Back to GetFilings.com
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended Commission file number 0-16143
December 31, 1998
FIRST ESSEX BANCORP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 04-2943217
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
71 Main Street, Andover, MA 01810
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (978) 681-7500
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.10 par value
(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 amendment to this
Form 10-K. [ ]
The aggregate market value of the voting stock of the registrant held by
non-affiliates of the registrant, based on the closing sale price on The Nasdaq
Stock Market on March 12, 1999 was $124,170,363.
As of March 12, 1999, 7,614,634 shares of the registrant's common stock, $.10
par value, were outstanding.
- --------------------------------------------------------------------------------
DOCUMENTS INCORPORATED BY REFERENCE
Selected information from the Registrant's Proxy Statement for the annual
meeting to be held May 6, 1999, to be filed with the Securities and Exchange
Commission within 120 days after December 31, 1998, is incorporated by reference
into Part III of this report
CAUTIONARY STATEMENT FOR PURPOSES OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
First Essex Bancorp, Inc. ( "First Essex" or the "Company") desires to take
advantage of the new "safe harbor" provisions of the Private Securities
Litigation Reform Act of 1995. This Report contains certain "forward-looking
statements" including statements concerning plans, objectives, future events or
performance, assumptions, and other statements which are other than statements
of historical fact. The Company wishes to caution readers that the following
important factors, among others, may have affected, and could in the future
affect, the Company's actual results and could cause the Company's actual
results for subsequent periods to differ materially from those expressed in any
forward-looking statement made by, or on behalf of, the Company herein: (i) the
effect of changes in laws and regulations, including federal and state banking
laws and regulations, with which the Company and the Bank must comply, the cost
of compliance either currently or in the future as applicable; (ii) the effect
of changes in accounting policies and practices, as may be adopted by the
regulatory agencies as well as by the Financial Accounting Standards Board, or
of changes in the Company's organization, compensation and benefit plans; (iii)
the effect on the Company's competitive position within in its market area,
increasing consolidation within the banking industry, and increasing competition
from larger regional and out-of-state banking organizations as well as nonbank
providers of various financial services; (iv) the effect of unforeseen changes
in interest rates; and (v) the effect of changes in the business cycle and
downturns in the New England and national economy.
TABLE OF CONTENTS
Part I
Item 1. Business 1
Item 2. Properties 9
Item 3. Legal Proceedings 11
Item 4. Submission of Matters to a Vote of Security Holders 11
Part II
Item 5. Market for the Registrant's Equity and Related Stockholder Matters 12
Item 6. Selected Financial Data 13
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 14
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 29
Item 8. Financial Statements and Supplementary Data 34
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74
Part III
Item 10. Directors and Executive Officers of the Registrant 74
Item 11. Executive Compensation 74
Item 12. Security Ownership of Certain Beneficial Owners and Management 74
Item 13. Certain Relationships and Related Transactions 74
Part IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 74
Signatures 77
PART I
ITEM 1. BUSINESS
GENERAL
First Essex Bancorp, Inc.
The Company is a Delaware corporation whose primary activity is to act as the
parent holding company for First Essex Bank, FSB (the "Bank"). Until December 1,
1993, the business of First Essex Bancorp, Inc. was conducted through two
banking subsidiaries, First Essex Savings Bank, a Massachusetts-chartered
savings bank and First Essex Savings Bank of New Hampshire, a Guaranty Savings
Bank. The New Hampshire bank was owned through a second tier holding company,
First Essex Bancorp of New Hampshire, Inc., which was merged into First Essex
Bancorp, Inc. on December 1, 1993.
On December 30, 1996, Finest Financial Corp. ("Finest"), the parent holding
company of Pelham Bank and Trust Company ("Pelham"), a New Hampshire chartered
bank, was merged into the Company in a transaction that was accounted for as a
purchase. Pelham was simultaneously merged into the Bank. The purchase price was
composed of 1,353,998 shares of common stock issued at a price of $11.50 per
share and a total cash outlay of $16.3 million. Included in the total
acquisition cost was approximately $1.4 million of capitalized costs incurred in
connection with the acquisition. This transaction was accounted for as a
purchase and, accordingly, the consolidated statement of operations includes the
results of Finest's operations since the acquisition.
First Essex Bank, FSB
The Bank was originally founded under a Massachusetts legislative charter issued
in 1847. On December 1, 1993, First Essex Savings Bank converted to a federal
savings bank with a charter issued by the Office of Thrift Supervision, (the
"OTS") under the name of First Essex Bank, FSB. On the same day First Essex
Savings Bank of New Hampshire was merged into First Essex Bank, FSB. As stated
above, the Bank merged with Pelham on December 30, 1996.
Pursuant to a Purchase and Assumption Agreement, the Bank purchased certain
assets and assumed certain deposit liabilities of another financial institution
in June 1998. Because this branch acquisition was an acquisition of assets and
not the acquisition of a business, separate entity or a subsidiary, no
historical financial statements or pro-forma financial statements are required,
and because the deposit liabilities assumed exceed the assets acquired, there
was a cash payment made to the Bank as a result of this transaction.
At December 31, 1998, the Bank had total assets of $1.2 billion. The Bank is
principally engaged in the business of attracting deposits from the general
public and investing in residential mortgage, construction, commercial real
estate, commercial and consumer loans. The Bank also makes investments in
various investment securities to provide a source of interest and dividend
income. The Bank currently maintains 19 full service banking offices at various
locations throughout its market area. The Bank's deposits are insured by the
Federal Deposit Insurance Corporation (the "FDIC").
MARKET AREA
First Essex's market area is centered approximately 25 miles north of Boston at
the intersection of two major highways: Interstate Route 93, the major
north-south roadway connecting Boston with the northern Boston suburban
communities and New Hampshire, and Interstate Route 495. The Bank's principal
executive offices are located in Andover, Massachusetts, and its main banking
office and two of its branches are located in Lawrence, Massachusetts. Other
branches are in the surrounding communities of Andover, North Andover,
Haverhill, Lowell and Methuen, Massachusetts and Concord, Hillsboro,
Londonderry, Manchester, Pelham, Salem and Windham, New Hampshire.
1
CURRENT MARKET CONDITIONS
The New England region, including those portions of northeastern Massachusetts
and southern New Hampshire that constitute First Essex's market area, continues
to experience growth.
Loan demand to finance new and existing home sales has remained strong for the
last three years. Commercial loans to small and mid-size businesses in the area
continue to benefit from a growing economy characterized by expansion with
little price inflation, although the competition among lenders for these loans
remains intense. Automobile sales continued to show strength in 1998 and First
Essex participated in that growth through an indirect automobile lending program
that was begun early in 1994. The general improvement in consumer confidence and
the consumer's willingness to take on additional debt was reflected in the
growth in direct lending to consumers.
REGULATION
General
The Office of Thrift Supervision ("OTS") is the primary regulator of the Company
and the Bank. The Bank's deposits are insured up to applicable limits by the
Bank Insurance Fund ("BIF") of the FDIC. The Company and the Bank must file
reports with the OTS concerning activities and financial condition, in addition
to obtaining regulatory approvals prior to entering into certain transactions
such as mergers with or acquisitions of other financial institutions. Periodic
examinations are conducted by the OTS to test the Company's and the Bank's
compliance with various regulatory requirements. The Bank is also a member of
the Federal Home Loan Bank ("FHLB") system, which provides a central credit
facility primarily for member institutions. The Company, as a thrift holding
company, is also required to file certain reports, and otherwise comply, with
the rules and regulations of the OTS and of the Securities and Exchange
Commission ("SEC") under the federal securities laws.
Business Activities
The activities of federal savings institutions are governed by the Home Owners'
Loan Act, as amended (the "HOLA") and, in certain respects, the Federal Deposit
Insurance Act (the "FDI Act"). The HOLA and the FDI Act were amended by the
Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA").
FDICIA, among other things, requires that federal banking regulators intervene
promptly when a depository institution experiences financial difficulties,
mandates the establishment of a risk-based deposit insurance assessment system
and requires the imposition of numerous additional safety and soundness
operational standards and restrictions. FDICIA contains provisions affecting
numerous aspects of the operations of federal savings institutions and empowers
the OTS and the FDIC, among other agencies, to promulgate regulations
implementing its provision.
Qualified Thrift Lender Test
The HOLA requires saving institutions to meet a qualified thrift lender ("QTL")
test. Under the QTL test, as modified by FDICIA, a savings association is
required to maintain at least 65% of its "portfolio assets" (total assets less
(i) specified liquid assets up to 20% of total assets, (ii) intangibles,
including goodwill, and (iii) the value of property used to conduct the
association's business) in certain "qualified thrift investments" (primarily
residential mortgages and related investments, including certain mortgage-backed
securities) on a monthly basis in 9 out of every 12 months.
Limitation on Capital Distributions
OTS regulations impose limitations upon all capital distributions, other than
stock dividends, by savings institutions. The rule establishes three tiers of
institutions, which are based primarily on an institution's capital level. An
institution that meets or exceeds all fully phased-in capital requirements
before and after a proposed capital distribution ("Tier I Bank") and has not
been advised by the OTS that it is in need of more than normal supervision,
could, after prior notice but without the approval of the OTS, make capital
distributions during a calendar year equal to the greater of: (i) 100% of its
net income to date during the calendar year plus the amount that would reduce by
one-half its "surplus capital ratio" (the percentage by which its capital to
assets ratio exceeds the ratio of its fully phased-in capital requirements to
its assets) at the beginning of the calendar year; or
2
(ii) 75% of its net income for the previous four quarters. Any additional
capital distributions would require prior regulatory approval. In the event the
Bank's capital fell below its fully-phased in requirement or the OTS notified
the Bank that it was in need of more than normal supervision, the Bank's ability
to make capital distributions would be restricted. In addition, the OTS could
prohibit any proposed capital distribution by any institution if it determines
that such distribution would constitute an unsafe or unsound practice.
Furthermore, under the OTS prompt corrective action regulations, which took
effect on December 19, 1992, the Bank generally would be prohibited from making
any capital distribution if, after the distribution, the Bank would have (i) a
total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital
ratio of less than 4% or (iii) a Tier I core capital ratio of less than 3%. As
of December 31, 1998, the Bank exceeds all fully-phased in capital requirements.
Branching
The Bank currently meets the tests provided in the HOLA and OTS regulations to
permit savings institutions to branch nationwide. Additionally, the OTS
authority preempts any state law purporting to regulate branching by savings
institutions.
Capital Requirements
The Bank is subject to various regulatory capital requirements administered by
the federal banking agencies. Failure to meet minimum capital requirements can
initiate certain mandatory, and possibly additional discretionary, actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements. Under capital adequacy guidelines and the
regulatory framework for prompt corrective action, the Company must meet
specific capital guidelines that involve quantitative measures of the Bank's
assets, liabilities, and certain off-balance-sheet items as calculated under
regulatory accounting practices. The Company's capital amounts and
classification are also subject to qualitative judgments by the regulators about
the components of capital, risk weightings of assets, and other factors.
Quantitative measures are established by regulation regarding minimum amounts
and ratios of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to average
assets (as defined). Management believes, as of December 31, 1998, that the
Company meets all capital adequacy requirements to which it is subject.
As of December 31, 1998, the most recent notification received from the OTS
categorized the Company as well capitalized under the regulatory framework for
prompt corrective action. To be categorized as well capitalized the Company must
maintain the total risk-based, Tier I risk-based and Tier I adjusted asset
ratios. There are no conditions or events since that notification that
management believes have changed the institution's category.
FDICIA required that the OTS revise risk-based capital standards, with
appropriate transition rules, to ensure that they take account of interest rate
risk, concentration of risk and the risks of nontraditional activities. Under
OTS regulation effective January 1, 1994, a savings institution with interest
rate risk exposure above a specified percentage must deduct a specified interest
rate risk component when calculating total capital for purposes of determining
whether it meets OTS risk-based capital requirements. As of December 31, 1998,
the OTS did not deem it necessary for an interest-rate risk component to be
deducted from capital in determining risk-based capital requirements.
The Company may not declare or pay cash dividends on its shares of common stock
if the effect thereof would cause stockholders' equity to be reduced below
applicable capital maintenance requirements or if such declaration and payment
would otherwise violate regulatory requirements.
The capital ratios discussed above, along with the Company's actual capital
amounts and ratios are presented in a table within Note 16 to the Consolidated
Financial Statements included in response to Item 8 - "Financial Statements and
Supplementary Data" of this report.
3
INSURANCE OF DEPOSIT ACCOUNTS
As required by FDICIA, in 1993, the FDIC established a risk-based assessment
system for insured depository institutions that takes into account the risks
attributable to different categories and concentrations of assets and
liabilities, the likely amounts of any loss, and the revenue needs of the
insurance fund.
Insurance of deposits may be terminated by the FDIC after notice and hearing,
upon finding by the FDIC that the savings institution has engaged in unsafe or
unsound practices, is in an unsafe or unsound condition to continue operations,
or has violated any applicable law, rule, regulation, order or condition imposed
by, or written agreement with, the FDIC. Additionally, if insurance termination
proceedings are initiated against a savings institution, the FDIC temporarily
may suspend insurance on new deposits received by an institution under certain
circumstances. Management is not aware of any activity or condition which could
result in a termination of its deposit insurance.
FEDERAL RESERVE SYSTEM
The Federal Reserve Board regulations require financial institutions to maintain
noninterest earning reserves against their transaction accounts (primarily NOW
and regular checking accounts). Because required reserves must be maintained in
the form of either vault cash, a noninterest bearing account at a Federal
Reserve Bank or a pass-through account as defined by the Federal Reserve Board,
the effect of this reserve requirement is to reduce the Bank's interest-earning
assets.
HOLDING COMPANY REGULATION
The Company is a nondiversified unitary savings and loan holding company within
the meaning of the HOLA. As such, the Company has registered with the OTS and is
subject to OTS regulations, examinations, supervision and reporting
requirements. As a unitary savings and loan holding company, the Company
generally will not be restricted under existing laws as to the types of business
activities in which it may engage, provided that the Bank continues to be a QTL.
The HOLA requires the Company to obtain regulatory approvals prior to entering
into certain transactions such as mergers with or acquisitions of other
institutions or holding companies.
LENDING ACTIVITIES
General
At December 31, 1998, the loan portfolio, before deducting the allowance for
loan losses, was $733.9 million, representing 58.8% of total assets and an
increase of $15.2 million over the prior year. See Item 7 - "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Allowance for Loan Losses."
During 1998, every category of loans evidenced growth with the exception of
residential real estate, which experienced sizable paydowns as a result of the
significant refinancings that took place in the first half of the year. The
overall increase reflects the loans acquired in the branch acquisition (Note 2)
together with the stronger marketing effort by the Bank in the commercial and
consumer loan areas. First Essex originates residential first mortgage loans,
commercial real estate loans, construction loans, consumer loans and commercial
loans. See Item 7 - "Management's Discussion and Analysis of Financial Condition
and Results of Operations - Financial Condition."
4
The following table sets forth information concerning First Essex's loan
portfolio, including mortgage loans held for sale, at the dates indicated. The
balances shown in the table are net of unadvanced funds and unearned discounts
and fees. Required disclosure regarding maturity distribution is shown on pages
26 and 27.
- --------------------------------------------------------------------------------
Years Ended December 31,
1998 1997 1996 1995 1994
---------------- ----------------- ---------------- ----------------- -----------------
(Dollars in Thousands)
Real Estate:
Residential $189,983 25.9% $274,865 38.2% $301,869 42.9% $235,204 47.0% $264,848 61.6%
Commercial 88,774 12.1 83,077 11.6 102,718 14.6 53,504 10.7 25,786 6.0
Construction 43,220 5.9 31,851 4.4 24,855 3.5 14,210 2.8 15,527 3.6
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total real estate loans $321,977 43.9 $389,793 54.2 $429,442 61.0 $302,918 60.5 $306,161 71.2
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Owner occupied commercial
real estate 62,800 8.6 52,335 7.3 29,465 4.2 -- -- -- --
Commercial loans 89,690 12.2 67,018 9.3 63,695 9.0 66,737 13.4 55,377 12.9
Aircraft loans 59,657 8.1 41,220 5.8 33,802 4.8 14,478 2.9 522 0.1
Consumer loans:
Home Equity, Home
Improvement
& Second Mortgage 59,003 8.0 59,897 8.3 52,280 7.4 35,257 7.1 25,263 5.9
Automobile 134,613 18.4 103,551 14.4 92,175 13.1 76,590 15.3 34,906 8.1
Other 6,143 0.8 4,901 0.7 3,800 0.5 4,071 0.8 7,582 1.8
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total consumer loans 199,759 27.2 168,349 23.4 148,255 21.0 115,918 23.2 67,751 15.8
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total loans $733,883 100.0% $718,715 100.0% $704,659 100.0% $500,051 100.0% $429,811 100.0%
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
- --------------------------------------------------------------------------------
Residential Mortgage Loans
The Bank originates residential first mortgage loans in its market area. At
December 31, 1998, the residential mortgage loan portfolio was $190.0 million,
representing 25.9% of the loan portfolio. The Bank's residential first mortgage
loan products consist of six-month, one-year, three-year, five-year and
seven-year adjustable-rate mortgages and fixed-rate mortgages, having terms of
15 to 30 years.
Commercial Real Estate Loans
The Bank also holds loans secured by commercial real estate, such as
manufacturing, retail, apartment and office buildings. At December 31, 1998, the
commercial real estate loan portfolio had an outstanding balance of $88.8
million, representing 12.1% of the Bank's loan portfolio.
Generally, commercial real estate loans in the portfolio have been made to
finance the acquisition or retention of income producing properties. The current
policy of the Company is to limit commercial real estate loans primarily to
properties in eastern Massachusetts and southern New Hampshire.
Commercial real estate loans generally reprice over periods ranging from six
months to five years based on a published prime rate or other index.
5
Construction Loans
Construction loans are primarily made to developers and builders for the
construction of commercial and single family properties. Construction loans have
generally been made with maturities of one year or less and a price based on the
published prime rate, subject to renewal or extension by the Bank. Additionally,
loans are made to qualified individuals for construction of single-family
owner-occupied homes that convert to permanent mortgages upon completion of
construction. At December 31, 1998, the Bank's construction loan portfolio had
an outstanding balance of $43.2 million, representing 5.9% of the loan
portfolio.
Owner-Occupied Commercial Real Estate Loans
Owner-occupied commercial real estate loans are extensions of credit to
commercial borrowers for the construction or purchase of business space,
primarily for the borrower's own use, or loans to commercial borrowers for
operating purposes in which the Bank has taken real estate occupied by the
borrower as collateral. In these instances, the cash flow of the borrower's
business is the primary source of repayment. At December 31, 1998, this
portfolio had total outstandings of $62.8 million, representing 8.6% of the
Bank's loan portfolio.
Commercial Loans
At December 31, 1998, the portfolio of commercial loans totaled $89.7 million,
representing 12.2% of the loan portfolio. The Bank offers secured and unsecured
demand loans, time loans, term loans, lines of credit and working capital loans
which are short term or have adjustable rates. Commercial loans are originated
by the Bank's commercial lending officers who are supported by a credit,
processing and documentation staff.
Aircraft Loans
The Bank also has a niche market in commercial and consumer aircraft lending,
which represented 8.1% of the loan portfolio, at December 31, 1998. Commercial
aircraft loans totaled $54.8 million and consumer aircraft loans totaled $4.9
million of the $59.7 million aircraft portfolio.
Consumer Loans
The portfolio of consumer loans, representing 27.2% of the loan portfolio,
consists of automobile loans, fully or partially secured personal loans, boat
loans, second mortgage loans, home equity loans and education loans, as well as
unsecured personal loans, which totaled $199.8 million at December 31, 1998.
Automobile loans include dealer indirect loans, as well as loans originated
directly in retail branches. The Bank offers a variable rate home equity line of
credit called "First Line Equity Credit". This product consists of a line of
credit, secured by a second mortgage on residential property, with a monthly
adjustable interest rate at a margin above a published prime rate.
Risks Associated with Commercial Real Estate, Commercial, Owner-Occupied
Commercial Real Estate and Construction Loans
Commercial real estate and commercial lending involve significant additional
risks compared with one-to-four family residential mortgage lending, and,
therefore, typically account for a disproportionate share of delinquent loans
and real estate owned through foreclosure. Such lending generally involves
larger loan balances to single borrowers or groups of related borrowers than
does residential lending, and repayment of the loan depends in part on the
underlying business and financial condition of the borrower and is more
susceptible to adverse future developments. If the cash flow from
income-producing property is reduced (for example, because leases are not
obtained or renewed), the borrower's ability to repay the loan may be materially
impaired. These risks can be significantly affected by considerations of supply
and demand in the market for office, manufacturing and retail space and by
general economic conditions. As a result, commercial real estate and commercial
loans are likely to be subject, to a greater extent than residential property
loans, to adverse conditions in the economy generally.
Construction loans are, in general, subject to the same risks as commercial real
estate loans, but involve additional risks as well. Such additional risks are
due to uncertainties inherent in estimating construction costs, delays arising
from labor problems, shortages of material, uncertain marketability of a
complete project and other unpredictable contingencies that make it relatively
difficult to determine accurately the total loan funds required to complete a
project or the value of the completed project. Construction loan funds are
advanced on the security of the project under construction, which is of
uncertain value
6
prior to the completion of construction. When a construction project encounters
cost overruns, marketing or other problems, it may become necessary, in order to
sustain the project and to preserve collateral values, for the lender to advance
additional funds and to extend the maturity of its loan. In a declining market,
there is no assurance that this strategy will successfully enable the lender to
recover outstanding loan amounts and interest due. Moreover, foreclosing on such
properties results in administrative expense and substantial delays in recovery
of outstanding loan amounts and provides no assurance that the lender will
recover all monies due to it, either by developing the property, subject to
regulatory limitations and to the attendant risks of development, or by selling
the property to another developer.
Residential Loan Servicing and Purchase and Sale of Loans
The Bank generally writes residential mortgage loans to meet the requirements
for sale in the secondary market. From time to time, the Bank sells residential
mortgage loans and residential loan servicing. Such loan sales represent a
potential source of liquidity to meet lending demand and deposit flows. See Item
7 - "Management's Discussion and Analysis of Financial Condition and Results of
Operations - Asset/Liability Management."
At December 31, 1998, the Bank's residential loan servicing portfolio totaled
$23.2 million.
NONPERFORMING ASSETS
General
Nonperforming assets consist of nonaccruing loans (including impaired and
restructured loans) and foreclosed property. For further information regarding
the impairment of loans see "Provision for Loan Losses" included in Item 7 -
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
Nonaccruing Loans
It is the general practice of the Bank to discontinue accrual of interest on
loans for which payment of interest or principal is 90 days or more past due and
such other loans where collection of interest and principal is doubtful. All
previously accrued but uncollected interest is reversed against current period
interest income when a loan is placed on nonaccrual status. At December 31,
1998, the Bank's nonaccruing loans totaled $5.5 million which was essentially
the same amount at December 31, 1997. For further information regarding the
Bank's nonaccruing loans, see Item 7 - "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Financial Condition -
Non-Performing Assets."
Restructured Loans
These are loans on which concessions have been made in light of the debtor's
financial difficulty with the objective of maximizing recovery and with respect
to which the renegotiated payment terms are being met. At December 31, 1998 and
1997, the Bank had restructured loans with outstanding principal balances of
$447,000 and $905,000 respectively. For further information regarding
restructured loans, see Item 7 - "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Nonperforming Assets."
Foreclosed Property
Foreclosed property at December 31, 1998 totaled $575,000 compared to $891,000
at December 31, 1997.
Foreclosed property consists of real or tangible property that collateralized a
loan prior to foreclosure or repossession. These properties are carried at the
lower of cost or the estimated net realizable values. Any decreases in value
prior to sale are charged to operations.
For further information regarding the Bank's foreclosed property, see Item 7 -
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Financial Condition - Nonperforming Assets."
7
INVESTMENT ACTIVITIES
The Bank maintains an investment portfolio to provide a source of interest and
dividend income and a potential source of liquidity to meet lending demand and
deposit flows. At December 31, 1998, the investment portfolio, consisting of
short-term investments, investment securities, mortgage-backed securities, stock
in the Federal Home Loan Bank of Boston and stock of the Savings Bank Life
Insurance Company of Massachusetts, was $367.0 million, or 29.4% of total
assets.
Interest and dividend income on the investment portfolio generated 29.4% of
total interest and dividend income for the year ended December 31, 1998. See
Item 7 - "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Financial Condition - Investments" for further
information regarding the investment portfolio.
The Bank's investment strategy seeks to provide liquidity and realize current
income while preserving principal. The Bank will generally invest only in
government or corporate bonds or securities issued in the United States and will
only purchase bonds which are rated A or higher at the time of purchase.
DEPOSITS
The Bank offers a range of deposit accounts including regular and passbook
savings, NOW, money market and demand deposit accounts. The Bank offers a number
of relationship products which allow customers to combine balances in checking
and savings accounts in order to avoid service and maintenance fees, and obtain
free banking services. These relationship products also include discounts on
installment loans and bonus rates on certificates of deposit. The Bank also
offers 60-day to 7 year term deposit certificates. Interest rates on these
certificates vary according to the term selected. From time to time, the Bank
promotes various types of accounts with the intention of changing the maturity
schedule of its liabilities. See also Item 7. "Management's Discussion and
Analysis of Financial Condition and Results of Operation - Deposits."
The Bank offers its retail banking customers a wide range of deposit services
and the convenience of drive- up ATMs. The Bank is a member of the NYCE(TM),
EXCHANGE(TM), TX(TM) and CIRRUS(TM) networks. These networks allow the Bank's
depositors access to their accounts through ATMs at the Bank, other banks and
locations nationwide and worldwide.
COMPETITION
The Bank faces competition both in originating loans and in attracting deposits.
Competition in originating loans comes from a variety of sources, including, but
not limited to, other thrift institutions, commercial banks, mortgage companies,
insurance companies and consumer and commercial finance companies. The Bank
competes for loans principally on the basis of interest rates and loan fees, the
types and terms of loans originated and the quality of services provided to
borrowers. In attracting deposits, the primary competitors are other thrift
institutions, commercial banks, mutual funds and credit unions. The ability to
attract and retain deposits depends on the ability to provide investment
opportunities that satisfy the requirements of investors with respect to rate of
return, liquidity, risk, service, convenience and other factors. The Bank
competes for deposits on the basis of interest rates and by offering convenient
branch locations, extended business hours and an automated teller network.
EMPLOYEES
At December 31, 1998, the Bank had 340 employees, of whom 81 were part-time.
None of the employees of the Bank are represented by a collective bargaining
group and management considers its relations with its employees to be good.
8
ITEM 2. PROPERTIES
The following table sets forth certain information relating to properties owned
or used in banking activities at December 31, 1998
Owned Lease Renewal Total Office Space
First Essex Bank or Leased Expiration Date Option Through in Square Feet
---------------- --------- --------------- -------------- --------------
Corporate Headquarters (1):
71 Main Street Leased January 31, 2005 January 31, 2015 12,859
Andover, MA
Main Banking Office (2):
296 Essex Street Owned N/A N/A 32,000
Lawrence, MA
Operations Center:
900 Chelmsford Street Leased May 12, 2000 May 12, 2010 31,478
Lowell, MA
Mortage Origination Office:
216 Lafayette Road Leased October 31, 1999 N/A 661
North Hampton, NH
Consumer Lending Office:
211 North Main Street Leased May 30, 1999 May 30, 2001 1,260
Andover, MA May 30, 2000 May 30, 2010 800
Branch Offices:
460 South Union Street Leased February 28, 2009 February 28, 2029 3,500
Lawrence, MA
555 Broadway Owned N/A N/A 2,000
Lawrence, MA
750 Main Street Owned N/A N/A 3,100
Haverhill, MA
555 Chickering Road Leased March 31, 2002 March 31, 2012 4,549
North Andover, MA
211 North Main Street Leased April 30, 2002 April 30, 2007 4,710
Andover, MA
125 Merrimack Street Owned N/A N/A 3,000
Methuen, MA
9
Item 2. Properties
(continued)
Owned Lease Renewal Total Office Space
First Essex Bank or Leased Expiration Date Option Through in Square Feet
---------------- --------- --------------- -------------- --------------
Branch Offices (continued):
15 Burnham Road Leased June 30, 2000 June 30, 2015 3,700
Methuen, MA
539 South Broadway (3) Leased September 30, 2002 September 30, 2012 5,400
Salem, NH
1 Wall Street (4) Owned N/A N/A 7,400
Windham, NH
100 Bridge Street Leased June 30, 2003 June 30, 2008 6,899
Pelham, NH
24 Orchard View Drive Leased November 30, 2003 November 30, 2008 3,130
Londonderry, NH
900 Chelmsford Street Leased September 30, 2001 September 30, 2006 1,400
Lowell, MA
20 North Broadway Owned N/A N/A 3,800
Salem, NH
73 West Street Owned N/A N/A 5,600
Concord, NH
161 North State Street Owned N/A N/A 22,560
Concord, NH
53 West Main Street Owned N/A N/A 4,276
Hillsborough, NH
1 Wall Street (5) Leased June 30, 2001 June 30, 2011 21,787
Manchester, NH
(1) In February 1995, the address of the corporate headquarters and the
principal executive offices of the Company moved to 71 Main Street, Andover,
Massachusetts. This site also serves as a branch location.
(2) Includes two contiguous buildings at 284 Essex Street and 286-288 Essex
Street which were aquired in 1972 and 1980, respectively, as well as an
adjacent parking lot at 7 Lawrence Street which was acquired in 1981.
(3) Second floor of building is subleased for a two year term, commencing on
April 1, 1998 and terminating on March 31, 2000. There is an option to renew
for three additional 3 year terms.
(4) Second floor of building is leased for a two year term, commencing on March
1, 1999 and terminating on February 28, 2001. There is an option to renew
for two additional 1 year terms.
(5) 1,500 s/f of space is subleased on a month to month basis.
Management believes that the Company's existing facilities are adequate for the
conduct of its business.
10
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in various legal proceedings incident to its business,
none of which are believed by management to be material to the financial
condition or operations of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of the shareholders during the fourth
quarter of 1998.
11
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S EQUITY AND
RELATED STOCKHOLDER MATTERS
First Essex Bancorp, Inc. common stock is traded over-the-counter on the Nasdaq
National Market System under the symbol FESX.
At December 31, 1998, there were 7,611,635 shares outstanding and 1,266
shareholders of record. This does not reflect the number of persons or entities
who hold their stock in nominee or street name through various brokerage firms.
The price information regarding the Company's common stock in the following
table is based on high and low closing sales prices.
- --------------------------------------------------------------------------------
Dividend
Price Per Share Declared
1998 HIGH LOW per Share
---- ---- --- ---------
First Quarter $26.125 $20.000 $.14
Second Quarter 25.250 21.250 .14
Third Quarter 23.984 15.000 .14
Fourth Quarter 18.875 13.750 .16
1997
----
First Quarter $16.750 $13.375 $.12
Second Quarter 17.500 14.500 .12
Third Quarter 20.500 16.500 .12
Fourth Quarter 23.250 19.000 .14
- --------------------------------------------------------------------------------
The only funds available to the Company for the payment of dividends are cash
and cash equivalents held at the holding company level, dividends from the Bank
and borrowings. In addition, bank regulatory authorities generally restrict the
amounts available for the payment of dividends by the Bank to First Essex to the
net profit of the Bank for that year, see Item 1 - "Business - Regulation -
Limitation on Capital Distributions". The Federal Reserve Act also restricts the
Bank in lending or advancing funds to First Essex unless such loans are
collateralized by specific obligations, and limits collateralized loans to 10%
of the Bank's capital stock and surplus.
The Bank is prohibited from paying cash dividends, to the extent that any such
payment would reduce its capital below required regulatory capital levels or
would impair the liquidation account established in connection with its
conversion from mutual to stock form. See Item 1. "Business - Regulation -
Limitation on Capital Distributions" and Note 16 to the consolidated financial
statements included in response to Item 8 - "Financial Statements and
Supplementary Data" of this report for further discussion.
The payment of dividends by the Bank could carry significant adverse tax
consequences. To the extent that distributions by the Bank to the holding
company exceeds the Bank's current and accumulated earnings and profits (as
computed for federal income tax purposes for taxable years beginning after
December 31, 1951), those distributions would be treated for tax purposes as
first being made out of the Bank's bad debt reserve. In that case, the Bank
would have federal taxable income equal to approximately one and one-half times
the amount of the actual shareholder distribution that is treated as made out of
the Bank's bad debt reserves.
12
ITEM 6. SELECTED FINANCIAL DATA
At December 31,
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(Dollars in thousands)
Balance Sheet Data:
Total assets $1,248,014 $1,197,459 $1,067,175 $808,792 $806,872
Loans receivable, net 722,622 708,145 694,121 493,499 422,574
Investment securities (1) 367,407 416,021 315,749 275,900 346,943
Foreclosed property 575 891 1,880 1,756 3,038
Deposits 934,695 744,322 690,953 491,469 456,878
Borrowed funds 201,499 343,557 274,958 245,569 279,948
Stockholders' equity 97,082 91,065 83,141 60,172 54,757
Years Ended December 31,
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(Dollars in thousands, except per share data)
Operating Data:
Interest and
dividend income $93,460 $90,078 $63,545 $60,914 $45,057
Interest expense 52,512 52,377 37,317 37,081 22,707
-------- ------- ------- ------- -------
Net interest income 40,948 37,701 26,228 23,833 22,350
Provision for loan losses 1,440 2,040 1,415 770 --
Net gain (loss) on sales
of securities 1,344 439 497 (13) --
Net gain on sales of mortgage loans
and mortgage servicing rights 1,338 1,628 1,352 1,431 260
Net gain on sales of
foreclosed property 373 502 109 53 141
Other income 4,183 3,021 2,416 2,290 2,301
Noninterest expenses 28,551 24,866 20,034 19,297 19,331
Income tax
expense (benefit) 7,130 6,672 40 75 (805)
-------- ------- ------- ------- -------
Net income $11,065 $9,713 $9,113 $7,452 $6,526
-------- ------- ------- ------- -------
Per Share Data:
Earnings per share - basic (2) $1.46 $1.30 $1.51 $1.24 $1.08
Earnings per share - diluted (2) 1.41 1.25 1.47 1.22 1.08
Dividends declared 0.58 0.50 0.48 0.40 0.28
Book value at
end of period 12.75 12.08 11.20 9.99 9.10
Selected Financial Ratios:
Return on average assets 0.90% 0.80% 1.08% 0.91% 0.94%
Return on average equity 11.73 10.54 14.37 12.79 12.42
Average equity as a
percentage of average assets 7.63 7.32 7.54 7.09 7.56
Weighted average interest
rate spread 2.84 2.77 2.72 2.56 3.02
Net yield on average
earning assets 3.44 3.31 3.22 2.99 3.33
(1) Investment securities include short term investments, U.S. government and
agency obligations, mortgage-backed securities, other bonds and
obligations, stock in the Federal Home Loan Bank of Boston and stock in the
Savings Bank Life Insurance Company.
(2) Earnings per share computed in accordance with Statement of Financial
Accounting Standards No. 128.
- --------------------------------------------------------------------------------
13
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
General
The results of operations of the Company consist primarily of the results of
operations of the Bank which is the Company's sole subsidiary. Net income for
the year ended December 31, 1998 totaled $11.1 million (or $1.41 per diluted
share) compared to $9.7 million (or $1.25 per diluted share) for the same period
in 1997, an increase of 14% or $1.4 million. The improvement was in part due to
the increase in net average earnings assets combined with the increase in the
weighted average interest rate spread.
14
Analysis of Average Yields Earned and Rates Paid
The following table presents an analysis of average yields earned and rates paid
for the years indicated:
Years Ended December 31,
------------------------
1998 1997 1996
--------------------------- ---------------------------- ---------------------------
Interest Average Interest Average Interest Average
Average Earned/ Yield/ Average Earned/ Yield/ Average Earned/ Yield/
Balance Paid Rate Balance Paid Rate Balance Paid Rate
------- ---- ---- ------- ---- ---- ------- ---- ----
(Dollars in thousands)
Assets
------
Earning assets:
Short-term investments $42,580 $2,318 5.45% $9,826 $585 5.95% $8,589 $451 5.25%
Investment securities 390,182 25,054 6.42 405,639 26,418 6.51 267,493 16,202 6.06
Other earning assets 17,336 1,043 6.02 7,333 517 7.05 -- --
Total loans (1) 739,091 65,045 8.80 715,772 62,558 8.74 538,758 46,892 8.70
---------- ------- ---------- ------- -------- -------
Total earning assets 1,189,189 93,460 7.86 1,138,570 90,078 7.91 814,840 63,545 7.80
---------- ------- ---------- ------- -------- -------
Allowance for loan losses (11,037) (10,197) (6,734)
---------- ---------- --------
Total earning assets less
allowance for loan losses 1,178,152 1,128,373 808,106
Other assets 57,071 57,841 32,652
---------- ---------- --------
Total Assets $1,235,223 $1,186,214 $840,758
---------- ---------- --------
Liabilities and Stockholders' Equity
- ------------------------------------
NOW accounts 44,048 518 1.18% 40,806 527 1.29% 32,846 399 1.21%
Money market accounts 66,263 2,200 3.32 73,571 1,698 2.31 72,632 1,606 2.21
Savings accounts 196,343 7,037 3.58 123,204 4,134 3.36 49,822 862 1.73
Time deposits 450,104 25,602 5.69 422,978 24,870 5.88 320,649 19,079 5.95
---------- ------- ---------- ------- -------- -------
Total interest bearing
deposits 756,758 35,357 4.67 660,559 31,229 4.73 475,949 21,946 4.61
Borrowed funds 289,229 17,155 5.93 359,390 21,148 5.88 259,070 15,371 5.93
---------- ------- ---------- ------- -------- -------
Total interest bearing deposits
and borrowed funds 1,045,987 52,512 5.02 1,019,949 52,377 5.14 735,019 37,317 5.08
Demand deposits 77,467 62,220 30,804
Other liabilities 17,473 17,204 11,530
---------- ---------- --------
Total liabilities 1,140,927 1,099,373 777,353
Stockholders' equity 94,296 86,841 63,405
---------- ---------- --------
Total liabilities and
stockholders' equity $1,235,223 $1,186,214 $840,758
---------- ---------- --------
Net interest income $40,948 $37,701 $26,228
------- ------- -------
Weighted average rate spread 2.84% 2.77% 2.72%
---- ---- ----
Net yield on earning assets (2) 3.44% 3.31% 3.22%
-- ---- ---- ----
(1) Loans on a non-accrual status are included in the average balance.
(2) Net interest income before provision for loan losses divided by average
interest earnings assets
- --------------------------------------------------------------------------------
15
Rate/Volume Analysis
The following table presents, for the periods indicated, the changes in interest
and dividend income and the changes in interest expense attributable to changes
in interest rates and changes in the volume of interest earning assets and
interest bearing liabilities. The change attributable to both volume and rate
has been allocated proportionally to the two categories.
- --------------------------------------------------------------------------------
Years ended December 31,
------------------------
1998 Compared to 1997 1997 Compared to 1996
--------------------- ---------------------
Increase (Decrease) Increase (Decrease)
Due to Due to
------------------- --------------------
Volume Rate Total Volume Rate Total
------ ---- ----- ------ ---- -----
(Dollars in thousands)
Interest and dividend income:
Loans before the allowance for
loan losses $2,038 $449 $2,487 $15,392 $274 $15,666
Investment securities (1,007) (357) (1,364) 8,917 1,299 10,216
Interest on other earning assets 705 (179) 526 517 0 517
Federal funds sold and short-term investments 1,788 (55) 1,733 70 64 134
------ ----- ------ ------- ---- -------
Total interest and dividend income 3,524 (142) 3,382 24,896 1,637 26,533
------ ----- ------ ------- ---- -------
Interest expense:
Savings deposits 2,457 449 2,906 2,122 1,370 3,492
Time deposits 1,162 60 1,222 6,089 (298) 5,791
Borrowed funds (4,125) 132 (3,993) 5,952 (175) 5,777
------ ----- ------ ------- ---- -------
Total interest expense (506) 641 135 14,163 897 15,060
------ ----- ------ ------- ---- -------
Net interest and dividend income $4,030 ($783) $3,247 $10,733 $740 $11,473
------ ----- ------ ------- ---- -------
- --------------------------------------------------------------------------------
Net Interest Income
Net interest income increased by $3.2 million to $40.9 million for the year
ended December 31, 1998, representing an 8.6% increase from $37.7 million in
1997. The increase in net interest income was primarily due to the increase of
13 basis points in the net yield on average earning assets combined with the
volume increases in outstanding loans and short term investments partially
offset by the decreased investment securities.
Net interest income increased by $11.5 million to $37.7 million for the year
ended December 31, 1997, representing a 43.7% increase from $26.2 million in
1996. The increase in net interest income was primarily due to the $323.7
million increase (39.7%) in average earning assets (primarily associated with
the Finest acquisition) along with an increase of 9 basis points in the net
yield on average earning assets. As reflected in the above rate/volume table,
the primary contributor to the 1997 increase was the volume increases in
outstanding loans.
Interest and Dividend Income
Interest and dividend income increased by $3.4 million (3.8%) to $93.5 million
for the year ended December 31, 1998 from $90.1 million for the year ended
December 31, 1997. This increase was due to an overall increase in average
earning assets from $1,138.6 million in 1997 to $1,189.2 million in 1998, a 4.4%
increase. The net yield on average earning assets rose 13 basis points from the
1997 yield of 3.31% to 3.44% in 1998 primarily due to a decrease in the cost of
funds and secondarily due to a shift to higher yielding commercial loans.
Interest and dividend income increased by $26.5 million (41.8%) to $90.1 million
for the year ended December 31, 1997 from $63.5 million in 1996. This increase
was due to the increase in average earning assets associated with the Finest
acquisition and the increased leveraging. Average earning assets increased from
$814.8 million in 1996 to $1,138.6 million in 1997, a 39.7% increase. The net
yield on average earning assets rose 9 basis points from the 1996 yield of 3.22%
to 3.31% in 1997 due primarily to the volume increases associated with the
Finest acquisition.
16
Interest Expense
Interest expense increased marginally ($135,000 or 0.3%) to $52.5 million for
the year ended December 31, 1998 from $52.4 million in 1997. The volume
increases in savings and time deposits were more than offset by the volume
decreases in borrowed funds. The total weighted cost of funds decreased 12 basis
points from 5.14% in 1997 to 5.02% in 1998.
Interest expense increased by $15.1 million (40.4%) to $52.4 million for the
year ended December 31, 1997 from $37.3 million in 1996. The increase was also
volume related and attributable to deposits acquired in the Finest acquisition
together with increased borrowings. The total weighted cost of funds increased
slightly from a level of 5.08% in 1996 to 5.14% in 1997.
Provision for Loan Losses
The Company considers a loan impaired if it is ninety days or more past due as
to principal and interest, or if management's credit risk assessment determines
that it is probable that principal and interest will not be collected as
contractually scheduled. In addition, loans which are restructured at market
rates and comparable to loans with similar risks are considered impaired only in
the year of the restructuring, so long as they continue to perform according to
the restructured terms. Excluded from the impaired category, but otherwise
considered non-accruing loans, are small balance homogeneous loans which are
ninety days or more past due. Small balance homogeneous loans include
residential mortgage loans, residential construction loans to individuals
(excluding builder construction loans) and consumer loans.
Losses on loans are provided for under the accrual method of accounting.
Assessing the adequacy of the allowance for loan losses involves substantial
uncertainties and is based upon management's evaluation of the amount required
to meet estimated losses inherent in the loan portfolio after weighing various
factors. Among the factors management may consider are the quality of specific
loans, risk characteristics of the loan portfolio generally, the level of
non-accruing loans, current economic conditions, trends in delinquencies and
charge-offs and collateral values of the underlying security. See "Financial
Condition - Allowance for Loan Losses". Ultimate losses may vary significantly
from the current estimates. Losses on loans, including impaired loans, are
charged against the allowance when management believes the collectability of
principal is doubtful.
Provisions for loan losses totaled $1.4 million, $2.0 million, and $1.4 million
for the years ended December 31, 1998, 1997 and 1996, respectively. The 1998
provision was net of a $463,000 reversal of previous provisions for impaired
loans. Included in the other provision amounts were $635,000 and $659,000,
respectively, of provisions for losses related to impaired loans for fiscal 1997
and 1996. Provisions result from management's continuing internal review of the
loan portfolio as well as its judgment as to the adequacy of the reserves in
light of the condition of the regional real estate market and the economy
generally. As a result of increased loans, there is an expectation that the Bank
will continue to find it necessary to make provisions for loan losses in the
future. See "Financial Condition - Non-Performing Assets."
The Bank's total allowance for loan losses was $11.3 million or 204.8% of
non-accruing loans at December 31, 1998 compared to $10.6 million or 190.7% at
December 31, 1997 and $10.5 million or 222.4% at December 31, 1996.
Noninterest Income
Noninterest income consists of net gains from sales of securities, net gains
from sales of loans and loan servicing rights, fee
17
and other noninterest income.
Noninterest income increased 34.9% to $6.9 million for the year ended December
31, 1998 compared to $5.1 million in 1997. The primary reasons for this $1.8
million increase were a $905,000 increase in gains on the sales of investment
securities (of which approximately $231,000 were the result of gains realized on
the sale of securities transferred from the held-to-maturity classification),
and a $71,000 increase in total fee income, offset by a $290,000 decrease in
gains on sales of mortgage loans. Other noninterest income was a result of a
special payment received from the Massachusetts Depositors Insurance Fund of
$346,000 and interest on a state tax refund of $145,000.
Noninterest income increased 19.3% to $5.1 million for the year ended December
31, 1998 compared to $4.3 million in 1996. The primary reason for the increase
from 1996 to 1997 was a $631,000 increase in fee income from $2.4 million in
1996 to $3.0 million in 1997. Gains on the sales of mortgage loans and mortgage
servicing rights also rose by $276,000 from $1.4 million in 1996, to $1.6
million in 1997
Noninterest Expenses
Noninterest expenses increased by $3.8 million (15.7%) to $28.2 million for the
year ended December 31, 1998 compared to $24.4 million in 1997. The majority of
this increase relates to the acquisition of four banking offices in June 1998,
and the operation, throughout the reminder of the year, of these additional
banking offices.
Noninterest expenses increased by $4.4 million (22.3%) to $24.4 million for the
year ended December 31, 1997 compared to $19.9 million in 1996. Much of this
increase is attributable to operating five more banking offices in 1997 than in
1996.
Salaries and employee benefits increased by $1.4 million (12.2%) to $13.0
million for the year ended December 31, 1998 from $11.6 million in 1997 and
$10.1 million in 1996. The increases were primarily due to costs associated with
personnel to support the business growth associated with the acquisition of four
additional banking offices for half of 1998, and a full year of operations at
five new banking offices in 1997 when compared to 1996.
Amortization of intangible assets associated with the branch acquisition in 1998
and the purchase of Finest Financial Corp. in 1996 amounted to $1.7 million in
1998 and $780,000 in 1997.
All other operating expenses increased in total by $1.5 million (12.7%) to $13.4
million for the year ended December 31, 1998 compared to $11.9 million in 1997
and $9.8 million in 1996.
Income Taxes
The net provision for income taxes amounted to $7.1 million in 1998 compared to
provisions of $6.7 million and $40,000 recorded in 1997 and 1996, respectively.
The Company returned to the position of providing income taxes at the full
statutory rates in 1997.
FINANCIAL CONDITION
Total assets remained constant at $1.2 billion at December 31, 1998 compared to
the previous period.
18
Loans
At December 31, 1998, the loan portfolio, excluding the allowance for loan
losses, and including mortgage loans held-for-sale, was $733.9 million,
representing 58.8% of total assets, compared to $718.7 million or 60.0% of total
assets at December 31, 1997. See Item 1 - "Business - Lending Activities -
General" for a table setting forth the composition of the loan portfolio of the
Bank at the end of each of the past five years.
The Bank's indirect automobile lending program had total loans outstanding of
$134.6 million, $103.6 million and $92.2 million for the years ending December
31, 1998, 1997 and 1996, respectively. Aircraft loans, an increasing lending
activity for the Bank, totaled $59.7 million at December 31, 1998 compared to
$41.2 million and $33.8 million at December 31, 1997 and 1996, respectively.
Nonperforming Assets
Nonperforming assets consist of nonaccruing and restructured loans (including
impaired loans), and foreclosed property. Nonperforming assets totaled $6.1
million at December 31, 1998, compared to $6.4 million at December 31, 1997 and
$6.6 million at December 31, 1996.
The Bank's general practice is to discontinue the accrual of interest on loans
(including impaired loans) for which payment of interest or principal is ninety
days or more past due or for such other loans as considered necessary by
management if collection of interest and principal is doubtful. When a loan is
placed on nonaccrual status, all previously accrued but uncollected interest is
reversed against current period interest income.
The principal balance of restructured loans was $447,000 for the year ended
December 31, 1998, $905,000 for the year ended December 31, 1997 and $1.0
million for the year ended December 31, 1996.
If the nonaccruing loans at December 31, 1998 and 1997 had been current in
accordance with their original terms, the amount of interest income that would
have been recorded is $456,000 and $570,000, respectively. The amount of
interest that was collected and recorded as income on non-performing loans was
$494,000 and $465,000 for the years ended December 31, 1998 and 1997
respectively, of which $265,000 and $293,000, respectively, represented interest
income on impaired loans.
Foreclosed property at December 31, 1998 totaled $575,000 compared to $891,000
at December 31, 1997 and consists mainly of real estate collateral from loans
which were foreclosed together with repossessed automobiles.
At December 31, 1998, the recorded investment in loans that are considered to be
impaired totaled $2.6 million of which $940,000 had a related allowance for loan
losses of $547,000. The remaining $1.6 million of impaired loans did not require
a related allowance for loan losses. The average recorded investment in impaired
loans during 1998 was approximately $3.0 million.
The following table shows the composition of nonperforming assets for the five
years ended December 31, 1998:
19
- --------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(Dollars in thousands)
Nonaccruing loans:
Real estate $3,260 $3,159 $2,693 $2,559 $6,548
Other 1,792 1,480 1,004 814 776
Restructured loans 447 905 1,042 1,043 --
------ ------ ------ ------ -------
Total nonaccruing loans 5,499 5,544 4,739 4,416 7,324
Foreclosed property 575 891 1,880 1,756 3,038
------ ------ ------ ------ -------
Total nonperforming assets $6,074 $6,435 $6,619 $6,172 $10,362
------ ------ ------ ------ -------
Percentage of nonperforming
to total assets 0.49% 0.54% 0.62% 0.76% 1.28%
Percentage of allowance for
loan losses
to nonaccruing loans 204.8% 190.7% 222.4% 148.4% 98.8%
- --------------------------------------------------------------------------------
The following table summarizes the activity of foreclosed property during the
year ended December 31, 1998:
Other
Residential Construction Commercial Repossessed
Real Estate Real Estate Real Estate Assets Total
----------- ----------- ----------- ------ -----
(Dollars in thousands)
Balance at beginning of year $500 $0 $303 $88 $891
Transfer from loans 341 -- 320 2,436 3,097
Write-downs 0 -- (16) (16)
Sales (841) -- (331) (2,225) (3,397)
---- ---- ---- ------ ------
Balance at end of year $0 $0 $276 $299 $575
---- ---- ---- ------ ------
- --------------------------------------------------------------------------------
20
Allowance for Loan Losses
The allowance for loan losses is maintained at a level determined by management
to be adequate to provide for probable losses inherent in the loan portfolio
including commitments to extend credit. The allowance for loan losses is
maintained through the provision for loan losses, which is a charge to
operations. The potential for loss in the portfolio reflects the risks and
uncertainties inherent in the extension of credit.
The determination of the adequacy of the allowance of loan losses is based upon
management's assessment of risk elements in the portfolio, factors affecting
loan quality and assumptions about the economic environment in which the Company
operates. The process includes identification and analysis of loss potential in
various portfolio segments utilizing a credit risk grading process and specific
reviews and evaluations of significant individual problem credits. In addition,
management reviews overall portfolio quality through an analysis of current
levels and trends in charge-off, delinquency and nonaccruing loan data,
forecasted economic conditions and the overall banking environment. These
reviews are of necessity dependent upon estimates, appraisals and judgments,
which may change quickly because of changing economic conditions and the
Company's perception as to how these factors may affect the financial condition
of debtors.
The methodology for assessing the appropriateness of the allowance consists of a
review of the following key elements:
o A formula allowance for the various loan portfolio classifications,
o A valuation allowance for loans identified as impaired, and
o The unallocated allowance.
The formula allowance is a percentage-based reflection of historical loss
experience and assigns required allowance allocations by loan classification
based on a fixed percentage of all outstanding loan balances and commitments to
extend credit. The formula allowance employs a risk-rating model that grades
loans based on general characteristics of credit quality and relative risk. As
credit quality becomes more suspect, so-called "watch list" loans, the risk
rating and allocation percentage increase. The sum of these allocations comprise
the Company's "formula" or "general" allowance.
The Company also has "valuation" allowances for impaired loans. Loans are
evaluated for impairment by measuring the net present value of the expected
future cash flows using the loan's original effective interest rate, or looking
at the fair value of the collateral if the loan is collateral dependent. When
the difference between the net present value of a loan (or fair value of the
collateral if the loan is collateral dependent) is lower than the recorded
investment of the loan, the difference is provided to expense with a resulting
"valuation" allowance.
In addition to the formula and valuation components, there is an unallocated
allowance that is composed of two additional elements. The first element, which
is based on the Company's credit policy, consists of an amount that is at least
20% to 25% of the formula and valuation allowances. This element recognizes the
estimation risks associated with the formula model and the valuation allowance.
The second element is based upon management's evaluation of various conditions,
the effects of which are not directly measured in determining the formula and
valuation allowances. The evaluation of the inherent loss resulting from these
conditions involves a higher degree of uncertainty because they are not
identified with specific problem credits or portfolio segments. The conditions
evaluated in connection with the unallocated allowance include the following:
- then-existing general economic and business conditions affecting the
Company's key lending areas,
- credit quality trends, including trends in nonperforming loans
expected to result from existing conditions,
- collateral values,
- loan volumes and concentrations,
- seasoning of the loan portfolio,
- specific industry conditions within portfolio segments,
- recent loss experience in particular segements of the portfolio,
- duration of the current business cycle,
- bank regulatory examination results, and
- findings of our internal credit examiners.
When an evaluation of these conditions signifies a change in the level of risk,
the Company adjusts the formula allowance. Periodic credit reviews enable
further adjustment to the allowance through the risk-rating of loans and
identification of loans requiring a valuation allowance. In addition, the
formula model is designed to be self-correcting by taking into
21
account recent loss experience
The annual provision for loan losses is set based on the factors discussed
above. In addition, it is management's intent to maintain the allowance at a
level consistent with the Company's peers in the banking industry. The allowance
to loans ratio of 1.53% at December 31, 1998 was slightly below the Company's
peer group's average allowance ratio of 1.7%.
The following table summarizes the activity in the allowance for loan losses for
the five years ended December 31, 1998:
- --------------------------------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(Dollars in thousands)
Balance at beginning of year $10,570 $10,538 $6,552 $7,237 $7,747
Acquired allowance - Finest -- -- 4,080 -- --
Acquired allowance - branch acquisition 765 -- -- -- --
Provision for loan losses 1,440 2,040 1,415 770 --
Charge-offs:
Mortgage (709) (1,212) (1,148) (1,448) (1,703)
Construction -- -- (1) (96) (5)
Owner-occupied commercial
real estate -- -- -- -- --
Commercial (726) (2) (157) (230) (248)
Consumer (2,111) (1,612) (1,029) (711) (155)
-------- -------- -------- -------- --------
Total Charge-offs (3,546) (2,826) (2,335) (2,485) (2,111)
Recoveries:
Mortgage 1,288 575 277 234 535
Construction 12 14 6 279 240
Owner-occupied commercial
real estate -- -- -- -- --
Commercial 578 85 461 431 727
Consumer 154 144 82 86 99
-------- -------- -------- -------- --------
Total Recoveries 2,032 818 826 1,030 1,601
Net Charge-offs (1,514) (2,008) (1,509) (1,455) (510)
-------- -------- -------- -------- --------
Balance at end of year $11,261 $10,570 $10,538 $6,552 $7,237
-------- -------- -------- -------- --------
Total loans at end of year $733,883 $718,715 $704,659 $500,051 $429,811
Average loans for the year 739,091 715,772 538,758 473,069 325,922
Allowance to loans ratio 1.53% 1.47% 1.50% 1.31% 1.68%
Net Charge-offs to average loans ratio 0.20% 0.28% 0.28% 0.30% 0.16%
- --------------------------------------------------------------------------------
Investments
At December 31, 1998, the Company's investment portfolio, consisting of
short-term investments, investment securities, mortgage-backed securities,
Federal Home Loan Bank ("FHLB") stock and Savings Bank Life Insurance Company of
Massachusetts stock, totaled $367.4 million or 29.4% of assets, compared to
$416.0 million or 34.7% of assets at December
22
31, 1997. The portfolio included U.S. government and agency obligations having a
book value of $100.1 million and mortgage-backed securities with a value of
$244.1 million. Interest and dividend income on the Company's investment
portfolio which amounted to $27.4 million generated 29.3% of total interest and
dividend income for the year ended December 31, 1998. During 1998, the
investment portfolio decreased by $48.6 million.
To identify and control risks associated with the investment portfolio, the
Company has established policies and procedures, which include stop loss limits
and stress testing on a periodic basis. During the second quarter of 1998, the
Company reclassified to available-for-sale all securities previously classified
as held-to-maturity. This reclassification was the result of an analysis of the
strategic alternatives for the securities portfolio. Under Securities and
Exchange Commission guidelines, this reclassification prohibits the Company from
classifying securities as held-to-maturity for a period of at least two years.
The Company does not have any investments in off-balance-sheet financial
instruments, except as noted in Note 11 to the consolidated financial statements
included in response to Item 8 - "Financial Statements and Supplementary Data"
of this report.
The following table sets forth the composition of the investment portfolio for
the years indicated
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
(Dollars in thousands)
Short-term investments:
Interest bearing deposits $107 $122 $3,507
Federal funds sold 281 4,000 16,350
-------- -------- --------
Total short-term investments 388 4,122 19,857
Investment securities held-to-maturity:
U.S. government & agency obligations -- 54,421 9,978
Mortgage backed securities -- 109,661 94,487
Other bonds and obligations -- 14,917 --
-------- -------- --------
Total investment securities held-to-maturity -- 178,999 104,465
Investment securities available-for-sale:
U.S. government & agency obligations 100,122 67,960 41,962
Mortgage-backed securities 244,083 121,977 111,062
Other bonds and obligations 1,635 21,966 21,692
-------- -------- --------
Total investment securities available for sale 345,840 211,903 174,716
Stock in Federal Home Loan Bank of Boston 19,985 19,803 15,517
Stock in Savings Bank Life Insurance Company 1,194 1,194 1,194
-------- -------- --------
Total investments $367,407 $416,021 $315,749
-------- -------- --------
Percent of total assets 29.4% 34.7% 29.6%
For further information regarding the Company's investment portfolio, including
information regarding amortized cost and fair value as of December 31, 1997, see
notes 1, 3, and 20 to the Company's consolidated financial statements included
in response to Item 8 hereof.
- --------------------------------------------------------------------------------
Set forth below is a breakdown of yields and contractual maturities for the
amortized cost of indicated investment securities at December 31, 1998.
- --------------------------------------------------------------------------------
23
- --------------------------------------------------------------------------------
U.S. Other
government bonds Mortgage-
and agency and backed
obligations obligations securities Total
----------- ----------- ---------- -----
(Dollars in thousands)
Due in 1 year or less:
Amount -- $1,511 $59,768 $61,279
Yield -- 5.24% 5.85% 5.47%
Due from 1 to 2 years:
Amount 398 -- 45,596 45,994
Yield 7.24% -- 5.99% 7.25%
Due from 2 to 3 years:
Amount 14,531 -- 22,427 36,958
Yield 6.86% -- 6.00% 6.73%
Due from 3 to 5 years:
Amount 25,947 -- 45,289 71,236
Yield 6.75% -- 6.27% 6.48%
Due from 5 to 10 years:
Amount 55,793 -- 41,109 96,902
Yield 6.55% -- 6.16% 6.88%
Due after 10 years:
Amount 1,476 126 30,749 32,351
Yield 4.20% 4.50% 6.41% 6.07%
------- ------ -------- --------
Total:
Amount $98,145 $1,637 $244,938 $344,720
Yield 6.84% 5.17% 6.08% 6.31%
- --------------------------------------------------------------------------------
24
Deposits
Deposits have historically been the Bank's primary source of funds for lending
and investment activities. Deposit flows vary significantly and are influenced
by prevailing interest rates, market conditions, economic conditions and
competition. At December 31, 1998 the Bank had total deposits of $934.7 million,
representing a net increase of $190.4 million compared to $744.3 million at
December 31, 1997. The majority of this increase is represented by the deposit
liabilities assumed in the branch acquisition in June.
While deposit flows are by nature unpredictable, management attempts to manage
its deposits through selective pricing. Because of the uncertainty of market
conditions, it is not possible for the Bank to predict how aggressively it will
compete for deposits in the future or the likely effect of any such decision on
deposit levels, interest expense and net interest income.
The following table sets forth the composition of average deposits and rates for
the years indicated with respect to categories exceeding 10% of total average
deposits:
- --------------------------------------------------------------------------------
1998 1997 1996
---- ---- ----
Weighted Weighted Weighted
Average Average Average
Interest Interest Interest
Amount Rate Amount Rate Amount Rate
------ ---- ------ ---- ------ ----
(Dollars in thousands)
NOW $44,048 1.18 % $40,806 1.29 % $32,846 1.21 %
Money market accounts 66,263 3.32 73,571 2.31 72,632 2.21
Savings and notice accounts 196,343 3.58 123,204 3.36 49,822 1.73
Time deposits 450,104 5.69 422,978 5.88 320,649 5.95
Total interest bearing deposits 756,758 4.67 660,559 4.73 475,949 4.61
Demand deposits 77,467 62,220 30,804
-------- -------- --------
Total deposits $834,225 $722,779 $506,753
-------- -------- --------
- --------------------------------------------------------------------------------
At December 31, 1998, 1997 and 1996, outstanding certificates of deposits in
denominations of $100,000 and over had maturities as follows:
- --------------------------------------------------------------------------------
Remaining Term to Maturity 1998 1997 1996
- -------------------------- ---- ---- ----
(Dollars in thousands)
Three months or less $13,220 $10,644 $13,993
Three to six months 8,709 6,673 3,998
Six to twelve months 36,688 27,543 11,816
Over twelve months 12,494 16,926 18,530
------- ------- -------
Total $71,111 $61,786 $48,337
------- ------- -------
- --------------------------------------------------------------------------------
25
Borrowed Funds
The primary source of the Bank's borrowings come from the Federal Home Loan Bank
("FHLB"). The Bank also utilizes short-term repurchase agreements, generally
with maturities less than three months, as an additional source of funds.
Repurchase agreements are secured by U.S. government and agency securities.
Borrowings are an alternative source of funds compared to deposits and totaled
$201.5 million at December 31, 1998 compared to $343.6 million and $275.0
million at December 31, 1997 and 1996, respectively. The decrease in borrowings
in 1998 to 1997 reflects the growth in deposits and the Company's diminished
need to borrow funds to support its assets. The increase in borrowings in 1997
from 1996 was used to fund the investment portfolio and loan growth throughout
the year.
The following table summarizes the maximum and average amounts of borrowings
outstanding, the majority of which are short-term, during 1998, 1997 and 1996
together with the weighted average interest rates thereon.
================================================================================
For the Year Ended December 31, 1998 At December 31, 1998
------------------------------------ --------------------
Maximum Average Weighted Weighted
Amount Amount Average Amount Average
Outstanding Outstanding Interest Rate Outstanding Interest Rate
----------- ----------- ------------- ----------- -------------
(Dollars in thousands)
FHLB Borrowings $411,605 $261,662 6.07 % $161,582 5.93 %
Repurchase Agreements 49,495 27,567 4.65 39,917 4.04
For the Year Ended December 31, 1997 At December 31, 1997
------------------------------------ --------------------
Maximum Average Weighted Weighted
Amount Amount Average Amount Average
Outstanding Outstanding Interest Rate Outstanding Interest Rate
----------- ----------- ------------- ----------- -------------
(Dollars in thousands)
FHLB Borrowings $394,184 $342,975 5.94 % $319,744 5.98 %
Repurchase Agreements 27,708 16,415 4.75 23,813 4.90
For the Year Ended December 31, 1996 At December 31, 1996
------------------------------------ --------------------
Maximum Average Weighted Weighted
Amount Amount Average Amount Average
Outstanding Outstanding Interest Rate Outstanding Interest Rate
----------- ----------- ------------- ----------- -------------
(Dollars in thousands)
FHLB Borrowings $278,318 $249,278 5.89 % $267,275 5.74 %
Repurchase Agreements 33,473 12,732 5.28 7,683 5.18
- --------------------------------------------------------------------------------
26
YEAR 2000
The Company is addressing the issues inherent in the impending change of
century, otherwise known as "Year 2000", or "Y2K". The following constitutes the
Company's Year 2000 Readiness disclosure under the Year 2000 Information and
Readiness Disclosure Act. The potential problem with Year 2000 concerns the
inability of information systems, primarily software programs, to properly
recognize and process date sensitive information for the year 2000 and beyond. A
bank-wide project team has been organized to address and resolve Y2K issues. In
addition, the Board has established a Year 2000 Compliance Oversight Committee
to oversee activities of management and others in dealing with Y2K issues.
A principal issue the Company faces is the Y2K readiness of its third party
vendor who supplies the Company's primary application systems which are the loan
systems, deposits systems and the general ledger application. This vendor has
developed plans to deal with the Y2K problem and the Company is closely
monitoring the remediation progress of this plan. The Company is also involved
in the testing of all applicable changes that have occurred in the vendor's
software, together with addressing other mission critical systems.
A. The Company's State of Readiness
In preparing for the change of century, the Company has reviewed and assessed
both information technology (IT) and non-IT systems. IT systems include all
significant operating systems (e.g., the deposit system, platform teller system,
financial reporting system, payroll system, loan systems, etc.). The non-IT
systems (otherwise known as "embedded technology") include items such as vault
doors, elevators and security systems. Monitoring the state of readiness is
accomplished by reviewing the various phases of the Company's project plan.
These phases are defined as follows:
1. Awareness - defining the Y2K problem, informing employees and customers,
developing a strategy, project team and plan to resolve issues and risks
attendant to the problem.
2. Assessment - determining the size and complexity of the Y2K problem
together with the magnitude of the effort needed to correct the issues. It
includes establishing an inventory of IT and non-IT systems, identification
of the "mission critical" items, and a determination of the resources
necessary to address the mission critical items.
3. Analysis, renovation (or remediation) and implementation - analyzing and
replacing hardware and software (e.g., personal computers, e-mail, voice
response units, etc.), software reprogramming, third-party vendor
certifications, and other associated changes necessary to correct the items
determined to be mission critical.
4. Validation (or testing) and contingency planning - post-renovation
incremental testing of new, existing and renovated hardware and software,
together with testing the connectivity of new, existing and renovated
systems to each other. The major validation for the Company relates to the
renovation efforts of its third party provider of the Company's major
application systems. Contingency planning accounts for the possibility
that, even with renovation, Y2K issues may still arise
The following table reflects the Company's progress to date, and expected
completion date, with respect to these phases:
- --------------------------------------------------------------------------------
Estimated Estimated
Completion Completion/Completed
% (*) Date
================================================================================
Awareness 100% August 1998
- --------------------------------------------------------------------------------
Assessment 100 August 1998
- --------------------------------------------------------------------------------
Analysis, renovation and
Implementation 90 April 1999
- --------------------------------------------------------------------------------
Validation and contingency
Planning 80 June 1999
- --------------------------------------------------------------------------------
(*) Percentages are rounded to the nearest 10%.
B. Costs To Address the Company's Year 2000 Issues
27
The following table details the expenditures (period and capital) incurred to
date by the Company, together with the estimated expenditures that will be
incurred to bring the Y2K project to closure. Period expenditures have been or
will be expensed in the period incurred. Capital expenditures have been or will
be capitalized and amortized over the estimated useful life of the item. All
capital expenditures reflect hardware and software upgrades that were either
previously planned or would have occurred in the normal course, and not as a
direct result of Y2K remediation efforts.
- --------------------------------------------------------------------------------------------
Additional %
Description 1998 1999 Total Complete
Expenditures Expenditures Expenditures (*)
============================================================================================
Period expenditures: ($000's)
- --------------------------------------------------------------------------------------------
Management and staff salaries
and Board fees $ 130 $ 130 $ 260 50%
- --------------------------------------------------------------------------------------------
Y2K consulting fees 45 80 135 30
- --------------------------------------------------------------------------------------------
Third party vendor expense and
system testing 40 20 60 70
- --------------------------------------------------------------------------------------------
Capital expenditures:
- --------------------------------------------------------------------------------------------
Replacement of noncompliant
IT and non-IT systems 180 370 550 30
- --------------------------------------------------------------------------------------------
(*) Percentages are rounded to the nearest 10%.
C. The Risks of the Company's Year 2000 Issues
The reasonably likely worst case risk related to Y2k for the Company would be
major and prolonged disruptions in electrical power and telephone
communications. Due to the branch network's dependence on computer and telephone
links for data retrieval and security mechanisms, it would be difficult to
operate in either or both of these situations. The Company has been and will
continue to interact with these suppliers, and review the results of their
testing, to confirm their readiness for the Year 2000. Another risk scenario for
the Company would be temporary business disruptions of its large commercial
borrowers due to their failure(s) to be prepared for Y2K. The financial impact
of this contingency on borrowers could cause income and cash flow shortfalls for
the Company. The Company has begun a process of surveying and evaluating its
commercial customers with respect to their readiness for the change of century
by means of a questionnaire. This process allows the Company to be more
proactive in planning for this contingency. If warranted, the Company's
Allowance for Loan Losses would be increased and an appropriate charge-off would
be recorded for the estimated impact of the customer's failure to be compliant.
New loans and loan renewals have clauses inserted in the loan documents to
address the borrowers' Y2K readiness. Because the more probable risk scenarios
of the Company would be intermittent, minor and short-term IT systems failures
that were not previously anticipated, the Company is addressing these risks by
means of formulating contingency plans.
D. The Company's Contingency Plans
The Company has developed contingency plans for its core business operations.
Core business operations are those processes that are required to maintain the
ongoing business of the Company. There have been 10 core operations identified.
Contingency plans for these 10 core business operations have been developed and
are 100% complete. These contingency plans will next be tested to validate the
feasibility of each plan by means of simulations and/or walk through scenarios.
The testing and validation of these plans will be completed by June 30, 1999,
which corresponds with the guideline date imposed by the Federal Financial
Institutions Examination Council (FFIEC) for all financial institutions.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
28
ASSET/LIABILITY MANAGEMENT
The Bank's asset/liability management strategy is designed to increase net
interest income and provide adequate earnings in expected future interest rate
environments. As part of this strategy, a balance is sought between the
repricing characteristics of its earning assets and funding sources while
maximizing the spread between interest income and expense. The Bank adjusts the
level of its liquid assets and the mix of its loans and investments based on
management's judgment as to the quality of specific investment opportunities and
the relative attractiveness of their maturities and yields.
In order to achieve a better repricing balance between its assets and
liabilities, the Bank continued to originate and hold in portfolio adjustable
rate residential mortgage loans. The Bank generally writes substantially all
newly originated fixed rate residential loans to meet the requirements for sale
in the secondary market. During 1998, the Bank sold $110.3 million of
residential loans. As a result of this strategy and the low interest rate
environment, which resulted in increased refinancing activity, residential loans
decreased by $75.6 million during the year.
The Bank's commercial real estate, construction, consumer and commercial
business lending programs also provide opportunities to better match the
interest rate sensitivity of its loan portfolio and liabilities due to the
adjustable rate or short term characteristics of these types of loans. These
types of loans increased by $71.1 million during the year. This growth was due
in part to the addition of approximately $60 million in loans as a result of a
branch acquisition completed June 1998. Total loans increased by $24.4 million
during the year.
During 1998, investments decreased by $45.1 million. This decline was due to
maturities, amortization, prepayments, and the sale of approximately $126.3
million of securities. Most of the proceeds from these sales were utilized to
pay off maturing Federal Home Loan Bank borrowings as well as fund the
prepayment of additional advances. Total Federal Home Loan Bank borrowings
decreased by $158.2 million during the year.
Deposits increased by $190.4 million in 1998. This increase was primarily due to
the addition of approximately $140.3 million of deposits acquired in the branch
acquisition. The Bank also continued to administer an aggressive marketing
campaign for savings and money market products, which resulted in a significant
increase in the balances of these products at December 31, 1998 compared to
December 31, 1997.
It is management's opinion that interest rates will continue to exhibit
volatility. With this in mind, the Bank will continue to follow a strategy which
seeks to achieve a balance in the repricing characteristics of its assets and
liabilities and provide adequate earnings in a variety of interest rate
environments.
MARKET RISK
Market risk is the risk of loss in a financial instrument arising from adverse
changes in market rates/prices such as interest rates, foreign currency exchange
rates, commodity prices and equity prices. The Company's primary market risk
exposure is interest rate risk. The ongoing monitoring and management of this
risk is an important component of the Company's asset/liability management
process which is governed by policies established by its Board of Directors that
are reviewed and approved annually. The Board of Directors delegates
responsibility for carrying out the asset/liability management policies to the
Asset/Liability Committee ("ALCO"). In this capacity ALCO develops guidelines
and strategies impacting the Company's asset/liability management related
activities based upon estimated market risk sensitivity, policy limits and
overall market interest rate levels/trends.
29
Interest Rate Risk
Interest rate risk represents the sensitivity of earnings to changes in market
interest rates. As interest rates change the interest income and expense streams
associated with the Company's financial instruments also change thereby
impacting net interest income (NII), the primary component of the Company's
earnings. ALCO utilizes the results of a detailed and dynamic simulation model
to quantify the estimated exposure of NII to sustained interest rate changes.
While ALCO routinely monitors simulated NII sensitivity over a rolling two-year
horizon, it also utilizes additional tools to monitor potential longer-term
interest rate risk.
The simulation model captures the impact of changing interest rates on the
interest income received and interest expense paid on all assets and liabilities
reflected on the Company's balance sheet. This sensitivity analysis is compared
to ALCO policy limits which specify a maximum tolerance level for NII exposure
over a one year horizon, assuming no balance sheet growth, given both a 200
basis point (bp) upward and downward shift in interest rates. A parallel and pro
rata shift in rates over a 12 month period is assumed. The following reflects
the Company's NII sensitivity analysis as of December 31, 1998.
Estimated
Rate Change NII Sensitivity
----------- ---------------
+ 200 bp (1.56%)
- 200 bp 0.02%
The preceding sensitivity analysis does not represent a Company forecast and
should not be relied upon as being indicative of expected operating results.
These hypothetical estimates are based upon numerous assumptions including: the
nature and timing of interest rate levels including yield curve shape,
prepayments on loans and securities, deposit deca