UNITED STATESSECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005
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 þ NO o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES þ NO o
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
FINANCIAL INSTITUTIONS, INC.
INDEX
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Item 1. Financial Statements (Unaudited)
FINANCIAL INSTITUTIONS, INC. AND SUBSIDIARIES
See Accompanying Notes to Unaudited Consolidated Financial Statements.
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(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”.
The Company formerly qualified as a financial holding company under the Gramm-Leach-Bliley Act, which allowed FII to expand business operations to include financial services businesses. The Company currently 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 facilitate 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.
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, 2005. The interim consolidated financial statement should be read in conjunction with the Company’s 2004 Annual report on Form 10-K. The consolidated financial information included herein combines the results of operations, 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 period’s consolidated financial statements are reclassified when necessary to conform to the current period 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. A material estimate that is particularly susceptible to near-term change is the allowance for loan losses.
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(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.”
Pro-forma disclosure utilizing the estimated value of the options granted under SFAS No. 123, is as follows:
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 123R, “Share-Based Payment.” Under previous practice, the reporting entity could account for share-based payments under the provisions of APB Opinion No. 25 and disclose share-based compensation as accounted for under the provisions of SFAS No. 123. SFAS No. 123R requires all share-based payments to be recognized in the financial statements based on their fair values. The Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at the date of adoption. In April 2005, the Securities and Exchange Commission (“SEC”) postponed the effective date of SFAS No. 123R until the fiscal year beginning after June 15, 2005. The Company expects to adopt SFAS No. 123R in January 2006. The Company is currently evaluating the requirements of SFAS No. 123R and has not yet determined the effect of adopting SFAS No. 123R, and it has not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123.
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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 approximately 218,000 and 48,000 weighted average stock options for the three months ended March 31, 2005 and 2004, 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 primarily comprised of the subsidiary banks as the Company evaluates performance on an individual bank basis. The Financial Services Group (FSG) is also included as a reportable segment as the Company evaluates the performance of this line of business separately from the banks. The reportable segment information is as follows:
As of and for the three months ended March 31, 2005
As of December 31, 2004
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For the three months ended March 31, 2004
(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 expects to contribute approximately $1,579,000 to the pension plan during the year ended December 31, 2005.
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 $3,000 and $18,000 for the three months ended March 31, 2005 and 2004, respectively.
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(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 $246.7 million and $245.8 million were contractually available at March 31, 2005 and December 31, 2004, 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 $10.6 million and $10.8 million at March 31, 2005 and December 31, 2004, respectively. As of March 31, 2005, the fair value of the standby letters of credit was not material to the Company’s consolidated financial statements.
(7) Supervision and Regulation
The supervision and regulation of financial and bank holding companies and their subsidiaries is intended primarily for the protection of depositors, the deposit insurance funds regulated by the FDIC and the banking system as a whole, and not for the protection of shareholders or creditors of bank holding companies. The various bank regulatory agencies have broad enforcement power over bank holding companies and banks, including the power to impose substantial fines, operational restrictions and other penalties for violations of laws and regulations.
During 2003, the Company disclosed that the Boards of Directors of its two national bank subsidiaries, NBG and BNB entered into formal 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 towards improving compliance with applicable laws and regulations.
The Company is also subject to various regulatory capital requirements administered by the Federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary, actions by regulators that, if undertaken, could have a direct material impact on the Company’s consolidated financial statements.
For evaluating regulatory capital adequacy, companies are required to determine capital and assets under regulatory accounting practices. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain minimum amounts and ratios. The leverage ratio requirement is based on period-end capital to average adjusted total assets during the previous three months. Compliance with risk-based capital requirements is determined by dividing regulatory capital by the sum of a company’s weighted asset values. Risk weightings are established by the regulators for each asset category according to the perceived degree of risk. As of March 31, 2005 and December 31, 2004, the Company and each subsidiary bank met all capital adequacy requirements to which they are subject.
As of December 31, 2004, the most recent notification from the Federal Deposit Insurance Corporation (“FDIC”) categorized the Company and its subsidiary banks as well capitalized under the regulatory framework for prompt corrective action. For purposes of determining the annual deposit insurance assessment rate for insured depository institutions, each insured institution is assigned an assessment risk classification. Each institution’s assigned risk classification is composed of a group and subgroup assignment based on capital group and supervisory subgroup. Although NBG and BNB remain assigned
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to the well-capitalized capital group, during 2003 these two subsidiaries received notification of a downgrade in supervisory subgroup based on the formal agreements in place with the OCC. During 2004, NBG received notification of a further downgrade in supervisory subgroup based on the OCC report of examination for the period as of December 31, 2003.
Payments of dividends by the subsidiary banks to FII are limited or restricted in certain circumstances under banking regulations. One of the terms of the OCC formal agreements 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 formal agreements entered into by NBG and BNB with the OOC also required both banks to develop capital plans enabling them to achieve, by March 31, 2004, 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%. As indicated in the following table, each of the banks met the required levels at March 31, 2005.
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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 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 for the first quarter of 2005 was $2.3 million down $0.3 million compared with $2.6 million for the first quarter of 2004. The lower net income is primarily a result of a $1.5 million increase in noninterest expense, offset by a $1.1 million decrease in provision for loan losses. The increase in noninterest expense largely represents additional legal, professional and personnel costs related to managing credit and regulatory issues. On a diluted per share basis, earnings for the first quarter of 2005 were $0.17, a decrease of 15% from $0.20 per share for the comparable quarter last year. Return on average common equity (annualized) for the first quarter of 2005 was 4.67% down 0.75% compared with same quarter last year. Return on average assets (annualized) also declined for the 2005 first quarter to 0.43% compared to 0.49% for the same quarter in 2004.
Nonperforming assets at March 31, 2005 were $63.6 million, up $8.4 million from December 31, 2004. During the quarter, an $8.8 million substandard but accruing credit to one borrowing relationship was downgraded to nonaccrual status based on deterioration in the business. The ratio of nonperforming assets to total loans and other real estate was 5.18% at March 31, 2005 compared with 4.39% and 3.84% at December 31, 2004 and March 31, 2004, respectively. Net loan charge-offs in the first quarter of 2005 were $2.9 million, down $0.9 million from the prior year’s first quarter. Net loan charge-offs to average loans (annualized) for the first quarter 2005 was 0.93% compared with 1.15% in the same quarter last year.
During 2003, increased regulatory oversight was put in place in the form of formal agreements at the two national banks, NBG and BNB. The Company has taken various corrective actions to remediate its asset quality issues. By their nature such actions require a period of time to become fully effective. The Company has increased its staff and resources available to the Chief Risk Officer and the centralized credit function. Responsibilities for commercial loan credit administration requirements have been placed in a new position, Portfolio Manager, with responsibilities for timely line renewals, risk rating identification, credit file maintenance, collateral assignment, credit analysis, credit strategies, and action plans. The former Commercial Lending Officer position will no longer contain those functions and will be solely business development and sales functions. This will facilitate more timely recognition of changing risks, better allocation of more qualified, specialized individuals to portfolio administration functions, and make for more timely and easier training of staff. In addition, Credit Risk Officers now report to the Chief Risk Officer, and are separate from the lending function. A Credit Risk Officer has been named the Credit Department Manager with primary responsibility to support Portfolio Managers with all underwritings of credits through a team of Credit Analysts. The position of Chief of Community Banking has been created
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and filled, to provide greater consistency and oversight of the commercial-related loan administration at all four bank subsidiaries. New Board members have been added at NBG and BNB, and the Board-level compliance committees at these respective banks have been reorganized to better manage and monitor compliance with the formal agreements. The level for risk grading decisions requiring review and approval by the Credit Risk Officers on commercial loans has been decreased to loans greater than $250,000. In addition, all commercial loans greater than $250,000, which meet certain other criteria, now must be reviewed annually by Credit Risk Officers. In addition, the Company’s centralized credit administration function recently completed a special review of loan files and loan risk grades for approximately 65% of the Company’s commercial loan portfolio. Procedures are being written to provide for better documentation of the subjective factors incorporated in the calculation of the allowance for loan losses.
The Company’s financial results for the quarter reflect our ongoing efforts to address the weaknesses in the loan portfolio. As previously indicated, the Company is evaluating the possibility of a sale of a substantial portion of our problem loans and have engaged an investment banking firm as an advisor to provide a review and assessment of those loans.
The Company for many years has operated under a decentralized, “Super Community Bank” business model, with four largely autonomous subsidiary Banks whose Boards and management have the authority to operate the Banks within guidelines set forth in broad corporate policies established at the holding company level. The Board has evaluated the effectiveness of this model and believes that changes to the Company’s governance structure may enhance its performance. The Board is evaluating whether consolidating two or more of the Company’s four Banks would result in more effective management of its operations and capital at both the Bank and holding company levels.
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, 2004, dated March 16, 2005, 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 consolidated financial statements, results of operations or liquidity, and are therefore considered to be critical accounting policies as discussed below.
Allowance for Loan Losses: The allowance for loan losses represents management’s estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfolio. Changes in these estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.
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A loan is considered impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts of principal and interest under the original terms of the agreement or the loan is restructured in a troubled debt restructuring. Accordingly, the Company evaluates impaired commercial and agricultural loans individually based on the present value of future cash flows discounted at the loan’s effective interest rate, or at the loan’s observable market price or the net realizable value of the collateral if the loan is collateral dependent. The majority of the Company’s loans are collateral dependent.
Loans, including impaired loans, are generally classified as nonaccrual if they are past due as to maturity or payment of principal or interest for a period of more than 90 days (120 days for consumer loans), unless such loans are well-collateralized and in the process of collection. Loans that are on a current payment status or past due less than 90 days may also be classified as nonaccrual if repayment in full of principal and/or interest is in doubt.
For additional discussion related to the Company’s accounting policies for the allowance for loan losses, see the section titled “Analysis of the Allowance for Loan Losses.”
Goodwill: Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. 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 or liquidity. During 2004, the Company evaluated goodwill for impairment using a discounted cash flow analysis and determined no impairment existed.
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. There are a number of important factors that could affect the Company’s forward-looking statements which include the ability of the Company to implement the necessary changes to be in compliance with the formal agreements with the OCC, the effectiveness of the changes the Company is making, quality of collateral associated with nonperforming loans, the ability of customers to continue to make payments on criticized or substandard loans, the impact of rising interest rates on customer cash flows, the speed or cost of resolving bad loans, the ability to hire and train personnel, the economic conditions in the area the Company operates, customer preferences, the competition and other factors discussed in the Company’s filings 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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NET INCOME ANALYSIS
Average Balance Sheets
The following table presents the average annualized yields and rates on interest-earning assets and interest-bearing liabilities on a fully tax equivalent basis for the periods indicated. All average balances are average daily balances.
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Net Interest Income
Net interest income, the principal source of the Company’s earnings, totaled $18.4 million for the first quarter of 2005, down $0.1 million in comparison with the 2004 first quarter. Interest income from securities offset the decline in interest earned on a lower loan base. Comparing the first quarter of 2005 with the first quarter of 2004, the Company’s average total loans declined $89.8 million while average total investment securities, federal funds sold and interest-bearing deposits increased $82.2 million.
The net interest margin for the first quarter of 2005 was 3.90% compared to 3.89% in the prior year. The yield on interest earning assets improved 7 basis points to 5.52% for the first quarter 2005, while the cost of funds increased 6 basis points to 1.62%. The rise in both yield and cost of funds was a result of the rising interest rate environment.
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 LossesThe provision for loan losses represents management’s estimate of the expense necessary to maintain the allowance for loan losses at a level representative of probable credit losses inherent in the portfolio. The provision for loan losses for the first quarter of 2005 totaled $3.7 million, a decrease of $1.1 million compared to the $4.8 million provision for loan losses for the first quarter of 2004. The decrease in the provision for loan losses is primarily the result of a lower level of net loan charge-offs during the first quarter of 2005 compared to the first quarter of 2004. Net loan charge-offs in the first quarter of 2005 were $2.9 million, down $0.9 million from the prior year’s first quarter. Net loan charge-offs to average loans (annualized) for the first quarter 2005 was 0.93% compared with 1.15% in the same quarter last year. See the section titled “Analysis of the Allowance for Loan Losses” also.
Noninterest Income
Noninterest income for the first quarter of 2005, declined $0.2 million to $5.7 million from $5.9 million in the first quarter of 2004, principally the result of a $0.2 million decline in service charges on deposits. The decline in service charges is a result of the introduction of a free retail checking product, an increase in commercial earnings credits and a decline in insufficient funds fees. Financial services group fees and commissions increased $0.1 million to $1.5 million in the first quarter 2005, primarily the result of an increase in brokerage fees.
Noninterest Expense
Noninterest expense increased $1.5 million for the first quarter of 2005 to $17.4 million in comparison to the same quarter last year. Professional fees increased $0.5 million in the most recent quarter due to higher costs associated with credit and regulatory issues. The $0.3 million increase in salaries and benefits compared to the same quarter last year reflects the addition of staff to the centralized credit administration function and the enhancement of the loan administration team, while $0.5 million of the increase in other expense relates to separation costs recorded during the most recent quarter. The higher noninterest expense, combined with flat revenue, resulted in an efficiency ratio of 67.62% for the 2005 first quarter compared to 61.15% for the first quarter of 2004.
Income Tax Expense
The provision for income taxes provides for Federal and New York State income taxes, which amounted to $0.7 million and $1.0 million for the three months ended March 31, 2005 and 2004, respectively. The decline in income tax expense corresponds in general with taxable income levels for each period. The effective tax rate decreased to 24.6% for the first quarter of 2005, compared to 26.6% for the first quarter of 2004. The lower effective tax rate in the first quarter 2005 is largely a result of tax exempt interest income constituting a larger proportion of income before income tax expense.
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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 $28.7 million to $1.224 billion at March 31, 2005 from $1.252 billion at December 31, 2004. Commercial loans decreased $13.8 million to $189.3 million or 15.5% of the portfolio at March 31, 2005 from $203.1 million or 16.2% at December 31, 2004. Agricultural loans decreased $12.8 million, to $182.4 million at March 31, 2005 from $195.2 million at December 31, 2004. The decline in loans relates to decreased loan production coupled with loan charge-offs and pay-offs. Loan originations have slowed as the Company has implemented more stringent underwriting requirements and focused resources on the existing loan portfolio. Included in agricultural loans were $94.7 million in loans to dairy farmers, or 7.7% of the total loan portfolio at March 31, 2005 compared to $96.8 million or 7.7% of the total loan portfolio at December 31, 2004.
Loans held for sale (not included in the above table) totaled $1.5 million at March 31, 2005, comprised of residential mortgages of $1.2 million and student loans of $0.3 million. Loans held for sale (not included in the above table) totaled $2.6 million as of December 31, 2004, comprised of residential mortgages of $1.8 million and student loans of $0.8 million.
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Nonaccruing Loans and Nonperforming Assets
Information regarding nonaccruing loans and other nonperforming assets is as follows:
Nonperforming assets at March 31, 2005 increased to $63.6 million, compared with $55.2 million at December 31, 2004 and $50.5 million at March 31, 2004. During the first quarter of 2005, an $8.8 million substandard but accruing agricultural borrowing relationship was downgraded to nonaccrual status based on deterioration in the business.
The following table details nonaccrual loan activity for the periods indicated.
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During the first quarter of 2005, the Company received $3.5 million in payments on nonaccrual loans and $0.2 million of nonaccrual loans were returned to accruing status. Also during the first quarter, the Company charged-off $2.8 million in loans that were on nonaccrual status at December 31, 2004 and transferred $17.5 million in loans to nonaccrual status. The Company has focused considerable resources on working to reduce the level of nonperforming assets and is currently exploring a more immediate strategy, the potential sale of a substantial portion of the problem loans, as an investment banking firm has been retained as an advisor to provide a review and assessment of those loans.
Approximately $29.8 million or 48% of the $62.6 million in nonaccrual loans at March 31, 2005 are current with respect to payment of principal and interest. Although these loans are current, the Company has classified the loans as nonaccrual because reasonable doubt exists with respect to the future collectibility of principal and interest.
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 considers loans classified as substandard, which continue to accrue interest, to be potential problem loans. The Company identified $137.7 million and $142.9 million in loans that continued to accrue interest which were classified as substandard as of March 31, 2005 and December 31, 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 March 31, 2005.
Assessing the adequacy of the allowance for loan losses involves substantial uncertainties and is based upon management’s evaluation of the amounts required to meet estimated charge-offs in the loan portfolio after weighing various factors. The adequacy of the allowance for loan losses is subject to ongoing management review, and the approach taken by management in calculating the allowance is discussed by management with the Company’s outside auditors and, in the case of NBG and BNB, with the OCC. As of December 31, 2004, management identified a material weakness in internal controls over financial reporting related to determining the allowance for loan losses and the provision for loan losses. Management evaluated the allowance for loan losses with consideration of the material weakness and based on Management’s analysis the Company believes that the allowance for loan losses is adequate at March 31, 2005.
While management evaluates currently available information in establishing the allowance for loan losses, future adjustments to the allowance may be necessary if conditions differ substantially from the assumptions used in making the evaluations. In addition, various regulatory agencies, as an integral part of their examination process, periodically review a financial institution’s allowance for loan losses and carrying amounts of other real estate owned. Such agencies may require the financial institution to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
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The following table sets forth the activity in the allowance for loan losses for the periods indicated.
Net loan charge-offs were $2.9 million for the first quarter of 2005 or 0.93% (annualized) of average loans compared to $3.8 million or 1.15% (annualized) of average loans in the same period last year. The ratio of the allowance for loan losses to nonperforming loans was 64% at March 31, 2005 compared to 73% at December 31, 2004 and 61% at March 31, 2004. The ratio of the allowance for loan losses to total loans was 3.27% at March 31, 2005 compared to 3.12% at December 31, 2004 and 2.29% a year ago.
Investing Activities
The Company’s total investment security portfolio totaled $767.7 million as of March 31, 2005 compared to $766.5 million as of December 31, 2004. The investment portfolio increased modestly from prior year-end as the excess cash resulting from the decline in loans and increase in deposits was invested on a short-term basis in overnight federal funds sold for liquidity purposes. Further detail regarding the Company’s investment portfolio follows.
U.S. Treasury and Agency Securities
At March 31, 2005, the U.S. Treasury and Agency securities portfolio totaled $242.1 million, all of which was classified as available for sale. The portfolio is comprised entirely of U. S. federal agency securities of which approximately 70% are callable securities. These callable securities provide higher yields than similar securities without call features. At March 31, 2005 included in callable securities are $95.5 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 March 31, 2005, the structured notes had a current average coupon of 4.08% that adjust on average to 6.50% within five years. At December 31, 2004, the U.S. Treasury and Agency securities portfolio totaled $233.2 million, all of which was classified as available for sale.
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State and Municipal Obligations
At March 31, 2005, the portfolio of state and municipal obligations totaled $248.4 million, of which $210.6 million was classified as available for sale. At that date, $37.8 million was classified as held to maturity, with a fair value of $38.3 million. At December 31, 2004, the portfolio of state and municipal obligations totaled $251.3 million, of which $212.0 million was classified as available for sale. At that date, $39.3 million was classified as held to maturity, with a fair value of $40.0 million.
Mortgage-Backed Securities
Mortgage-backed securities, all of which were classified as available for sale, totaled $272.7 million and $278.5 million at March 31, 2005 and December 31, 2004, respectively. The portfolio was comprised of $182.7 million of mortgage-backed pass-through securities, $82.2 million of collateralized mortgage obligations (CMOs) and $7.8 million of other asset-backed securities at March 31, 2005. The mortgage backed pass-through securities were predominantly issued by government sponsored enterprises (FNMA, FHLMC, or GNMA). Approximately 89% 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, 2004 the portfolio consisted of $187.6 million of mortgage-backed pass-through securities, $81.3 million of CMOs and $9.6 million of other asset-backed securities. The mortgage-backed portfolio at December 31, 2004 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 $0.5 million at March 31, 2005 and December 31, 2004. 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.
Equity Securities
Available for sale equity securities totaled $4.0 million and $3.0 million at March 31, 2005 and December 31, 2004, respectively.
Funding Activities
Deposits
The Banks offer a broad array of deposit products including checking accounts, interest-bearing transaction accounts, savings and money market accounts and certificates of deposit. At March 31, 2005, total deposits were $1.870 billion in comparison to prior year-end of $1.819 billion.
The Company considers all deposits core except certificates of deposit over $100,000. Core deposits amounted to $1.628 billion or approximately 87% of total deposits at March 31, 2005 compared to $1.597 billion or approximately 88% of total deposits at December 31, 2004. The core deposit base consists almost exclusively of in-market customer accounts. Core deposits are supplemented with certificates of deposit over $100,000, which amounted to $242.0 million and $221.6 million as of March 31, 2005 and December 31, 2004, respectively. The Company also uses brokered certificates of deposit as a funding source. Brokered certificates of deposit included in certificates of deposit over $100,000 totaled $67.9 million and $68.1 million at March 31, 2005 and December 31, 2004, respectively.
Non-Deposit Sources of Funds
The Company’s most significant source of non-deposit funds is FHLB borrowings. FHLB advances outstanding amounted to $60.3 million and $62.3 million as of March 31, 2005 and December 31, 2004, respectively. These FHLB borrowings include both short and long-term advances maturing on various
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dates through 2014. The Company had approximately $68.6 million and $65.1 million of immediate credit available under lines of credit with the FHLB at March 31, 2005 and December 31, 2004, respectively. The FHLB lines of credit are collateralized by FHLB stock and real estate mortgage loans. The Company also had $54.8 million and $54.4 million of credit available under unsecured lines of credit with various banks at March 31, 2005, and December 31, 2004, respectively. There were no advances outstanding on these lines of credit at March 31, 2005 and December 31, 2004. The Company also utilizes securities sold under agreements to repurchase as a source of funds. These short-term repurchase agreements amounted to $26.9 million and $28.6 million as of March 31, 2005 and December 31, 2004, respectively.
The Company also has a credit agreement with M&T Bank. 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 4.76% as of March 31, 2005. 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 March 31, 2005. The Company was in default with one of the provisions in the credit agreement due to certain aspects of non-compliance with formal regulatory agreements by NBG and BNB. On March 2, 2005 M&T Bank waived the event of default. 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 March 31, 2005, 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,” 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 $178.4 million at March 31, 2005, a decrease of $5.9 million from $184.3 million at December 31, 2004. The decrease in shareholders’ equity during the first quarter of 2005 results from the $2.3 million in net income offset by $2.2 million in dividends declared and $6.0 million in unrealized loss 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.
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The primary source of liquidity for the parent company is dividends from 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. The Company’s subsidiaries rely on cash flows from operations, core deposits, borrowings, short-term liquid assets, and, in the case of non-banking subsidiaries, funds from the parent company. Payment of dividends to the parent company from NBG and BNB are currently restricted by the terms of the formal agreements entered into with the OCC in September 2003. Dividends from WCB and FTB have not, nor are they expected to, fully cover the cost of the parent company’s current debt service, preferred stock dividends and common stock dividends. The banks are important sources of funds to the parent company and, if they are unable, or limited in their ability, to pay dividends, that may adversely affect the liquidity of the parent company and, over time, could adversely affect the parent company’s ability to pay dividends to its shareholders or meet its other financial obligations. The parent company cash and interest-bearing deposits totaled $9.6 million and $11.9 million at March 31, 2005 and December 31, 2004, respectively.
The Company’s cash and cash equivalents were $111.6 million at March 31, 2005, an increase of $65.5 million from the balance of $46.1 million at December 31, 2004. The Company’s net cash provided by operating activities was $8.0 million. The principal source of operating activity cash flow was the Company’s net income adjusted for noncash income and expense items, which together accounted for approximately $6.3 million of net cash flow. The Company’s net cash provided by investing activities was the result of $25.8 million of loan payments in excess of loan originations, offset by cash utilized in the net acquisition of $11.5 million in securities and $2.0 million in premises and equipment. The $45.1 million in net cash provided by financing activities resulted primarily from a $51.0 million increase in deposits, offset by $3.6 million in net borrowing repayments and $2.2 million in dividends paid to shareholders.
The Company’s cash and cash equivalents were $111.4 million at March 31, 2004, an increase of $25.8 million from the balance of $85.6 million at December 31, 2003. The primary factors leading to the increase in cash during the first three months of 2004 were the increase in deposits and decrease in loans, offset by an increase in securities and decrease in borrowings.
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 the following minimums:
The Company’s Tier 1 leverage ratio was 7.30% and 7.13% at March 31, 2005 and December 31, 2004, respectively, both of which are well above minimum regulatory capital requirements. The Company’s Tier 1 risk-based capital ratio was 11.40% and 11.27% at March 31, 2005 and December 31, 2004, respectively, both of which are well above minimum regulatory capital requirements. Total Tier 1 capital of $153.5 million at March 31, 2005 increased $0.2 million from $153.3 million at December 31, 2004.
The Company’s total risk-based capital ratio was 12.67% at March 31, 2005 and 12.54% at December 31, 2004, respectively, both well above minimum regulatory capital requirements. Total risk-based capital was $170.6 million at both March 31, 2005 and December 31, 2004.
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 March 31, 2005:
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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.
The primary tool the Company uses to manage interest rate risk is a “rate shock” simulation to measure the rate sensitivity of the balance sheet. Rate shock simulation is a modeling technique used to estimate the impact of changes in rates on net interest income and economic value of equity. The Company measures net interest income at risk by estimating the changes in net interest income resulting from instantaneous and sustained parallel shifts in interest rates of different magnitudes over a period of 12 months. This simulation is based on management’s assumption as to the effect of interest rate changes on assets and liabilities and assumes a parallel shift of the yield curve. It also includes certain assumptions about the future pricing of loans and deposits in response to changes in interest rates. Further, it assumes that delinquency rates would not change as a result of changes in interest rates, although there can be no assurance that this will be the case. While this simulation is a useful measure as to net interest income at risk due to a change in interest rates, it is not a forecast of the future results and is based on many assumptions that, if changed, could cause a different outcome.
In addition to the changes in interest rate scenarios listed above, the Company also runs other scenarios to measure interest rate risk, which vary as deemed appropriate as the economic and interest rate environments change.
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.
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, 2004, dated March 16, 2005, as filed with the Securities and Exchange Commission.
Item 4. Controls and Procedures
As of March 31, 2005 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 Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)). The Company had previously reported that as of December 31, 2004, it had identified a material weakness in its internal control over financial reporting related to determining the allowance for loan losses and the provision for loan losses. While the Company has made progress in remediating the deficiencies in its internal controls over financial reporting relating to determining the allowance for loan losses and provision for loan losses all actions have not been fully implemented and there has been an insufficient period of time to determine whether those processes that have been implemented are operating effectively. Based upon this evaluation the CEO and CFO have
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concluded the Company’s disclosure controls and procedures and internal control over financial reporting were not effective at March 31, 2005.
There were no changes in the Company’s internal control over financial reporting that occurred during the first quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. However, the Company has taken various corrective actions to remediate the material weakness condition. By their nature such actions require a period of time to become fully effective. The following actions were taken during the first quarter of 2005 to address these issues:
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PART II — OTHER INFORMATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
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 March 31, 2005:
The Company’s previously announced share repurchase program expired on August 7, 2004.
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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