Chemung Financial Corporation - 10-Q quarterly report FY

CHEMUNG FINANCIAL CORPORATION AND SUBSIDIARIES

INDEX

The available for sale segment of the securities portfolio totaled $197.9 million at June 30, 2006, compared to $232.9 million at the end of 2005, a decrease of approximately $35.0 million or 15.0%. At amortized cost, the available for sale portfolio was down approximately $31.4 million. Federal agency bonds declined $20.0 million, as during the first six months of 2006, $20.0 million of bonds were called. Other major factors in this decrease included a $9.5 million decrease in mortgage-backed securities and a $1.9 million decrease in municipal bonds. The decrease in mortgage-backed securities reflects paydowns received during the first half of 2006. A $3.6 million decrease in unrealized appreciation related to the available for sale portfolio reflects the impact of higher mid to long-term interest rates on bond portfolio values. The held to maturity portion of the portfolio, consisting primarily of local municipal obligations, totaled approximately $8.6 million at both June 30, 2006 and December 31, 2 005.

A $1.7 million 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, 2005 included a $2.6 million increase in other assets, a $1.2 million increase in premises and equipment, net, and a $3.0 million decrease in cash and cash equivalents. The $2.6 million increase in other assets reflects higher net deferred tax assets as well as an increase in Other Real Estate Owned ("OREO"). The increase in premises and equipment resulted primarily from renovations to the property housing the new Ithaca Station office, which was opened during the second quarter of 2006, as well as ongoing investments in equipment. The above noted increases were partially offset by the $3.0 million decrease in cash and cash equivalents resulting primarily from decreases in federal transit items and branch cash levels.

Since December 31, 2005, total deposits have increased $34.3 million or 6.5% from $524.9 million to $559.2 million. While non-interest bearing demand deposits were down $909 thousand, interest-bearing deposits increased $35.2 million. Approximately $18.5 million of the increase in interest-bearing deposits was in public fund balances, principally reflected in higher time deposit and insured money market balances. The balance of the increase in interest-bearing balances was due primarily to higher personal time deposit balances and non-personal insured money market balances, offset to some extent primarily by lower period-end personal savings and insured money market balances. A $24.7 million decrease in securities sold under agreements to repurchase reflects the fact that during the first six months of this year, repurchase agreement advances from the FHLB totaling $19.0 million matured, and repurchase agreement advances totaling $7.5 million were called. Additionally, a $10.0 million long term advance from the FHLB was called.

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

In addition to non-performing loans, as of June 30, 2006, the Corporation has identified 16 commercial loan relationships totaling $9.7 million in potential problem loans, as compared to $9.3 million (15 commercial loan relationships) at December 31, 2005. 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 days 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. With the level of non-performing relationships having declined, the Corporation has reduced its provision for loan losses during the first half of 2006 to $125 thousand as compared to $650 thousand during the first half of 2005. At June 30, 2006, the Corporation's allowance for loan losses totaled $9.264 million, resulting in a coverage ratio of allowance to non-performing loans of 133.8%. The allowance for loan losses is an amount that management believes will be adequate to absorb probable loan losses on existing loans. Net loan charge-offs for the first six months of 2 006 totaled $639 thousand as compared to $246 thousand during the first six months of 2005, this increase primarily due to a $402 thousand increase in net commercial loan charge-offs. The allowance for loan losses to total loans at June 30, 2006 was 2.05% as compared to 2.34% as of December 31, 2005.

Despite a $9.4 million increase in average earning assets as compared to the second quarter of 2005, net interest income was down $105 thousand or 1.7% from $6.199 million to $6.094 million, as the net interest margin declined 12 basis points from 3.78% to 3.66%. This reduction has been impacted by rising short term interest rates and a flat yield curve, with a 48 basis point increase in yield on earning assets from 5.42% to 5.90%, offset by an 82 basis point increase in the cost of interest bearing liabilities from 2.19% to 3.01%. The increase in average earning assets was due to a $46.6 million increase in average loans offset by a $35.3 million decrease in the average securities portfolio and a $1.9 million decrease in average federal funds sold and interest bearing deposits. The increase in average loans reflects growth in all segments of the loan portfolio, with average mortgages increasing $17.3 million, and average consumer loans and commercial loans increasing $16.6 million and $12.7 million, resp ectively. The decrease in average securities has been impacted by the flat 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 $9.6 million or 1.5% compared to second quarter 2005 averages, as a $48.8 million increase in average deposits and a $6.9 million increase in average overnight borrowings under the Corporations line of credit with the FHLB, were partially offset by a $33.8 million decrease in average term repurchase agreements funded by the FHLB and a $12.9 million decrease in average term advances from the FHLB. While average non-interest bearing demand deposits increased $6.7 million, average interest bearing deposits were up $42.1 million. The increase in interest bearing liabilities was reflected primarily in higher average time deposits and insured money market deposits of $48.1 million and $7.2 million, respectively, somewhat offset primarily by an $8.8 million decrease in average savings account balances. The decreases in average securities sold under agreements to repurchase and term advances from the FHLB reflects the mat urity or call of advances that had been utilized to leverage securities purchases. While average interest bearing liabilities increased $2.9 million or 0.6%, interest expense increased $1.033 million or 38.5%, as the average cost of interest bearing liabilities rose 82 basis points from 2.19% to 3.01%, reflective of the fact that the increase in average deposits was primarily due to an increase in higher cost time deposits.

As discussed more fully under the Asset Quality section of this report, the $325 thousand decrease in the provision for loan losses reflects the adequacy of the allowance for loan losses and the continuing decline in non-performing loans.

Non-interest income during the second quarter of 2006 compared to the second quarter of 2005 increased $470 thousand or 14.5%. This increase was impacted to a great extent by a $205 thousand increase in service charges on deposit accounts as well as a $94 thousand increase in revenue from the Corporation's equity investment in Cephas Capital Partners, LP ("Cephas"), and a $91 thousand increase in revenue generated by Other Real Estate Owned ("OREO"), these being properties acquired through foreclosure proceedings. The increase in service charges was primarily due to an increase in fees for insufficient funds, as this fee was increased during the first quarter of 2006. The increase in revenue from Cephas was due primarily to an increase in realized gains on the sale of equity positions taken in companies to which Cephas had provided financing. The increase in revenue generated by OREO was due primarily to the operation of a golf course which the Corporation acquired through foreclosure in the first quarter of this year. While this property is for sale, management determined that the marketability of the course would be enhanced by its ongoing operation as opposed to sitting vacant. Additionally, the revenue generated through the operation of the course has helped to offset maintenance costs which would have been incurred whether or not the golf course was in operation. In addition to the above, other significant increase included a $49 thousand increase in Trust and Investment Center fee income and a $30 thousand increase in debit card interchange income.

Second quarter 2006 operating expenses were $595 thousand or 8.9% higher than the comparable period last year. Areas having the greatest impact on this increase include a $242 thousand increase in costs associated with OREO, a $143 thousand increase in salaries and wages, a $119 thousand increase in net occupancy costs and a $114 thousand increase in data processing and software costs. The increase in OREO expense is due primarily to the above mentioned operation of the golf course acquired through foreclosure. The salary increase was impacted by merit increases effective in January of 2006 as well as increased compensation costs related to the Corporation's expansion into the New York State counties of Tompkins and Broome. The increase in net occupancy costs was impacted to a great extent by the above mentioned expansion, while the increase in data processing and software costs was principally related to higher software maintenance and license costs, an increase in Trust and Investment Center data proce ssing fees and an increase in debit and credit card merchant processing costs. The above mentioned increases were somewhat offset primarily by a $111 thousand decrease in pension and other employee benefits, primarily due to reductions in post-retirement medical benefits and health insurance expenses, offset to some extent primarily by increases in pension costs and payroll taxes. A $94 thousand decrease in post-retirement medical benefits resulted from an amendment to this plan during the second quarter of this year. Prior to this amendment, all retirees age 55 and older were eligible for coverage under the Corporation's self insured plan, contributing 40% of the cost of the coverage. Under the new plan, coverage for retirees age 65 and older who reside in the designated plan area is provided under a group plan offered through Blue Cross, Blue Shield called Medicare Blue PPO, with the retiree paying 100% of the cost of coverage. Current retirees age 65 and older who reside outside of the designated are a, as well as current and future retirees between the ages of 55 and 65 will continue to be eligible for coverage under our self insured plan, with the retiree contribution increasing from 40% to 50%. These plan changes have resulted in an approximate $220 thousand reduction in our estimated 2006 expense, half of which was recognized during the second quarter of 2006.

A $47 thousand increase in income tax expense resulted from both a $95 thousand increase in pre-tax income, and an increase in the effective tax rate from 27.6% in the second quarter of 2005 to 28.4% in the second quarter of 2006.

Year-To-Date 2006 vs. Year-To-Date 2005

Net income for the six-month period ended June 30, 2006 totaled $3.393 million, an increase of $65 thousand or 2.0% as compared to net income of $3.328 million for the six month period ended June 30, 2005. Earnings per share were up 3.3% from $0.90 per share to $0.93 per share on 50,162 fewer average shares outstanding. Similar to second quarter results, this increase in year-to-date income resulted primarily from an increase in non-interest income and a reduction in the provision for loan losses, somewhat offset by higher operating expenses and a decrease in net interest income.

With net interest income and margin contracting in the second quarter, year-to-date net interest income compared to the first six months of last year has decreased $29 thousand or 0.2% from $12.200 million to $12.171 million, with the net interest margin down 3 basis points from 3.72% to 3.69%. Average earning assets increased $5.2 million or 0.8%, as an increase in average loans of $42.0 million was offset by decreases in the average securities portfolio and federal funds sold and interest bearing deposits of $22.3 million and $14.4 million, respectively. The $42.0 million increase in average loans reflects growth in all segments of the loan portfolio with average consumer loans increasing $14.1 million, average commercial loans up $14.0 million and average mortgages increasing $13.9 million. As mentioned above, the decrease in the average securities portfolio has been impacted by the flat yield curve and resulting inadequate spreads available on these investments. While average earning assets increased 0.8%, total interest and dividend income increased $1.772 million or 10.1%, as the yield rose 49 basis points from 5.34% to 5.83%.

Total average funding liabilities for the six month period ended June 30, 2005 increased $5.2 million or 0.8% when compared to the first six months of last year, the result of a $32.3 million increase in average deposits, as well as an $11.3 million increase in average short term borrowings under the Corporation's line of credit with the FHLB. These increases were somewhat offset primarily by decreases in average securities sold under agreements to repurchase funded by the FHLB and term advances from the FHLB totaling $29.7 million and $9.0 million, respectively. The increase in average deposits was greatly impacted by a $34.6 million increase in average time deposits, as these deposits represented a significant funding source for average loan growth during the first six months of this year. In addition to this increase, average demand deposits and insured money market balances were up $6.3 million and $3.2 million respectively, offset by decreases in average savings balances of $8.0 million, and interest - -bearing Now accounts of $3.9 million. As was noted above, the decreases in average securities sold under agreements to repurchase and term advances from the FHLB reflects the maturity or call of advances that had been utilized to leverage securities purchases. While average interest bearing liabilities decreased $1.1 million or 0.2%, total interest expense increased $1.801 million or 34.1%, as the average cost of interest bearing liabilities increased 74 basis points to 2.88%, impacted primarily by an 86 basis point increase in the cost of interest bearing deposits.

As noted above and discussed more fully under the Asset Quality section of this report, with the level of non-performing loans declining, and given the adequacy of the Corporation's allowance for loan losses, the provision for loan losses during the first six months of this year totaled $125 thousand as compared to $650 thousand during the first half of 2005, a decrease of $525 thousand.

Non-interest income for the first half of 2006 increased $765 thousand or 12.4% when compared to the comparable period of 2005. The major factors behind this increase were the same as reported under the second quarter results, with the most significant factors including a $375 thousand increase in service charges on deposit accounts and a $139 thousand increase in revenue from our equity investment in Cephas. As was the case with second quarter results, other areas affecting this increase included a $92 thousand increase in revenue generated from the operation of OREO, as well as increases in Trust and Investment Center fee income and debit card interchange income of $87 thousand and $64 thousand, respectively.

Operating expenses for the first six months of this year increased $1.119 million or 8.5% compared to the corresponding period in 2005. As was the case with the second quarter operating expense increase, and for reasons discussed above, the areas having the greatest impact on this increase include a $242 thousand increase in costs associated with OREO, a $294 thousand increase in salaries and wages, a $215 thousand increase in net occupancy costs and a $261 thousand increase in data processing and software costs. The above mentioned increases were somewhat offset primarily by a $111 thousand decrease in pension and other employee benefits, primarily due to reductions in post-retirement medical benefits and health insurance expenses, offset to some extent primarily by increases in pension costs and payroll taxes.

Income taxes for the first six months of 2006 were $76 thousand higher than last year. This increase reflects an increase in pre-tax income of $141 thousand as well as an increase in the effective tax rate from 27.7% to 28.5%.

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):

Cash generated during the first six months of 2006 was used primarily to fund a net increase in loans of $38.4 million, reduce securities sold under agreements to repurchase by $24.7 million and retire $10.0 million of term advances from the FHLB. Other significant uses of cash during this period included purchases of premises and equipment of $2.5 million, the payment of cash dividends totaling $1.7 million, and the purchase of treasury shares totaling $1.1 million. Cash generated during the first six months of 2005 was used primarily to fund the purchase of securities totaling $43.1 million, a net increase in loans of $23.5 million, and to reduce securities sold under agreements to repurchase by $17.2 million. Other significant uses of cash during this period included the payment of cash dividends totaling $1.8 million, the purchase of treasury shares totaling $1.5 million and purchases of premises and equipment of $1.1 million.

Since year-end 2005, the Corporation's total shareholders' equity has decreased from $81.2 million to $79.5 million. This decrease is primarily reflected in a $2.2 million decrease in accumulated other comprehensive income, reflecting a decrease in net after-tax unrealized gains on available for sale securities. The decrease was also impacted by a $907 thousand increase in treasury stock, offset primarily by a $1.7 million increase in retained earnings.

As of June 30, 2006, the Corporation's consolidated leverage ratio was 10.67%. The Tier I and Total Risk Adjusted Capital ratios were 15.46% and 17.45%, 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 17, 2004, the Corporation announced that its Board of Directors authorized the repurchase of up to 180,000 shares, or approximately 5% of its outstanding common shares, either through open market or privately negotiated transactions over a two-year period. During the first six months of 2006, the Corporation purchased 38,148 shares at an average price of $29.77 per share. As of June 30, 2006, a total of 118,013 shares had been purchased since the inception of the announced repurchase program. Additionally during the first half of 2006, 9,156 shares were re-issued from treasury to fund the stock component of directors' 2005 compensation as well as distributions under the Corporation's directors' deferred stock plan.

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 chief executive officer, president, 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 June 30, 2006, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the next 12 months net interest income by 2.02% and an immediate 200-basis point increase would negatively impact the next 12 months net interest income by 3.88%. 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 June 30, 2006, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the market value of our capital account by 1.95% and an immediate 200-basis point increase in interest rates would negatively impact the market value by 6.13%. 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 six months of 2006.

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 June 30, 2006. 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 June 30, 2006.

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.