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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The financial review which follows will focus on the factors affecting the financial condition and results of operations of TrustCo during 2016 and, in summary form, the two preceding years. Unless otherwise indicated, net interest income and net interest margin are presented in this discussion on a taxable equivalent basis. Balances discussed are daily averages unless otherwise described. The consolidated financial statements and related notes and the quarterly reports to shareholders for 2016 should be read in conjunction with this review. Reclassifications of prior year data are made where necessary to conform to the current year’s presentation.

TrustCo continued to make progress in 2016 despite a challenging operating environment and mixed economic conditions. Among the key results for 2016, in management’s view:

·	Net income increased 0.9% to $42.6 million in 2016 versus 2015;

·	Period-end loans and deposits were up $137 million and $96 million, respectively, for 2016 compared to the prior year;

·	Nonperforming assets declined $5.4 million or 15.5% to $29.3 million from year-end 2015 to year-end 2016;

·	At 55.7%, the efficiency ratio remained substantially better than peer-group levels (see Non-GAAP Financial Measures Reconciliation); and

·	The regulatory capital levels of both the Company and the Bank improved at December 31, 2016 relative to the prior year, and the Bank continues to meet the definition of “well capitalized” for regulatory purposes.

Management believes that the Company was able to achieve these accomplishments, despite a continued mixed economy and increased regulatory expectations, by executing its long term plan focused on traditional lending criteria and balance sheet management. Achievement of specific business goals such as the continued expansion of loans and deposits, along with tight control of operating expenses and manageable levels of nonperforming assets, is fundamental to the long term success of the Company as a whole.

Return on average equity was 9.94% in 2016 compared to 10.41% in 2015, while return on average assets was 0.89% in both 2016 and 2015.

The economic and business environment improved during 2016 but remains mixed. Real gross domestic product (“GDP”) increased 1.6% in 2016 and 2.6% in 2015, based on the advance estimate published on January 27, 2017, with growth rates declining in late 2016. This annual rate of growth remains well below the range exhibited during more robust periods of economic activity, such as the 4% to 6% range experienced during the 1990s. Equity markets performed well during 2016 with the Dow Jones Industrial Average up 13.4%, the S&P 500 up 9.5% and the Russell 2000 index up 19.5%. The bulk of the gains came late in the year, mostly after the Presidential Election.  United States Treasuries saw significant price changes over the course of 2016, with the slope of the yield curve shifting considerably. Yields on most maturities declined gradually for the first half of the year before stabilizing, then increasing gradually in the third quarter and spiking upward after Election Day.  The net result was that yields moved up from the beginning of the year to the end of the year, but the overall magnitude of the change was less dramatic over the full year then the sharp increase late in the year.  The steepness of the yield curve, as measured by the spread between longer term (10 year) and shorter term (2 year) yields did not change much as measured at the beginning (121 basis points) and end (125 basis points) of the year, but actually was between 85 and 105 basis points for much of the year (roughly February through Election Day).  Most overseas markets experienced somewhat better conditions in 2016 than in recent years, but generally remain in low growth modes with less than full employment and a lack of demand.  The crisis environment that persisted for a number of years generally dissipated during 2016, but some fundamental underlying issues such as high debt levels in a number of nations persisted and the Brexit vote in the United Kingdom added new uncertainty in the European Union.  Economic growth slowed again in China. The outlook for the United States economy in 2017 is complicated by the significant changes in direction being pursued by the new administration.  Proposed changes in tax rates and other fiscal support, such as increased spending on infrastructure, could contribute to improved conditions while other initiatives such as potentially adding barriers to trade could do the opposite and may have unintended effects on American consumers.  Employment increased and the unemployment rate declined, although labor force participation remains an ongoing issue. Wage growth also remains mixed, with progress on this front in recent months. The weakened dollar provides some significant benefits in terms of making US products more competitive overseas, but also makes imported goods and services more expensive. Regulatory changes put in place in response to the 2007-2008 financial crisis have added significant cost to the banking industry.  The new administration has indicated that reducing regulatory burden is an important goal, which could benefit the banking industry both in terms of cost structure and in terms of operational efficiency.

 

TrustCo’s long-term focus on traditional banking services has enabled the Company to avoid significant impact from asset quality problems, and the Company’s strong liquidity and solid capital positions have allowed the Company to continue to conduct business in a manner consistent with past practice. TrustCo has not engaged in the types of high risk loans and investments that often led to industry problems in prior years. While we continue to adhere to prudent underwriting standards, as a lender, we may be adversely impacted by general economic weaknesses and by a downturn in the housing market in the areas we serve.

Regulatory Agreement

Trustco Bank entered into an agreement with its primary regulator, the Office of the Comptroller of the Currency (OCC), on July 21, 2015. The agreement calls for the Bank to take various actions in areas such as compliance, corporate governance, audit, capital planning including dividends, and strategic planning, among others. The agreement followed the completion of the OCC’s regularly scheduled exam of the Bank. Since the completion of the examination, the Bank has been working to address the issues raised. The Bank’s Board of Directors and management remain committed to fully addressing all provisions of the agreement.

Overview

2016 results were marked by growth in the two key drivers of the Company’s long-term performance: deposits and loans. Deposits ended 2016 at $4.20 billion, an increase of $95.8 million or 2.3% from the prior year-end. The loan portfolio grew to a total of $3.43 billion, an increase of $137.3 million or 4.2% over the 2015 year-end balance. The year-over-year increases in deposits and loans reflect the success the Company has had in attracting customers to the Bank, both in newer branch locations as well as in its established offices. Management believes that TrustCo’s success is predicated on providing core banking services to a wider number of customers and continuing to provide added services to existing customers where possible. Growing the customer base should contribute to continued growth of loans and deposits, as well as net interest income and non-interest income.

TrustCo recorded net income of $42.6 million or $0.445 of diluted earnings per share for the year ended December 31, 2016, compared to $42.2 million or $0.444 of diluted earnings per share for the year ended December 31, 2015.

During 2016, the following had a significant effect on net income:

·	an increase of $2.9 million in net interest income from 2015 to 2016 as a result of a combination of 1.5% growth in average interest earning assets and a 2 basis point increase in the net interest margin to 3.11%;

·	a decrease in the provision for loan losses from $3.7 million in 2015 to $3.0 million in 2016;

·	an increase of $723 thousand in non-interest income (excluding net gain on sales of securities) in 2016 as compared to 2015;

·	the recognition of net gains on securities transactions of $668 thousand in 2016 compared to net securities gains of $251 thousand recorded in 2015;

·	an increase of $2.7 million in non-interest expense (excluding other real estate expense, net) as compared to 2015;

·	a $557 thousand increase in other real estate expenses (net) as compared to 2015, and;

·	an increase of $1.2 million in income tax expense from $24.5 million in 2015 to $25.7 million in 2016.

TrustCo performed well in comparison to its peers with respect to a number of key performance ratios during 2016 and 2015, including:

·	return on average equity of 9.94% for 2016 and 10.41% for 2015, compared to medians of 9.16% in 2016 and 8.84% in 2015 for a peer group comprised of all publicly traded banks and thrifts tracked by SNL Financial with assets of $2 billion to $10 billion, and

·	an efficiency ratio, as calculated by SNL Financial, of 55.67% for 2016 and 55.08% for 2015, compared to the peer group medians of 60.52% in 2016 and 61.86% in 2015.

 

During 2016, TrustCo’s results were positively affected by the growth of total deposits, including low-cost core deposits, strong loan growth and a shift in asset mix. The low short-term rate environment prevailing throughout much of 2016 allowed the Company to continue to attract deposits at relatively low yields. On average for 2016, non-maturity deposits were 72.0% of total deposits, up from 71.4% in 2015. Overall, the cost of interest bearing liabilities decreased 2 basis points to 0.39% in 2016 as compared to 2015. Average loan balances increased 3.5% from 2015 to 2016, while the total of short-term investments, available for sale securities and held to maturity securities decreased 3.3%, resulting in average loans growing to 71.3% of average earning assets in 2016 from 69.9% in 2015. Given that loan yields were approximately 300 basis points above the yield on the total of short-term investments and securities, this shift, combined with the growth of the balance sheet, contributed to the $2.9 million increase in net interest income from 2015 to 2016. The Company has traditionally maintained a high liquidity position, and taken a conservative stance in its investment portfolio through the use of relatively short-term securities. The low rate environment that prevailed during most of 2016 resulted in maturing and called securities being reinvested at low yields in some cases or being shifted to the higher yielding loan portfolio. The Federal Reserve Board’s (“FRB”) continued accommodative monetary policy, along with modest economic growth domestically and low rates in other nations, were key drivers of the rate environment during 2016. The 2007-2008 easing of monetary policy by the FRB included a particularly sharp reduction in the Federal Funds rate in 2008, from the 4.25% rate at the beginning of the year to a target range of between 0.00% to 0.25% by year-end. That target range was in place throughout 2015 and most of 2016. The FRB increased the target range by 25 basis points in December of 2015 and again in December of 2016, with the target range now at 0.50% to 0.75%. The FRB Federal Open Market Committee (“FOMC” or “Committee”) affirmed in its February 1, 2017 press release that it would maintain “…the target range for the federal funds rate at 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, hereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.”  In regard to the future path of rates, the Committee noted, “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. In light of the current shortfall of inflation from 2 percent, the Committee will carefully monitor actual and expected progress toward its inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”  Most economists currently believe that there will likely be two or three increases in the target rate in 2017, very much subject to what new data indicates about the strength of the economy.

As discussed previously, market interest rates moved quite a bit during the course of 2016, but ultimately ended the year only modestly higher than where they were at the end of 2015.  Overall, trends in market rates caused a flattening of the yield curve, on average, during the year.   The average daily spread between the ten year Treasury and the two year Treasury was 102 basis points in 2016, down from an average of 145 basis points in 2015. The spread widened somewhat late in the year, ending 2016 at 125 basis points, compared to 121 at the end of 2015. A more positive slope in the yield curve is generally beneficial for the Company’s earnings derived from its core mix of loans and deposits. The tables below illustrate the range of key Treasury bond interest rates during 2015 and 2016.

		3 Month T Bill (BEY) Yield(%)				2 Year T Note Yield(%)				5 Year T Note Yield(%)				10 Year T Note Yield(%)				10 Year - 2 Year Spread(%)
2016
Beginning of Year			0.16				1.06				1.76				2.27				1.21
Peak			0.55				1.29				2.10				2.60				1.34
Trough			0.16				0.56				0.94				1.37				0.76
End of Year			0.51				1.20				1.93				2.45				1.25
Average			0.31				0.84				1.35				1.86				1.02
Median			0.30				0.81				1.26				1.79				1.00
2015
Beginning of Year			0.04				0.67				1.65				2.17				1.50
Peak			0.29				1.09				1.81				2.50				1.77
Trough			0.00				0.44				1.18				1.68				1.19
End of Year			0.16				1.06				1.76				2.27				1.21
Average			0.05				0.69				1.53				2.14				1.45
Median			0.02				0.66				1.54				2.16				1.43

 

Source: SNL Financial

In addition to changes in interest rates, economic conditions have a significant impact on the allowance for loan losses. The decrease in the provision for loan losses from $3.7 million in 2015 to $3.0 million in 2016 positively affected net income. Net charge-offs decreased from $5.3 million in 2015 to $3.8 million in 2016. Nonperforming loans decreased from $28.3 million to $25.1 million and the nature of these loans changed slightly in terms of both geographic location and loan type. Details on nonperforming loans and net charge-offs are included in the notes to the financial statements. The decline in the provision for loan losses is primarily a reflection of the improvement in the performance of the loan portfolio and economic conditions, with reductions in both nonperforming loans (“NPLs”) and charge-offs.

TrustCo focuses on providing high quality service to the communities served by its branch-banking network. The financial results for the Company are influenced by economic events that affect those communities, as well as national economic trends, primarily interest rates, affecting the entire banking industry.

 

TrustCo consolidated one branch in 2016, bringing the total to 145 at year-end. The Company remains focused on building its customer relationships, deposits and loans throughout its branch network, with a particular emphasis on the branches added during the major branch expansion that was completed in 2010.

Although that specific expansion program is complete, the Company typically opens new offices each year, filling in or extending existing markets. The expansion program was established to expand the franchise to areas experiencing economic growth, specifically in central Florida and the downstate New York region. The Company has experienced significant growth in both markets as measured by deposit balances, and to a lesser extent, by loan balances. All new branches have the same products and features found at other Trustco Bank locations. With a combination of competitive rates, excellent service and convenient locations, management believes that the new branches will continue to attract deposit and loan customers and be a welcome addition to these communities. The branches opened since the expansion program began have continued to add to the Company’s customer base. As expected, some branches have grown more rapidly than others. Generally, new bank branches continue to grow for years after being opened, although there is no specific time frame that could be characterized as typical. The expansion program has contributed significantly to the growth of both deposits and loans in recent years, as well as to non-interest income and non-interest expense. The higher costs are offset by net interest income earned on core loans and deposits generated by these branches, as well as associated non-interest income. The costs associated with the major expansion program have stabilized. Revenue growth is expected to continue, as these branches typically continue to add new customers and increase penetration with existing customers over time.

Asset/Liability Management

In managing its balance sheet, TrustCo utilizes funding and capital sources within sound credit, investment, interest rate, and liquidity risk guidelines established by management and approved by the Board of Directors. Loans and securities (including Federal Funds sold and other short-term investments) are the Company’s primary earning assets. Average interest earning assets were 98.1% of average total assets for 2016 and for 2015.

TrustCo, through its management of liabilities, attempts to provide stable and flexible sources of funding within established liquidity and interest rate risk guidelines. This is accomplished through core deposit banking products offered within the markets served by the Company. TrustCo does not actively seek to attract out-of-area deposits or so-called “hot money,” but rather focuses on core relationships with both depositors and borrowers.

TrustCo’s objectives in managing its balance sheet are to limit the sensitivity of net interest income to actual or potential changes in interest rates and to enhance profitability through strategies that should provide sufficient reward for predicted and controlled risk. The Company is deliberate in its efforts to maintain adequate liquidity under prevailing and projected economic conditions and to maintain an efficient and appropriate mix of core deposit relationships. The Company relies on traditional banking investment instruments and its large base of core deposits to help in asset/liability management. Predicting the impact of changing rates on the Company’s net interest income and net fair value of its balance sheet is complex and subject to uncertainty for a number of reasons. For example, in making a general assumption that rates will rise, a myriad of other assumptions regarding whether the slope of the yield curve remains the same or changes, whether the spreads of various loans, deposits and investments remain unchanged, widen or narrow and what changes occur in customer behavior all need to be made. The Company routinely models various rate changes and monitors basis changes that may be incorporated into that modeling.

Interest Rates

TrustCo competes with other financial service providers based upon many factors including quality of service, convenience of operations and rates paid on deposits and charged on loans. The absolute level of interest rates, changes in rates and customers’ expectations with respect to the direction of interest rates have a significant impact on the volume of loan and deposit originations in any particular year.

Interest rates have a significant impact on the operations and financial results of all financial services companies. One of the most important interest rates used to control national economic policy is the “Federal Funds” rate. This is the interest rate utilized within the banking system for overnight borrowings for institutions with the highest credit rating. As noted previously, during 2007-2008 the FRB aggressively reduced the Federal Funds rate, including a decrease from 4.25% at the beginning of 2008 to a target range of 0.00% to 0.25% by the end of 2008. The target range remained at that level until December 2015 when the range was increased to 0.25% to 0.50%.  In December of 2016 the target range was again increased, to 0.50% to 0.75%.

The yield on the ten-year Treasury bond increased by 18 basis points from 2.27% at the beginning of 2016 to the year-end level of 2.45%. The rate on the ten year Treasury bond and other long-term interest rates have a significant influence on the rates offered for new residential real estate loans. These changes in interest rates have an effect on the Company relative to the interest income on loans, securities, and Federal Funds sold and on other short-term instruments as well as the interest expense on deposits and borrowings. Residential real estate loans and longer-term investments are most affected by the changes in longer term market interest rates such as the ten-year Treasury. The Federal Funds sold portfolio and other short-term investments are affected primarily by changes in the Federal Funds target rate. Deposit interest rates are most affected by short term market interest rates. Also, changes in interest rates have an effect on the recorded balance of the securities available for sale portfolio, which are recorded at fair value. Generally, as market interest rates increase, the fair value of the securities will decrease and the reverse is also generally applicable. Interest rates on new residential real estate loan originations are also influenced by the rates established by secondary market participants such as Freddie Mac and Fannie Mae. Because TrustCo is a portfolio lender and does not sell loans into the secondary market, the Company establishes rates that management determines are appropriate in light of the long-term nature of residential real estate loans while remaining competitive with the secondary market rates. Higher market interest rates also generally increase the value of retail deposits.

 

While the increase in the Federal Funds target range had a beneficial impact on earnings on the Company’s cash position, the net effect of market changes in interest rates during 2016 was that yields earned on both the investment portfolios and loans remained quite low in 2016, while deposit costs were roughly stable.

Earning Assets

Average earning assets during 2016 were $4.70 billion, which was an increase of $68.2 million from 2015. This increase was the result of growth in the average balance of net loans of $113.5 million, offset by a $12.8 million decrease in held-to-maturity securities and a $30.6 million decrease in securities available for sale between 2015 and 2016. The increase in the loan portfolio is the result of a significant increase in residential mortgage loans, which more than offset decreases in each of the other loan categories. The increase in real estate loans is a result of a strategic focus on growth of this product throughout the Trustco Bank branch network through an effective marketing campaign and competitive rates and closing costs.

Total average assets were $4.79 billion for 2016 and $4.72 billion for 2015.

The table “Mix of Average Earning Assets” shows how the mix of the earning assets has changed over the last three years. While the growth in earning assets is critical to improved profitability, changes in the mix also have a significant impact on income levels, as discussed below.

MIX OF AVERAGE EARNING ASSETS

(dollars in thousands)
														2016 vs.				2015 vs.				Components of Total Earning Assets
		2016				2015				2014				2015				2014				2016				2015				2014
Loans, net		$	3,348,324				3,234,806				3,014,156				113,518				220,650				71.3	%			69.9				67.2
Securities available for sale (1):
U.S. government sponsored enterprises			101,242				107,436				113,563				(6,194	)			(6,127	)			2.2				2.3				2.5
State and political subdivisions			991				1,812				3,924				(821	)			(2,112	)			0.0				0.0				0.1
Mortgage-backed securities and collateralized mortgage obligations-residential			410,646				439,343				555,430				(28,697	)			(116,087	)			8.7				9.5				12.4
Corporate bonds			17,088				613				3,156				16,475				(2,543	)			0.4				0.0				0.1
Small Business Administration-guaranteed participation securities			86,407				97,496				107,029				(11,089	)			(9,533	)			1.8				2.1				2.4
Mortgage-backed securities and collateralized mortgage obligations-commercial			10,284				10,566				10,837				(282	)			(271	)			0.2				0.2				0.2
Other			683				685				674				(2	)			11				0.0				0.0				0.0
Total securities available for sale			627,341				657,951				794,613				(30,610	)			(136,662	)			13.4				14.2				17.7
Held-to-maturity securities:
Mortgage-backed securities and collateralized mortgage obligations			40,830				53,763				68,404				(12,933	)			(14,641	)			0.9				1.2				1.5
Corporate bonds			10,145				9,967				9,952				178				15				0.2				0.2				0.2
Total held-to-maturity securities			50,975				63,730				78,356				(12,755	)			(14,626	)			1.1				1.4				1.7
Federal Reserve Bank and Federal Home
Loan Bank stock			9,554				9,414				10,135				140				(721	)			0.2				0.2				0.2
Federal funds sold and other short-term investments			662,436				664,516				589,873				(2,080	)			74,643				14.1				14.4				13.1
Total earning assets		$	4,698,630			$	4,630,417			$	4,487,133				68,213				143,284				100.0	%			100.0				100.0

(1)	The average balances of securities available for sale are presented using amortized cost for these securities.

 

Loans

In 2016, the Company experienced another year of significant loan growth. The $137.3 million increase in the Company’s gross loan portfolio from December 31, 2015 to December 31, 2016 was due to higher residential mortgage balances, which offset lower balances in other loan categories. Average loans increased $113.5 million during 2016 to $3.35 billion. Interest income on the loan portfolio increased to $143.7 million in 2016 from $141.9 million in 2015. The average yield declined 10 basis points to 4.29% in 2016 compared to 2015.

LOAN PORTFOLIO

(dollars in thousands)		As of December 31,
		2016								2015								2014
		Amount				Percent				Amount				Percent				Amount				Percent
Commercial		$	182,653				5.3	%		$	192,789				5.9	%		$	202,469				6.4	%
Real estate - construction			24,826				0.7				26,594				0.8				38,522				1.2
Real estate - mortgage			2,879,448				83.9				2,705,205				82.1				2,557,613				81.1
Home equity lines of credit			334,841				9.8				359,325				10.9				352,134				11.1
Installment loans			8,818				0.3				9,391				0.3				7,594				0.2
Total loans			3,430,586				100.0	%			3,293,304				100.0	%			3,158,332				100.0	%
Less: Allowance for loan losses			43,890								44,762								46,327
Net loans (1)		$	3,386,696							$	3,248,542							$	3,112,005

		Average Balances
		2016								2015								2014								2013								2012
		Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent				Amount				Percent
Commercial		$	186,800				5.6	%		$	195,265				6.0	%		$	201,317				6.7	%		$	193,065				7.0	%		$	209,323				8.1	%
Real estate - construction			23,645				0.7				29,101				0.9				35,109				1.2				36,689				1.3				34,387				1.3
Real estate - mortgage			2,779,451				83.0				2,647,265				81.8				2,428,383				80.6				2,201,348				79.4				2,004,059				77.9
Home equity lines of credit			350,004				10.5				354,718				11.0				343,264				11.4				335,409				12.1				321,299				12.5
Installment loans			8,424				0.3				8,457				0.3				6,083				0.2				5,152				0.2				3,915				0.2
Total loans			3,348,324				100.0	%			3,234,806				100.0	%			3,014,156				100.0	%			2,771,663				100.0	%			2,572,983				100.0	%
Less: Allowance for loan losses			44,718								46,023								47,409								48,452								49,148
Net loans (1)		$	3,303,606							$	3,188,783							$	2,966,747							$	2,723,211							$	2,523,835

(1)	Presented net of deferred direct loan origination fees and costs.

Through marketing, pricing and a customer-friendly service delivery network, TrustCo has attempted to distinguish itself from other mortgage lenders by highlighting the uniqueness of its loan products. Specifically, low closing costs, no escrow or private mortgage insurance, quick loan decisions and fast closings were identified and marketed. The fact that the Company holds mortgages in its loan portfolio rather than selling them into secondary markets was also highlighted. The average balance of residential real estate mortgage loans was $2.78 billion in 2016 and $2.65 billion in 2015. Income on real estate loans increased to $119.8 million in 2016 from $117.8 million in 2015. The yield on the portfolio decreased from 4.43% in 2015 to 4.29% in 2016 due to changes in retail rates in the marketplace. The vast majority of TrustCo’s real estate loans are secured by properties within the Bank’s market area.

TrustCo does not make subprime loans or purchase investments collateralized by subprime loans. A loan may be considered subprime for a number of reasons, but effectively subprime loans are loans where the certainty of repayment of principal and interest is lower than for a traditional prime loan due to the structure of the loan itself, the credit worthiness of the borrower, the underwriting standards of the lender or some combination of these. For instance, adjustable loans underwritten at initial low “teaser” rates instead of the fully indexed rate and loans to borrowers with poor payment history would generally be classified as subprime. Other than for it’s small credit card portfolio, TrustCo underwrites its loan originations in a traditional manner, focusing on key factors that have proven to result in good credit decisions, rather than relying on automated systems or basing decisions primarily on one factor, such as a borrower’s credit score.

Average commercial loans of $196.1 million in 2016 decreased by $14.1 million from $210.2 million in 2015.  Average commercial loans included $9.3 million and $14.9 million of commercial real estate construction loans in 2016 and 2015, respectively.   The average yield on the commercial loan portfolio increased to 5.27% for 2016 from 5.17% in 2015, which resulted in interest income on commercial loans of $10.3 million in 2016 and $10.9 million in 2015.

TrustCo’s commercial lending activities are focused on balancing the Company’s commitment to meeting the credit needs of businesses in its market areas with the necessity of managing its credit risk. In accordance with these goals, the Company has consistently emphasized the origination of loans within its market area. TrustCo’s commercial loan portfolio contains no foreign loans, nor does it contain any significant concentrations of credit to any single borrower or industry. The Capital Region commercial loan portfolio reflects the diversity of businesses found in the market area, including light manufacturing, retail, service, and real estate-related businesses. Commercial loans made in the downstate New York market area and in the central Florida market area also reflect the businesses in those areas, with a focus on real estate.

 

TrustCo strives to maintain strong asset quality in all segments of its loan portfolio, especially commercial loans. There is significant competition for commercial loans continues to be intense in the Bank’s market regions.

TrustCo has a strong position in the home equity credit line product in its market area. TrustCo was one of the first financial institutions in its market area to market and originate this product, and, management believes, has developed significant expertise with respect to its risks and rewards. During 2016, the average balance of home equity credit lines was $350.0 million, a decrease from $354.7 million in 2015. The home equity credit line product has developed into a significant business line for many financial services companies. Trustco Bank competes with both regional and national concerns for these lines of credit and faces stiff competition with respect to interest rates, closing costs, and customer service for these loans. TrustCo continuously reviews changes made by competitors with respect to the home equity credit line product and adjusts its offerings to remain competitive. TrustCo’s average yield on this portfolio was 3.65% for 2016 and 3.53% in 2015. This resulted in interest income on home equity credit lines of $12.8 million in 2016, compared to $12.5 million in 2015.

MATURITIES AND SENSITIVITIES OF LOANS TO CHANGE IN INTEREST RATES

(dollars in thousands)		December 31, 2016
		In 1 Year or Less				After 1 Year But Within 5 Years				After 5 Years				Total
Commercial		$	53,704				58,714				70,235				182,653
Real estate construction			24,826				-				-				24,826
Total			78,530				58,714				70,235				207,479
Predetermined rates			33,454				58,714				70,235				162,403
Floating rates			45,076				-				-				45,076
Total		$	78,530				58,714				70,235				207,479

At December 31, 2016 and 2015, the Company had approximately $24.8 million and $26.6 million of real estate construction loans, respectively. Of the $24.8 million in real estate construction loans at December 31, 2016, approximately $16.3 million were secured by first mortgages to residential borrowers with the remaining $8.5 million were loans to commercial borrowers for residential construction projects.  Of the $26.6 million in real estate construction loans at December 31, 2015, approximately $16.0 million were secured by first mortgages to residential borrowers while approximately $10.6 million were to commercial borrowers for residential construction projects.  The vast majority of the Company’s construction loans are in the Company’s New York market.

 

Investment Securities

INVESTMENT SECURITIES

(dollars in thousands)		As of December 31,
		2016								2015								2014
		Amortized Cost				Fair Value				Amortized Cost				Fair Value				Amortized Cost				Fair Value
Securities available for sale:
U. S. government sponsored enterprises		$	119,887				117,266				86,899				86,737				78,420				77,800
State and political subdivisions			873				886				1,270				1,290				2,232				2,271
Mortgage backed securities and collateralized mortgage obligations-residential			378,068				372,308				416,625				411,729				486,107				483,560
Corporate bonds			40,956				40,705				-				-				1,500				1,500
Small Business Adminstration-guaranteed participation securities			81,026				78,499				92,620				90,416				103,273				100,496
Mortgage backed securities and collateralized mortgage obligations-commercial			10,130				10,011				10,422				10,180				10,696.00				10,447.00
Other			650				650				650				650				650				650
Total debt securities available for sale			631,590				620,325				608,486				601,002				682,878				676,724
Equity securities			35				35				35				35				35				35
Total securities available for sale			631,625				620,360				608,521				601,037				682,913				676,759
Held to maturity securities:
Mortgage backed securities and collateralized mortgage obligations-residential			35,500				37,236				46,490				48,798				60,986				64,320
Corporate bonds			9,990				10,290				9,975				10,641				9,960				11,022
Total held to maturity securities			45,490				47,526				56,465				59,439				70,946				75,342
Total investment securities		$	677,115				667,886				664,986				660,476				753,859				752,101

Securities available for sale: The portfolio of securities available for sale is designed to provide a stable source of interest income and liquidity. The portfolio is also managed by the Company to take advantage of changes in interest rates and is particularly important in providing greater flexibility in the current low interest rate environment. The securities available for sale portfolio is managed under a policy detailing the types and characteristics acceptable in the portfolio. Mortgage backed securities and collateralized mortgage obligations held in the portfolio include only pass-throughs issued by United States government agencies or sponsored enterprises.

Holdings of securities issued by states and political subdivisions have declined in recent years, reflecting management’s concern regarding the potential impact of the economy on the financial condition of the issuing entities. Corporate bond holdings increased in 2016 following declines previously.  Improving economic conditions as well as the improved financial condition and performance of corporations following the financial crisis resulted in an improved credit outlook, which resulted in TrustCo’s management reassessing the attractiveness of these securities.  Holdings of both municipal and corporate securities are subject to additional monitoring requirements under current regulations, adding to the costs of owning those securities.

Proceeds from sales, calls and maturities of securities available for sale have been invested in higher yielding assets, such as loans, or temporarily held in Federal Funds sold and other short term investments until deployed to fund future loan growth or future investment opportunities.

The designation of securities as “available for sale” is made at the time of purchase, based upon management’s intent and ability to hold the securities for an indefinite period of time. These securities are available for sale in response to changes in market interest rates, related changes in prepayment risk, needs for liquidity, or changes in the availability of and yield on alternative investments. At December 31, 2016 some securities in this portfolio had fair values that were less than the amortized cost due to changes in interest rates and market conditions and not related to the credit condition of the issuers. At December 31, 2016, the Company did not intend to sell, and it is not likely that the Company will be required to sell these securities before market recovery. Accordingly, at December 31, 2016 the Company did not consider any of the unrealized losses to be other-than-temporary.

At December 31, 2016, the carrying value of securities available for sale amounted to $620.4 million, compared to $601.0 million at year end 2015. For 2016, the average balance of securities available for sale was $627.3 million with an average yield of 1.87%, compared to an average balance in 2015 of $658.0 million with an average yield of 1.95%. The taxable equivalent income earned on the securities available for sale portfolio in 2015 was $11.7 million, compared to $12.9 million earned in 2016.

 

Securities available for sale are recorded at their fair value, with any unrealized gains or losses, net of taxes, recognized as a component of shareholders’ equity. Average balances of securities available for sale are stated at amortized cost. At December 31, 2016, the fair value of TrustCo’s portfolio of securities available for sale carried gross unrealized gains of approximately $136 thousand and gross unrealized losses of approximately $11.4 million. At December 31, 2015, the fair value of the company’s portfolio of securities available for sale carried gross unrealized gains of approximately $469 thousand and gross unrealized losses of approximately $8.0 million. As previously noted, in both periods, unrealized losses were related to market interest rate levels and were not credit related.

Held to Maturity Securities: At December 31, 2016 the Company held $45.5 million of held to maturity securities, compared to $56.5 million at December 31, 2015. For 2016, the average balance of held to maturity securities was $51.0 million, compared to $63.7 million in 2015. Similar to securities available for sale, cash flow from calls and maturities of these securities has been reinvested in higher yielding assets, such as loans, or temporarily held in Federal Funds sold and other short term investments to fund future loan growth or future investment opportunities. The average yield on held to maturity securities increased from 3.86% in 2015 to 4.06% in 2016 as the mix within the portfolio changed due primarily to paydowns and prepayment assumptions on the mortgage-backed securities held in the porfolio. Interest income on held to maturity securities declined from $2.5 million in 2015 to $2.1 million in 2016, reflecting the decline in average balances. Held to maturity securities are recorded at amortized cost. The fair value of these securities as of December 31, 2016 was $47.5 million.

The designation of securities as “held to maturity” is made at the time of purchase, based upon management’s intent and ability to hold the securities until final maturity. At December 31, 2016 none of the securities in this portfolio had fair values that were less than the amortized cost. At December 31, 2016, the Company has the intent and ability to hold these securities until maturity.

Securities Gains: During 2016, TrustCo recognized approximately $668 thousand of net gains from securities transactions, compared to net gains of $251 thousand in 2015 and $717 thousand in 2014. There were no sales or transfers of held to maturity securities in 2016, 2015 and 2014.

TrustCo has not invested in any exotic investment products such as interest rate swaps, forward placement contracts, or other instruments commonly referred to as derivatives. In addition, the Company has not invested in securities backed by subprime mortgages or in collateralized debt obligations (CDOs). By actively managing a portfolio of high quality securities, TrustCo believes it can meet the objectives of asset/liability management and liquidity, while at the same time producing a reasonably predictable earnings stream.

 

SECURITIES PORTFOLIO MATURITY DISTRIBUTION AND YIELD

(dollars in thousands)		As of December 31, 2016
		Maturing:
		Within 1 Year				After 1 But Within 5 Years				After 5 But Within 10 Years				After 10 Years				Total
Debt securities available for sale:
U. S. government sponsored enterprises
Amortized cost		$	5,000				99,887				15,000				-				119,887
Fair Value			4,990				97,779				14,497				-				117,266
Weighted average yield			0.92	%			1.71				1.67				-				1.65
State and political subdivisions
Amortized cost		$	8				799				66				-				873
Fair Value			8				812				66				-				886
Weighted average yield			5.59	%			5.37				5.12				-				5.31
Mortgage backed securities and collateralized mortgage obligations-residential
Amortized cost		$	159				167				377,742				-				378,068
Fair Value			164				189				371,955				-				372,308
Weighted average yield			4.99	%			5.99				2.32				-				2.44
Corporate bonds
Amortized cost		$	-				40,956				-				-				40,956
Fair Value			-				40,705				-				-				40,705
Weighted average yield			-	%			1.46				-				-				1.46
Small Business Administration-guaranteed participation securities
Amortized cost		$	-				-				-				81,026				81,026
Fair Value			-				-				-				78,499				78,499
Weighted average yield			-	%			-				-				2.10				2.10
Mortgage backed securities and collateralized mortgage obligations-commercial
Amortized cost		$	-				10,130				-				-				10,130
Fair Value			-				10,011				-				-				10,011
Weighted average yield			-	%			1.44				-				-				1.44
Other
Amortized cost		$	-				650				-				-				650
Fair Value			-				650				-				-				650
Weighted average yield			-	%			2.25				-				-				2.25
Total securities available for sale
Amortized cost		$	5,167				152,589				392,808				81,026				631,590
Fair Value			5,162				150,146				386,518				78,499				620,325
Weighted average yield			1.05	%			1.65				2.30				2.10				2.17
Held to maturity securities:
Mortgage backed securities and collateralized mortgage obligations-residential
Amortized cost		$	-				-				2,067				33,433				35,500
Fair Value			-				-				2,117				35,119				37,236
Weighted average yield			-	%			-				4.56				5.03				5.00
Corporate bonds
Amortized cost		$	9,990				-				-				-				9,990
Fair Value			10,290				-				-				-				10,290
Weighted average yield			6.14	%			-				-				-				6.17
Total held to maturity securities
Amortized cost		$	9,990				-				2,067				33,433				45,490
Fair Value			10,290				-				2,117				35,119				47,526
Weighted average yield			6.14	%			-				4.56				5.03				5.26

Weighted average yields have not been adjusted for any tax-equivalent factor.

Maturity and call dates of securities: Many of the securities in the Company’s portfolios have a call date in addition to the stated maturity date. Call dates allow the issuer to redeem the bonds prior to maturity at specified dates and at predetermined prices. Normally, securities are redeemed at the call date when the issuer can reissue the security at a lower interest rate. Therefore, for cash flow, liquidity and interest rate management purposes, it is important to monitor both maturity dates and call dates. The level of calls in 2016 was consistent with the 2015 level. The probability of future calls will change depending on market interest rate levels. The tables labeled “Securities Portfolio Maturity and Call Date Distribution,” show the distribution, based on both final maturity and call date of each security, broken out by the available for sale and held to maturity portfolios as of December 31, 2016. Mortgage backed securities and collateralized mortgage obligations are reported using an estimate of average life. Actual maturities may differ from contractual maturities because of securities’ prepayments and the right of certain issuers to call or prepay their obligations without penalty. The table, “Securities Portfolio Maturity Distribution and Yield,” shows the distribution of maturities for each of the securities portfolios, based on final maturity, as well as the average yields at December 31, 2016 on each type/maturity grouping.

 

SECURITIES PORTFOLIO MATURITY AND CALL DATE DISTRIBUTION

Debt securities available for sale:

(dollars in thousands)		As of December 31, 2016
		Based on Final Maturity								Based on Call Date
		Amortized Cost				Fair Value				Amortized Cost				Fair Value
Within 1 year		$	5,167				5,162				120,393				117,779
1 to 5 years			152,589				150,146				363,102				357,841
5 to 10 years			392,808				386,518				148,095				144,705
After 10 years			81,026				78,499				-				-
Total debt securities available for sale		$	631,590				620,325				631,590				620,325

Held to maturity securities:

(dollars in thousands)		As of December 31, 2016
		Based on Final Maturity								Based on Call Date
		Amortized Cost				Fair Value				Amortized Cost				Fair Value
Within 1 year			9,990				10,290				9,990				10,290
1 to 5 years			-				-				33,008				34,446
5 to 10 years			2,067				2,117				2,492				2,790
After 10 years			33,433				35,119				-				-
Total held to maturity securities		$	45,490				47,526				45,490				47,526

Federal Funds Sold and Other Short-term Investments

During 2016, the average balance of Federal Funds sold and other short-term investments was $662.4 million, an increase from $664.5 million in 2015. The average rate earned on these assets was 0.26% in 2015 and 0.50% in 2016. The increase in the average rate in 2016 was due to an increase in the Federal Funds target rate in December 2015.  The increase in the Federal Funds target range that occurred in December 2016 had a minimal impact on the yield for the year because it occurred so late in the year but will be fully realized in 2017. TrustCo utilizes this category of earning assets as a means of maintaining strong liquidity. The Federal Funds sold and other short-term investments portfolio is significantly affected by changes in the target Federal Funds rate, as are virtually all interest-sensitive instruments.

The year-end balance of Federal Funds sold and other short term investments was $658.6 million for 2016, compared to $676.5 million at year end 2015. Yields on investment securities with acceptable risk characteristics were insufficient to justify shifting overnight liquidity into other investment types despite the low return on Federal Funds. Management will continue to evaluate the overall level of the Federal Funds sold and other short-term investments in 2017 and will make appropriate adjustments based upon market opportunities and interest rates.

Funding Sources

TrustCo utilizes various traditional sources of funds to support its earning asset portfolio. The table, “Mix of Average Sources of Funding,” presents the various categories of funds used and the corresponding average balances for each of the last three years.

 

Deposits: Average total deposits were $4.15 billion in 2016, compared to $4.10 billion in 2015, an increase of $45.7 million. Changes in deposit categories (average balances 2016 versus 2015) included: demand deposits up $21.3 million, interest-bearing checking deposits up $56.1 million, savings up $26.9 million, money market down $48.0 million and time deposits down $10.6 million. While many customers remain in one product type for many years, others may move funds between product types to maximize the yield earned or as a result of increased or decreased liquidity needs.  The increase in deposits reflects the impact of new branches opened over the last several years, and the continuing focus at TrustCo on providing core banking services better, faster and cheaper than its competitors.  The increase in time deposits over $250 thousand is not the result of any incentive pricing as TrustCo does not offer premium rates on large certificates of deposit.

MIX OF AVERAGE SOURCES OF FUNDING

(dollars in thousands)														2016 vs.				2015 vs.				Components of Total Funding
		2016				2015				2014				2015				2014				2016				2015				2014
Demand deposits		$	369,820				348,552				319,458				21,268				29,094				8.5	%			8.1				7.7
Retail deposits
Savings			1,272,015				1,245,100				1,227,473				26,915				17,627				29.3				29.0				29.4
Time deposits under $250 thousand			1,018,571				1,075,880				1,066,318				(57,309	)			9,562				23.5				25.1				25.6
Interest bearing checking accounts			764,399				708,331				636,140				56,068				72,191				17.6				16.5				15.3
Money market deposits			580,125				628,096				650,779				(47,971	)			(22,683	)			13.4				14.6				15.6
Total retail deposits			3,635,110				3,657,407				3,580,710				(22,297	)			76,697				83.9				85.3				85.9
Total core deposits			4,004,930				4,005,959				3,900,168				(1,029	)			105,791				92.4				93.4				93.6
Time deposits over $250 thousand			144,271				97,546				78,800				46,725				18,746				3.3				2.3				1.9
Short-term borrowings			185,672				184,725				189,430				947				(4,705	)			4.3				4.3				4.5
Total purchased liabilities			329,943				282,271				268,230				47,672				14,041				7.6				6.6				6.4
Total sources of funding		$	4,334,873				4,288,230				4,168,398				46,643				119,832				100.0	%			100.0				100.0

 

AVERAGE BALANCES, YIELDS AND NET INTEREST MARGINS

(dollars in thousands)		2016												2015												2014
		Average Balance				Interest Income/ Expense				Average Rate				Average Balance				Interest Income/ Expense				Average Rate				Average Balance				Interest Income/ Expense				Average Rate
Assets
Loans, net		$	3,348,324				143,705				4.29	%		$	3,234,806				141,915				4.39	%		$	3,014,156				135,989				4.51	%
Securities available for sale:
U.S. government sponsored enterprises			101,242				1,489				1.47				107,436				1,418				1.32				113,563				1,417				1.25
State and political subdivisions			991				80				8.07				1,812				133				7.40				3,924				280				7.14
Mortgage backed securities and collateralized mortgage obligations-residential			410,646				7,963				1.94				439,343				9,132				2.08				555,430				12,150				2.19
Corporate bonds			17,088				246				1.44				613				1				0.16				3,156				65				2.04
Small Business Administration-guaranteed participation securities			86,407				1,801				2.08				97,496				2,004				2.06				107,029				2,154				2.01
Mortgage backed securities and collateralized mortgage obligations-commercial			10,284				133				1.29				10,566				149				1.41				10,837				151				1.40
Other			683				16				2.34				685				16				2.34				674				16				2.37
Total securities available for sale			627,341				11,728				1.87				657,951				12,853				1.95				794,613				16,233				2.04
Held to maturity securities:
Mortgage backed securities and collateralized mortgage obligations-residential			40,830				1,454				3.56				53,763				1,844				3.43				68,404				2,259				3.30
Corporate bonds			10,145				617				6.08				9,967				615				6.17				9,952				615				6.18
Total held to maturity securities			50,975				2,071				4.06				63,730				2,459				3.86				78,356				2,874				3.67
Federal Reserve Bank and Federal Home
Loan Bank stock			9,554				502				5.25				9,414				467				4.96				10,135				511				5.04
Federal funds sold and other short-term investments			662,436				3,407				0.50				664,516				1,725				0.26				589,873				1,464				0.25
Total interest earning assets			4,698,630				161,413				3.44	%			4,630,417				159,419				3.44	%			4,487,133				157,071				3.50	%
Allowance for loan losses			(44,718	)											(46,023	)											(47,409	)
Cash and noninterest earning assets			136,789												136,752												135,217
Total assets		$	4,790,701											$	4,721,146											$	4,574,941
Liabilities and shareholders' equity
Interest bearing deposits:
Interest bearing checking accounts		$	764,399				473				0.06	%		$	708,331				448				0.06	%		$	636,140				365				0.06	%
Savings			1,272,015				2,148				0.17				1,245,100				2,468				0.20				1,227,473				2,662				0.22
Time deposits and money markets			1,742,967				11,592				0.67				1,801,522				12,067				0.67				1,795,897				11,064				0.62
Total interest bearing deposits			3,779,381				14,213				0.38				3,754,953				14,983				0.40				3,659,510				14,091				0.39
Short-term borrowings			185,672				1,091				0.59				184,725				1,214				0.66				189,430				1,397				0.74
Total interest bearing liabilities			3,965,053				15,304				0.39	%			3,939,678				16,197				0.41	%			3,848,940				15,488				0.40	%
Demand deposits			369,820												348,552												319,458
Other liabilities			27,439												27,155												23,733
Shareholders' equity			428,389												405,761												382,810
Total liabilities and shareholders' equity		$	4,790,701											$	4,721,146											$	4,574,941
Net interest income							146,109												143,222												141,583
Taxable equivalent adjustment							(54	)											(74	)											(130	)
Net interest income							146,055												143,148												141,453
Net interest spread											3.05	%											3.03	%											3.10	%
Net interest margin (net interest income to total interest earnings assets)											3.11												3.09												3.16