Independent Bank Corp. - 10-Q quarterly report FY

 

 

(Exact name of registrant as specified in its charter)

288 Union Street, Rockland, Massachusetts 02370
(Address of principal executive offices, including zip code)

(781) 878-6100
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yesþ   No

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yesþ   No

     As of August 1, 2005, there were 15,395,028 shares of the issuer’s common stock outstanding, par value $0.01 per share.

 

 

The accompanying condensed notes are an integral part of these unaudited consolidated financial statements.

The accompanying condensed notes are an integral part of these unaudited consolidated financial statements.

The accompanying condensed notes are an integral part of these unaudited consolidated financial statements.

The accompanying condensed notes are an integral part of these unaudited consolidated financial statements.

          Independent Bank Corp. (the “Company”) is a state chartered, federally registered bank holding company headquartered in Rockland, Massachusetts incorporated in 1986. The Company is the sole stockholder of Rockland Trust Company (“Rockland” or “the Bank”), a Massachusetts trust company chartered in 1907. The Company also owns 100% of the common stock of Independent Capital Trust III (“Trust III”) and Independent Capital Trust IV (“Trust IV”), each of which have issued trust preferred securities to the public. As of March 31, 2004, Trust III and Trust IV are no longer included in the Company’s consolidated financial statements (see FIN No. 46 discussion withinRecent Accounting Pronouncements Note 3 below). The Bank’s subsidiaries consist of: two Massachusetts securities corporations, RTC Securities Corp. I and RTC Securities Corp. X; Taunton Avenue Inc.; and, Rockland Trust Community Development LLC. Taunton Avenue Inc. was formed in May 2003 to hold loans, industrial development bonds and other assets. Rockland Trust Community Development LLC was formed in August 2003 to make loans and to provide financial assistance to qualified businesses and individuals in low-income communities in accordance with New Markets Tax Credit Program criteria. All material intercompany balances and transactions have been eliminated in consolidation. Certain amounts in prior year financial statements have been reclassified to conform to the current year’s presentation.

     The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements, primarily consisting of normal recurring adjustments, have been included. Operating results for the quarter and six months ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ended December 31, 2005 or any other interim period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission.

     The Company measures compensation cost for stock-based compensation plans as the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted. The Company discloses pro forma net income and earnings per share in the notes to its consolidated financial statements as if compensation was measured at the date of grant based on the fair value of the award and recognized over the service period. Beginning January 1, 2006, the Company will adopt Statement of Financial Accounting Standard (“SFAS”) No. 123 (revised 2004) (“SFAS 123R”), “Share-Based Payment (See discussion which follows in recent accounting pronouncements),” which will require the Company to record compensation measured at the date of grant based on the fair value of the awards and recognized over its requisite service period.

     The Company has four stock option plans: the Amended and Restated 1987 Incentive Stock Option Plan (“The 1987 Plan”), the 1996 Non-employee Directors’ Stock Option Plan (“The 1996 Plan”), the 1997 Employee Stock Option Plan (“The 1997 Plan”), and the 2005 Employee Stock Option Plan (“The 2005 Plan”). All four plans were approved by the Company’s Board of Directors and shareholders. The 2005 Plan was approved by the Company’s Board of Directors on February 10, 2005 and ratified by the Company’s shareholders on April 21, 2005. The 2005 Plan was approved to allow issuance of either stock options or restricted stock awards for up to 800,000 shares of common stock. No awards have been granted from the 2005 Plan to date.

     Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” encourages, but does not require, adoption of a fair-value based method of accounting for employee stock-based compensation plans, where compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period. An entity may continue to apply Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, and related interpretations, whereby compensation cost is the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted, provided the entity discloses the pro forma net income and earnings per share as if the fair-value method had been applied. The Company measures compensation cost for stock-based compensation plans as the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted. Compensation cost is not recognized as the exercise price has historically equaled the grant date fair value of the underlying stock. Had the Company recognized compensation cost for these plans determined as the fair market value of the Company’s stock at the grant date and recognized over the service period, as determined using the Black-Scholes option-pricing model, the Company’s net income and earnings per share would have been reduced to the following pro forma amounts:

     The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants under the 1997 Plan and the 1996 Plan:

     SFAS No. 123 (revised 2004) (“SFAS 123R”), “ Share-Based Payment ” In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004). SFAS No. 123R replaces SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”. SFAS No. 123R will require that the compensation cost relating to share-based payment transactions be recognized in the Company’s financial statements, eliminating pro forma disclosure as an alternative. That cost will be measured based on the grant-date fair value of the equity or liability instruments issued. On April 14, 2005, the SEC issued a press release deferring the compliance date of SFAS 123R, which had an original effective date of the first interim or annual period beginning after June 15, 2005, until the beginning of a company’s next fiscal year for calendar-year companies. For the Company, implementation would therefore be required beginning January 1, 2006. The impact of the Company adopting such accounting can be seen in Note 2, Stock-Based Compensation of the Notes to Consolidated Financial Statements included in Item 1 hereof. The Company estimates the 2006 compensation expense related to share-based payment transactions to be recognized will be approximately $800,000 before tax for the year ending December 31, 2006 for options granted to date upon adoption of SFAS 123R. Management has not yet decided the transition method it will use upon adoption of SFAS 123R nor has it decided the amount or type of share-based compensation to be issued for the remainder of 2005 and beyond.

     FIN No. 46 “Consolidation of Variable Interest Entities – an Interpretation of Accounting Research Bulletin No. 51” In January 2003, the FASB issued FIN No. 46. FIN 46 established accounting guidance for consolidation of variable interest entities (“VIE”) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIEs were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The Company adopted FIN No. 46 as of February 1, 2003 for all arrangements entered into after January 31, 2003.

     In December 2003, the FASB issued a revised FIN No. 46 (“FIN 46R”), which, in part, addressed limited purpose trusts formed to issue trust preferred securities. FIN 46R required the Company to deconsolidate its two subsidiary trusts (Independent Capital Trust III and Independent Capital Trust IV) on March 31, 2004. The result of deconsolidating these trusts was that trust preferred securities of the trusts, which were classified between liabilities and equity on the balance sheet (mezzanine section), no longer appear on the consolidated balance sheet of the Company. The related minority interest expense also no longer is included in the consolidated statement of income. Due to FIN 46R, the junior subordinated debentures of the parent company that were previously eliminated in consolidation are now included on the consolidated balance sheet within total borrowings. The interest expense on the junior subordinated debentures is included in the net interest margin of the consolidated company, negatively impacting the net interest margin by approximately 0.19% on an annualized basis. There is no impact to net income as the amount of interest previously recognized as minority interest is equal to the amount of interest expense that is recognized currently in borrowings expense offset by the dividend income on the subsidiary trusts

common stock that is recognized in other non-interest income. Prior periods were not restated to reflect the changes made by FIN 46R.

     On March 1, 2005, the Board of Governors of the Federal Reserve issued a final ruling amending its risk-based capital standards for bank holding companies to allow continued inclusion of outstanding and prospective issuances of trust preferred securities in Tier 1 capital for regulatory capital purposes subject to quantitative limits applied in the aggregate amount of trust preferred securities and certain other capital elements and qualitative standards. After a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier 1 capital elements, net of goodwill less any associated deferred tax liability. The amount of trust preferred securities and certain other elements in excess of the core capital limit generally will be includable in Tier 2 capital.

     For all other arrangements entered into subsequent to January 31, 2003, the Company adopted FIN 46R as of December 31, 2003. There was no material impact on the Company’s financial position or results of operations.

     Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 105 - “Application of Accounting Principles to Loan Commitments” In March 2004, the SEC issued SAB No. 105. SAB No. 105 summarizes the views of the SEC regarding the application of Generally Accepted Accounting Principles (“GAAP”) to loan commitments for mortgage loans that will be held for sale accounted for as derivatives. The guidance requires the measurement at fair value of such loan commitments include only the differences between the guaranteed interest rate in the loan commitment and a market interest rate; future cash flows related to servicing the loan or the customer relationship should not be recorded as a part of the loan commitment derivative. SAB No. 105 is effective for said loan commitments accounted for as derivatives entered into beginning April 1, 2004. The Company adopted this SAB on April 1, 2004. The adoption of SAB No. 105 did not have a material impact on the Company as the Company was valuing loan commitments to be accounted for as derivatives consistent with this guidance.

     FASB Staff Position (“FSP”) 106-2: “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” In May 2004, the FASB issued FSP 106-2. FSP 106-2 provides guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) for employers that sponsor postretirement health care plans that provide prescription drug benefits that are “actuarially equivalent” to Medicare Part D. It also requires certain disclosures regarding the effect of the Federal subsidy provided by the Act. FSP 106-2 is effective for interim or annual periods beginning after June 15, 2004. The reported measures of net periodic postretirement benefit costs for year to date June 30, 2005 do not reflect any amount associated with the Federal subsidy provided by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) because the Company does not believe that the benefits provided by the postretirement benefit plans that fall under the Act have a material impact upon the Company’s financial statements.

     FASB Emerging Issues Task Force (“EITF”) Issue 03-1: “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” In November 2003 and March 2004, the FASB’s EITF issued a consensus on EITF Issue 03-1. EITF 03-1 contains new guidance on other-than-temporary impairments of investment securities. The guidance dictates when impairment is deemed to exist, provides guidance on determining if impairment is other than temporary, and directs how to calculate impairment loss. Issue 03-1

also details expanded annual disclosure rules. In September 2004, the FASB issued FSP EITF Issue No. 03-1-1 “Effective Date of Paragraphs 10-20 of EITF Issue 03-1 The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, which delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1 to be concurrent with the final issuance of FSP EITF 03-1-a “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1 The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”.

     On June 29, 2005, the FASB met and decided not to provide additional guidance on the meaning of other-than-temporary impairment. The FASB will issue the proposed FSP EITF 03-1-a as final and the final FSP will supersede EITF Issue No. 03-1 and EITF Topic No. D-44, “Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value,” and will replace guidance set forth in paragraphs 10-18 of EITF Issue No. 03-1 with references to existing other-than-temporary impairment guidance. When issued, the final FSP will be titled, “FSP FAS 115-1 “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The new FSP will be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. The adoption of the original EITF 03-1 (excluding paragraphs 10-20) did not have a material impact on the Company’s financial position or results of operations nor does the Company believe that the adoption of FSP FAS 115-1 will have a material impact on the Company’s financial position.

     Statement of Position 03-3 (“SOP 03-3”): “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” In December 2003, the American Institute of Certified Public Accountants (“AICPA”) issued SOP 03-3. SOP 03-3 requires loans acquired through a transfer, such as a business combination, where there are differences in expected cash flows and contractual cash flows due in part to credit quality be recognized at their fair value. The yield that may be accreted is limited to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows over the investor’s initial investment in the loan. The excess of contractual cash flows over expected cash flows is not to be recognized as an adjustment of yield, loss accrual, or valuation allowance. Any future excess of cash flows over the original expected cash flows is to be recognized as an adjustment of future yield. Future decreases in actual cash flow compared to the original expected cash flow are recognized as a valuation allowance and expensed immediately. Valuation allowances can not be created nor “carried over” in the initial accounting for loans acquired in a transfer of loans with evidence of deterioration of credit quality since origination. However, valuation allowances for non-impaired loans acquired in a business combination can be carried over. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004, with early adoption encouraged. The Company does not believe the adoption of SOP 03-3 will have a material impact on the Company’s financial position or results of operations.

     Basic earnings per share (“EPS”) excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that share in the earnings of the entity.

     Earnings per share consisted of the following components for the three and six months ended June 30, 2005 and 2004:

     Options to purchase common stock with an exercise price greater than the average market price of common shares for the period are excluded from the calculation of diluted earnings per share, as their effect on earnings per share would be anti-dilutive. For the three and six months ended June 30, 2005 there were 346,555 and 330,756 shares, respectively, excluded from the calculation of diluted earnings per share. For the three and six months ended June 30, 2004 there were 135,695 and 129,901, respectively, of shares excluded from the calculation of diluted earnings per share.

     The following table illustrates the status of the post-retirement benefit plan and supplemental executive retirement plans (“SERPs”) as of June 30, for the periods presented:

     The Company previously disclosed in its financial statements for the fiscal year ended December 31, 2004 that it expected to contribute $65,000 to its post retirement benefit plan and $124,000 to its SERPs in 2005 and presently anticipates making these contributions. For the three months ended June 30, 2005, $13,000 and $28,000 of contributions have been made to the post retirement benefit plan and the SERPs, respectively, and for the six months ended June 30, 2005, $44,000 and $57,000 of contributions have been made to the post retirement benefit plan and the SERPs, respectively.

     Not included in the above summary are the components of net periodic benefit cost for the noncontributory defined benefit pension plan administered by Pentegra (“the Fund”). The Fund does not segregate the assets or liabilities of all participating employers and, accordingly, disclosure of accumulated vested and non-vested benefits is not possible. The pension plan year is July 1^st through June 30^th. The Company anticipates that contributions paid to the defined benefit pension plan will be $1.2 million beginning in the third quarter of 2005 related to the 2005-2006 plan year. Contributions for the 2004-2005 plan year were all paid in 2004. Pension expense was $1.8 million for the year 2004 and is expected to be $2.2 million for the full year 2005 of which $596,000 has been recognized for the three months ended June 30, 2005 and $1.1 million has been recognized year to date.

     Both wholesale and retail repurchase agreements are collateralized by mortgage-backed securities and U.S. Government obligations. At June 30, 2005, the Company had $25.0 million securities of repurchase agreements outstanding with third party brokers and $62.0 million of customer repurchase agreements outstanding. The related securities are included in the securities available for sale.

     Information on the Company’s comprehensive income (loss), presented net of taxes, is set forth below for the three and six months ended June 30, 2005 .

     The following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the Securities and Exchange Commission.

     A number of the presentations and disclosures in this Form 10-Q, including, without limitation, statements regarding the level of allowance for loan losses, the rate of delinquencies and amounts of charge-offs, and the rates of loan growth, and any statements preceded by, followed by, or which include the words “may,” “could,” “should,” “will,” “would,” “hope,” “might,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “assume” or similar expressions constitute forward-looking statements.

     These forward-looking statements, implicitly and explicitly, include the assumptions underlying the statements and other information with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business, including the Company’s expectations and estimates with respect to the Company’s revenues, expenses, earnings, return on equity, return on assets, efficiency ratio, asset quality and other financial data and capital and performance ratios.

     Although the Company believes that the expectations reflected in the Company’s forward-looking statements are reasonable, these statements involve risks and uncertainties that are subject to change based on various important factors (some of which are beyond the Company’s control). The following factors, among others, could cause the Company’s financial performance to differ materially from the Company’s goals, plans, objectives, intentions, expectations and other forward-looking statements:

     If one or more of the factors affecting the Company’s forward-looking information and statements proves incorrect, then the Company’s actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Form 10-Q. Therefore, the Company cautions you not to place undue reliance on the Company’s forward-looking information and statements.

     The Company does not intend to update the Company’s forward-looking information and statements, whether written or oral, to reflect change. All forward-looking statements attributable to the Company are expressly qualified by these cautionary statements.

     The Company’s results of operations are largely dependent on net interest income, which is the difference between the interest earned on loans and securities and interest paid on deposits and borrowings. The results of operations are also affected by the level of income/fees from loans, deposits, mortgage banking, and investment management activities, as well as operating expenses, the provision for loan losses, the impact of federal and state income taxes, and the relative levels of interest rates and economic activity.

     The Company reported strong earnings growth during the quarter. Net income for the quarter ended June 30, 2005 was $8.0 million, an increase of 21.5% from the same period last year. Strong growth in both loans and deposits as well as a stabilized net interest margin contributed significantly to the quarter’s growth in earnings.

* In the 3^rd Quarter of 2004, the Company acquired $96.9 million of loans, resulting from the Falmouth Bancorp, Inc. acquisition.

* In the 3^rd Quarter of 2004, the Company acquired $136.7 million in deposits, resulting from the Falmouth Bancorp, Inc. acquisition.

     * The net interest margin of the Company was negatively impacted by 0.19% on an annualized basis due to the adoption of Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities - An Interpretation of ARB No. 51” (see Recent Accounting Pronouncements, Fin No. 46 in Item 1 hereof) effective March 31, 2004. The net interest margin for prior periods shown above have not been adjusted to reflect the adoption of this interpretation.

     While changes in the prevailing interest rate environment have and will continue to have an impact on the level of the Company’s earnings, management strives to mitigate volatility in net interest income resulting from changes in benchmark interest rates by adjustable rate asset generation, effective liability management and off-balance sheet interest rate derivatives, illustrated in Table 8 – Interest Rate Sensitivity and the discussion to follow within the Market Risk section of the management discussion and analysis.

     Looking ahead to the remainder of 2005, the Company expects the quarterly net interest margin to expand in to the high 3.80%’s for the remainder of the year, with deposit pricing being a key determinant. Competition for deposit generation in the Company’s footprint remains strong.

     Asset quality continues to be a highlight for the Company’s strong performance and is not anticipated to change significantly in the near term.

     Management plans to continue to grow earnings through prudent asset growth, increasing deposit originations, generating growth in non-interest income, and non-interest expense control. As previously reported, there are a number of initiatives that are expected to contribute in 2005 and beyond. The Company’s continued success in 2005 will be predicated upon the disciplined execution and the careful monitoring of the Strategic Plan that has been put in place.

A number of the objectives in 2005 are:

     Management believes that its commitment and execution of the objectives outlined above will be critical to continuing to deliver strong financial performance.

     Loan Portfolio Total loans increased by $93.8 million, or 4.9%, during the six months ended June 30, 2005. The increases were mainly in commercial loans which increased $50.5 million, or 5.6%, in total with commercial construction representing the largest growth of $23.7 million, or 18.7%. Commercial real estate loans increased by $22.7 million, or 3.7%, and commercial and industrial loans increased $4.1 million, or 2.6%. Consumer loans in total increased $36.4 million, or 6.9% primarily due to growth in variable Home Equity lending. The Consumer- Auto loan portfolio decreased by $2.4 million, or 0.85%, during the six months ended June 30, 2005 as this segment of the loan portfolio has been de-emphasized due to narrowing spreads. Business banking loans totaled $48.7 million, representing growth of 11.6% during the six months ending June 30, 2005. Residential loans increased $1.9 million, or 0.4% during the first six months.

     Asset Quality Rockland Trust Company actively manages all delinquent loans in accordance with formally drafted policies and established procedures. In addition, Rockland Trust Company’s Board of Directors reviews delinquency statistics, by loan type, on a monthly basis.

     Delinquency The Bank’s philosophy toward managing its loan portfolios is predicated upon careful monitoring which stresses early detection and response to delinquent and default situations. The Bank seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. Generally, the Bank requires that a delinquency notice be mailed to a borrower upon expiration of a grace period (typically no longer than 15 days beyond the due date). Reminder notices and telephone calls may be issued prior to the expiration of the grace period. If the delinquent status is not resolved within a reasonable time frame following the mailing of a delinquency notice, the Bank’s personnel charged with managing its loan portfolios, contacts the borrower to ascertain the reasons for delinquency and the prospects for payment. Any subsequent actions taken to resolve the delinquency will depend upon the nature of the loan and the length of time that the loan has been delinquent. The borrower’s needs are considered as much as reasonably possible without jeopardizing the Bank’s position. A late charge is usually assessed on loans upon expiration of the grace period.

     On loans secured by one-to-four family owner-occupied properties, the Bank attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure action. If such efforts do not result in a satisfactory arrangement, the loan is referred to legal counsel whereupon counsel initiates foreclosure proceedings. At any time prior to a sale of the property at foreclosure, the Bank may and will terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan. On loans secured by commercial real estate or other business assets, the Bank similarly seeks to reach a satisfactory payment plan so as to avoid foreclosure or liquidation.

     The following table sets forth a summary of certain delinquency information as of the dates indicated:

     Nonaccrual Loans As permitted by banking regulations, consumer loans and home equity loans past due 90 days or more continue to accrue interest. In addition, certain commercial and real estate loans that are more than 90 days past due may be kept on an accruing status if the loan is well secured and in the process of collection. As a general rule, a commercial or real estate loan more than 90 days past due with respect to principal or interest is classified as a nonaccrual loan. Income accruals are suspended on all nonaccrual loans

and all previously accrued and uncollected interest is reversed against current income. A loan remains on nonaccrual status until it becomes current with respect to principal (and in certain instances remains current for up to three months) and interest, when the loan is liquidated, or when the loan is determined to be uncollectible and is charged-off against the allowance for loan losses.

     Nonperforming Assets Nonperforming assets are comprised of nonperforming loans, nonperforming securities and other real estate owned (“OREO”). Nonperforming loans consist of nonaccrual loans and loans that are more than 90 days past due but still accruing interest. OREO includes properties held by the Bank as a result of foreclosure or by acceptance of a deed in lieu of foreclosure. Nonperforming assets totaled $2.1 million at June 30, 2005 (0.07% of total assets), as compared to the $2.7 million (0.09% of total assets) reported at December 31, 2004. The Company’s allowance for loan losses to nonperforming loans is 1,241.07% as compared to 932.53% at December 31, 2004 and the Company maintained an allowance to loan ratio of 1.30% at June 30, 2005 compared to 1.31% at December 31, 2004. The Bank held no OREO property on June 30, 2005 or December 31, 2004 and all securities were performing.

     Repossessed automobile loan balances continue to be classified as nonperforming loans, and not as other assets, because the borrower has the potential to satisfy the obligation within twenty days from the date of repossession (before the Bank can schedule disposal of the collateral). The borrower can redeem the property by payment in full at any time prior to the disposal of it by the Bank. Repossessed automobile loan balances amounted to $490,000, $703,000 and $462,000 for the periods ending June 30, 2005, December 31, 2004, and June 30, 2004, respectively.

     The following table sets forth information regarding nonperforming assets held by the Company at the dates indicated.

     In the course of resolving nonperforming loans, the Bank may choose to restructure the contractual terms of certain commercial and real estate loans. Terms may be modified to fit the ability of the borrower to repay in line with the current financial status. It is the Bank’s policy to maintain restructured loans on nonaccrual status for approximately six months before management considers a return to accrual status. At June 30, 2005, the Bank had $397,000 of restructured loans. At June 30, 2005, the Bank also had 32 potential problem loans which were not included in nonperforming loans with an outstanding balance of $23.2 million. Potential problem loans are any loans, which are not included in nonaccrual or non-performing loans and which are not considered troubled debt restructures, where known information about possible credit problems of the borrowers causes management to have concerns as to the ability of such borrowers to comply with present loan repayment terms .

     Real estate acquired by the Bank through foreclosure proceedings or the acceptance of a deed in lieu of foreclosure is classified as OREO. When property is acquired, it is recorded at the lesser of the loan’s remaining principal balance or the estimated fair value of the property acquired, less estimated costs to sell. Any loan balance in excess of the estimated fair value less estimated cost to sell on the date of transfer is charged to the allowance for loan

losses on that date. All costs incurred thereafter in maintaining the property, as well as subsequent declines in fair value are charged to non-interest expense.

     Interest income that would have been recognized for the three months ended June 30, 2005 and June 30, 2004, if nonperforming loans at the respective dates had been performing in accordance with their original terms, approximated $47,000 and $68,000, respectively. Interest income that would have been recognized for the six months ended June 30, 2005 and June 30, 2004, if nonperforming loans at the respective dates had been performing in accordance with their original terms, approximated $113,000 and $158,000, respectively. The actual amount of interest that was collected on nonaccrual and restructured loans during the three months ended June 30, 2005 and June 30, 2004 and included in interest income was $13,000 and $78,000, respectively. The actual amount of interest that was collected on nonaccrual and restructured loans during the six months ended June 30, 2005 and June 30, 2004 and included in interest income was $44,000 and $119,000, respectively.

     A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, commercial real estate, and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

     Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer or residential loans for impairment disclosures. At June 30, 2005, impaired loans include all commercial real estate loans and commercial and industrial loans on nonaccrual status, restructured loans and certain potential problem loans for which a collateral deficit exists and a specific allocation of allowance for loan loss has been assigned. Total impaired loans at June 30, 2005 and December 31, 2004 were $1.6 million and $2.6 million, respectively.

     Allowance For Loan Losses While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on increases in non-performing loans, changes in economic conditions, or for other reasons. Various regulatory agencies, as an integral part of their examination processes, periodically review the Company’s allowance for loan losses. The Federal Deposit Insurance Corporation (“FDIC”) regulators examined the Company during the first quarter of 2005.

     The allowance for loan losses is maintained at a level that management considers adequate to provide for potential loan losses based upon evaluation of known and inherent risks in the loan portfolio. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and is reduced by loans charged-off. Additionally, in 2004 the Bank’s allowance increased by $869,000 upon acquisition of Falmouth Bancorp, Inc.

This increase represents management’s estimate of potential inherent losses in the acquired portfolio.

     As of June 30, 2005, the allowance for loan losses totaled $26.1 million, or 1.30%, of total loans as compared to $25.2 million, or 1.31%, of total loans at December 31, 2004. Based on the analyses described herein, management believes that the level of the allowance for loan losses at June 30, 2005 is adequate.

     The following table summarizes changes in the allowance for possible loan losses and other selected loan data for the periods presented:

     The allowance for loan losses is allocated to various loan categories as part of the Bank’s process of evaluating its adequacy. The amount of allowance allocated to these loan categories was $22.7 million at June 30, 2005, compared to $22.4 million at December 31, 2004. The distribution of allowances allocated among the various loan categories as of June 30, 2005 was categorically similar to the distribution as of December 31, 2004. Increases or decreases in the amounts allocated to each category, as compared to those shown as of December 31, 2004, generally, reflect changes in portfolio balances outstanding due to new loan originations, loans paid off, changes in levels of credit line usage and the results of ongoing credit risk assessments of the loan portfolio.