of funds for future requirements.
Accrued expenses and other liabilities:Rate reductions in interest-bearing deposits and short-term borrowings caused accrued interest payable to decrease from $2,757,000 at December 31, 2001, to $1,707,000 at December 31, 2002.
A $746,000 non-interest bearing liability for the pending settlement of investment securities purchased was recorded at December 31, 2002. The Bank did not have any pending investment purchases at December 31, 2001.
Short-term borrowings:Interest rate reductions and customer liquidity needs caused repurchase agreements, (Repos) to decrease from $54,258,000 at December 31, 2001, to $47,232,000 at December 31, 2002. Repos are non-insured interest-bearing liabilities that have a security interest in qualified pledged investment securities of the Bank. Repos offered are either a fixed term or a sweep product of the Bank.
Sweep accounts comprise approximately 64% of Repos. A sweep account is designed to insure that an attached DDA is adequately funded and then excess DDA funds are transferred into an interest-bearing overnight Repo, on a daily basis. The sweep will also transfer funds back to the DDA as is necessary, to cover checks presented for payment. The nature of the sweep makes the account more volatile than a fixed term Repo.
Funding requirements of the Bank necessitated $2,850,000 overnight borrowings from the Federal Home Loan Bank of Pittsburgh, (FHLB), at December 31, 2002. There were no borrowings at December 31, 2001.
Repos and overnight borrowings are included with short-term borrowings on the balance sheet (see Note 7 “Short-term Borrowings”, contained within the Notes to Consolidated Financial Statements).
Long-term debt:Long-term debt consists of borrowings from the FHLB. The weighted average rate on funds borrowed at December 31, 2002, was 5.59%. The weighted-average rate is 76 basis points below the tax-equivalent yield of 6.35% on average earning assets for the year ending December 31, 2002. Rates on the advances are adjustable quarterly, should market rates increase. However, year-end rates on similar FHLB advances are 416 basis points below the rates being paid by the Bank. It is unlikely that during 2003 FHLB borrowing rates will increase above the rates currently being quoted by the FHLB. Should this occur, the Bank has the option, at that time, to repay or renegotiate the advances.
At December 31, 2002, the Bank had the ability to borrow an additional $62,375,000 at the FHLB. The FHLB has short, medium and long-term funding products available to the Bank. Most lines of credit extended to banks by other lenders are short-term.
Balance Sheet, Assets:Total assets of the Company increased $8,959,000 or 1.575% during 2002. The increase is the result of growth in deposits, as previously discussed, and the retention of profits.
Investments:Discounting $3,829,000 appreciation in the market value of available-for-sale, (AFS) investments, total investments decreased $8,254,000, during 2002.
With the fall in market rates, United States Government Agency, state and municipal securities of $90,600,000 were called during 2002. No losses were incurred on any of the called bonds.
The market environment also caused many borrowers to prepay or refinance home mortgages. In terms of investments, this contributed to a major reduction in mortgage-backed securities(MBS). MBS are pools of residential mortgages. The majority of MBS owned by the Bank are guaranteed by United States Governmental Agencies. Prepayments on MBS were $18,229,000 in 2002, compared to $2,820,000 in 2001.
Market conditions necessitated a restructuring of the investment portfolio to protect earnings which were being adversely impacted by bond calls and adjustable rate MBS. To accomplish the restructuring, the Bank sold AFS investments having a net book value of $37,193,000. There were no sales of investments categorized as held-to–maturity in 2002.
Proceeds from the called bonds and MBS prepayments were reinvested primarily in fixed rate MBS. The MBS purchased provide a monthly cash flow which can be reinvested into potentially higher yielding assets. This will become beneficial when market rates begin to increase. The particular bonds purchased had yields in excess of comparable Treasury securities and the current rates being paid on federal funds sold.
After careful consideration of the characteristics of the individual securities and their potential reaction to market changes, $9,058,000, purchased bonds were classified as held-to-maturity and $128,932,000, were classified as AFS.
Classifying bonds as held-to-maturity protects the balance sheet from downward market trends that AFS securities are exposed to. The decision to classify securities as AFS gives the Bank greater flexibility in the management of the investment portfolio and overall liquidity management.
The Bank actively monitors depreciation in the bond portfolio. When an individual bond, classified AFS, starts to depreciate, the Bank will determine if it is advisable to sell the security and reinvest the proceeds at a higher yield. Such considerations are based on current market conditions and liquidity needs. Even though bonds in the Bank’s portfolio may depreciate in market value, the principal and interest of the United States Government Agency bonds, United States Government Agency issued MBS and municipal investments is guaranteed by the issuer.
A comparison of investments at year-end for the three previous periods is as follows:
2002 2001 2000
Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ -------
U.S. Government Agencies $ 13,275,625 8.88% $118,229,745 76.78% $ 81,513,237 68.07%
Mortgage Backed Securities 118,614,057 79.31 19,349,772 12.57 15,033,019 12.55
State & Municipal Subdivisions 9,736,815 6.51 11,609,765 7.54 17,530,127 14.64
Preferred Term Securities 3,990,000 2.67 1,000,000 0.65 0 0.00
Equity Securities 3,933,110 2.63 3,784,706 2.46 5,680,007 4.74
------------- ------- ------------ ------- ------------- --------
Total $ 149,549,607 100.00% $153,973,988 100.00% $119,756,390 100.00%
============= ======= ============ ======= ============= ========
The distribution of debt securities by stated maturity date at December 31, 2002 is as follows:
1 Year 1 Through 5 Through More than
or less 5 years 10 years 10 years Total
------- ------- -------- -------- -----
U.S. Government Agencies $ 2,038,794 $ 3,030,938 $ 8,205,893 $ 0 $ 13,275,625
Mortgage Backed Securities 0 0 4,813,782 113,800,275 118,614,057
State & Municipal Subdivisions 882,045 202,784 3,608,628 5,043,358 9,736,815
----------- ------------ ----------- ----------- ------------
Preferred Term Securities 0 0 0 3,990,000 3,990,000
----------- ------------ ----------- ----------- ------------
Total debt securities $2,920,839 $3,233,722 $16,628,303 $122,833,633 $ 145,616,497
=========== ============ =========== =========== ============
Debt securities are stated net of unrealized gain on AFS securities. Net unrealized gain on AFS debt securities at December 31, 2002, was $1,867,000. Debt securities do not include equity securities. Net unrealized gain on equity securities was $50,000 at December 31, 2002.
The tax equivalent yield on debt securities by stated maturity date at December 31, 2002, is as follows:
1 Year 1 through 5 through More than
Or less 5 years 10 years 10 years Total
------- ------- -------- -------- -----
U.S. Government Agencies 4.50% 4.10% 5.70% 0.00% 5.15%
Mortgaged Backed Securities 0.00 0.00 5.50 5.16 5.18
State & Municipal Subdivisions 7.41 7.57 6.84 6.43 6.64
Preferred Term Securities 0.00 0.00 0.00 3.77 3.77
---- ---- ---- ---- ----
Total debt securities 5.39% 4.32% 5.89% 5.17% 5.24%
===== ===== ===== ===== =====
There were no trading securities during 2002.
Loans:Loans, net of unearned income, increased $444,000 or 0.12% from $357,718,000 at December 31, 2001, to $358,162,000 at December 31, 2002. Gross loans represent 61.97% of total assets at December 31, 2002.
Growth in the portfolio was slowed by the economic downturn both nationally and locally. As lending rates fell, prepayments on existing loans increased. Loans refinanced at lower rates increased the Bank’s exposure to interest-rate risk from potential market upturns. Many new and refinanced loans were classified as AFS, with the intention of immediate sale.
For a further discussion on these issues, see the MD&A sections entitled, “Loans available-for-sale” and “Liquidity Management and Interest Rate Sensitivity”. Additional discussion is in Note 1 “Nature of Operations and Summary of Significant Accounting Policies – Loans Held for Sale”, contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.
Being committed to the market area, the Bank seeks quality loans, both commercial and consumer. However, the results of 2001 caused the Bank to review lending policies and collection efforts. Additional personnel, including a new experienced Chief Credit Officer, were hired late in 2001, to address these concerns. As a result of these efforts, delinquencies and net charge-offs were reduced and the overall quality of the portfolio improved during 2002.
For a further discussion of delinquencies and net charge-offs, see the MD&A section entitled “Provision for Loan Losses”. Further discussion is in Note 1 “Nature of Operations and Summary of Significant Accounting Policies – Allowance for Loan Losses” and Note 4 “Loans and Leases” contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference.
It is anticipated that the volume of prepayments and refinance requests will slow, as rates become stable or increase. Furthermore, new loans will be structured to better withstand market fluctuations and improved collection efforts should curtail serious delinquencies.
The commitment of the Bank to our local communities remains strong and the Bank is sufficiently capitalized and structured to deal with these challenges.
Commercial loans increased $23,930,000 or 13.37% during 2002. This increase in commercial loans was primarily due to increased lending within the small business community.
The Bank continues to originate loans using the Small Business Administration (SBA) guaranteed loan program. In return for the Bank funding a loan, which met the criteria of the program, the SBA guarantees a material portion of the principal balance to the Bank, should the borrower default.
Tax-free industrial development loans made to or backed by local municipalities decreased to $8,401,000 at December 31, 2002. Large payoffs at the end of the year contributed to the decline. However, the 2002 year- to-date outstanding average balance of tax-free industrial development loans was $14,882,000 compared to $11,186,000 during 2001.
The Bank participates in the Pennsylvania Capital Access Program (PENNCAP). PENNCAP is a small business lending program whereby the State allocates a reserve fund to be used in the event the Bank were to experience a loss on a loan registered in the program. At December 31, 2002, $4,974,000 commercial loans were registered in this program.
The Bank serves the local market with real estate loans. Real estate and construction loan totals of $114,163,000 were 29.46% of gross loans and AFS loans at December 31, 2002.
Included with real estate loans are home equity lines of credit. The outstanding balance on the credit lines increased $1,384,000 or 23.33% from $5,931,000 at December 31, 2001, to $7,315,000 at December 31, 2002.
The Bank determined that it was prudent to classify a majority of new or refinanced mortgages as AFS during the low interest rate environment experienced during 2002. Thus, providing the ability to maintain interest rate risk sensitivity by selling these mortgages, when mortgage rates begin to rise and the means to produce liquidity, as needed, to fund operations and loan demand. The delay in actively selling these loans caused the considerable net growth in the loans AFS portfolio.
Consumer loans and direct-financing leases decreased $14,181,000 or 18.24% during 2002. A combination of prepayments, the reclassification of credit card receivables to loans available for sale, tightened credit underwriting standards on indirect auto loans and the decision to not aggressively seek leases brought about this decline.
A comparison of loans by amount at year-end for the five previous periods is as follows (all loans are domestic):
2002 2001 2000 1999 1998
----- ----- ---- ---- ----
Real estate $ 85,447,703 $ 96,740,226 $109,942,570 $111,242,490 $99,955,640
Consumer 56,984,927 67,782,196 66,441,389 64,998,362 47,549,512
Commercial 202,974,155 179,043,816 146,610,685 113,061,093 85,425,708
Direct financing leases 6,578,720 9,961,967 12,733,075 5,710,579 2,248,990
Real estate construction 6,797,002 5,446,870 2,971,504 5,335,753 3,810,975
--------- --------- --------- --------- ---------
Gross loans 358,782,507 358,975,075 338,699,223 300,348,277 238,990,825
Less:
Unearned discount 620,703 1,256,818 1,833,968 982,384 553,033
Allowance for loan losses 3,899,753 3,741,933 3,264,280 3,172,375 3,007,713
--------- --------- --------- --------- ---------
Net Loans $354,262,050 $353,976,324 $333,600,975 $296,193,518 $235,430,079
============ ============ ============ ============ ============
Loans available-for-sale $ 28,715,355 $16,150,020 $9,953,958 $4,895,124 $8,527,076
============ =========== ========== ========== ==========
A comparison of gross loans by percent at year-end for the five previous periods is as follows:
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Real estate 23.82% 26.95% 32.46% 37.04% 41.82%
Consumer 15.88 18.88 19.62 21.64 19.90
Commercial 56.57 49.88 43.29 37.64 35.74
Direct financing leases 1.83 2.77 3.76 1.90 0.94
Real estate construction 1.89 1.52 0.87 1.78 1.60
------ ------- ------- ------- ------
Gross loans 100.00% 100.00% 100.00% 100.00% 100.00%
======= ======= ======= ======= =======
There are no concentrations of loans to a number of borrowers engaged in similar activities exceeding 10.00% of total loans that are not otherwise disclosed as a category in tables above.
The following table sets forth the maturity distribution of the loan portfolio at December 31, 2002. Excluded from the table are non-construction real estate loans, consumer loans and direct financing leases (amounts in thousands):
1 year 1 - 5 More than
or less Years 5 years Total
------- ----- ------- -----
Commercial loans $ 28,904 $ 35,581 $138,489 $202,974
Real estate construction 6,797 0 0 6,797
-------- -------- -------- --------
Total $ 35,701 $ 35,581 $138,489 $209,771
======== ======== ======== ========
The following table sets forth the sensitivity changes in interest rates for commercial and real estate construction loans at December 31, 2002 (amounts in thousands):
1 - 5 More than
years 5 years Total
----- ------- -----
Fixed interest rate $ 12,611 $ 28,841 $ 41,452
Variable interest rate 22,970 109,648 132,618
-------- -------- --------
Total $ 35,581 $138,489 $174,070
======== ======== ========
Residential mortgages, guaranteed portion of Small Business Administration loans and student loans are generally classified as available-for-sale at origination. Should market rates increase, fixed rate loans and loans not immediately repricable would no longer produce yields consistent with the current market. In a declining rate environment, the rates on adjustable rate loans would decrease and interest income would be negatively affected. To protect the Bank from interest-rate risk, loans meeting these conditions may be classified as saleable. Certain consideration is also given to current liquidity needs.
Fees or costs associated with loan originations are capitalized and charged or credited to loan income over the term of the loan. The measures apply to both available-for-sale and held-to- maturity loans.
Saleable loans are carried on the balance sheet at the lower of cost or fair value. If the fair value falls below cost, the difference is charged to current earnings. Appreciation in the portfolio is credited to current earnings, only to the extent of previous write-downs below cost.
The Bank increased loans available-for-sale by $12,565,000 or 77.80% to $28,715,000 at December 31, 2002 from concern of potential interest-rate risk due to the falling rate environment experienced in 2002.
At December 31, 2002, AFS loans include $2,872,000 of credit card receivables. During the fourth quarter of 2002, the Company entered into a credit card receivable sale agreement. The decision was based upon the system in place which was not adequate to properly service the clientele, there was a high level of overhead related to credit card activities, a lack of consistent growth in the portfolio and a high loss experience on non-performing credit cards.
Sale of the portfolio will be concluded during the first quarter of 2003. The purchaser is an experienced handler of credit card lines and there will be no disruption of service. The cards will be marketed with the Bank logo.
Full recourse will be required for two years on customers with a defined below average credit score. The Company will estimate and accrue a recourse liability from sale proceeds to cover the two year full recourse provision, based on the Company’s past loss experience.
The Company expects to recognize a gain on the sale of the credit card receivables in 2003. The recourse liability will be periodically evaluated and increased, if necessary, through a charge to earnings. After the two year recourse period is completed, the remaining recourse liability, if any, will be recognized in earnings.
As detailed in the “Consolidated Statement of Cash Flows” contained herein, proceeds from the sale of loans in 2002 were $26,413,000. The sales were primarily residential mortgages.
Servicing rights on sold loans were retained by the Bank. Servicing rights are retained so the borrower can still deal directly with the Bank. The loans were sold to provide the Bank with liquidity necessary to meet loan demand and to mitigate potential interest-rate risk from potential market rate increases. At December 31, 2002, the outstanding balance of sold residential mortgage loans in which the Bank retained servicing rights was $56,986,000.
Bank premises and equipment, net:Additions to premises and equipment were $2,542,000 before depreciation of $1,068,000 in 2002.
A new core processing system was installed during the fourth quarter of 2002. Additions for the system, including hardware, software, licensing and installation were $1,232,000. The projected cost of the system was $1,300,000. Capitalized expenditures will be depreciated over their estimated useful lives using the straight-line method.
Additions for the new branch at Eynon were $746,000 for leasehold improvements and $133,000 for furniture and fixtures. Capital expenditures for Eynon, excluding equipment, were originally projected at $250,000. Capitalized expenditures will be depreciated over their estimated useful lives.
During 2002, the Bank determined that a new branch would not be established at the property owned in Clarks Green, Pennsylvania and the property was sold. The property had a net book value of $217,000, at the time of sale.
Other equipment having a net book value of $36,000, was disposed of in 2002. The majority of the equipment was made obsolete by the new core processing system.
A net loss of $44,000 was incurred from the disposition of the property and equipment.
Foreclosed assets held for sale:Real estate acquired through foreclosure decreased $203,000 due to the net disposal of properties. Repossessed vehicles had a net decrease of $48,000 from the sale of the vehicles at auction.
The year 2001:Personal DDA balances increased $3,051,000, or 15.82%, from $19,283,000 at December 31, 2000, to $22,334,000 at December 31, 2001. DDA balances at the Kingston office, opened 2001, were $273,000 and deposits from the Peckville branch, which opened in 2000, increased $217,000 during 2001,
Non-personal and Public Fund DDA balances grew $4,302,000 or 19.40% in 2001.
Official Bank checks issued and outstanding decreased $1,237,000 in 2001.
As a net result of these changes non-interest bearing deposits grew $6,116,000 or 12.96% from $47,186,000 at December 31, 2000, to $53,302,000 at December 31, 2001. The increase in non interest-bearing deposits represents 9.06% of the growth in total deposits during 2001.
Interest-bearing deposits increased $62,352,000 or 21.34% from $292,125,000 at December 31, 2000, to $354,477,000 at December 31, 2001.
Savings and club accounts collectively increased $2,029,000 in 2001.
The decline in market rates contributed to a $2,191,000 decrease in NOW accounts and a $7,980,000 decline in money market deposits in 2001 Some of the deposits were placed into CDs, as depositors favored a guaranteed rate over liquidity.
CDs increased $70,494,000 or 34.20%. Personal CDs grew $32,601,000, non-personal CDs grew $19,739,000 and public fund CDs increased $18,154,000.
Total deposits increased $68,469,000 or 20.18% from $339,310,000 at December 31, 2000, to $407,779,000 at December 31, 2001.
Short-term Borrowings:Repos increased $18,271,000 or 50.77% from $35,987,000 at December 31, 2001, to $54,258,000 at December 31, 2001. Sweep accounts comprise approximately 74% of Repos.
With the increases in both deposits and Repos, $10,950,000 borrowed from the FHLB was paid off.
Balance sheet Assets:Total assets of the Company increased $77,983,000 or 15.87% during 2001. The increase is the result of growth in the liability section, as previously discussed and the retention of profits.
Cash and Due from Banks:During the final week of 2001, daily cash processing was transferred from FHLB, Pittsburgh to the Federal Reserve Bank Philadelphia, (Fed). Cash letters consist of cashed or deposited checks that are not drawn on the Bank and are sent for collection. The Fed was selected based on lower handling costs and improved availability of fund collection. Estimated savings from the transfer will approximate $30,000 annually.
Total investments had an increase during 2001 of $34,218,000, net of the change in the market value of AFS investments.
United States Government Agency bonds totaling $89,295,000 and municipal securities of $3,820,000 were called due to the fall in market rates. Principal payments on MBS, also affected by the change in market rates, increased $1,613,000.
Sales of AFS United States Government bonds and AFS municipal securities totaled $14,004,000 in 2001. Sales were necessitated by the call provisions attached to all the bonds sold.
To replace the investments called, prepaid or sold, the Bank purchased $137,904,000 United States Government Agency bonds, $7,107,000 MBS and $1,000,000 preferred term securities. After careful analysis of the characteristics of the individual securities, $18,994,000 United States Agency bonds were classified as held-to maturity. The remaining bonds were classified as AFS.
Preferred term securities are pooled borrowings of FDIC insured financial institutions located within the United States. The institutions are required to have a five-year satisfactory operating history and tier 1 capital ratios greater than ten percent. Preferred term securities a provide diversification within the portfolio. Rates paid on the securities are approximately 200 basis points above Fed Fund rates and are adjustable. The securities have five-year call protection.
Investments constituted 27.06% of total assets at December 31, 2001. Held-to maturity securities were $21,640,000 and AFS investments were $132,334,000.
The tax equivalent yield on debt securities by stated maturity date at December 31, 2001, is as follows (yields are based on amortized cost):
1 year 1 through 5 through More than
or less 5 years 10 years 10 years Total
------- ------- -------- -------- -----
U.S. Government Agencies 0.00% 4.50% 5.78% 6.62% 5.75%
Mortgage Backed Securities 7.86 7.00 5.38 6.28 6.21
State & Municipal Subdivisions 6.88 7.30 7.25 7.11 7.20
Preferred Term Securities 0.00 0.00 0.00 3.63 3.63
---- ---- ---- ---- ----
Total debt securities 6.39% 4.58% 5.96% 6.52% 5.91%
===== ===== ===== ===== =====
Gross loans increased $20,276,000 or 5.99% from $338,699,000 in 2000, to $358,975,000 in 2001. Gross loans represent 63.09% of total assets at December 31, 2001.
Commercial loans increased $32,433,000 or 22.12% during 2001.
Tax-free industrial development loans, which are a component of commercial loans, increased 18.03% to $12,112,000 at December 31, 2001.
Real estate and construction loans of $102,187,000 were 28.47% of gross loans at December 31, 2001. Outstanding balances of these loans declined $10,727,000 since December 31, 2000, due to principal repayments and by classifying new mortgages as AFS.
Included with real estate loans are home equity lines of credit. The outstanding balance on the credit lines increased $642,000 or 12.14% from $5,289,000 at December 31, 2000, to $5,931,000 at December 31, 2001.
Consumer loans and direct financing leases decreased $1,430,000 or 1.81% during 2001. A combination of principal payments and the implementation of strategy not to aggressively book indirect auto loans and leases caused the decrease.
The following table sets forth the maturity distribution of the loan portfolio at December 31, 2001. Excluded from the table are real estate loans, consumer loans and direct financing leases (amounts in thousands):
1 year 1 - 5 More than
or less Years 5 years Total
------- ----- ------- -----
Commercial loans $51,482 $49,655 $77,907 $179,044
Real estate construction 5,447 - - 5,447
------- ------- ------- --------
Total $56,929 $49,655 $77,907 $184,491
======= ======= ======= ========
The following table sets forth the sensitivity changes in interest rates for commercial and real estate construction loans at December 31, 2001, (amounts in thousands):
1 - 5 More than
Years 5 years Total
----- ------- -----
Fixed interest rate $17,657 $21,814 $ 39,471
Variable interest rate 31,998 56,093 88,091
-------- ------- --------
Total $49,655 $77,907 $127,562
======= ======= ========
Due to the falling rate environment, loans available-for-sale increased $6,196,000 or 62.25% to mitigate the potential interest-rate risk.
Fixed Assets:Additions to premises and equipment were $1,224,000 before depreciation of $1,101,000 in 2001. Improvements to and equipping the Kingston branch were $718,000. System improvements and the expansion of the ATM network comprised the majority of the other additions.
Foreclosed assets held for sale:An increase of $335,000 was due to repossessed vehicles.
The Company’s major source of capital has been from the retention of equity in undistributed earnings of subsidiary, as reflected below:
Net Dividends Earnings
Income Declared Retained
---------- ---------- -----------
2002 $4,046,173 $1,526,371 $2,519,802
2001 3,848,136 1,426,097 2,422,039
2000 3,182,628 1,366,075 1,816,553
1999 3,797,693 1,344,141 2,453,552
1998 3,535,889 1,200,409 2,335,480
Capital was further increased in 2002 through the Dividend Reinvestment Plan (DRIP). Shareholders reinvested $479,000 in dividends to purchase additional shares of stock.
Capital was affected by changes in market rates. The Bank’s investment strategy reacting to market changes resulted in a $2,527,000 improvement, net of deferred taxes, in the fair value of investments classified as available-for-sale. At December 31, 2001, the Bank reported a net unrealized loss on AFS securities of $1,262,000. At December 31, 2002, a net unrealized gain of $1,265,000 was reported.
During the second quarter of 2002, 12,960 shares of common stock became available on the open market. The Company purchased the stock for $479,640 with the intention to reissue the stock under the dividend reinvestment plan. After the March 10, 2003 dividend payment date, 12,432 shares of treasury stock were reissued under the dividend reinvestment plan.
Fluctuations in the capital markets cause frequent changes in the fair value of available-for-sale securities. A future decline in value should not indicate a material weakness in the capital position of the Company. The Company monitors market conditions closely and is prepared to take remedial action when appropriate.
Capital is evaluated in relation to total assets and the risk associated with those assets. With greater capital resources, a bank is more likely to be able to meet its cash obligations and absorb unforeseen losses. Federal regulatory definitions of capital adequacy take the form of minimum ratios. The Bank exceeds all minimum regulatory capital requirements (see Note 15 “Regulatory Matters”, contained within the Notes to Consolidated Financial Statements, and incorporated herein by reference).
A yearly comparison of growth trends is as follows (increase/decrease)):
Earning Short-term Other
Assets % Assets % Deposits % Borrowings % Borrowings %
------ - ------ - -------- - ---------- - ---------- -
2002 $ 8,859,398 2% $ 7,325,219 1% $ 6,009,448 1% ($ 3,267,974) (6%) $ 0 0%
2001 77,952,784 16 60,585,502 13 68,468,400 20 6,456,267 13 0 0
2000 44,507,549 10 44,562,595 10 44,943,343 15 (12,224,325) (20) 5,695,000 10
1999 98,499,609 29 88,171,199 26 54,632,595 23 30,843,747 105 15,053,000 36
1998 58,311,070 20 54,885,888 19 21,962,495 10 304,848 1 30,000,000 245
Earning assets do not include loans placed on non-accrual.
Liquidity Management and Interest Rate Sensitivity:Liquidity management is to ensure that adequate funds will be available to meet anticipated and unanticipated deposit withdrawals, debt servicing payments, investment commitments, commercial and consumer loan demand and ongoing operating expenses. Funding sources include principal repayments on loans and investments, sales of assets, growth in core deposits, short- and long-term borrowings and repurchase agreements. Regular loan payments are a dependable source of funds, while the sale of loans and investment securities, deposit flows, and loan prepayments are significantly influenced by general economic conditions and level of interest rates.
At December 31, 2002, the Company maintained $26.2 million in cash and cash equivalents, which includes Federal funds sold in the form of cash and due from banks (after reserve requirements). In addition, the Company had $28.7 million of loans held for resale and $137.8 million in AFS securities. This combined total of $192.7 million represented 33.4% of total assets at December 31, 2002. The Company believes that its liquidity is adequate.
The Company considers its primary source of liquidity to be its core deposit base. This funding source has grown steadily over the years and consists of deposits from customers throughout the branch network. The Company will continue to promote the acquisition of deposits through its branch offices. At December 31, 2002, approximately 71.6% of the Company’s assets were funded by deposits acquired within its market area. An additional 7.8% of the assets were funded by the Company’s equity. These two components provide a substantial and stable source of funds.
Net cash provided by operating activities was $7.4 million for the year ended December 31, 2002, as compared to net cash provided by operating activities of $6.8 million for the comparable period in 2001. Net cash used in investing activities decreased $54.7 million for the year ended December 31, 2002, from $63.9 million to $9.2 million, which was primarily attributable to investment securities transactions. Net cash provided by financing activities decreased $71.6 million from 2001. A net decrease in the annual growth of interest-bearing deposits from 2001 to 2002 was the major component impacting funds provided by financing activities.
At December 31, 2002, the Bank had approximately $68.2 million in unused sources of borrowed funds available to meet liquidity requirements as follows:
The borrowing capacity at the Federal Reserve Bank of Philadelphia is the discounted market value of investment securities pledged as collateral at the date of borrowing.
Interest rate risk management:Interest rate risk management involves managing the extent to which interest-sensitive assets and interest-sensitive liabilities are matched. Interest rate sensitivity is the relationship between market interest rates and earnings volatility due to the repricing characteristics of assets and liabilities. The Company’s net interest income is affected by changes in the level of market interest rates. In order to maintain consistent earnings performance, the Company seeks to manage, to the extent possible, the repricing characteristics of its assets and liabilities.
Asset/Liability Management. One major objective of the Company when managing the rate sensitivity of its assets and liabilities is to stabilize net interest income. The management of and authority to assume interest rate risk is the responsibility of the Company’s Asset/Liability Committee (ALCO), which is comprised of senior management and Board members. ALCO meets quarterly to monitor the ratio of interest sensitive assets to interest sensitive liabilities. The process to review interest rate risk management is a regular part of management of the Company. Consistent policies and practices of measuring and reporting interest rate risk exposure, particularly regarding the treatment of non-contractual assets and liabilities, are in effect. In addition, there is an annual process to review the interest rate risk policy with the Board of Directors which includes limits on the impact to earnings from shifts in interest rates.
Interest Rate Risk Measurement. Interest rate risk is monitored through the use of three complementary measures: static gap analysis, earnings at risk simulation and economic value at risk simulation. While each of the interest rate risk measurements has limitations, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk in the Company and the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships.
Repricing Gap. The ratio between assets and liabilities repricing in specific time intervals is referred to as an interest rate sensitivity gap. Interest rate sensitivity gaps can be managed to take advantage of the slope of the yield curve as well as forecasted changes in the level of interest rate changes.
To manage this interest rate sensitivity gap position, an asset/liability model called cumulative gap analysis is used to monitor the difference in the volume of the Company’s interest sensitive assets and liabilities that mature or reprice within given periods. A positive gap (asset sensitive) indicates that more assets reprice during a given period compared to liabilities, while a negative gap (liability sensitive) has the opposite effect. The Company employs computerized net interest income simulation modeling to assist in quantifying interest rate risk exposure. This process measures and quantifies the impact on net interest income through varying interest rate changes and balance sheet compositions. The use of this model assists the ALCO to gauge the effects of the interest rate changes on interest sensitive assets and liabilities in order to determine what impact these rate changes will have upon the net interest spread.
At December 31, 2002, the Bank maintained a one year cumulative gap of positive $36.0 million or 6.23% of total assets. The effect of this gap position provided a positive mismatch of assets and liabilities which can expose the Bank to interest rate risk during a period of decreasing interest rates. Conversely, in a rising interest rate environment, net income could be positively affected because more assets than liabilities will reprice during a given period.
Interest Sensitivity Gap at December 31, 2002
3 months 3 through 1 through Over
or less 12 months 3 years 3 years Total
------------ --------- ----------- ------- -----
(Dollars in thousands)
Cash and cash equivalents $ 7,611 $ - $ - $ 18,608 $ 26,219
Investment securities(1)(2) 17,699 35,043 56,537 40,271 149,550
Loans (2) 131,730 90,068 101,367 59,812 382,977
Fixed and other assets - - - 19,243 19,243
--------- --------- --------- -------- ---------
Total assets $157,040 $ 125,111 $157,904 $137,934 $ 577,989
======== ========= ======== ======== =========
Non interest-bearing transaction deposits (3)$ - $ 6,126 $ 16,848 $ 38,177 $ 61,151
Interest-bearing transaction deposits (3) 3,552 46,723 35,036 9,905 95,216
Time 15,987 42,257 63,983 5,708 127,935
Time over $100,000 25,150 54,150 45,684 4,502 129,486
Repurchase Agreements 47,232 - - - 47,232
Short-term borrowings 4,978 - - - 4,978
Long-term debt - - 5,000 58,000 63,000
Other liabilities - - - 4,754 4,754
--------- --------- --------- -------- ---------
Total Liabilities $ 96,899 $ 149,256 $ 166,551 $121,046 $ 533,752
========= ========= ========= ======== =========
Interest sensitivity gap $ 60,141 $ (24,145) $ (8,647) $ 16,888
========= ========= ========== ==========
Cumulative gap $ 60,141 $ 35,996 $ 27,349 $ 44,237
========= ========= ========= =========
Cumulative gap to total assets 10.41% 6.23% 4.73% 7.65%
(1) Includes net unrealized gains/losses on available-for-sale securities.
(2) Investments and loans are included in the earlier of the period in which
interest rates were next scheduled to adjust or the period in which they
are due. In addition, loans were included in the periods in which they are
scheduled to be repaid based on scheduled amortization. For amortizing
loans and mortgage-backed securities, annual prepayment rates are assumed
reflecting historical experience as well as management's knowledge and
experience of its loan products.
(3) The Bank's demand and savings accounts were generally subject to immediate
withdrawal. However, management considers a certain amount of such accounts
to be core accounts having significantly longer effective maturities based
on the retention experiences of such deposits in changing interest rate
environments. The effective maturities presented are the recommended
maturity distribution limits for non-maturing deposits based on historical
deposit studies.
Certain shortcomings are inherent in the method of analysis presented in the above table. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react in different degrees to changes in market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgages, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In the event of a change in interest rates, prepayment and early withdrawal levels may deviate significantly from those assumed in calculating the table. The ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.
Earnings at Risk and Economic Value at Risk Simulations. The Company recognizes that more sophisticated tools exist for measuring the interest rate risk in the balance sheet beyond static repricing gap analysis. Although it will continue to measure its repricing gap position, the Company utilizes additional modeling for identifying and measuring the interest rate risk in the overall balance sheet. The ALCO is responsible for focusing on “earnings at risk” and “economic value at risk”, and how both relate to the risk-based capital position when analyzing the interest rate risk.
Earnings at Risk. Earnings at risk simulation measures the change in net interest income and net income should interest rates rise and fall. The simulation recognizes that not all assets and liabilities reprice one for one with market rates (e.g., savings rate). The ALCO looks at “earnings at risk” to determine income changes from a base case scenario under an increase and decrease of 200 basis points in interest rates simulation model.
Economic Value at Risk. Earnings at risk simulation measures the short-term risk in the balance sheet. Economic value (or portfolio equity) at risk measures the long-term risk by finding the net present value of the future cash flows from the Company’s existing assets and liabilities. The ALCO examines this ratio quarterly utilizing an increase and decrease of 200 basis points in interest rates simulation model. The ALCO recognizes that, in some instances, this ratio may contradict the “earnings at risk” ratio.
The following table illustrates the simulated impact of 200 basis points upward or downward movement in interest rates on net interest income, net income, and the change in economic value (portfolio equity). This analysis assumed that interest-earning asset and interest-bearing liability levels at December 31, 2002 remained constant. The impact of the rate movements was developed by simulating the effect of rates changing over a twelve-month period from the December 31, 2002 levels.
Rates +200 Rates -200
---------- ----------
Earnings at risk:
Percent change in:
Net Interest Income 9.60% (16.30)%
Net Income 26.70 (45.40)
Economic value at risk:
Percent change in:
Economic value of equity (18.40) (8.30)
Economic value of equity
as a percent of total assets (1.19) (0.54)
Economic value has the most meaning when viewed within the context of risk-based capital. Therefore, the economic value may normally change beyond the Company’s policy guideline for a short period of time as long as the risk-based capital ratio (after adjusting for the excess equity exposure) is greater than 10%.
Results of Operations
2002 2001 2000
---- ---- ----
Net income $4,046,173 $3,848,136 $3,182,628
Diluted earnings per share $2.22 $2.12 $1.76
Increase/(decrease) per share 0.47% 20.45% (16.98)%
Per share data has been adjusted for the stock exchange in 2000.
Net Interest Income:The Federal Reserve Bank lowered the discount rate once in 2002. The discount rate is the rate at which the Federal Reserve Bank lends overnight funds to banks. In response to these actions, national prime dropped 50 basis points from 4.75% to 4.25%.
There is a 223 basis point differential between the weighted average of national prime in 2002 and 2001. The weighted average of national prime in 2002 and 2001 was 4.67% and 6.90%, respectively. This difference reflects on the yield on earning assets and the cost of funds when comparing both years.
The actions of the Federal Reserve Bank caused decreases in the rates charged on loans that were subject to repricing and on the rates offered on new loans in 2002. Approximately 20% of the entire loan portfolio was subject to immediate repricing at December 31, 2002. Rates charged on new loans paralleled the reductions in prime. Sales of older loans contributed to the decline in the overall yield on loans.
Market reaction to the drop in prime significantly increased the amount of bonds called during 2002. To properly collateralize public fund deposits and Repos, the Bank had to replace the called bonds with bonds producing a lower yield.
Excess funds from asset turnover and the increase of liabilities were sold daily. The rates on these “Fed funds sold” were at historic lows.
Due to the combination of these factors, the tax equivalent yield on earning assets decreased 90 basis points.
Interest expense was also affected by the decline in market rates. There were deposit rate promotions at the new Eynon branch to develop deposit growth. However, these promotions had a minimal effect on the overall reduction of interest expense.
The effect of market changes caused a 100 basis point decrease in the cost of funds throughout 2002.
With the 10 basis point increase in the tax-equivalent net interest spread and volume increases in loans and investments, net interest income rose $1,159,000 or 7.46% during 2002.
The year 2001 as compared to 2000During 2001, the Federal Reserve Bank reduced the discount rate eleven times. These actions caused national prime to decrease from 9.50% to 4.75%. The weighted average rate of national prime decreased 234 basis points.
The actions of the Federal Reserve Bank caused decreases in the rates charged on loans that were subject to repricing and on the rates offered on new loans in 2001. Approximately 23% of the entire loan portfolio was subject to immediate repricing at December 31, 2001.
Bonds that were called due to market rate decreases were replaced with lower yielding investments.
As a result of the change in market rates, the tax equivalent yield on earning assets decreased 58 basis points.
Interest rates paid on liabilities were reduced due to the decline in market rates. This action and a $10,950,000 reduction in short term-borrowings produced a 72 basis point decrease in the cost of funds.
With the 14 basis point improvement in tax-equivalent net interest spread and volume increases in investments and loans, net interest income rose $1,909,000 or 14.02% during 2001. A comparison of average earnings assets and the net tax equivalent yields for 2002, 2001 and 2000, in thousands, is as follows:
2002 2001 2000
Average Revenue Yield Average Revenue Yield Average Revenue Yield
Balance (Expense) (Cost) Balance (Expense) (Cost) Balance (Expense) (Cost)
------- --------- ------ ------- --------- ------ ------- --------- ------
Earning assets
--------------
Interest-bearing deposits $919 $17 1.81% $12,716 $181 1.42% $6,833 $45 0.66%
Investments:
US Government Agencies 76,396 4,374 5.73 85,365 5,535 6.48 81,741 5,545 6.78
Mortgage-backed securities 61,082 3,106 5.08 16,971 1,070 6.30 13,180 876 6.65
State & Municipal 10,185 662 6.50 15,144 1,017 6.72 21,320 1,520 7.12
Other 6,337 240 3.78 4,311 272 6.31 5,555 383 6.90
------- ----- ---- ------- ----- ---- ------- ----- ----
Total Investments 154,000 8,382 5.44 121,791 7,894 6.48 121,796 8,324 6.51
======= ===== ==== ======= ===== ==== ======= ===== ====
Loans:
Commercial 202,500 12,547 6.20 169,621 13,748 8.11 138,420 12,473 9.01
Consumer 58,157 4,925 8.47 62,180 5,436 8.74 60,728 5,272 8.68
Real estate 113,679 8,095 7.12 110,854 8,207 7.40 118,375 8,720 7.37
Direct financing leases 7,558 552 7.30 10,026 724 7.22 8,775 764 8.71
Credit cards 2,897 283 9.77 2,959 283 9.56 2,054 202 9.83
------- ----- ---- ------- ----- ---- ------- ----- ----
Total loans 384,791 26,402 6.86 355,640 28,398 7.99 328,352 27,431 8.35
======= ====== ==== ======= ====== ==== ======= ====== ====
Federal funds sold 11,584 190 1.64 20,501 544 2.65 0 0 0
------- ----- ---- ------- ----- ---- ------- ----- ----
Total earning assets $551,294 $34,991 6.35% $510,648 $37,017 7.25% $456,981 $35,800 7.83%
======== ======= ===== ======== ======= ===== ======== ======= =====
Interest-bearing liabilities
- ----------------------------
Deposits:
Savings $36,031 ($363) 1.01% $31,523 ($448) 1.42% $32,881 ($631) 1.92%
NOW 37,068 (400) 1.08 35,513 (747) 2.10 38,125 (1,840) 4.83
MMDA 9,895 (142) 1.44 11,538 (324) 2.81 13,655 (533) 3.90
CDs ‹ $100,000 141,964 (6,422) 4.53 130,494 (7,133) 5.47 109,665 (6,291) 5.74
CDs › $100,000 144,802 (5,929) 4.11 123,928 (6,871) 5.54 91,055 (5,783) 6.35
Clubs 1,518 (29) 1.94 1,287 (33) 2.56 1,216 (32) 2.61
------- ----- ---- ------- ----- ---- ------- ----- ----
Total Deposits 371,278 (13,285) 3.58 334,283 (15,556) 4.65 286,597 (15,110) 5.27
Repurchase agreements 45,872 (996) 2.17 40,970 (1,510) 3.69 34,149 (1,917) 5.61
Borrowed funds 64,045 (3,601) 5.62 66,674 (3,788) 5.68 74,070 (4,441) 6.00
------- ----- ---- ------- ----- ---- ------- ----- ----
Total interest-bearing
liabilities $481,195 ($17,882) 3.72% $441,927 ($20,854) 4.72% $394,816 ($21,468) 5.44%
======== ========= ===== ======== ========= ===== ======== ========= =====
Net interest income $17,103 $16,163 $14,332
======= ======= =======
Net interest spread 2.63% 2.53% 2.39%
===== ===== =====
Net interest margin 3.10% 3.17% 3.14%
===== ===== =====
Total average assets $580,769 $533,007 $472,838
======== ======== ========
Average non-interest bearing
deposits $53,504 $46,921 $41,813
======= ======= =======
Interest income was adjusted to a tax-equivalent basis to recognize the income from tax-exempt assets as if the interest was taxable. This treatment allows a uniform comparison to be made between yields on assets. The calculations were computed on a fully tax-equivalent basis using the corporate federal tax rate of 34%.
Non-accrual loans and any related interest recorded have been included in computing the average rate earned on the loan portfolio. Installment loans and direct financing leases are presented net of unearned interest. All deposits are in domestic bank offices. The average balances are based on amortized cost and do not reflect unrealized gains or losses.
Net yield on earning assets represents the difference between interest income and interest expense divided by total average earning assets.
The following table reflects the change in net interest income attributable to fluctuations in volume and rate:
Years ended December 31,
( in thousands )
2002 Compared to 2001 2001 Compared to 2000
Increase (Decrease) due to Increase (Decrease) due to
-------------------------- --------------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ---- -----
Interest income:
Loans and leases:
Mortgage $ 208 $(320) $(112) $(553) $39 $(514)
Commercial 1,965 (3,084) (1,119) 2,462 (1,304) 1,158
Consumer (530) (126) (656) 303 (83) 220
----- ----- ----- --- ---- ---
Total loans and leases 1,643 (3,530) (1,887) 2,212 (1,348) 864
Investment securities, interest-
bearing deposits and federal
funds sold 987 (912) 75 886 (456) 430
--- ----- -- --- ----- ---
Total interest income $ 2,630 $(4,442) $(1,812) $ 3,098 $(1,804) $ 1,294
------- -------- -------- ------- -------- -------
Interest expense:
Deposits:
Certificates of deposit greater than
$100,000 $ 492 $(1,411) $(919) $ 1,821 $(726) $ 1,095
Other 66 (1,418) (1,352) 1,069 (1,717) (648)
-- ------- ------- ----- ------- -----
Total deposits 558 (2,829) (2,271) 2,890 (2,443) 447
Other interest-bearing liabilities 635 (1,335) (700) (169) (893) (1,062)
--- ------- ----- ----- ----- -------
Total interest expense $ 1,193 $(4,164) $(2,971) $ 2,721 $(3,336) $ (615)
------- -------- -------- ------- -------- -------
Net interest income $ 1,437 $(278) $ 1,159 $ 377 $(1,532) $ 1,909
======= ====== ======= ===== ======== =======
The portion of the total difference attributable to both volume and rate changes during the periods has been allocated to the volume and rate components based upon the absolute dollar amount of the change in each component prior to the allocation. Tax- exempt income was not converted to a tax-equivalent basis on the rate volume analysis.
Provision for Loan Losses:The provision is an expense charged against earnings for actual or potential losses from uncollectible loans and leases. Through the provision, the allowance for loan loss is funded. Loans determined to be uncollectible are charged-off against the allowance.
The Bank has established a Special Asset Committee which meets monthly to review known and potential problem loans and leases. The committee is comprised of senior management, loan officers, credit administration and collection personnel. The committee reports quarterly to the Credit Administration Committee of the Board of Directors.
Management continuously reviews the risks inherent in the loan and lease portfolios. Specific factors used to evaluate the adequacy of the loan loss
provision during this formal process include:
The Bank does not have significant concentrations of loans in specific industries or outside the Northeastern Pennsylvania geographic area. For the period ended December 31, 2002, adjustments were made to the historical loan loss experience for both the level and trends in delinquent loans. Adjustments were also made based on local and national economic trends.
The following table sets forth loans and lease financing charge-offs and recoveries, through the allowance for loan loss by category for the past five years:
(in thousands)
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Balance at beginning of period $3,742 $3,264 $3,172 $3,008 $2,809
Charge-offs:
- ------------
Commercial and all other 928 1,003 602 139 193
Real estate 40 119 75 146 43
Consumer 850 909 456 196 258
Lease financing 131 180 18 - 86
--- --- -- - --
Total 1,949 2,211 1,151 481 580
Recoveries:
- -----------
Commercial and all other 359 86 14 46 56
Real estate - 3 17 6 36
Consumer 69 108 53 63 39
Lease financing 15 17 1 - 2
-- -- - - -
Total 443 214 85 115 133
--- --- -- --- ---
Net charge-offs 1,506 1,997 1,066 366 447
Additions charged to operations 1,664 2,475 1,158 530 646
----- ----- ----- --- ---
Balance at end of period $3,900 $3,742 $3,264 $3,172 $3,008
====== ====== ====== ====== ======
Net charge-offs to average loans outstanding 0.40% 0.56% 0.33% 0.13% 0.20%
Allowance for loan loss to net charge-offs 258.96% 187.38% 306.19% 866.67% 672.93%
Allowance for loan loss to net loans 1.02% 1.01% 0.95% 1.05% 1.23%
Loans 30 - 89 days past due and accruing $6,047 $7,156 $11,049 $4,914 $2,829
Loans 90 days or more past due and accruing $2,599 $5,398 $1,493 $2,917 $2,689
Allowance for loan loss to loans 90 days or more
past due and accruing 150.02% 69.32% 218.69% 108.74% 111.86%
Non-accruing loans $4,000 $4,914 $2,287 $1,210 $1,364
Allowance for loan loss to non-accruing loans 97.50% 76.15% 142.75% 262.15% 220.49%
Allowance for loan loss to non-performing
loans 59.09% 36.29% 86.37% 76.86% 74.21%
Average net loans $380,892 $352,230 $325,163 $277,809 $218,170
As evidenced in the table above, there has been no significant difference between the additions charged to operations and actual net charge-off results over the last five years.
The allowance for loan losses can generally absorb losses throughout the loan and lease portfolios. However, in some instances an allocation is made for specific loans or groups of loans.
As detailed in the table above, the allowance for loan loss expressed as a percent of net charge-offs has been declining for the past two years due to the increase in the amount of loans being charged off.
The slowing economy has impacted the loan portfolio the past three years. That trend is reflected in the increase in charged-off loans over the three year period, especially commercial and consumer.
Allocation of the allowance among major categories of loans for the past five years is summarized below. This table should not be interpreted as an indication that charge-offs in future periods will occur in these amounts or proportions, or that the allocation indicates future charge-off trends.
Category 2002 2001 2000 1999 1998
- -------- ---- ---- ---- ---- ----
Real Estate $ 383,858 $ 269,490 $ 117,534 $1,165,295 $1,066,687
Consumer 1,092,140 959,408 736,613 692,878 507,946
Commercial 2,198,783 2,197,365 2,270,663 1,196,789 914,305
Direct financing leases 81,664 136,091 131,150 62,989 25,397
Real estate 0 0 0 31,494 25,397
construction
Unallocated 143,307 179,579 8,320 22,930 467,981
------- ------- ----- ------ -------
Total $3,899,752 $3,741,933 $3,264,280 $3,172,375 $3,007,713
========== ========== ========== ========== ==========
Consumer loans include credit cards receivables.
The December 31, 2001 allocation for commercial loans was $2,197,365 compared to actual 2002 net commercial loan charge-offs of $569,635. The positive variance was the result of collection efforts in 2002. The 2002 commercial loan allocation is based upon a specific allocation of $780,479 and historical and qualitative adjustments of $1,418,304.
The December 31, 2001 allocation for all other categories of loans was adequate compared to the actual net charge-offs in 2002. Since the Bank is discontinuing direct financing leases, the allocation is also adequate.
Over the last five years, management has analyzed and relied on similar factors in determining the amount of loan loss provision relative to the adequacy of the allowance for loan loss.
The methodology used by the bank to analyze the adequacy of the allowance for loan losses is as follows (loans and leases are collectively referred to as loans):
Allocation of the allowance for loan losses for different categories of loans is based on the methodology used by the Bank, as explained above. The changes in the allocations from year to years are based upon year end reviews of the loan and lease portfolios.
The following table sets forth non-performing assets for the past five years (in thousands):
2002 2001 2000 1999 1998
---- ---- ---- ---- ----
Net loans, including loans available-for-sale $382,977 $370,126 $343,555 $301,089 $243,957
======== ======== ======== ======== ========
Restructured loans not in compliance with modified terms
$0 $0 $0 $0 $0
Loans past due 90 days or more and accruing 2,599 5,398 1,493 2,917 2,689
Non-accrual loans 4,000 4,914 2,287 1,210 1,364
Non-performing loans 6,599 10,312 3,780 4,127 4,053
Foreclosed real estate 262 465 353 413 201
Repossessed assets 175 158 0 0 0
------ ------- ------ ------ ------
Total non-performing assets $7,036 $10,935 $4,133 $4,540 $4,254
====== ======= ====== ====== ======
Non-accrual loans to net loans 1.04% 1.33% 0.67% 0.40% 0.56%
Non-performing assets to net loans, foreclosed real estate
and repossessed assets 1.84% 2.95% 1.20% 1.51% 1.74%
Non-performing assets to total assets 1.22% 1.92% 0.84% 1.02% 1.22%
Non-performing loans to net loans 1.72% 2.79% 1.10% 1.37% 1.66%
Gross interest income that would have been recorded in 2002, if non-accrual loans were current, was $612,909. There was no recognition of interest income on non-accrual loans during 2002.
Payments received on non-accrual loans are recognized on a cash basis. Payments are first applied against the outstanding principal balance until the balance is satisfied. Subsequent payments are then recorded as interest income and finally late charges.
In the internal review of loans for both delinquency and collateral sufficiency, management concluded that there were an above average number of loans that lacked the ability to repay in accordance with contractual terms. The decision to place loans or leases on a non-accrual basis is made on an individual basis after considering factors pertaining to the loan.
In addition, it was determined throughout the year there were other loans that did not have the ability to make any repayment. Accordingly, management found it necessary to charge-off $1,949,000 of these loans and to increase the allowance for loan loss for certain other loans. The charge-offs were made after collateral was repossessed, foreclosed upon or notice was forwarded to governmental guarantors. The allowance for loan loss was increased through the provision for loan loss. The majority of non-performing loans and loans past due 90 days or more for the period is attributed to small commercial business loans, indirect auto lending and real estate loans in the process of foreclosure.
Several of the commercial loans are guaranteed by governmental agencies and the Bank's loss exposure is reduced accordingly.
Consumer loan payments have improved during 2002, due to collection efforts.
Reflecting the improvement, the percentage of non-performing loans to net loans has decreased from 2.79% at December 31, 2001, to 1.72% at December 31, 2002.
A specific reserve through PENNCAP has been established for eligible loans to cover losses sustained by the Bank on enrolled loans. The reserve balance at December 31, 2002 was $125,232.
The Ba