Chemung Financial Corporation - 10-Q quarterly report FY

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CHEMUNG FINANCIAL CORPORATION AND SUBSIDIARIES

INDEX

See accompanying notes to unaudited consolidated financial statements.

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CHEMUNG FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME

(UNAUDITED)

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The available for sale segment of the securities portfolio totaled $220.0 million at March 31, 2006, compared to $238.3 million at the end of 2005, a decrease of approximately $18.3 million or 7.7%. Unrealized appreciation related to the available for sale portfolio has decreased $756 thousand since December 31, 2005, reflecting the impact of an increase in mid to long-term rates on bond portfolio values. At amortized cost, the available for sale portfolio was down $17.6 million since December 31, 2005. Federal agency bonds were down $10.0 million, as during the quarter a bond was called. Other major factors in this decrease included a $4.3 million decrease in mortgage-backed securities and a $1.9 million decrease in the stock portfolio. The decrease in mortgage-backed securities reflects paydowns received during the quarter, while the decline in the stock portfolio was due to net redemptions of shares by the Federal Home Loan Bank of New York ("FHLB"). The held to maturity segment of the portf olio, consisting primarily of local municipal obligations, totaled $8.4 million at amortized cost as of March 31, 2006, down slightly from the December 31, 2005 balance of $8.6 million.

The $7.2 million increase in cash and cash equivalents since December 31, 2005 was primarily the result of a $4.4 million increase in

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period-end federal funds sold as well as a $3.4 million increase in federal transit items.

Deposits at March 31, 2006 totaled $574.7 million, an increase of $49.7 million or 9.5% as compared to December 31, 2005. While period-end non-interest bearing demand deposits were down $3.6 million due primarily to lower period-end non-personal balances, this was offset by a $53.3 million increase in interest bearing balances. Approximately $44.9 million of this increase was in public fund deposits, principally reflected in higher time and insured money market balances. The balance of the increase in interest-bearing balances was due primarily to higher personal time balances and higher non-personal insured money market balances. A $22.8 million decrease in securities sold under agreements to repurchase reflects the fact that during the quarter two advances from the FHLB totaling $19.0 million matured, and two advances totaling $5.0 million were called. Additionally, with deposits increasing $49.7 million during the quarter, borrowings under the Corporation's line of credit with the FHLB were reduced b y $18.0 million.

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

In addition to non-performing loans, as of March 31, 2006, the Corporation, through its loan review function, has identified 18 commercial loan relationships totaling $8.830 million in potential problem loans, as compared to $9.315 million (15 commercial loan relationships) at December 31, 2005. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms, and which may result in the disclosure of such loans as non-performing at some time in the future. At the Corporation, potential problem loans are typically loans that are performing but are classified in the Corporation's loan rating system as "substandard." Management cannot predict the extent to which

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economic conditions may worsen or other factors which may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on non-accrual, become restructured, or require increased allowance coverage and provisions for loan losses.

Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the historical loan loss experience, review of specific problem loans (including evaluation of the underlying collateral), changes in the composition and volume of the loan portfolio, overall portfolio quality, and current economic conditions that may affect the borrowers' ability to pay. With the level of non-performing relationships continuing to decline, the Corporation reduced its provision for loan losses during the first quarter of 2006 to $125 thousand as compared to $325 thousand during the first quarter of 2005. At March 31, 2006, the Corporation's allowance for loan losses totaled $9.833 million, resulting in a coverage ratio of allowance to non-performing loans of 125.7%. The allowance for loan losses is an amount that management believes will be adequate to absorb probable loan losses on existing loans. Due primarily to slightly higher net cons umer loan charge-offs, net loan charge-offs for the first three months of 2006 totaled $70 thousand as compared to $60 thousand during the first quarter of 2005. The allowance for loan losses to total loans at March 31, 2006 was 2.26% as compared to 2.34% as of December 31, 2005.

Activity in the allowance for loan losses was as follows:

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income, as well as a reduction in the provision for loan losses. These positive results were offset to some extent by an increase in operating expenses.

Net interest income before the provision for loan losses increased $75 thousand or 1.2%, with the net interest margin increasing 4 basis points to 3.71%. This change was driven primarily by the higher volume of loans versus securities as a percentage of average earning assets, together with a somewhat lower volume of average interest bearing liabilities. The change in interest rates slightly offset the benefits of increased volume in average earning assets as interest bearing liabilities repriced more rapidly. As compared to the first quarter of 2005, average earning assets were up $1.0 million or 0.2%, with total interest and dividend income increasing $843 thousand or 9.8% from $8.591 million in the first quarter of 2005 to $9.434 million in the first quarter of 2006, as the average yield rose 51 basis points to 5.76%. The increase in average earning assets was due to a $37.3 million increase in average loans, offset by a $27.0 million decrease in average fed funds sold and interest bearing deposits, a nd a $9.2 million decrease in the average securities portfolio. The $37.3 million increase in average loans reflects growth in all segments of the portfolio, with average commercial loans increasing $15.4 million, and average consumer loans and mortgages increasing $11.5 million and $10.4 million, respectively.

Total average funding liabilities increased $777 thousand or 0.1% when compared to the first quarter of 2005, the result of a $15.5 million increase in average deposits, and a $15.8 million increase in average overnight borrowings under the Corporation's line of credit with the FHLB, these increases offset by decreases in average securities sold under agreements to repurchase funded by the FHLB and term advances from the FHLB totaling $25.6 million and $5.0 million, respectively. The increase in average deposits was primarily related to higher average time deposit balances of $20.9 million, principally due to higher public fund and personal time deposit balances. The increase in these balances reflects the fact that during the first quarter of 2006, the Corporation was more aggressive in the pricing of these deposit products, which were a significant funding source for the Corporation's average loan growth. Additionally impacting this increase was a $6.0 million increase in average demand deposit balances , as both personal and non-personal averages increased. These increases were offset primarily by a $7.2 million decrease in average savings account balances, mostly due to lower personal account averages. The decrease in average securities sold under agreements to repurchase and FHLB term advances reflects the maturity or call of advances that had been utilized to leverage securities purchases. A flat yield curve has precluded the Corporation from instituting new leveraging due to the inadequate spreads available in the marketplace. In total, while average interest bearing liabilities decreased $5.2 million or 1.0% compared to first quarter 2005 averages, interest expense increased $768 thousand or 29.7% with the average cost of interest-bearing liabilities increasing 66 basis points to 2.76%.

As discussed more fully under the Asset Quality section of this report, with the level of non-performing loans continuing to show improvement, the provision for loan losses during the first quarter of

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2006 totaled $125 thousand as compared to $325 thousand during the first quarter of 2005, a decrease of $200 thousand.

Non-interest income during the first quarter of 2006 compared to the first quarter of 2005 increased $295 thousand or 10.0%. This increase was impacted to a great extent by a $170 thousand increase in service charges on deposit accounts, principally due to an increase in fees for insufficient funds. Other significant increases included a $38 thousand increase in fee income generated through our Trust and Investment Center, a $34 thousand increase in debit card interchange income and a $45 thousand increase in revenue from our equity investment in Cephas Capital Partners, LP.

Operating expenses were $524 thousand or 8.1% higher than the comparable period last year. Areas having the greatest impact on this increase include a $150 thousand increase in salaries and wages, as well as increases in data processing and net occupancy costs of $147 thousand and $95 thousand, respectively. The increase in salaries and wages reflects merit increases effective in January of 2006, as well as increased compensation costs related to the Corporation's expansion during 2005 in the New York State counties of Tompkins and Broome. The increase in data processing cost was primarily due to higher software maintenance and license costs, as well as increases in debit and credit card merchant processing costs, while the increase in net occupancy costs resulted in large part from the above mentioned expansion into Tompkins and Broome counties.

The $29 thousand increase in income tax expense is primarily a function of higher pre-tax profits, with the effective tax rate increasing from 27.9% for the first quarter of 2005 to 28.6% for the first quarter of 2006.

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Average Consolidated Balance Sheet and Interest Analysis

For the purpose of these computations, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. No tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions.

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The following table sets forth for the periods indicated, a summary of the changes in interest and dividends earned and interest paid resulting from changes in volume and changes in rates (in thousands of dollars):

Cash generated during the first quarter of 2006 was used primarily to reduce securities sold under agreements to repurchase by $22.8 million, fund a net increase in loans of $18.7 million, and a net decrease in FHLB overnight advances of $18.0 million, and to purchase

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securities of $4.8 million. Other significant uses of cash during this period included the purchase of treasury shares ($486 thousand), payment of cash dividends ($864 thousand) and purchases of premises and equipment ($691 thousand). During the first quarter of 2005, the primary uses of cash included the purchase of securities totaling $34.9 million, a reduction in securities sold under agreements to repurchase of $16.5 million and a net increase in loans of $10.5 million. Other significant uses of cash during the first quarter of 2005 included the payment of cash dividends ($878 thousand) and the purchase of treasury shares ($816 thousand).

Since year-end 2005, the Corporation's total shareholders' equity has decreased $194 thousand from $81.2 million to $81.0 million. This decrease is primarily reflected in a $462 thousand decrease in accumulated other comprehensive income and a $287 thousand increase in treasury stock, partially offset by a $735 thousand increase in retained earnings.

As of March 31, 2006, the Corporation's consolidated leverage ratio was 10.67%. The Tier I and Total Risk Adjusted Capital ratios were 15.72% and 17.76%, respectively. All of the above ratios are in excess of the requirements for being considered "well capitalized" by the FDIC, the Federal Reserve and the New York State Banking Department.

When shares of the Corporation become available in the market, we may purchase them after careful consideration of our capital position. On November 17, 2004, the Corporation announced that its Board of Directors authorized the repurchase of up to 180,000 shares, or approximately 5% of its outstanding common shares, either through open market or privately negotiated transactions over a two-year period. During the first quarter of 2006, the Corporation purchased 16,136 shares at an average price of $30.13 per share. As of March 31, 2006, a total of 96,001 shares had been purchased since the inception of the announced repurchase program. Additionally, during January of 2006, 7,963 shares were re-issued from treasury to fund the stock component of directors' 2005 compensation.

Interest Rate Risk

As intermediaries between borrowers and savers, commercial banks incur both interest rate risk and liquidity risk. The Corporation's Asset/Liability Committee ("ALCO") has the strategic responsibility for setting the policy guidelines on acceptable exposure to these areas. These guidelines contain specific measures and limits regarding these risks, which are monitored on a regular basis. The ALCO is made up of the president, two executive vice presidents, chief financial officer, asset liability management officer, senior marketing officer, and others representing key functions.

The ALCO is also responsible for supervising the preparation and annual revisions of the financial segments of the annual budget, which

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is built upon the committee's economic and interest-rate assumptions. It is the responsibility of the ALCO to modify prudently the Corporation's asset/liability policies.

Interest rate risk is the risk that net interest income will fluctuate as a result of a change in interest rates. It is the assumption of interest rate risk, along with credit risk, that drives the net interest margin of a financial institution. For that reason, the ALCO has established tolerance limits based upon a 200-basis point change in interest rates. At March 31, 2006, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the next 12 months net interest income by 4.03% and an immediate 200-basis point increase would negatively impact the next 12 months net interest income by 4.27%. Both are within the Corporation's policy guideline of 15% established by ALCO.

A related component of interest rate risk is the expectation that the market value of our capital account will fluctuate with changes in interest rates. This component is a direct corollary to the earnings-impact component: an institution exposed to earnings erosion is also exposed to shrinkage in market value. At March 31, 2006, it is estimated that an immediate 200-basis point decrease in interest rates would negatively impact the market value of our capital account by 3.68% and an immediate 200-basis point increase in interest rates would negatively impact the market value by 5.35%. Both are within the established tolerance limit of 15.0%.

Management does recognize the need for certain hedging strategies during periods of anticipated higher fluctuations in interest rates and the Board-approved Funds Management Policy provides for limited use of certain derivatives in asset liability management. These strategies were not employed during the first three months of 2006.

Item 3: Quantitative and Qualitative Disclosures About Market Risk

Information required by this Item is set forth herein in Management's Discussion and Analysis of Financial Condition and Results of Operations under the heading "Interest Rate Risk."

Item 4: Controls and Procedures

The Corporation's management, under the supervision and with the participation of our President and Chief Executive Officer, who is the Corporation's principal executive officer, and our Treasurer and Chief Financial Officer, who is the Corporation's principal financial officer, has evaluated the effectiveness of the Corporation's disclosure controls and procedures as of March 31, 2006. Based upon that evaluation, the President and Chief Executive Officer and the Treasurer and Chief Financial Officer have concluded that the Corporation's disclosure controls and procedures are effective as of March 31, 2006.

There were no significant changes in the Corporation's internal control over financial reporting that occurred during the Corporation's most recent fiscal quarter that have materially

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affected, or that are reasonably likely to materially affect, the Corporation's internal control over financial reporting.

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