UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004
Commission File Number 0-26481
Registrant’s Telephone Number Including Area Code:
(585) 786-1100
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 twelve months (or for such shorter period that the Registrant was required to file reports) and (2) has been subject to such requirements for the past 90 days. YES[X] NO[ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES[X] NO[ ]
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
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FINANCIAL INSTITUTIONS, INC.
INDEX
Item 1. Financial Statements (Unaudited)
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
See Accompanying Notes to Unaudited Consolidated Financial Statements.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)
(1) Basis of Presentation
Financial Institutions, Inc. (“FII”), a bank holding company organized under the laws of New York State, and subsidiaries (the “Company”) provides deposit, lending and other financial services to individuals and businesses in Central and Western New York State. FII and subsidiaries are each subject to regulation by certain federal and state agencies.
The consolidated financial statements include the accounts of FII and its four banking subsidiaries, Wyoming County Bank (99.65% owned) (“WCB”), National Bank of Geneva (100% owned) (“NBG”), First Tier Bank & Trust (100% owned) (“FTB”) and Bath National Bank (100% owned) (“BNB”), collectively referred to as the “Banks”. During 2003, the Company disclosed that the Boards of Directors of its two national bank subsidiaries, NBG and BNB, entered into agreements with their primary regulator, the Office of the Comptroller of the Currency (“OCC”). Under the terms of the agreements, NBG and BNB, without admitting any violations, have taken actions designed to assure that their operations are in accordance with applicable laws and regulations. On July 23, 2004, the OCC sent “15-day letters” to certain current and former directors and officers of NBG, notifying them that the OCC is considering an administrative action against them, such as reprimand or civil money penalty, arising out of violations of law identified in the September 30, 2002 Report of Examination, and providing them an opportunity to submit information prior to the commencement of any administrative action. Four NBG directors and one officer who received such letters submitted a response on September 9, 2004. NBG’s By-Laws provide that, to the fullest extent permitted by law, it shall indemnify directors and officers made a party to an administrative proceeding, provided that the acts of the indemnified party that are the subject of the proceeding were not committed in bad faith, were not the result of dishonesty, and did not result in personal gain. Federal law prohibits indemnifying directors for fines and civil money penalties, but indemnification is permitted under certain circumstances for legal and professional expenses. The five individuals who participated in the joint response to the “15-day letters” that was submitted on September 9, 2004 have transmitted their legal bills to NBG for payment.
The Company also has two financial services subsidiaries: The FI Group, Inc. (“FIGI”) and the Burke Group, Inc. (“BGI”), collectively referred to as the “Financial Services Group” (“FSG”). FIGI is a brokerage subsidiary that commenced operations as a start-up company in March 2000. BGI is an employee benefits and compensation consulting firm acquired by the Company in October 2001. During 2003, the Company terminated its financial holding company status to operate instead as a bank holding company. The change in status did not affect the non-financial subsidiaries or activities being conducted by the Company, although future acquisitions or expansions of non-financial activities may require prior Federal Reserve Board approval and will be limited to those that are permissible for bank holding companies.
In February 2001, the Company formed FISI Statutory Trust I (“FISI” or “Trust”) (100% owned) and capitalized the trust with a $502,000 investment in FISI’s common securities. The Trust was formed to accommodate the private placement of $16.2 million in capital securities (“trust preferred securities”), the proceeds of which were utilized to partially fund the acquisition of BNB. Effective December 31, 2003, the provisions of FASB Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities,” resulted in the deconsolidation of the Company’s wholly-owned Trust. The deconsolidation resulted in the derecognition of the $16.2 million in trust preferred securities and the recognition of $16.7 million in junior subordinated debentures and a $502,000 investment in the subsidiary trust recorded in other assets in the Company’s consolidated statements of financial condition.
In management’s opinion, the interim consolidated financial statements reflect all adjustments necessary for a fair presentation. The results of operations for the interim periods are not necessarily indicative of the results of operation to be expected for the full year ended December 31, 2004. The interim consolidated financial statement should be read in conjunction with the Company’s 2003 Annual report on Form 10K. The consolidated financial information included herein consolidates the results of operations,
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the assets, liabilities and shareholders’ equity of the Company and its subsidiaries. All significant inter-company transactions and balances have been eliminated in consolidation. Amounts in the prior year’s consolidated financial statements are reclassified when necessary to conform to the current year’s presentation.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America and prevailing practices in the banking industry. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities, and the reported revenues and expenses for the period. Actual results could differ from those estimates.
(2) Stock Compensation Plans
The Company uses a fixed award stock option plan to compensate certain key members of management of the Company and its subsidiaries. The Company accounts for issuance of stock options under the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under APB No. 25, compensation expense is recorded on the date the options are granted only if the current market price of the underlying stock exceeded the exercise price. SFAS No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans. As allowed under SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above and has adopted only the disclosure requirements of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock — Based Compensation – Transition and Disclosure.”
Had the Company recognized compensation cost based on the fair value method under SFAS No. 123, the Company’s net income and earnings per share would have been as follows:
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(3) Earnings Per Common Share
Basic earnings per share, after giving effect to preferred stock dividends, has been computed using weighted average common shares outstanding. Diluted earnings per share reflect the effects, if any, of incremental common shares issuable upon exercise of dilutive stock options.
Earnings per common share have been computed based on the following:
There were stock options totaling 222,427 and 52,057 for the three months ended September 30, 2004 and 2003, respectively that were not considered in the calculation of diluted earnings per share since the stock options’ exercise price was greater than the average market price during these periods. There were stock options totaling 139,785 and 82,974 for the nine months ended September 30, 2004 and 2003, respectively that were not considered in the calculation of diluted earnings per share since the stock options’ exercise price was greater than the average market price during these periods.
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(4) Segment Information
Reportable segments are comprised of WCB, NBG, BNB, FTB and the Financial Services Group. The reportable segment information is as follows:
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(5) Retirement Plans and Postretirement Benefits
The Company participates in The New York State Bankers Retirement System, which is a defined benefit pension plan covering substantially all employees. The benefits are based on years of service and the employee’s highest average compensation during five consecutive years of employment. The Company’s funding policy is to contribute at least the minimum funding requirement as determined actuarially to cover current service cost plus amortization of prior service costs.
Net periodic pension cost consists of the following components:
The Company contributed $1,406,000 to the pension plan on August 31, 2004.
The Company’s BNB subsidiary has a postretirement benefit plan that provides health and dental benefits to eligible retirees. The plan was amended in 2001 to curtail eligible benefit payments to only retired employees and active participants who were fully vested under the plan. Expense for the plan amounted to $54,000 and $142,000 for the nine months ended September 30, 2004 and 2003, respectively.
(6) Commitments and Contingencies
In the normal course of business, the Company has outstanding commitments to extend credit not reflected in the Company’s consolidated financial statements. The commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. The Company uses the same credit policy to make such commitments as it uses for on-balance-sheet items. Unused lines of credit and loan commitments totaling $253.4 million and $271.9 million were contractually available at September 30, 2004 and December 31, 2003, respectively. Since commitments to extend credit and unused lines of credit may expire without being fully drawn upon, the amount does not necessarily represent future cash commitments.
The Company guarantees the obligations or performance of customers by issuing stand-by letters of credit to third parties. The risk involved in issuing stand-by letters of credit is essentially the same as the credit risk involved in extending loan facilities to customers, and they are subject to the same credit origination, portfolio maintenance and management procedures in effect to monitor other credit and off-balance sheet products. Typically, these instruments have terms of five years or less and expire unused; therefore, the amount does not necessarily represent future cash requirements. Standby letters of credit totaled $11.1 million and $11.8 million at September 30, 2004 and December 31, 2003, respectively. As of September 30, 2004, the fair value of the standby letters of credit was not material to the Company’s consolidated financial statements.
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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
GENERAL
The principal objective of this discussion is to provide an overview of the financial condition and results of operations of Financial Institutions, Inc. and its subsidiaries for the periods covered in this quarterly report. This discussion and tabular presentations should be read in conjunction with the accompanying consolidated financial statements and accompanying notes.
Income. The Company’s results of operations are dependent primarily on net interest income, which is the difference between the income earned on loans and securities and the cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the provision for loan losses, service charges on deposits, financial services group fees and commissions, mortgage banking activities, gain or loss on the sale or call of investment securities and other miscellaneous income.
Expenses. The Company’s noninterest expenses primarily consist of salaries and employee benefits, occupancy and equipment, supplies and postage, amortization of intangible assets, computer and data processing, professional fees, other miscellaneous expense and income tax expense. Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, government policies and the actions of regulatory authorities.
OVERVIEW
Net income was $5.1 million, or $0.42 per share (diluted), and $4.1 million, or $0.33 per share (diluted), for the quarter ended September 30, 2004 and 2003, respectively. Return on average common equity (annualized) for the quarter ended September 30, 2004 was 11.36%, compared to 8.70% for the same period a year ago. Return on average assets (annualized) for the three months ended September 30, 2004 was 0.94%, compared to 0.75% for the same period a year ago.
Net income was $13.3 million, or $1.08 per share (diluted), and $12.0 million, or $0.97 per share (diluted), for the nine months ended September 30, 2004 and 2003, respectively. Return on average common equity (annualized) for the nine months ended September 30, 2004 was 9.79%, compared to 8.73% for the same period a year ago. Return on average assets (annualized) for the nine months ended September 30, 2004 was 0.81%, compared to 0.74% for the same period a year ago.
The improved earnings during 2004 is due primarily to a decrease in the provision for loan losses, which was $2.1 million for the third quarter of 2004 and $9.5 million for the nine months ended September 30, 2004 compared to $5.6 million for the third quarter 2003 and $14.2 million for the nine months ended September 30, 2003.
Net interest income, the principal source of the Company’s earnings, was $19.2 million for the third quarter of 2004 compared to $18.5 million for the same quarter last year. Net interest margin was 3.98% for the three months ended September 30, 2004, an increase of 12 basis points from the 3.86% level for the same quarter last year. Net interest income was $56.4 million for the nine months ended September 30, 2004 compared to $56.6 million for the same period last year. Net interest margin for the nine months ended September 30, 2004 was 3.88%, a drop of 7 basis points from 3.95% for the nine months ended September 30, 2003.
As the Company has been actively working to reduce credit risk in the loan portfolio and implement more stringent underwriting requirements, its loan origination processes have slowed. The Company has made investments in people and processes to provide for a stronger credit and sales culture within the organization. The Company is in the process of expanding its loan origination staff, providing additional training on the new credit processes and increasing sales training activities in an effort to grow the loan portfolio. On October 13, 2004, the Company announced the appointment of James T. Rudgers as Senior Vice President and Chief of Community Banking. In that position, Mr. Rudgers will oversee and support the management of the Company’s four banking subsidiaries.
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CRITICAL ACCOUNTING POLICIES
The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and are consistent with predominant practices in the financial services industry. Application of critical accounting policies, those policies that Management believes are the most important to the Company’s financial position and results, requires Management to make estimates, assumptions, and judgments that affect the amounts reported in the consolidated financial statements and accompanying notes and are based on information available as of the date of the financial statements. Future changes in information may affect these estimates, assumptions, and judgments, which, in turn, may affect amounts reported in the financial statements.
The Company has numerous accounting policies, of which the most significant are presented in Note 1 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K as of December 31, 2003, dated March 12, 2004, as filed with the Securities and Exchange Commission. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets, liabilities, revenues and expenses are reported in the financial statements and how those reported amounts are determined. Based on the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, Management has determined that the accounting policies with respect to the allowance for loan losses and goodwill require particularly subjective or complex judgments important to the Company’s financial position and results of operations, and, as such, are considered to be critical accounting policies as discussed below.
Allowance for Loan Losses: Arriving at an appropriate level of allowance involves a high degree of judgment. The Company’s allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Management uses historical information to assess the adequacy of the allowance for loan losses and considers the prevailing business environment, as it is affected by changing economic conditions and various external factors, which may impact the loan portfolio. Management also uses a loan risk rating system as well as current portfolio performance to determine the allowance. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and reduced by loans charged-off.
Goodwill: SFAS No. 141 requires that the purchase method of accounting be used for all business combinations and further clarifies the criteria for the initial recognition and measurement of intangible assets separate from goodwill. SFAS No. 142 prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. The provisions of SFAS No. 142 discontinue the amortization of goodwill and intangible assets with indefinite lives. Instead, these assets are subject to at least an annual impairment review, and more frequently if certain impairment indicators are in evidence. Changes in the estimates and assumptions used to evaluate impairment may have a material impact on the Company’s consolidated financial statements or results of operations. SFAS No. 142 also requires that reporting units be identified for the purpose of assessing impairment of goodwill.
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FORWARD LOOKING STATEMENTS
This report contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), that involve substantial risks and uncertainties. When used in this report, or in the documents incorporated by reference herein, the words “anticipate”, “believe”, “estimate”, “expect”, “intend”, “may”, “project”, “plan”, “seek” and similar expressions identify such forward-looking statements. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. These forward-looking statements are based on the current expectations of the Company or the Company’s management and are subject to a number of risks and uncertainties, including but not limited to, economic, competitive, regulatory, and other factors affecting the Company’s operations, markets, products and services, as well as expansion strategies and other factors discussed elsewhere in this report filed by the Company with the Securities and Exchange Commission. Many of these factors are beyond the Company’s control.
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SELECTED FINANCIAL DATA
The following tables present certain information and ratios that management of the Company considers important in evaluating performance:
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SELECTED FINANCIAL DATA (CONTINUED)
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NET INCOME ANALYSIS
Average Balance Sheets
The tables on the following pages set forth certain information relating to the Company’s consolidated statements of financial condition and reflects the average yields earned on interest-earning assets, as well as the average rates paid on interest-bearing liabilities as of and for the periods presented. Dividing interest income or interest expense by the average balances of interest-earning assets or interest-bearing liabilities, respectively, derived such yields and rates. Tax equivalent adjustments have been made. All average balances are average daily balances. Nonaccrual loan balances are included in the yield calculations in these tables.
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Net Interest Income
Net interest income, the principal source of the Company’s earnings, increased $0.7 million or 4% in the third quarter of 2004 to $19.2 million compared to $18.5 million in the third quarter of 2003. Net interest margin was 3.98% for the third quarter of 2004, an increase of 12 basis points from 3.86% for the same period last year. The increase in net interest income is the result of a $0.7 million drop in interest income being more than offset by a $1.4 million decline in interest expense. The change in interest income is a result of decreases attributed to changes due to rate of $0.8 million with only a $0.1 million increase in changes due to volume offsetting the rate changes. The change in interest expense is a result of decreases attributed to changes in rate of $1.3 million and decreases attributed to changes in volume of $0.1 million.
Net interest income for the nine months ending September 30, 2004 was $56.4 million compared to $56.6 million for the nine months ending September 30, 2003. Net interest margin was 3.88% for the nine months ended September 30, 2004, a drop of 7 basis points from 3.95% for the same period last year. Interest income declined $5.2 million while interest expense declined $5.0 million when comparing the first nine months of 2004 with 2003. The change in interest income is a result of decreases attributed to changes due to rate of $5.5 million with only a $0.3 million increase in changes due to volume offsetting the rate changes. The change in interest expense is a result of decreases attributed to changes in rate of $4.9 million and decreases attributed to changes in volume of $0.2 million.
Increases in market interest rates during the third quarter of 2004 have had a positive effect on net interest margin, as the increase in rates had a favorable impact on earning asset yields without increasing funding costs. However, the recent market rate increase is expected to have a greater impact on funding costs in the future. Comparing the third quarter of 2004 with the third quarter of 2003, the Company’s average loans declined $94.0 million and average deposits increased $35.7 million, the principal factors leading to the $111.5 million increase in average investment securities and federal funds sold. Yields on loan assets are generally higher than yields on investment securities and federal funds sold, so the shift in earning asset mix to a lower percentage of loans and higher percentage of investment securities and federal funds sold had an adverse effect on earning asset yields. This change in mix together with the overall drop in market interest rates resulted in a decline in earning asset yields of 16 basis points from 5.58% in the third quarter of 2003 to 5.42% in the third quarter of 2004. Offsetting this decline was a drop of 32 basis points in the cost of interest bearing liabilities. The 16 basis point drop in earning asset yield coupled with the 32 basis point drop in the cost of interest bearing liabilities resulted in net interest spread improving 16 basis points to 3.69% in the third quarter of 2004 compared to 3.53% in the third quarter of 2003.
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Rate/Volume Analysis
The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to: (i) changes attributable to changes in volume (changes in volume multiplied by current year rate); (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume); and (iii) the net change. The changes attributable to the combined impact of volume and rate have been allocated proportionately to the changes due to volume and the changes due to rate.
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Provision for Loan Losses
The provision for loan losses for the third quarter of 2004 totaled $2.1 million, a decrease of $3.5 million compared to the $5.6 million provision for loan losses for the third quarter of 2003. The provision for the nine months ended September 30, 2004 totaled $9.5 million, a decrease of $4.7 million compared to the $14.2 million provision for the same period last year. The decrease in the provision for loan losses on both a quarter-to-date and year-to-date basis is primarily a result of a reduced level of impaired loans requiring specific allocations. See further discussion of the Analysis of the Allowance for Loan Losses.
Noninterest Income
Noninterest income decreased 10% in the third quarter of 2004 to $6.4 million from $7.1 million for the third quarter of 2003, and increased 1% in the first nine months of 2004 to $19.5 million from $19.3 million for the same period last year. The third quarter decline was partially attributed to the lower volume of residential mortgage loans sold in the current quarter relative to the historically high levels of refinancing activity in 2003. Higher income from service fees reflects FII’s expanding portfolio of products provided to its customers throughout its four-bank service territory. This increase in income from service fees, financial services group fees and commissions and other income mostly offset the decline in gain on securities compared with last year’s third quarter.
Noninterest Expense
Noninterest expense for the third quarter of 2004 totaled $16.4 million compared with $14.9 million for the third quarter of 2003. Noninterest expense for the nine months ended September 30, 2004 increased to $47.9 million compared to $45.4 million for the same period last year. The primary component of noninterest expense is salaries and benefits, which totaled $9.2 million for the third quarter of 2004 and $8.5 million for the third quarter of 2003. Salaries and benefits for the nine months ended September 30, 2004 increased to $27.4 million compared to $25.4 million for the same period last year. The increase in salaries and benefits relates primarily to additional lending and credit administration staff. The company also experienced an increase in professional fees during the current year. Professional fees totaled $1.0 million and $0.4 million for the three months ended September 30, 2004 and 2003, respectively. Professional fees totaled $2.1 million and $1.5 million for the nine months ended September 30, 2004 and 2003, respectively. The increases were primarily attributable to consulting fees surrounding the reorganization of loan operations and compliance with the Sarbanes-Oxley Act of 2002, as well as higher legal fees related to credit collection. The additional noninterest expenses, coupled with a slowing of revenue growth, were the principal factors in the rise in the Company’s efficiency ratio to 60.82% for the quarter ended September 30, 2004, compared to 55.30% for the same quarter last year, and 60.49% for the nine months ended September 30, 2004, compared to 55.87% for the same period a year ago.
Income Tax Expense
The provision for income taxes provides for Federal and New York State income taxes and amounted to $2.0 million and $1.1 million for the third quarter of 2004 and 2003, respectively. The provision amounted to $5.1 million and $4.3 million for the nine months ended September 30, 2004 and 2003. The effective tax rate increased during the third quarter of 2004 to 27.7%, compared to 20.7% for the third quarter of 2003. The third quarter of 2003 effective tax rate of 20.7% was lower than normal due primarily to lower net income before income taxes, which resulted primarily from the increase in provision for loan losses. The effective tax rates are more comparable on a year-to-date basis at 27.8% for the first nine months of 2004, versus 26.3% for the first nine months of 2003.
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ANALYSIS OF FINANCIAL CONDITION
Lending Activities
Loan Portfolio Composition Set forth below is selected information regarding the composition of the Company’s loan portfolio at the dates indicated.
Total gross loans decreased $77.9 million to $1.267 billion at September 30, 2004 from $1.345 billion at December 31, 2003. Commercial loans decreased $34.6 million to $213.7 million or 16.9% of the portfolio at September 30, 2004 from $248.3 million or 18.4% at December 31, 2003. Agricultural loans decreased $37.5 million, to $197.7 million at September 30, 2004 from $235.2 million at December 31, 2003. The decline in loans relates to decreased loan production coupled with loan charge-offs, pay-offs and refinances with other institutions a result of the Company working to reduce credit risk in the loan portfolio. The expansion of the loan origination staff and additional training on the new credit processes combined with expanded sales training activities is expected to contribute to future growth of the loan portfolio. Included in agricultural loans were $100.1 million in loans to dairy farmers, or 7.9% of the total loan portfolio at September 30, 2004 compared to $119.3 million or 8.9% of the total loan portfolio at December 31, 2003. Loans held for sale totaled $1.9 million at September 30, 2004, comprised of residential mortgages of $1.4 million and student loans of $0.5 million. Loans held for sale totaled $4.9 million as of December 31, 2003, comprised of residential mortgages of $3.1 million and student loans of $1.8 million.
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Nonaccruing Loans and Nonperforming Assets
The following table provides information regarding nonaccruing loans and other nonperforming assets at the dates indicated.
Nonperforming assets at September 30, 2004 declined to $49.7 million, compared with $52.1 million at December 31, 2003 and compared to $51.9 million at September 30, 2003. During the third quarter of 2004, the Company received $3.0 million in payments on nonaccrual loans and $0.5 million of nonaccrual loans were returned to accruing status. Also during the third quarter, the Company charged-off $1.9 million in loans that were on nonaccrual status at June 30, 2004 and transferred $6.2 million in loans to nonaccrual status. The Company has focused considerable resources on working to reduce the level of nonperforming assets in the most cost effective manner. The Company has also made investments in people and processes to provide for a stronger credit and sales culture within the organization.
The following table details nonaccrual loan activity for the periods indicated.
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Potential problem loans are loans that are currently performing, but information known about possible credit problems of the borrowers causes management to have doubt as to the ability of such borrowers to comply with the present loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. Management evaluates loans classified as substandard, which continue to accrue interest, to be potential problem loans. The Company identified $114.5 million and $104.8 million in loans that continued to accrue interest which were classified as substandard as of September 30, 2004 and June 30, 2004, respectively. These loans remain in a performing status due to a variety of factors, including payment history, the value of collateral supporting the credits, and personal or government guarantees.
Analysis of the Allowance for Loan Losses
The allowance for loan losses represents the estimated amount of probable credit losses inherent in the Company’s loan portfolio. The Company performs periodic, systematic reviews of each Banks’ loan portfolios to estimate probable losses in the respective loan portfolios. In addition, the Company regularly evaluates prevailing economic and business conditions, industry concentrations, changes in the size and characteristics of the portfolio and other pertinent factors. The process used by the Company to determine the overall allowance for loan losses is based on this analysis, taking into consideration management’s judgment. Allowance methodology is reviewed on a periodic basis and modified as appropriate. Based on this analysis the Company believes the allowance for loan losses is adequate at September 30, 2004.
The following table sets forth the activity in the allowance for loan losses for the periods indicated.
Net loan charge-offs were $1.9 million for the third quarter of 2004 or 0.60% (annualized) of average loans compared to $3.1 million or 0.89% (annualized) of average loans in the same period last year. The ratio of the allowance for loan losses to nonperforming loans was 65% at September 30, 2004, compared
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to 56% at December 31, 2003 and 57% at September 30, 2003. The ratio of the allowance for loan losses to total loans increased to 2.46% at September 30, 2004, compared to 2.16% at December 31, 2003 and 2.12% a year ago.
Investing Activities
The Company’s total investment security portfolio increased $109.9 million to $762.0 million as of September 30, 2004 compared to $652.1 million as of December 31, 2003. The largest increase was in mortgage-backed securities, which increased $75.7 million as detailed below. The investment security increase corresponds with the increase in deposits and decrease in loans since year-end, as the Company invested excess cash and cash equivalents in investment securities. Further detail regarding the Company’s investment portfolio follows.
U.S. Treasury and Agency Securities
At September 30, 2004, the U.S. Treasury and Agency securities portfolio totaled $239.4 million, all of which was classified as available for sale. The portfolio is comprised entirely of U. S. federal agency securities of which approximately 90% are callable securities. These callable securities provide higher yields than similar securities without call features. At September 30, 2004 included in callable securities are $104.7 million of structured notes all of which are step callable agency debt issues. The step callable bonds step-up in rate at specified intervals and are periodically callable by the issuer. At September 30, 2004, the structured notes had a current average coupon of 4.06% that adjust on average to 6.40% within four years. At December 31, 2003, the U.S. Treasury and Agency securities portfolio totaled $211.9 million, all of which was classified as available for sale.
State and Municipal Obligations
At September 30, 2004, the portfolio of state and municipal obligations totaled $250.3 million, of which $209.5 million was classified as available for sale. At that date, $40.8 million was classified as held to maturity, with a fair value of $41.5 million. At December 31, 2003, the portfolio of state and municipal obligations totaled $242.5 million, of which $195.4 million was classified as available for sale. At that date, $47.1 million was classified as held to maturity, with a fair value of $48.1 million.
Mortgage-Backed Securities
Mortgage-backed securities, all of which were classified as available for sale, totaled $268.4 million and $192.7 million at September 30, 2004 and December 31, 2003, respectively. The portfolio was comprised of $187.1 million of mortgage-backed pass-through securities, $70.6 million of collateralized mortgage obligations (CMOs) and $10.7 million of other asset-backed securities at September 30, 2004. The mortgage backed pass-through securities were predominantly issued by government sponsored enterprises (FNMA, FHLMC, or GNMA). Approximately 87% of the mortgage-backed pass-through securities were in fixed rate securities that were most frequently formed with mortgages having an original balloon payment of five or seven years. The adjustable rate agency mortgage-backed securities portfolio is principally indexed to the one-year Treasury bill. The CMO portfolio consists of government agency issues and privately issued AAA rated securities. The other asset-backed securities are primarily Student Loan Marketing Association (SLMA) floaters, which are securities backed by student loans. At December 31, 2003 the portfolio consisted of $138.5 million of mortgage-backed pass-through securities, $45.1 million of CMOs and $9.1 million of other asset-backed securities. The mortgage-backed portfolio at December 31, 2003 was primarily agency issued (FNMA, FHLMC, GNMA) obligations, but also included privately issued AAA rated securities and SLMA floaters to further diversify the portfolio.
Corporate Bonds
The corporate bond portfolio, all of which was classified as available for sale, totaled $1.0 million and $4.1 million at September 30, 2004 and December 31, 2003, respectively. The portfolio was purchased to further diversify the investment portfolio and increase investment yield. The Company’s investment policy limits investments in corporate bonds to no more than 10% of total investments and to bonds rated as Baa or better by Moody’s Investors Service, Inc. or BBB or better by Standard & Poor’s Ratings Services at the time of purchase.
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Equity Securities
Available for sale equity securities totaled $2.9 million at September 30, 2004 and $0.9 million at December 31, 2003.
Funding Activities
Deposits
The Banks offer a broad array of core deposit products including checking accounts, interest-bearing transaction accounts, savings and money market accounts and certificates of deposit under $100,000. These core deposits totaled $1.644 billion or 88.3% of total deposits of $1.862 billion at September 30, 2004 compared to core deposits of $1.552 billion or 85.3% of total deposits of $1.819 billion at December 31, 2003. The core deposit base consists almost exclusively of in-market customer accounts. The Company had total public deposits of $418.5 million at September 30, 2004 compared to $355.6 million at December 31, 2003. Included in total deposits are certificates of deposit over $100,000, which amounted to $218.2 million and $267.1 million as of September 30, 2004 and December 31, 2003, respectively. The decline in certificates of deposit over $100,000 is mainly due to a decline in brokered certificates of deposit, which totaled $68.0 million and $125.4 million as of September 30, 2004 and December 31, 2003, respectively. A portion of the cash available from increases in core deposits and declines in loans outstanding has been utilized to reduce brokered certificates of deposit.
Non-Deposit Sources of Funds
The Company’s most significant source of non-deposit funds is FHLB borrowings. FHLB advances outstanding amounted to $66.4 million and $89.0 million as of September 30, 2004 and December 31, 2003, respectively. These FHLB borrowings include both short and long-term advances maturing on various dates through 2014. The decline in FHLB borrowings is also reflective of the deployment of cash generated from core deposit growth and the decline in loans outstanding. The Company had approximately $53.7 million of immediate credit available under lines of credit with the FHLB at September 30, 2004, collateralized by FHLB stock and real estate mortgage loans. The Company also has lines of credit with the Federal Agricultural Mortgage Corp. (Farmer Mac) permitting borrowings to a maximum of $25.0 million. No advances were outstanding against the Farmer Mac lines as of September 30, 2004. The Company also has cancelable overnight Federal funds purchased lines of credit with other commercial banks that totaled $60.0 million and $71.3 million as of September 30, 2004 and December 31, 2003. No advances were outstanding against the overnight lines of credit as of September 30, 2004. The Company also utilizes securities sold under agreements to repurchase as a source of funds. These short-term repurchase agreements amounted to $28.9 million and $22.5 million as of September 30, 2004 and December 31, 2003, respectively.
During 2003, FII expanded the terms of an existing credit agreement with M&T Bank. Proceeds of the loan were principally used to infuse capital to the NBG and BNB subsidiaries allowing those banks to meet higher capital ratios required in agreements imposed by their regulators. The credit agreement includes a $25.0 million term loan facility and a $5.0 million revolving loan facility. The term loan requires monthly payments of interest only, at a variable interest rate of London Interbank Offered Rate (“LIBOR”) plus 1.75%, which was 3.27% as of September 30, 2004. The $25.0 million term loan is included in long-term borrowings on the consolidated statements of financial condition as principal installments are due as follows: $5.0 million in December 2006, $10.0 million in December 2007 and $10.0 million in December 2008. The $5.0 million revolving loan accrues interest at a rate of LIBOR plus 1.50%. There were no advances outstanding on the revolving loan as of September 30, 2004. The credit agreement includes affirmative financial covenants, all of which were met as of September 30, 2004. FII pledged the stock of its subsidiary banks as collateral for the credit facility.
During 2001 FISI Statutory Trust I (the “Trust”) was established and issued 30 year guaranteed preferred beneficial interests in junior subordinated debentures of the Company (“capital securities”) in the aggregate amount of $16.2 million at a fixed rate of 10.2%. The Company used the net proceeds from the sale of the capital securities to partially fund the acquisition of BNB. As of September 30, 2004, all of the capital securities qualified as Tier I capital under regulatory definitions. Effective December 31, 2003, the provisions of FASB Interpretation No. 46 (Revised), “Consolidation of Variable Interest Entities,”
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resulted in the deconsolidation of the Company’s wholly-owned Trust. The deconsolidation resulted in the derecognition of the $16.2 million in trust preferred securities and the recognition of $16.7 million in junior subordinated debentures and a $502,000 investment in the subsidiary trust recorded in other assets in the Company’s consolidated statements of financial condition.
Equity Activities
Total shareholders’ equity amounted to $188.0 million at September 30, 2004, an increase of $4.9 million from $183.1 million at December 31, 2003. The increase in shareholders’ equity results from the $13.3 million in year-to-date net income partially offset by $6.5 million in dividends declared and $2.5 million in unrealized gain on securities.
LIQUIDITY AND CAPITAL RESOURCES
Liquidity
The objective of maintaining adequate liquidity is to assure the ability of the Company and its subsidiaries to meet their financial obligations. These obligations include the payment of interest on deposits, borrowings and junior subordinated debentures, as well as, withdrawal of deposits on demand or at their contractual maturity, the repayment of borrowings as they mature, the ability to fund new and existing loan commitments and the ability to take advantage of new business opportunities. The Company and its subsidiaries achieve liquidity by maintaining a strong base of core customer funds, maturing short-term assets, the ability to sell securities, lines of credit, and access to capital markets.
Liquidity at the subsidiary bank level is managed through the monitoring of anticipated changes in loans, the investment portfolio, core deposits and wholesale funds. The strength of the subsidiary banks’ liquidity position is a result of its base of core customer deposits. These core deposits are supplemented by wholesale funding sources, including credit lines with the other banking institutions, the FHLB, Farmer Mac and the Federal Reserve Bank.
The primary sources of liquidity for the Company are dividends from its subsidiaries, lines of credit, and access to capital markets. Dividends from subsidiaries are limited by various regulatory requirements related to capital adequacy and earnings trends. On September 4, 2003 the Boards of Directors of NBG and BNB entered into agreements with the Office of the Comptroller of the Currency (“OCC”) one of the terms of which required NBG and BNB to adopt dividend policies that would permit them to declare dividends only when they are in compliance with their approved capital plan and the provisions of 12 U.S.C. Section 56 and 60, and upon prior written notice to (but not consent of) the Assistant Deputy Comptroller. Neither bank has had their respective capital plan approved by the OCC or declared a dividend since entering into the agreements. The Boards of both NBG and BNB have recently adopted resolutions providing that no dividends will be declared without the prior written approval of the OCC, and the Board of the Company has adopted a parallel resolution pursuant to which it has agreed not to request a dividend from either bank until their respective capital plans and proposed dividend declarations have been approved by the OCC. The banks are important sources of funds to the Company and, if they are unable, or limited in their ability, to pay dividends to the Company, that may adversely affect the liquidity of the Company and, over time, could adversely affect the Company’s ability to pay dividends to its shareholders and meet its obligations on borrowings and junior subordinated debentures.
The Company’s cash and cash equivalents were $88.3 million at September 30, 2004, an increase of $2.7 million from the balance of $85.6 million at December 31, 2003. The Company has $197.0 million in unpledged investment securities at September 30, 2004 compared to $89.6 million at December 31, 2003.
Capital Resources
The Federal Reserve Board has adopted a system using risk-based capital guidelines to evaluate the capital adequacy of bank holding companies. The guidelines require a minimum total risk-based capital ratio of 8.0%. Leverage ratio is also utilized in assessing capital adequacy with a minimum requirement that can range from 3.0% to 5.0%.
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The Company’s Tier 1 leverage ratio was 7.30% and 7.03% at September 30, 2004 and December 31, 2003, respectively, both of which are well above minimum regulatory capital requirements. Total Tier 1 capital of $155.5 million at September 30, 2004 increased $7.8 million from $147.7 million at December 31, 2003.
The Company’s total risk-based capital ratio was 12.47% at September 30, 2004 and 11.44% at December 31, 2003, respectively, both well above minimum regulatory capital requirements. Total risk-based capital was $173.1 million at September 30, 2004, an increase of $7.1 million from $166.0 million at December 31, 2003.
In addition, the formal agreements entered into by NBG and BNB with their primary regulator requires both banks to maintain a Tier 1 leverage capital ratio equal to 8%, a Tier 1 risk-based capital ratio equal to 10%, and a total risk-based capital ratio of 12%. The following table details the capital ratios for each of the banks as of September 30, 2004.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
The principal objective of the Company’s interest rate risk management is to evaluate the interest rate risk inherent in certain assets and liabilities, determine the appropriate level of risk to the Company given its business strategy, operating environment, capital and liquidity requirements and performance objectives, and manage the risk consistent with the guidelines approved by the Company’s Board of Directors. The Company’s senior management is responsible for reviewing with the Board its activities and strategies, the effect of those strategies on the net interest margin, the fair value of the portfolio and the effect that changes in interest rates will have on the portfolio and exposure limits. Senior Management develops an Asset-Liability Policy that meets strategic objectives and regularly reviews the activities of the subsidiary Banks. Each subsidiary bank board adopts an Asset-Liability Policy within the parameters of the Company’s overall Asset-Liability Policy and utilizes an asset/liability committee comprised of senior management of the bank under the direction of the bank’s board.
Management of the Company’s interest rate risk requires the selection of appropriate techniques and instruments to be utilized after considering the benefits, costs and risks associated with available alternatives. Since the Company does not utilize derivative instruments, management’s techniques usually consider one or more of the following: (1) interest rates offered on products, (2) maturity terms offered on products, (3) types of products offered, and (4) products available to the Company in the wholesale market such as advances from the FHLB.
The Company uses a net interest income and economic value of equity model as one method to identify and manage its interest rate risk profile. The model is based on expected cash flows and repricing characteristics for all financial instruments and incorporates market-based assumptions regarding the impact of changing interest rates on these financial instruments. Assumptions based on the historical behavior of deposit rates and balances in relation to changes in interest rates are also incorporated into the model. These assumptions are inherently uncertain and, as a result, the model cannot precisely measure net interest income or precisely predict the impact of fluctuations in interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude, and frequency of interest rate changes as well as changes in market conditions and management strategies. The Company has experienced no significant changes in market risk due to changes in interest rates since the Company’s Annual Report on Form 10-K as of December 31, 2003, dated March 12, 2004, as filed with the Securities and Exchange Commission.
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Management also uses a static gap analysis to identify and manage the Company’s interest rate risk profile. Interest sensitivity gap (“gap”) analysis measures the difference between the assets and liabilities repricing or maturing within specific time periods.
Item 4. Controls and Procedures
As of September 30, 2004 the Company, under the supervision of its Chief Executive Officer and Chief Financial Officer conducted an evaluation of the effectiveness of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on their evaluation of the effectiveness of disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in ensuring that all material information required to be filed in the Company’s periodic SEC reports is made known to them in a timely fashion. There has been no change in the Company’s internal control over financial reporting that occurred during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II — OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities, Use of Proceeds and Issuer Purchases of Equity Securities
The table below sets forth the information with respect to purchases made by the Company (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of our common stock during the three months ended September 30, 2004:
The Company’s previously announced share repurchase program expired on August 7, 2004.
* Shares were purchased in a private transaction whereby the Company repurchased shares from an exiting director based on the Company’s book value as of December 31, 2003, pursuant to agreements in place with the bank directors to repurchase qualifying shares at book value.
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Item 6. Exhibits
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Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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