Chemung Financial Corporation - 10-Q quarterly report FY

Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the inherent uncertainty in evaluating the level of the allowance required to cover probable credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions, the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a sig nificant impact on the overall analysis of the adequacy of the allowance for loan losses. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses.

Financial Condition

Consolidated assets at March 31, 2007 totaled $750.1 million, an increase of $12.0 million or 1.6% since December 31, 2006. As discussed in greater detail below, this increase is reflected primarily in a $18.6 million increase in loans, net of deferred fees and costs and unearned income, and a $2.6 million increase in cash and cash equivalents, these increases somewhat offset primarily by a $7.0 million decrease in investment securities and a $1.5 million decrease in other assets.

As noted above, total loans, net of deferred fees and costs and unearned income increased $18.6 million or 3.9% from December 31, 2006 to March 31, 2007. Activity in all segments of the portfolio was strong during the first quarter of 2007 with total consumer loans increasing $8.7 million, and residential mortgages and commercial loans (including commercial mortgages) increasing $6.5 million and $3.4 million, respectively. The increase in total consumer loans was reflected primarily in higher installment loan balances of $7.2 million, as well as increases in student loan and term home equity balances of $2.0 million and $1.0 million, respectively, these increases somewhat offset primarily by a $1.3 million decrease in revolving home equity balances.

The composition of the loan portfolio is summarized as follows:

The available for sale segment of the securities portfolio totaled $177.9 million at March 31, 2007, down approximately $7.0 million or 3.8% from December 31, 2006. At amortized cost, the available for sale portfolio was down approximately $7.2 million, with unrealized appreciation related to the available for sale portfolio increasing $207 thousand. The decrease in this portfolio was primarily due to maturities of municipal bonds and paydowns on mortgage-backed securities, resulting in decreases of $2.2 million and $3.7 million, respectively, as well as the maturity during the quarter of a $1.3 million corporate bond. The held to maturity portion of the portfolio, consisting primarily of local municipal obligations, was virtually unchanged from December 31, 2006.

A $354 thousand decrease in Federal Home Loan Bank and Federal Reserve Bank stock is primarily due to net redemptions of shares by the Federal Home Loan Bank of New York ("FHLB").

Other significant changes since December 31, 2006 include a $2.6 million increase in cash and cash equivalents as explained under the "Liquidity and Capital Resources" section of this discussion, and a $1.5 million decrease in other assets. This decrease was primarily due to the sale during the quarter of a property previously foreclosed upon and held in Other Real Estate Owned ("OREO").

Since December 31, 2006, total deposits have increased $16.9 million or 2.9% from $585.1 million to $602.0 million. Non-interest bearing demand deposits were down $5.4 million due to a decline in period-end non-personal balances. A $22.3 million increase in interest bearing balances was reflected primarily in a $17.9 million increase in time deposits, due in large part to an increase in municipal deposits. Additionally, at quarter-end, NOW account balances were up $2.1 million, and savings and insured money market balances increased $1.2 million and $1.1 million, respectively.

Cash flow from the increase in deposits, as well as the decrease in securities was used to fund the above noted loan growth, as well as to reduce borrowings under our line of credit with the FHLB, which were down $7.9 million since December 31, 2006.

Asset Quality

Non-performing loans at March 31, 2007 totaled $3.106 million as compared to $3.610 million at December 31, 2006, a decrease of $504 thousand, reflected primarily in a $482 thousand decrease in non-accrual loans. This reduction resulted primarily from the upgrade of two commercial relationship totaling $357 thousand from non-accrual to accruing status during the quarter, principal payments on other non-accruing commercial loans totaling $380 thousand and a $106 thousand decrease in non-accruing mortgages. These reductions were somewhat offset primarily by the addition of $357 thousand of commercial loans to non-accrual status. A $1.1 million decrease in Other Real Estate Owned was due to the sale during the quarter of a commercial property previously acquired through foreclosure proceedings.

The following table summarizes the Corporation's non-performing assets:

In addition to non-performing loans, as of March 31, 2007, the Corporation has identified 15 commercial loan relationships totaling $11.9 million in potential problem loans, as compared to $12.0 million (15 commercial loan relationships) at December 31, 2006. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms, and which may result in the disclosure of such loans as non-performing at some time in the future. At the Corporation, potential problem loans are typically loans that are performing but are classified in the Corporation's loan rating system as "substandard". Management cannot predict the extent to which economic conditions may worsen or other factors may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 da ys or more past due, be placed on non-accrual, become restructured, or require increased allowance coverage and provisions for loan losses.

Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the historical loan loss experience, review of specific problem loans (including evaluation of the underlying collateral), changes in the composition and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrowers' ability to pay. The provision for loan losses during the first quarter of 2007 totaled $125 thousand, unchanged from the first quarter of 2006. At March 31, 2007, the Corporation's allowance for loan losses totaled $8.110 million, resulting in a coverage ratio of allowance to non-performing loans of 261.1%. The allowance for loan losses is an amount that management believes will be adequate to absorb probable loan losses on existing loans. During the first quarter of 2007, the Corporation realized net recoveries of $2 thousand as compared to net charge-offs of $70 thousand during the fir st quarter of 2006. This improvement is in large part due to net commercial loan recoveries of $45 thousand, as during the quarter we received payments totaling $162 thousand related to the balance of a commercial mortgage that had been charged off during 2006. Additionally, net consumer loan charge-offs were $28 thousand lower than those recorded during the first quarter of 2006. The allowance for loan losses to total loans at March 31, 2007 was 1.63% as compared to 1.67% as of December 31, 2006.

Activity in the allowance for loan losses was as follows:

Despite a 5 basis point decrease in net interest margin from 3.71% to 3.66%, net interest income increased $43 thousand or 0.7% from $6.076 million in the first quarter of 2006 to $6.119 million in the first quarter of 2007. This increase resulted from a $13.6 million or 2.0% increase in average earning assets as compared to the first quarter 2006 average, offset to some extent by the effect of a continuing inverted yield curve, as a 46 basis point increase in the average yield from 5.76% to 6.22% was exceeded by a 64 basis point increase in the average cost of interest bearing liabilities from 2.76% to 3.40%. The increase in average earning assets was due to a $59.1 million increase in average loans and a $2.2 million increase in average federal funds sold, offset primarily by a $47.7 million decrease in the average securities portfolio. The increase in average loans reflects growth in all segments of the loan portfolio, with average mortgages increasing $36.8 million, and average consumer loans and comm ercial loans increasing $12.7 million and $9.6 million, respectively. The decrease in average securities has been impacted by the inverted yield curve, and the resulting inability to leverage quality securities purchases at acceptable interest rate spreads.

Total average funding liabilities, including non-interest bearing demand deposits, increased $23.4 million or 3.7% compared to first quarter 2006 averages, as a $44.7 million increase in average deposits was somewhat offset primarily by a $15.5 million decrease in average term repurchase agreements funded by the FHLB, and a $6.9 million decrease in average overnight borrowings under the Corporations line of credit with the FHLB. While average non-interest bearing demand deposits increased $8.1 million, average interest bearing deposits were up $36.6 million. The increase in interest bearing deposits was reflected primarily in higher average time deposits and insured money market deposits of $38.2 million and $8.7 million, respectively, somewhat offset by an $8.3 million decrease in average savings account balances and a $2.0 million decrease in average NOW accounts. The decrease in average securities sold under agreements to repurchase reflects the maturity or call of advances since March of last year tha t had been utilized to leverage securities purchases. While average interest bearing liabilities increased $15.2 million or 3.1%, interest expense increased $917 thousand or 27.3%, as the average cost of interest bearing liabilities rose 64 basis points from 2.76% to 3.40%, reflective of the fact that the increase in average deposits was primarily due to an increase in higher cost time and insured money market deposits.

The $125 thousand provision for loan losses was unchanged from the first quarter of 2006.

Non-interest income during the first quarter of 2007 compared to the first quarter of 2006 increased $560 thousand or 17.3%. This increase was impacted to a great extent by a $464 thousand gain on the sale of a property held in OREO that had previously been acquired through foreclosure proceedings. Other significant increases include a $39 thousand increase in revenue from other OREO properties, as well as increases in credit card merchant earnings and revenue generated through CFS Group, Inc. of $32 thousand and $24 thousand, respectively. The aforementioned increases were offset to some extent primarily by a $55 thousand decrease in service charges due in large part to a decrease in fee income related to checks presented against insufficient funds.

First quarter operating expenses were $419 thousand or 6.0% higher than the comparable period last year. Areas having the greatest impact on this increase include a $363 thousand increase in salaries and wages, an $88 thousand increase in marketing and advertising costs and a $73 thousand increase in net occupancy expenses. The increase in salaries and wages reflects higher base pay associated with additions to staff during the second half of 2006, merit increases effective in January of this year, as well as an increase in incentive compensation. Marketing and advertising expenses have been impacted by higher costs related to agency production and design, and television and radio advertising. The net occupancy expense increase reflects higher depreciation expense, real estate taxes and buildings and grounds maintenance costs. The above increases were somewhat offset primarily by a $229 thousand decrease in pension and other employee benefit costs due to decreases in pension and postretirement medical e xpense accruals. A $225 thousand reduction in pension expense resulted primarily from an increase in the expected return on plan assets associated with the Corporation's $10 million contribution to this plan in the fourth quarter of 2006. Postretirement medical expenses decreased $103 thousand, the result of plan changes effective July 1, 2006. These reductions were offset primarily by higher payroll taxes and employee health insurance costs.

An $81 thousand increase in income tax expense was primarily due to the $184 thousand increase in pre-tax income, as well as a reduction in tax exempt income, with the effective tax rate increasing from 28.6% in the first quarter of 2006 to 29.8% in the first quarter of this year.

Average Consolidated Balance Sheet and Interest Analysis (dollars in thousands)

The following table sets forth for the periods indicated, a summary of the changes in interest and dividends earned and interest paid resulting from changes in volume and changes in rates (in thousands of dollars):

Liquidity and Capital Resources

Liquidity management involves the ability to meet the cash flow requirements of deposit customers, borrowers, and the operating, investing, and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings.

The Corporation is a member of the Federal Home Loan Bank of New York ("FHLB") which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. At March 31, 2007, the Corporation maintained a $144.4 million line of credit with the FHLB, as compared to $141.5 million at March 31, 2006.

During the first three months of 2007, cash and cash equivalents increased $2.6 million as compared to an increase of $7.2 million during the first three months of 2006. In addition to cash provided by operating activities, other primary sources of cash during the first three months of 2007 included a $16.9 million increase in deposits, $7.5 million from maturities and other principal payments on securities, a $3.0 million increase in securities sold under agreements to repurchase and proceeds from the sale of other real estate owned totaling $1.5 million. Proceeds from the above were used primarily to fund a $16.6 million net increase in loans, a $7.9 million reduction in advances from the FHLB, payment of cash dividends totaling $849 thousand, purchases of premises and equipment of $462 thousand, and purchases of securities and treasury stock in the amounts of $310 thousand and $311 thousand, respectively.

In addition to cash provided by operating activities, other primary sources of cash during the first three months of 2006 included a $49.7 million increase in deposits, $16.2 million from maturities and other principal payments on securities and $1.9 million in net redemptions of FHLB and Federal Reserve Bank stock. Proceeds from the above were used primarily to fund a $16.0 million net increase in loans, a $22.8 million decrease in securities sold under agreements to repurchase, an $18.0 million reduction in FHLB advances, the payment of cash dividends in the amount of $864 thousand, purchases of premises and equipment totaling $691 thousand, and purchases of securities and treasury shares in the amounts of $287 thousand and $486 thousand, respectively.

Since December 31, 2006, the Corporation's total shareholders' equity has increased from $81.8 million to $82.7 million, primarily reflected in the $852 thousand increase in retained earnings.

As of March 31, 2007, the Corporation's consolidated leverage ratio was 10.65%. The Tier I and Total Risk Adjusted Capital ratios were 15.00% and 16.94%, respectively. All of the above ratios are in excess of the requirements for being considered "well capitalized" by the FDIC, the Federal Reserve and the New York State Banking Department.

When shares of the Corporation become available in the market, we may purchase them after careful consideration of our capital position. On November 15, 2006, the Corporation's Board of Directors authorized the repurchase of up to 180,000 shares, or approximately 5% of its then outstanding common shares, either through open market or privately negotiated transactions over a two-year period. During the first quarter of 2007, the Corporation purchased 9,683 shares at an average price of $32.11 per share. As of March 31, 2007, a total of 21,483 shares had been purchased since the inception of the announced repurchase program. Additionally during the first quarter of 2007, 7,334 shares were re-issued from treasury to fund the stock component of directors' 2006 compensation.

Interest Rate Risk

As intermediaries between borrowers and savers, commercial banks incur both interest rate risk and liquidity risk. The Corporation's Asset/Liability Committee ("ALCO") has the strategic responsibility for setting the policy guidelines on acceptable exposure to these areas. These guidelines contain specific measures and limits regarding these risks, which are monitored on a regular basis. The ALCO is made up of the vice chairman of the board, president and chief executive officer, two executive vice presidents, chief financial officer, asset liability management officer, senior marketing officer, and others representing key functions.

The ALCO is also responsible for supervising the preparation and annual revisions of the financial segments of the annual budget, which is built upon the committee's economic and interest-rate assumptions. It is the responsibility of the ALCO to modify prudently the Corporation's asset/liability policies.

Interest rate risk is the risk that net interest income will fluctuate as a result of a change in interest rates. It is the assumption of interest rate risk, along with credit risk, that drives the net interest margin of a financial institution. For that reason, the ALCO has established tolerance limits based upon a 200-basis point change in interest rates. At March 31, 2007, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the next 12 months net interest income by 3.21% and an immediate 200-basis point increase would negatively impact the next 12 months net interest income by 3.28%. Both are within the Corporation's policy guideline of 15% established by ALCO.

A related component of interest rate risk is the expectation that the market value of our capital account will fluctuate with changes in interest rates. This component is a direct corollary to the earnings-impact component: an institution exposed to earnings erosion is also exposed to shrinkage in market value. At March 31, 2007, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the market value of our capital account by 6.83% and an immediate 200-basis point increase in interest rates would negatively impact the market value by 5.54%. Both are within the established tolerance limit of 15%.

Management does recognize the need for certain hedging strategies during periods of anticipated higher fluctuations in interest rates and the Board-approved Funds Management Policy provides for limited use of certain derivatives in asset liability management. These strategies were not employed during the first three months of 2007.

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Information required by this Item is set forth herein in Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Interest Rate Risk."

Item 4: Controls and Procedures

The Corporation's management, under the supervision and with the participation of our President and Chief Executive Officer, who is the Corporation's principal executive officer, and our Treasurer and Chief Financial Officer, who is the Corporation's principal financial officer, has evaluated the effectiveness of the Corporation's disclosure controls and procedures as of March 31, 2007. Based upon that evaluation, the President and Chief Executive Officer and the Treasurer and Chief Financial Officer have concluded that the Corporation's disclosure controls and procedures are effective as of March 31, 2007.

There were no significant changes in the Corporation's internal control over financial reporting that occurred during the Corporation's most recent fiscal quarter that have materially affected, or that are reasonably likely to materially affect, the Corporation's internal control over financial reporting.