SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005Commission File Number: 1-9047
Independent Bank Corp.
288 Union Street, Rockland, Massachusetts 02370(Address of principal executive offices, including zip code)
(781) 878-6100(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
As of May 2, 2005, there were 15,369,253 shares of the issuer’s common stock outstanding, par value $0.01 per share.
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INDEX
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PART 1. FINANCIAL INFORMATION
Item 1. Financial Statements
The accompanying condensed notes are an integral part of these unaudited consolidated financial statements.
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INDEPENDENT BANK CORP.
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CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 — BASIS OF PRESENTATION
Independent Bank Corp. (the “Company”) is a state chartered, federally registered bank holding company headquartered in Rockland, Massachusetts incorporated in 1986. The Company is the sole stockholder of Rockland Trust Company (“Rockland” or “the Bank”), a Massachusetts trust company chartered in 1907. The Company also owns 100% of the common stock of Independent Capital Trust III (“Trust III”) and Independent Capital Trust IV (“Trust IV”), each of which have issued trust preferred securities to the public. As of March 31, 2004, Trust III and Trust IV are no longer included in the Company’s consolidated financial statements (see FIN No. 46 discussion withinRecent Accounting Pronouncements Note 3 below). The Bank’s subsidiaries consist of: two Massachusetts securities corporations, RTC Securities Corp. I and RTC Securities Corp. X; Taunton Avenue Inc.; and, Rockland Trust Community Development LLC. Taunton Avenue Inc. was formed in May 2003 to hold loans, industrial development bonds and other assets. Rockland Trust Community Development LLC was formed in August 2003 to make loans and to provide financial assistance to qualified businesses and individuals in low-income communities in accordance with New Markets Tax Credit Program criteria. All material intercompany balances and transactions have been eliminated in consolidation. Certain amounts in prior year financial statements have been reclassified to conform to the current year’s presentation.
The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation of the financial statements, primarily consisting of normal recurring adjustments, have been included. Operating results for the quarter ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ended December 31, 2005 or any other interim period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission.
NOTE 2 — STOCK BASED COMPENSATION
The Company measures compensation cost for stock-based compensation plans as the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted. The Company discloses pro forma net income and earnings per share in the notes to its consolidated financial statements as if compensation was measured at the date of grant based on the fair value of the award and recognized over the service period. Beginning January 1, 2006, the Company will adopt Statement of Financial Accounting Standard (“SFAS”) No. 123 (revised 2004) (“SFAS 123R” in Note 3 below), “Share-Based Payment (See discussion which follows in recent accounting pronouncements),” which will require the Company to record compensation measured at the date of grant based on the fair value of the awards and recognized over its requisite service period.
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The Company has three stock option plans: the Amended and Restated 1987 Incentive Stock Option Plan (“The 1987 Plan”), the 1996 Non-employee Directors’ Stock Option Plan (“The 1996 Plan”) and the 1997 Employee Stock Option Plan (“The 1997 Plan”). All three plans were approved by the Company’s Board of Directors and shareholders. Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation” encourages, but does not require, adoption of a fair-value based method of accounting for employee stock-based compensation plans, where compensation cost is measured at the grant date based on the fair value of the award and is recognized over the service period. An entity may continue to apply Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”, and related interpretations, whereby compensation cost is the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted, provided the entity discloses the pro forma net income and earnings per share as if the fair-value method had been applied. The Company measures compensation cost for stock-based compensation plans as the excess, if any, of the fair market value of the Company’s stock at the date of grant over the exercise price of options granted. Compensation cost is not recognized as the exercise price has historically equaled the grant date fair value of the underlying stock. Had the Company recognized compensation cost for these plans determined as the fair market value of the Company’s stock at the grant date and recognized over the service period, as determined using the Black-Scholes option-pricing model, the Company’s net income and earnings per share would have been reduced to the following pro forma amounts:
The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants under the 1997 Plan and the 1996 Plan:
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(2) The 1996 plan option grant assumptions will be determined upon normal option grants in April 2005.
(3) On December 9, 2004, 175,500 options were granted from the 1997 Plan to the Company’s members of Senior Management. The risk free rate, expected dividend yield, expected life and expected volatility for this grant were determined on December 9, 2004.
(4) On both January 8, 2004 and June 10, 2004, 5,000 options were granted from the 1997 Plan to the Company’s Managing Director of Business Banking. The risk free rate, expected dividend yield, expected life and expected volatility for these grants were determined on the respective grant dates. On both July 19, 2004 and October 20, 2004 10,000 options were granted from the 1997 Plan to the Company’s Executive Vice President of Retail Banking and Corporate Marketing. The risk free rate, expected dividend yield, expected life and expected volatility for these grants were determined on the respective grant dates.
(5) On April 27, 2004, 11,000 options were granted from the 1996 Plan to the Company’s Board of Directors. The risk free rate, expected dividend yield, expected life and expected volatility for this grant were determined on April 27, 2004.
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NOTE 3 — RECENT ACCOUNTING DEVELOPMENTS
SFAS No. 123 (revised 2004)(“SFAS 123R”) , “ Share-Based Payment ” In December 2004, the FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004). SFAS No. 123R replaces SFAS No. 123 “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees”. SFAS No. 123R will require that the compensation cost relating to share-based payment transactions be recognized in the Company’s financial statements, eliminating pro forma disclosure as an alternative. That cost will be measured based on the grant-date fair value of the equity or liability instruments issued. On April 14, 2005, the SEC issued a press release deferring the compliance date of SFAS 123R, which had an original effective date of the first interim or annual period beginning after June 15, 2005, until the beginning of a company’s next fiscal year for calendar-year companies. For the Company, implementation will therefore be required beginning January 1, 2006. The impact of the Company adopting such accounting can be seen in Note 2, Stock-Based Compensation of the Notes to Consolidated Financial Statements included in Item 8 hereof. The Company estimates the 2006 compensation expense related to share-based payment transactions to be recognized will be approximately $800,000 before tax for the year ending December 31, 2006 for options granted to date upon adoption of SFAS 123R. Management has not yet decided the amount or type of share-based compensation to be issued for the remainder of 2005 and beyond.
FIN No. 46 “Consolidation of Variable Interest Entities – an Interpretation of Accounting Research Bulletin No. 51” In January 2003, the FASB issued FIN No. 46. FIN 46 established accounting guidance for consolidation of variable interest entities (“VIE”) that function to support the activities of the primary beneficiary. The primary beneficiary of a VIE is the entity that absorbs a majority of the VIE’s expected losses, receives a majority of the VIE’s expected residual returns, or both, as a result of ownership, controlling interest, contractual relationship or other business relationship with a VIE. Prior to the implementation of FIN 46, VIEs were generally consolidated by an enterprise when the enterprise had a controlling financial interest through ownership of a majority of voting interest in the entity. The Company adopted FIN No. 46 as of February 1, 2003 for all arrangements entered into after January 31, 2003.
In December 2003, the FASB issued a revised FIN No. 46 (“FIN 46R”), which, in part, addressed limited purpose trusts formed to issue trust preferred securities. FIN 46R required the Company to deconsolidate its two subsidiary trusts (Independent Capital Trust III and Independent Capital Trust IV) on March 31, 2004. The result of deconsolidating these trusts was that trust preferred securities of the trusts, which were classified between liabilities and equity on the balance sheet (mezzanine section), no longer appear on the consolidated balance sheet of the Company. The related minority interest expense also no longer is included in the consolidated statement of income. Due to FIN 46R, the junior subordinated debentures of the parent company that were previously eliminated in consolidation are now included on the consolidated balance sheet within total borrowings. The interest expense on the junior subordinated debentures is included in the net interest margin of the consolidated company, negatively impacting the net interest margin by approximately 0.19% on an annualized basis. There is no impact to net income as the amount of interest previously recognized as minority interest is equal to the amount of interest expense that is recognized currently in borrowings expense offset by the dividend income on the subsidiary trusts common stock that is recognized in other non-interest income. Prior periods were not restated to reflect the changes made by FIN 46R.
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On March 1, 2005, the Board of Governors of the Federal Reserve issued a final ruling amending its risk-based capital standards for bank holding companies to allow continued inclusion of outstanding and prospective issuances of trust preferred securities in Tier 1 capital for regulatory capital purposes subject to quantitative limits applied in the aggregate amount of trust preferred securities and certain other capital elements and qualitative standards. After a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier 1 capital elements, net of goodwill less any associated deferred tax liability. The amount of trust preferred securities and certain other elements in excess of the core capital limit generally will be includable in Tier 2 capital.
For all other arrangements entered into subsequent to January 31, 2003, the Company adopted FIN 46R as of December 31, 2003. There was no material impact on the Company’s financial position or results of operations.
Securities and Exchange Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 105 - “Application of Accounting Principles to Loan Commitments” In March 2004, the SEC issued SAB No. 105. SAB No. 105 summarizes the views of the SEC regarding the application of Generally Accepted Accounting Principles (“GAAP”) to loan commitments for mortgage loans that will be held for sale accounted for as derivatives. The guidance requires the measurement at fair value of such loan commitments include only the differences between the guaranteed interest rate in the loan commitment and a market interest rate; future cash flows related to servicing the loan or the customer relationship should not be recorded as a part of the loan commitment derivative. SAB No. 105 is effective for said loan commitments accounted for as derivatives entered into beginning April 1, 2004. The Company adopted this SAB on April 1, 2004. The adoption of SAB No. 105 did not have a material impact on the Company as the Company was valuing loan commitments to be accounted for as derivatives consistent with this guidance.
FASB Staff Position (“FSP”) 106-2: “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” In May 2004, the FASB issued FSP 106-2. FSP 106-2 provides guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) for employers that sponsor postretirement health care plans that provide prescription drug benefits that are “actuarially equivalent” to Medicare Part D. It also requires certain disclosures regarding the effect of the Federal subsidy provided by the Act. FSP 106-2 is effective for interim or annual periods beginning after June 15, 2004. The reported measures of net periodic postretirement benefit costs for year to date March 31, 2005 do not reflect any amount associated with the Federal subsidy provided by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) because the Company does not believe that the benefits provided by the postretirement benefit plans that fall under the Act have a material impact upon the Company’s financial statements.
FASB Emerging Issues Task Force (“EITF”) Issue 03-1: “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” In November 2003 and March 2004, the FASB’s EITF issued a consensus on EITF Issue 03-1. EITF 03-1 contains new guidance on other-than-temporary impairments of investment securities. The guidance dictates when impairment is deemed to exist, provides guidance on determining if impairment is other than temporary, and directs how to calculate impairment loss. Issue 03-1 also details expanded annual disclosure rules. In September 2004, the FASB’s EITF issued EITF Issue No. 03-1-1 “Effective Date of Paragraphs 10-20 of EITF Issue 03-1 The Meaning of
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Other-Than-Temporary Impairment and Its Application to Certain Investments”, which delays the effective date for the measurement and recognition guidance contained in paragraphs 10-20 of EITF 03-1 to be concurrent with the final issuance of EITF 03-1-a “Implementation Guidance for the Application of Paragraph 16 of EITF 03-1 The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. EITF 03-1-a is currently being debated by the FASB in regards to final guidance and effective date with a comment period that ended October 29, 2004. EITF 03-1, as issued, was originally effective for periods beginning after June 15, 2004 and the disclosure requirements of this consensus remain in effect. The adoption of the original EITF 03-1 (excluding paragraphs 10-20) did not have a material impact on the Company’s financial position or results of operations.
Statement of Position 03-3 (“SOP 03-3”): “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” In December 2003, the American Institute of Certified Public Accountants (“AICPA”) issued SOP 03-3. SOP 03-3 requires loans acquired through a transfer, such as a business combination, where there are differences in expected cash flows and contractual cash flows due in part to credit quality be recognized at their fair value. The yield that may be accreted is limited to the excess of the investor’s estimate of undiscounted expected principal, interest, and other cash flows over the investor’s initial investment in the loan. The excess of contractual cash flows over expected cash flows is not to be recognized as an adjustment of yield, loss accrual, or valuation allowance. Any future excess of cash flows over the original expected cash flows is to be recognized as an adjustment of future yield. Future decreases in actual cash flow compared to the original expected cash flow are recognized as a valuation allowance and expensed immediately. Valuation allowances can not be created nor “carried over” in the initial accounting for loans acquired in a transfer of loans with evidence of deterioration of credit quality since origination. However, valuation allowances for non-impaired loans acquired in a business combination can be carried over. This SOP is effective for loans acquired in fiscal years beginning after December 15, 2004, with early adoption encouraged. The Company does not believe the adoption of SOP 03-3 will have a material impact on the Company’s financial position or results of operations.
NOTE 4 — EARNINGS PER SHARE
Basic earnings per share (“EPS”) excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if options or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that share in the earnings of the entity.
Earnings per share consisted of the following components for the three months ended March 31, 2005 and 2004:
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For the Three Months Ended March 31,
Options to purchase common stock with an exercise price greater than the average market price of common shares for the period are excluded from the calculation of diluted earnings per share, as their effect on earnings per share would be anti-dilutive. For the three months ended March 31, 2005 there were 329,948 shares excluded from the calculation of diluted earnings per share. For the three months ended March 31, 2004 there were 127,350 shares excluded from the calculation of diluted earnings per share.
NOTE 5- EMPLOYEE BENEFITS
POST RETIREMENT BENEFITS AND SUPPLEMENTAL EXECUTIVE RETIREMENT PLANS
The following table illustrates the status of the post-retirement benefit plan and supplemental executive retirement plans (“SERPs”) as of March 31, for the years presented:
Components of Net Periodic Benefit Cost
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The Company previously disclosed in its financial statements for the fiscal year ended December 31, 2004 that it expected to contribute $65,000 to its post retirement benefit plan and $124,000 to its SERPs in 2005 and presently anticipates making these contributions. As of March 31, 2005, $31,000 and $30,000 of contributions have been made to the post retirement benefit plan and the SERPs, respectively.
Not included in the above summary are the components of net periodic benefit cost for the noncontributory defined benefit pension plan administered by Pentegra (“the Fund”). The Fund does not segregate the assets or liabilities of all participating employers and, accordingly, disclosure of accumulated vested and non-vested benefits is not possible. The pension plan year is July 1st through June 30th. The Company anticipates that contributions paid to the defined benefit pension plan will be $1.2 million beginning in the third quarter related to the 2005-2006 plan year. Contributions for the 2004-2005 plan year were all paid in 2004. Pension expense was $1.8 million for the year 2004 and is expected to be $2.2 million for the full year 2005 of which $472,000 has been recognized to date.
The above measures of net periodic postretirement benefit costs do not reflect any amount associated with the Federal subsidy provided by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) because the Company does not believe that the benefits provided by the postretirement benefit plans that fall under the Act have a material impact upon the Company’s financial statements.
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NOTE 6 - COMPREHENSIVE INCOME (LOSS)
Information on the Company’s comprehensive income (loss), presented net of taxes, is set forth below for the quarter ended March 31, 2005 .
Comprehensive income is reported net of taxes, as follows:(Unaudited - Dollars in Thousands)
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the consolidated financial statements, notes and tables included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, filed with the Securities and Exchange Commission.
Cautionary Statement Regarding Forward-Looking Statements
A number of the presentations and disclosures in this Form 10-Q, including, without limitation, statements regarding the level of allowance for loan losses, the rate of delinquencies and amounts of charge-offs, and the rates of loan growth, and any statements preceded by, followed by, or which include the words “may,” “could,” “should,” “will,” “would,” “hope,” “might,” “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “assume” or similar expressions constitute forward-looking statements.
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These forward-looking statements, implicitly and explicitly, include the assumptions underlying the statements and other information with respect to the Company’s beliefs, plans, objectives, goals, expectations, anticipations, estimates, intentions, financial condition, results of operations, future performance and business, including the Company’s expectations and estimates with respect to the Company’s revenues, expenses, earnings, return on equity, return on assets, efficiency ratio, asset quality and other financial data and capital and performance ratios.
Although the Company believes that the expectations reflected in the Company’s forward-looking statements are reasonable, these statements involve risks and uncertainties that are subject to change based on various important factors (some of which are beyond the Company’s control). The following factors, among others, could cause the Company’s financial performance to differ materially from the Company’s goals, plans, objectives, intentions, expectations and other forward-looking statements:
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If one or more of the factors affecting the Company’s forward-looking information and statements proves incorrect, then the Company’s actual results, performance or achievements could differ materially from those expressed in, or implied by, forward-looking information and statements contained in this Form 10-Q. Therefore, the Company cautions you not to place undue reliance on the Company’s forward-looking information and statements.
The Company does not intend to update the Company’s forward-looking information and statements, whether written or oral, to reflect change. All forward-looking statements attributable to the Company are expressly qualified by these cautionary statements.
EXECUTIVE LEVEL OVERVIEW
The Company’s results of operations are largely dependent on net interest income, which is the difference between the interest earned on loans and securities and interest paid on deposits and borrowings. The results of operations are also affected by the level of income/fees from loans, deposits, mortgage banking, and investment management activities, as well as operating expenses, the provision for loan losses, the impact of federal and state income taxes, and the relative levels of interest rates and economic activity.
As anticipated, the net interest margin compressed during the first quarter of 2005 to 3.84% from 3.95% for the fourth quarter of 2004. The compression is the product of numerous factors, such as:
The Company’s growth in earning assets, particularly in the loan portfolio, was sufficient to offset the impact a reduced net interest margin had on net interest income. The Company attempts to mitigate the impact of net interest income dependency through fee income opportunities.
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* The net interest margin of the Company was negatively impacted by 0.19% on an annualized basis due to the adoption of Financial Accounting Standards Board (“FASB”) Interpretation (“FIN”) No. 46R “Consolidation of Variable Interest Entities — An Interpretation of ARB No. 51” (see Recent Accounting Pronouncements, Fin No. 46 in Item 1 hereof) effective March 31, 2004. The net interest margin for prior periods shown above have not been adjusted to reflect the adoption of this interpretation.
Looking ahead to the remainder of 2005, the Company expects the net interest margin to be in a range of 3.80% — 3.85% for the year, depending upon deposit pricing. Management plans to mitigate the impact of net interest margin compression through continued prudent asset growth, increasing deposit originations, generating growth in non-interest income, and non-interest expense control. Additionally, there are a number of initiatives that are expected to contribute to 2005 and beyond. The Company’s success in 2005 will be predicated upon the disciplined execution and the careful monitoring of the Strategic Plan that has been put in place.
A number of the objectives in 2005 are:
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Management will focus in 2005 on refining and leveraging the strong business foundation we have developed and relentlessly executing our strategies.
FINANCIAL POSITION
Loan Portfolio Total loans increased by $38.0 million, or 2.0%, during the three months ended March 31, 2005. The increases were mainly in commercial loans which increased $26.0 million, or 2.9%, in total with commercial real estate representing the largest growth of $15.8 million, or 2.6%. Commercial construction loans increased by $7.0 million, or 5.5%, and commercial and industrial increased $3.2 million, or 2.1%. Consumer loans in total increased $14.6 million, or 2.7% primarily due to growth in Home Equity lending. The Consumer- Auto loan portfolio only grew by $3.1 million, or 1.1%, during the quarter as the profitability of this business tightened due to the flattening of the yield curve. During the first quarter of 2005 the Company has also reclassified certain commercial and consumer loans associated with the Company’s business banking initiative to a new Business Banking loan category. The Business Banking initiative was announced in 2004 and caters to those lending relationships with less than $250,000 in credit exposure and sales revenue of less then $2.5 million. Business banking loans totaled $46.2 million, representing growth of 5.8% during the first three months ending March 31, 2005. Residential loans decreased $5.1 million, or (1.1%) during the quarter mainly due to fewer loans held for sale at March 31, 2005 than at year-end 2004.
Asset Quality Rockland Trust Company actively manages all delinquent loans in accordance with formally drafted policies and established procedures. In addition, Rockland Trust Company’s Board of Directors reviews delinquency statistics, by loan type, on a monthly basis.
Delinquency The Bank’s philosophy toward managing its loan portfolios is predicated upon careful monitoring which stresses early detection and response to delinquent and default situations. The Bank seeks to make arrangements to resolve any delinquent or default situation over the shortest possible time frame. Generally, the Bank requires that a delinquency notice be mailed to a borrower upon expiration of a grace period (typically no longer than 15 days beyond the due date). Reminder notices and telephone calls may be issued prior to the expiration of the grace period. If the delinquent status is not resolved within
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a reasonable time frame following the mailing of a delinquency notice, the Bank’s personnel charged with managing its loan portfolios, contacts the borrower to ascertain the reasons for delinquency and the prospects for payment. Any subsequent actions taken to resolve the delinquency will depend upon the nature of the loan and the length of time that the loan has been delinquent. The borrower’s needs are considered as much as reasonably possible without jeopardizing the Bank’s position. A late charge is usually assessed on loans upon expiration of the grace period.
On loans secured by one-to-four family owner-occupied properties, the Bank attempts to work out an alternative payment schedule with the borrower in order to avoid foreclosure action. If such efforts do not result in a satisfactory arrangement, the loan is referred to legal counsel whereupon counsel initiates foreclosure proceedings. At any time prior to a sale of the property at foreclosure, the Bank may and will terminate foreclosure proceedings if the borrower is able to work out a satisfactory payment plan. On loans secured by commercial real estate or other business assets, the Bank similarly seeks to reach a satisfactory payment plan so as to avoid foreclosure or liquidation.
The following table sets forth a summary of certain delinquency information as of the dates indicated:
Table 1 — Summary of Delinquency Information
Nonaccrual Loans As permitted by banking regulations, consumer loans and home equity loans past due 90 days or more continue to accrue interest. In addition, certain commercial and real estate loans that are more than 90 days past due may be kept on an accruing status if the loan is well secured and in the process of collection. As a general rule, a commercial or real estate loan more than 90 days past due with respect to principal or interest is classified as a nonaccrual loan. Income accruals are suspended on all nonaccrual loans and all previously accrued and uncollected interest is reversed against current income. A loan remains on nonaccrual status until it becomes current with respect to principal (and in certain instances remains current for up to three months) and interest, when the loan is liquidated, or when the loan is determined to be uncollectible and is charged-off against the allowance for loan losses.
Nonperforming Assets Nonperforming assets are comprised of nonperforming loans, nonperforming securities and other real estate owned (“OREO”). Nonperforming loans consist of nonaccrual loans and loans that are more than 90 days past due but still accruing interest. OREO includes properties held by the Bank as a result of foreclosure or by acceptance of a deed in lieu of foreclosure. Nonperforming assets totaled $2.8 million at March 31, 2005
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(0.09% of total assets), as compared to the $2.7 million (0.09% of total assets) reported at December 31, 2004. The Company’s allowance for loan losses to nonperforming loans is 917.12% as compared to 932.53% at December 31, 2004. The Bank held no OREO property on March 31, 2005 nor December 31, 2004 and all securities were performing.
Repossessed automobile loan balances continue to be classified as nonperforming loans, and not as other assets, because the borrower has the potential to satisfy the obligation within twenty days from the date of repossession (before the Bank can schedule disposal of the collateral). The borrower can redeem the property by payment in full at any time prior to the disposal of it by the Bank. Repossessed automobile loan balances amounted to $557,000 $703,000 and $562,000 for the periods ending March 31, 2005, December 31, 2004, and March 31, 2004, respectively.
The following table sets forth information regarding nonperforming assets held by the Company at the dates indicated.
Table 2 — Nonperforming Assets / Loans
In the course of resolving nonperforming loans, the Bank may choose to restructure the contractual terms of certain commercial and real estate loans. Terms may be modified to fit
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the ability of the borrower to repay in line with the current financial status. It is the Bank’s policy to maintain restructured loans on nonaccrual status for approximately six months before management considers a return to accrual status. At March 31, 2005, the Bank had $406,000 of restructured loans. At March 31, 2005, the Bank also had 27 potential problem loans which were not included in nonperforming loans with an outstanding balance of $9.3 million. Potential problem loans are any loans, which are not included in nonaccrual or non-performing loans and which are not considered troubled debt restructures, where known information about possible credit problems of the borrowers causes management to have concerns as to the ability of such borrowers to comply with present loan repayment terms .
Real estate acquired by the Bank through foreclosure proceedings or the acceptance of a deed in lieu of foreclosure is classified as OREO. When property is acquired, it is recorded at the lesser of the loan’s remaining principal balance or the estimated fair value of the property acquired, less estimated costs to sell. Any loan balance in excess of the estimated fair value less estimated cost to sell on the date of transfer is charged to the allowance for loan losses on that date. All costs incurred thereafter in maintaining the property, as well as subsequent declines in fair value are charged to non-interest expense.
Interest income that would have been recognized for the three months ended March 31, 2005 and March 31, 2004, if nonperforming loans at the respective dates had been performing in accordance with their original terms, approximated $66,000 and $90,000, respectively. The actual amount of interest that was collected on nonaccrual and restructured loans during the three months ended March 31, 2005 and March 31, 2004 and included in interest income was $31,000 and $41,000, respectively.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial, commercial real estate, and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer or residential loans for impairment disclosures. At March 31, 2005, impaired loans include all commercial real estate loans and commercial and industrial loans on nonaccrual status and restructured loans. Total impaired loans at March 31, 2005 and December 31, 2004 were $2.7 million and $2.6 million, respectively.
Allowance For Loan Losses While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on increases in non-performing loans, changes in economic conditions, or for other reasons. Various regulatory agencies, as an integral part of their examination processes, periodically
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review the Company’s allowance for loan losses. The Federal Deposit Insurance Corporation (“FDIC”) regulators examined the Company during the first quarter of 2005. No additional provision for loan losses was required as a result of this examination.
The allowance for loan losses is maintained at a level that management considers adequate to provide for potential loan losses based upon evaluation of known and inherent risks in the loan portfolio. The allowance is increased by provisions for loan losses and by recoveries of loans previously charged-off and is reduced by loans charged-off. Additionally, in 2004 the Bank’s allowance increased by $870,000 upon acquisition of Falmouth Bancorp, Inc. This increase represents management’s estimate of potential inherent losses in the acquired portfolio.
As of March 31, 2005, the allowance for loan losses totaled $25.5 million, or 1.31%, of total loans as compared to $25.2 million, or 1.31%, of total loans at December 31, 2004. Based on the analyses described herein, management believes that the level of the allowance for loan losses at March 31, 2005 is adequate.
The following table summarizes changes in the allowance for possible loan losses and other selected loan data for the periods presented:
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Table 3 — Summary of Changes in the Allowance for Loan Losses
The allowance for loan losses is allocated to various loan categories as part of the Bank’s process of evaluating its adequacy. The amount of allowance allocated to these loan categories was $21.4 million at March 31, 2005, compared to $22.4 million at December 31, 2004. The distribution of allowances allocated among the various loan categories as of March 31, 2005 was categorically similar to the distribution as of December 31, 2004. Increases or decreases in the amounts allocated to each category, as compared to those shown as of
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December 31, 2004, generally, reflect changes in portfolio balances outstanding due to new loan originations, loans paid off, changes in levels of credit line usage and the results of ongoing credit risk assessments of the loan portfolio.
The following table summarizes the allocation of the allowance for loan losses for the dates indicated:
Table 4 — Summary of Allocation of the Allowance for Loan Losses
Allocated amounts of allowance for loan losses are determined using both a formula-based approach applied to groups of loans and an analysis of certain individual loans for impairment.
The formula-based approach evaluates groups of loans to determine the allocation appropriate within each portfolio segment. Individual loans within the commercial and industrial, commercial real estate and real estate construction loan portfolio segments are assigned internal risk-ratings to group them with other loans possessing similar risk characteristics. The level of allowance allocable to each group of risk-rated loans is then determined by management applying a loss factor that estimates the amount of probable loss inherent in each category. The assigned loss factor for each risk rating is a formula-based assessment of historical loss data, portfolio characteristics, economic trends, overall market conditions, past experience and management’s analysis of considerations of probable loan loss based on these factors.
During the quarter-ended March 31, 2005, enhancements to the Bank’s internal risk-rating framework were implemented. These enhancements refine the definitional detail of the risk attributes and characteristics that compose each risk grouping and add granularity to the assessment of credit risk across those defined risk groupings.
A similar formula-based approach, using a point-in-time credit grade distribution, was developed to evaluate the consumer installment segments of the loan portfolio. This method was developed in response both to the significance of the balance and the seasoning of this segment of the portfolio which has allowed for a more analytical overview of its inherent risk
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characteristics. This method has been combined with subjective factors, which reflect changing environmental conditions in the consumer installment loan market.
Allocations for residential real estate and other consumer loan categories are principally determined by applying loss factors that represent management’s estimate of probable or expected losses inherent in those categories. In each segment, inherent losses are estimated, based on a formula-based assessment of historical loss data, portfolio characteristics, economic trends, overall market conditions, past loan loss experience and management’s considerations of probable loan loss based on these factors.
The other method used to allocate allowances for loan losses entails the assignment of allowance amounts to individual loans on the basis of loan impairment. Certain loans are evaluated individually and are judged to be impaired when management believes it is probable that the Bank will not collect all of the contractual interest and principal payments as scheduled in the loan agreement. Under this method, loans are selected for evaluation based upon a change in internal risk rating, occurrence of delinquency, loan classification or nonaccrual status. A specific allowance amount is allocated to an individual loan when such loan has been deemed impaired and when the amount of a probable loss is able to be estimated on the basis of: (a) fair value of collateral, (b) present value of anticipated future cash flows or (c) the loan’s observable fair market price. Loans with a specific allowance and the amount of such allowance totaled $1.1 million and $202,000, respectively at March 31, 2005 and $1.1 million and $400,000, respectively, at December 31, 2004.
A portion of the allowance for loan loss is not allocated to any specific segment of the loan portfolio. This non-specific allowance is maintained for two primary reasons: (a) there exists an inherent subjectivity and imprecision to the analytical processes employed and (b) the prevailing business environment, as it is affected by changing economic conditions and various external factors, may impact the portfolio in ways currently unforeseen. Moreover, management has identified certain risk factors, which could impact the degree of loss sustained within the portfolio. These include: (a) market risk factors, such as the effects of economic variability on the entire portfolio, and (b) unique portfolio risk factors that are inherent characteristics of the Bank’s loan portfolio. Market risk factors may consist of changes to general economic and business conditions that may impact the Bank’s loan portfolio customer base in terms of ability to repay and that may result in changes in value of underlying collateral. Unique portfolio risk factors may include industry concentration or covariant industry concentrations, geographic concentrations or trends that may exacerbate losses resulting from economic events which the Bank may not be able to fully diversify out of its portfolio.
Due to the imprecise nature of the loan loss estimation process and ever changing conditions, these risk attributes may not be adequately captured in data related to the formula-based loan loss components used to determine allocations in the Bank’s analysis of the adequacy of the allowance for loan losses. Management, therefore, has established and maintains an imprecision allowance for loan losses. The amount of this measurement imprecision allocation was $4.1 million at March 31, 2005, compared to $2.8 million at December 31, 2004.
Management has increased the measurement imprecision allocation based upon its prospective judgment concerning the possible effects of changing business and economic conditions on borrowers in the loan portfolio, including, but not limited to, the effects of: (a) slower than anticipated employment growth, (b) rising interest rates, (c) inflationary pressure on commodity and energy prices, and (d) the continued uncertainty of geopolitical dynamics.
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Business and economic conditions notwithstanding, the credit quality of the Bank’s loan portfolio has remained stable and the incidence of default within the portfolio has not increased during the quarter-ended March 31, 2005.
As of March 31, 2005, the allowance for loan losses totaled $25.5 million as compared to $25.2 million at December 31, 2004. Based on the processes described above, management believes that the level of the allowance for possible loan losses, at March 31, 2005, is adequate.
Goodwill and Core Deposit Intangible Goodwill and Core Deposit Intangible decreased $81,000, or 0.14%, to $57.2 million at March 31, 2005 from March 31, 2004 resulting from the amortization of the core deposit intangible.
Investments Total investments increased $6.0 million, or 0.7%, to $824.2 million at March 31, 2005 from December 31, 2004, representing a ratio of investments to total assets of 27.4%. Purchases consisted primarily of U.S Government Agencies available for sale.
Deposits Total deposits of $2.1 billion at March 31, 2005 increased $78.7 million, or 3.8%, compared to December 31, 2004. The Company experienced growth in core deposits of $16.1 million, or 1.0%. Time deposits increased by $62.6 million, or 13.9% due to a longer-term certificate promotion as well as $25.0 million in brokered certificates. The brokered certificates are short term, 3 months in duration, with favorable pricing to comparable sources of wholesale funding.
Borrowings Total borrowings decreased $25.8 million, or 3.9%, to $629.3 million at March 31, 2005 from December 31, 2004.
Stockholders’ Equity Stockholders’ equity as of March 31, 2005 totaled $210.6 million, as compared to $210.7 million at December 31, 2004, as a result of a decrease of $7.4 million in the fair value of the Company’s available for sale securities portfolio, offset by net income of $7.9 million.
Equity to Assets Ratio The ratio of equity to assets was 7.0% at March 31, 2005 and 7.2% at December 31, 2004.
RESULTS OF OPERATIONS
Summary of Results of Operations The Company reported net income of $7.9 million for the first quarter of 2005 as compared with net income of $6.7 million for the first quarter of 2004. Diluted earnings per share were $0.51 for the three months ended March 31, 2005, compared to $0.45 per share for the same quarter in the prior year.
Net Interest Income The amount of net interest income is affected by changes in interest rates and by the volume and mix of interest earning assets and interest bearing liabilities.
On a fully tax equivalent basis, net interest income for the first quarter of 2005 increased $2.4 million, or 10.0%, to $26.3 million, as compared to the first quarter of 2004. The Company’s net interest margin decreased to 3.84% for the first quarter of 2005 from 4.14% in the first quarter of 2004. The Company’s interest rate spread (the difference between the
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weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities) decreased by 31 basis points to 3.46% during the first quarter of 2005 as compared to the same period in the prior year. Both the net interest margin and the interest rate spread were negatively impacted by the adoption of FIN46R (see Note 3 to the Condensed Notes to Unaudited Consolidated Financial Statements in Item 1 hereof). Had the Company adopted FIN 46R on January 1, 2004, the adjusted first quarter of 2004 for the impact of FIN 46R would result in a net interest margin of 3.96% and an interest rate spread of 3.59%.
The increase in net interest income for the first quarter of 2005 was mainly due to an increase in income from interest-earning assets, specifically increases in interest income from loans of $4.9 million, or 20.8%. This increase was partially offset by an increase in cost of funds of $3.5 million contributed by higher deposit costs as well as the cost of extending borrowings.
The net interest margin compression is a consequence of the prolonged low interest rate environment, coupled with what the Company believes to be the prudent management of its balance sheet in anticipation of rising interest rates. During this historically low interest rate environment, the Company has emphasized adjustable rate lending and extended the duration of its borrowings. While these measures, along with the use of promotional pricing for certain retail deposit products, have somewhat exacerbated the margin compression and decreased near-term earnings, Management believes that these measures will result in long-term franchise value. The Company’s continued ability to generate loan growth has offset the impact on earnings of the compression of the net interest margin.
The following tables present the Company’s average balances, net interest income, interest rate spread, and net interest margin for the three months ending March 31, 2005 and March 31, 2004. For purposes of the tables and the following discussion, income from interest-earning assets and net interest income are presented on a fully-taxable equivalent basis by adjusting income and yields earned on tax-exempt interest received on loans to qualifying borrowers and on certain of the Company’s securities to make them equivalent to income and yields on fully-taxable investments, assuming a federal income tax rate of 35%.
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Table 5 — Average Balance, Interest Earned/Paid & Average Yields
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The average balance of interest-earning assets for the first quarter of 2005 amounted to $2.7 billion, an increase of $433.2 million, or 18.8%, from the comparable time frame in 2004. Average loans increased by $329.9 million, or 20.6%. Average investments increased by $98.4 million, or 13.9%. Income from interest-earning assets amounted to $37.4 million for the three months ended March 31, 2005, an increase of $5.9 million, or 18.6%, from the three months ended March 31, 2004. The yield on interest earning assets was 5.46% for the three months ending March 31, 2005 compared to 5.47% for the three months ended March 31, 2004 as recent increases in benchmark interest rates have halted the decline in asset yields.
The average balance of interest-bearing liabilities for the first quarter of 2005 was $2.2 billion, an increase of $424.8 million, or 23.6%, from the comparable 2004 time frame. Average interest bearing deposits were higher by $239.4 million, or 17.7%, for the three months ending March 31, 2005 compared to the same period last year. Core interest bearing deposits grew by $211.2 million, or 23.8% for the three months ended March 31, 2005. Time deposits grew by $28.1 million, or 6.0% for the three months ended March 31, 2005, of this increase $13.9 million were from brokered certificates of deposit. The brokered certificates are short term, 3 months in duration, with favorable pricing to comparable sources of wholesale funding. The growth in average non-interest bearing demand deposits was $53.6 million, or 12.3%, for the quarter ending March 31, 2005 as compared to the same period in 2004. Also, contributing to the increase of total deposits are the deposits assumed in the Falmouth acquisition of $136.7 million on July 16, 2004. For the three months ended March 31, 2005, average borrowings were $627.3 million, representing an increase of $185.4 million, or 42.0%, from the three months ended March 31, 2004 resulting from increased FHLB borrowings to fund balance sheet growth and $51.1 million of junior subordinated debentures that are now being consolidated within debt due to the adoption of FIN 46R on March 31, 2004 (see Note 3 to the Condensed Notes to Unaudited Consolidated Financial Statements in Item 1 hereof). Interest expense on interest-bearing liabilities increased by $3.5 million, or 45.4%, to $11.1 million in the first quarter of 2005 as compared to the same period last year, as a result of balance sheet growth and the inclusion of the junior subordinated debentures. The total cost of all funding liabilities, including non-interest bearing demand deposits, was 1.64% for the first quarter of 2005 compared to 1.37% for the first quarter of 2004.
The following table presents certain information on a fully tax-equivalent basis regarding changes in the Company’s interest income and interest expense for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided with respect to changes attributable to: (1) changes in rate (change in rate multiplied by old volume), (2) changes in volume (change in volume multiplied by old rate), and (3) changes in volume/rate (change in volume multiplied by change in rate).
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Table 6 — Volume Rate Analysis
Provision For Loan Losses The provision for loan losses represents the charge to expense that is required to maintain an adequate level of allowance for loan losses. Management’s periodic evaluation of the adequacy of the allowance considers past loan loss experience, known and inherent risks in the loan portfolio, adverse situations which may affect borrowers’ ability to repay, the estimated value of the underlying collateral, if any, and current and prospective economic conditions. Substantial portions of the Bank’s loans are secured by real estate in Massachusetts. Accordingly, the ultimate collectibility of a substantial portion of the Bank’s loan portfolio is susceptible to changes in property values within the state.
The provision for loan losses increased to $930,000 for the three months ended March 31, 2005 compared with $744,000 for the three months ended March 31, 2004. The Company increased the provision for loan losses commensurate with loan growth. Asset quality remains sound with nonperforming assets of $2.8 million at March 31, 2005. At March 31, 2005, the allowance for loan loss covered nonperforming loans 9.2 times. Nonperforming loans at December 31, 2004 were $2.7 million, with the allowance covering nonperforming loans 9.3 times.
The provision for loan losses is based upon management’s evaluation of the level of the allowance for loan losses in relation to the estimate of loss exposure in the loan portfolio. An analysis of individual loans and the overall risk characteristics and size of the different loan portfolios is conducted on an ongoing basis. This managerial evaluation of individual loans is reviewed periodically by a third-party loan review consultant. As necessary, adjustments to the
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level of allowance for loan losses are reported in the earnings of the period in which they become known.
Non-Interest Income Non-interest income decreased by $668,000, or 9.2%, during the three months ended March 31, 2005, as compared to the same period in the prior year. The majority of the decrease is attributable to a decrease in commercial loan prepayment fees of $530,000 and lower security gains of $654,000.
Service charges on deposit accounts increased by $61,000, or 2.1%, for the three months ended March 31, 2005, as compared to the same period in 2004, reflecting a growth in core deposits partially offset by increased earnings credit rates on business deposits due to the rising rate environment. Investment management services income increased by $158,000, or 14.6%, for the three months ended March 31, 2005, compared to the same period last year due to growth in managed assets. Assets under administration increased by 13.3% from the same period last year to $562.6 million.
Mortgage banking income increased by $192,000, or 26.1% for the three months ended March 31, 2005 as compared to the three months ended March 31, 2004, due to an increase in the volume of loans sold and a partial recovery of the impairment valuation allowance on the mortgage servicing asset. Partially offsetting these increases were greater commissions on sold loans and a smaller gain on the fair value of mortgage banking derivatives, when compared to prior period. The balance of the mortgage servicing asset is $3.3 million and loans serviced amounted to $378.0 million as of March 31, 2005.
Other non-interest income decreased $467,000, or (40.6%), for the three months ended March 31, 2005, as compared to the same period in 2004, primarily due to decreases in commercial loan prepayment fees.
Gain on sale of securities totaled $343,000 in the first quarter of 2005, a decrease of $654,000, or 65.6% compared to the first quarter of 2004.
Non-Interest Expense Non-interest expense increased by $824,000, or 4.3%, for the three months ended March 31, 2005, as compared to the same period in the prior year.
Salaries and employee benefits increased by $826,000, or 7.5%, for the three months ended March 31, 2005, as compared to the same period in the prior year. Salaries increased by $414,000, or 5.3 %. The remaining increases were in benefits resulting primarily from payroll taxes, due to the timing of incentive payments, medical plan insurance and the current year accrual for incentive compensation.
Occupancy and equipment related expense increased by $307,000 or 13.4%, for the three months ended March 31, 2005 compared to the same period in the prior year. The increase in this expense is primarily driven by an increase in snow removal expense due to inclement weather.
Other non-interest expenses decreased by $214,000, or 4.6%, for the three months ended March 31, 2005, as compared to the same period in the prior year. The decrease in other non-interest expenses for the year is primarily attributable to decreases in consultant fees, telephone, and recovery and collection fees partially offset by increases in advertising.
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Income Taxes For the quarters ending March 31, 2005 and March 31, 2004, the Company recorded combined federal and state income tax provisions of $3.8 million and $3.2 million, respectively. These provisions reflect effective income tax rates of 32.6% and 32.4% for the quarters ending March 31, 2005 and March 31, 2004, respectively. During the second quarter of 2004, the Company announced that one of its subsidiaries (a Community Development Entity, or “CDE”) had been awarded $30 million in tax credit allocation authority under the New Markets Tax Credit Program of the United States Department of Treasury. During the third quarter of 2004, the Bank invested $5 million in the CDE providing it with the capital necessary to begin assisting qualified businesses in low-income communities throughout its market area. During the fourth quarter of 2004 the Bank invested an additional $10 million in the Community Development Entity. Based upon the Bank’s $15 million investment, it will be eligible to receive tax credits over a seven year period totaling 39% of its investment, or $5.85 million. The Company began recognizing the benefit of these tax credits in 2004. In the first quarter of 2005 the associated reduction to the provision for income taxes was $187,500 (see Note 3 to the Condensed Notes to Unaudited Consolidated Financial Statements with Item 1 hereof).
Minority Interest Minority interest expense was zero and $1.1 million for the quarters ending March 31, 2005 and March 31, 2004 respectively (see Note 3 to the Condensed Notes to Unaudited Consolidated Financial Statements within Item 1 hereof).
Return on Average Assets and Equity The annualized consolidated returns on average equity and average assets for the three months ended March 31, 2005 were 14.87% and 1.08%, respectively, compared to 15.17% and 1.08% reported for the same period last year, respectively.
Asset/Liability Management
The Bank’s asset/liability management process monitors and manages, among other things, the interest rate sensitivity of the balance sheet, the composition of the securities portfolio, funding needs and sources, and the liquidity position. All of these factors, as well as projected asset growth, current and potential pricing actions, competitive influences, national monetary and fiscal policy, and the regional economic environment are considered in the asset/liability management process.
The Asset/Liability Management Committee (“ALCO”), whose members are comprised of the Bank’s senior management, develops procedures consistent with policies established by the board of directors, which monitor and coordinate the Bank’s interest rate sensitivity and the sources, uses, and pricing of funds. Interest rate sensitivity refers to the Bank’s exposure to fluctuations in interest rates and its effect on earnings. If assets and liabilities do not re-price simultaneously and in equal volume, the potential for interest rate exposure exists. It is management’s objective to maintain stability in the growth of net interest income through the maintenance of an appropriate mix of interest-earning assets and interest-bearing liabilities and, when necessary, within prudent limits, through the use of off-balance sheet hedging instruments such as interest rate swaps, floors and caps. The Committee employs simulation analyses in an attempt to quantify, evaluate, and manage the impact of changes in interest rates on the Bank’s net interest income. In addition, the Bank engages an independent consultant to render advice with respect to asset and liability management strategy.
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The Bank is careful to increase deposits without adversely impacting the weighted average cost of those funds. Accordingly, management has implemented funding strategies that include FHLB advances, brokered certificates of deposits, and repurchase agreement lines. These non-deposit funds are also viewed as a contingent source of liquidity and, when profitable lending and investment opportunities exist, access to such funds provides a means to leverage the balance sheet.
From time to time, the Bank has utilized interest rate swap agreements and interest rates caps and floors as hedging instruments against interest rate risk. An interest rate swap is an agreement whereby one party agrees to pay a floating rate of interest on a notional principal amount in exchange for receiving a fixed rate of interest on the same notional amount for a predetermined period of time from a second party. Interest rate caps and floors are agreements whereby one party agrees to pay a floating rate of interest on a notional principal amount for a predetermined period of time to a second party up to or down to a specified rate of interest. The assets relating to the notional principal amount are not actually exchanged.
At March 31, 2005 the Company had swaps, designated as “cash flow” hedges, with total notional values of $110.0 million. The purpose of these swaps is to hedge the variability in the cash outflows of LIBOR based borrowings attributable to changes in interest rates. Under these swap agreements the Company pays a fixed rate of interest of 3.65% on $50 million of the notional value through November 2006, 2.49% on $25 million notional value through January 2007, and 4.06% on $35 million of the notional value through January 2010, and all receive a 3 month LIBOR rate of interest. These swaps had a positive fair value of $1.7 million at March 31, 2005. The Company also has a $100 million, 4.00%, 3-month LIBOR interest rate cap with an effective date of January 31, 2005 and a maturity date of January 31, 2008. The interest rate cap will pay the Company should 3-month LIBOR exceed 4.00% on a rate reset date during the effective period of the cap. At December 31, 2004 the Company had swaps with a total notional value of $75.0 million. These swaps had a positive fair value of $142,000 at December 31, 2004. All changes in the fair value of the interest rate swaps and caps are recorded, net of tax, through equity as other comprehensive income.
To improve the Company’s asset sensitivity, the Company sold interest rate swaps hedged against loans during the year ending December 31, 2002 resulting in total deferred gains of $7.1 million. The deferred gain is classified in other comprehensive income, net of tax, as a component of equity. The interest rate swaps sold had total notional amounts of $225.0 million. These swaps were accounted for as cash flow hedges, and therefore, the deferred gains are amortized into interest income over the remaining life of the hedged item, which range between two and five years. At March 31, 2005, there are $1.7 million gross, or $967,000, net of tax, of such deferred gains included in other comprehensive income.
Additionally, the Company enters into commitments to fund residential mortgage loans with the intention of selling them in the secondary markets. The Company also enters into forward sales agreements for certain funded loans and loan commitments to protect against changes in interest rates. The Company records unfunded commitments and forward sales agreements at fair value with changes in fair value as a component of Mortgage Banking Income. At March 31, 2005 the Company had residential mortgage loan commitments with a fair value of $134,000 and forward sales agreements with a fair value of $70,000. At December 31, 2004 the Company had residential mortgage loan commitments with a fair value of $148,000 and forward sales agreements with a fair value of ($47,000). Changes in these fair values of $102,000, and $242,000 for the quarters ending March 31, 2005, and March 31, 2004, respectively, are recorded as a component of mortgage banking income.
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Market Risk Market risk is the sensitivity of income to changes in interest rates, foreign exchange rates, commodity prices and other market-driven rates or prices. The Company has no trading operations and thus is only exposed to non-trading market risk.
Interest-rate risk is the most significant non-credit risk to which the Company is exposed. Interest-rate risk is the sensitivity of income to changes in interest rates. Changes in interest rates, as well as fluctuations in the level and duration of assets and liabilities, affect net interest income, the Company’s primary source of revenue. Interest-rate risk arises directly from the Company’s core banking activities. In addition to directly impacting net interest income, changes in the level of interest rates can also affect the amount of loans originated, the timing of cash flows on loans and securities and the fair value of securities and derivatives as well as other affects.
The primary goal of interest-rate risk management is to control this risk within limits approved by the Board. These limits reflect the Company’s tolerance for interest-rate risk over both short-term and long-term horizons. The Company attempts to control interest-rate risk by identifying, quantifying and, where appropriate, hedging its exposure. The Company manages its interest-rate exposure using a combination of on and off-balance sheet instruments, primarily fixed rate portfolio securities, and interest rate swaps.
The Company quantifies its interest-rate exposures using net interest income simulation models, as well as simpler gap analysis, and Economic Value of Equity (EVE) analysis. Key assumptions in these simulation analyses relate to behavior of interest rates and behavior of the Company’s deposit and loan customers. The most material assumptions relate to the prepayment of mortgage assets (including mortgage loans and mortgage-backed securities) and the life and sensitivity of nonmaturity deposits (e.g. DDA, NOW, savings and money market). The risk of prepayment tends to increase when interest rates fall. Since future prepayment behavior of loan customers is uncertain, the resultant interest rate sensitivity of loan assets cannot be determined exactly.
To mitigate these uncertainties, the Company gives careful attention to its assumptions. In the case of prepayment of mortgage assets, assumptions are derived from published dealer median prepayment estimates for comparable mortgage loans.
The Company manages the interest-rate risk inherent in its mortgage banking operations by entering into forward sales contracts. An increase in market interest rates between the time the Company commits to terms on a loan and the time the Company ultimately sells the loan in the secondary market will have the effect of reducing the gain (or increasing the loss) the Company records on the sale. The Company attempts to mitigate this risk by entering into forward sales commitments in amounts sufficient to cover all closed loans and a majority of rate-locked loan commitments.
The Company’s policy on interest-rate risk simulation specifies that if interest rates were to shift gradually up or down 200 basis points, estimated net interest income for the subsequent 12 months should decline by less than 6%.
The following table sets forth the estimated effects on the Company’s net interest income over a 12-month period following the indicated dates in the event of the indicated increases or decreases in market interest rates:
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Table 7 — Interest Rate Sensitivity
The results implied in the above table indicate estimated changes in simulated net interest income for the subsequent 12 months assuming a gradual shift up or down in market rates of 200 basis points across the entire yield curve. It should be emphasized, however, that the results are dependent on material assumptions such as those discussed above. For instance, asymmetrical rate behavior can have a material impact on the simulation results. If competition for deposits forced the Company to raise rates on those liabilities quicker than is assumed in the simulation analysis without a corresponding increase in asset yields net interest income may be negatively impacted. Alternatively, if the Company is able to lag increases in deposit rates as loans re-price upward net interest income would be positively impacted.
The most significant factors affecting market risk exposure of the Company’s net interest income during the first quarter of 2005 were (i) changes in the composition and prepayment speeds of mortgage assets and loans (ii) the shape of the U.S. Government securities and interest rate swap yield curve (iii) the level of changes in U.S. benchmark interest rates and (iv) the level of rates paid on deposit accounts.
Liquidity Liquidity, as it pertains to the Company, is the ability to generate adequate amounts of cash in the most economical way for the institution to meet its ongoing obligations to pay deposit withdrawals and to fund loan commitments. The Company’s primary sources of funds are deposits, borrowings, and the amortization, prepayment and maturities of loans and securities.
The Bank utilizes its extensive branch network to access retail customers who provide a stable base of in-market core deposits. These funds are principally comprised of demand deposits, interest checking accounts, savings accounts, money market accounts and certificates of deposit. Deposit levels are greatly influenced by interest rates, economic conditions, and competitive factors. For an alternative source of funding to borrowings the Bank will occasionally purchase brokered certificates of deposits. At March 31, 2005, the bank had $25.0 million of brokered certificates of deposits outstanding. The Bank has also established repurchase agreement lines, with major brokerage firms as potential sources of liquidity. At March 31, 2005 the Company had no advances outstanding under these lines. In addition to agreements with brokers, the Bank also had customer repurchase agreements outstanding amounting to $59.8 million at March 31, 2005. As a member of the Federal Home Loan Bank, the Bank has access to approximately $808.3 million of borrowing capacity. On March 31, 2005 the Bank had $516.6 million outstanding in FHLB borrowings.
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The Company, as a separately incorporated bank holding company, has no significant operations other than serving as the sole stockholder of the Bank. It’s commitments and debt service requirement, at March 31, 2005 consist of junior subordinated debentures, including accrued interest, issued to two unconsolidated subsidiaries, $25.8 million to Independent Capital Trust III and $25.8 million to Independent Capital Trust IV, in connection with the issuance of 8.625% Capital Securities due in 2031 and 8.375% Capital Securities due in 2032, respectively. The Parent only obligations relate to its reporting obligations under the Securities and Exchange Act of 1934, as amended and related expenses as a publicly traded company. The Company is directly reimbursed by the Bank for virtually all such expenses.
The Company actively manages its liquidity position under the direction of the Asset/Liability Management Committee. Periodic review under prescribed policies and procedures is intended to ensure that the Company will maintain adequate levels of available funds. At March 31, 2005, the Company’s liquidity position was within policy guidelines. Management believes that the Bank has adequate liquidity available to respond to current and anticipated liquidity demands.
Capital Resources and Dividends The Federal Reserve Board, the Federal Deposit Insurance Corporation, and other regulatory agencies have established capital guidelines for banks and bank holding companies. Risk-based capital guidelines issued by the federal regulatory agencies require banks to meet a minimum Tier 1 risk-based capital ratio of 4.0% and a total risk-based capital ratio of 8.0%. At March 31, 2005 the Company had a Tier 1 risk-based capital ratio of 10.18% and total risk-based capital ratio 11.43%. The Bank had a Tier 1 risk-based capital ratio of 9.96% and a total risk-based capital ratio of 11.21% as of the same date.
A minimum requirement of 4.0% Tier 1 leverage capital is also mandated. On March 31, 2005, the Company and the Bank had Tier 1 leverage capital ratios of 7.22% and 7.06%, respectively.
In March, the Company’s Board of Directors declared a cash dividend of $0.15 per share, a 7.1% increase from March 31, 2004, to stockholders of record as of the close of business on March 25, 2005. This dividend was paid on April 8, 2005. On an annualized basis, the dividend payout ratio amounted to 28.82% of the last four quarters’ earnings.
Contractual Obligations, Commitments, Contingencies, and Off-Balance Sheet Financial Instruments The Company has entered into contractual obligations and commitments and off-balance sheet financial instruments. The following tables summarize the Company’s contractual cash obligation and other commitment and off-balance sheet financial instruments at March 31, 2005:
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Table 8 — Contractual Obligations, Commitments and Off-Balance Sheet Financial Instruments by Maturity(Unaudited — Dollars in Thousands)
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Information required by this Item 3 is included in Item 2 of Part I of this Form 10-Q, entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
Item 4. Controls and Procedures
Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures. The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the Exchange Act). Based upon that evaluation, the Company’s Chief Executive Officer along with the Company’s Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective as of the end of the period covered by this quarterly report.
Changes in Internal Controls over Financial Reporting. There were no changes in our internal control over financial reporting that occurred during the first quarter that have materially affected, or are, reasonably likely to materially affect, the Company’s internal controls over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Company anticipates that the federal judge presiding over the pending case known asRockland Trust Company v. Computer Associates International, Inc., United States District Court for the District of Massachusetts Civil Action No. 95-11683-DPW, will issue a final trial court decision, in the form of Findings of Fact and Conclusions of Law, at some point. The case arises from a 1991 License Agreement (the “Agreement”) between the Bank and Computer Associates International, Inc. (“CA”) for an integrated system of banking software products.
In July 1995 the Bank filed a Complaint against CA in federal court in Boston which asserted claims for breach of the Agreement, breach of express warranty, breach of the implied covenant of good faith and fair dealing, fraud, and for unfair and deceptive practices in violation of section 11 of Chapter 93A of the Massachusetts General Laws (the “93A Claim”). The Bank is seeking damages of at least $1.23 million from CA. Under Massachusetts’s law, interest will be computed at a 12% rate on any damages which the Bank recovers, either from the date of breach or the date on which the case was filed. If the Bank prevails on the 93A Claim, it shall be entitled to recover its attorney fees and costs and may also recover double or triple damages. CA asserted a Counterclaim against the Bank for breach of the Agreement. CA seeks to recover damages of at least $1.1 million from the Bank, plus interest at a rate as high as 24% pursuant to the Agreement.
The non-jury trial of the case was conducted in January 2001. The trial concluded with post-trial submissions to and argument before the Court in February 2001. In September 2002 the court, in response to a joint inquiry from counsel for the Bank and counsel for CA, indicated that the judge is “actively working” on the case and anticipated, at that time, rendering a decision sometime in the fall of 2002. The court, however, has not yet rendered a decision.
The Company has considered the potential impact of this case, and all cases pending in the normal course of business, when preparing its financial statements. While the trial court decision may affect the Company’s operating results for the quarter in which the decision is rendered in either a favorable or unfavorable manner, the final outcome of this case will not likely have any material, long-term impact on the Company’s financial condition.
In addition to the foregoing, the Company is involved in routine legal proceedings occurring in the ordinary course of business which in the aggregate are believed by the Company to be immaterial to the Company’s financial condition and results of operations.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds — None
Item 3. Defaults Upon Senior Securities – None
Item 4. Submission of Matters to a Vote of Security Holders – None
Item 5. Other Information – None
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Item 6. Exhibits
Exhibits
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+Furnished herewith
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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.
INDEPENDENT BANK CORP.(registrant)
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