NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
Note
1
– Summary of Significant Accounting
Policies
Principles
of Consolidation and Basis of Presentation
In
the
opinion of management, the accompanying unaudited consolidated financial
statements contain all adjustments, consisting only of normal recurring
adjustments, necessary to present fairly the consolidated financial position
of
Harleysville National Corporation (the Corporation) and its wholly owned
subsidiaries-Harleysville National Bank (the Bank), HNC Financial Company and
HNC Reinsurance Company, as of September 30, 2007, the results of its operations
for the three and nine month periods ended September 30, 2007 and 2006 and
the
cash flows for the nine month periods ended September 30, 2007 and 2006. Certain
prior period amounts have been reclassified to conform to current year
presentation. All significant intercompany accounts and transactions have been
eliminated in consolidation. We recommend that you read these unaudited
consolidated financial statements in conjunction with the audited consolidated
financial statements of the Corporation and the accompanying notes in the
Corporation's 2006 Annual Report on Form 10-K. The results of operations for
the
three and nine month periods ended September 30, 2007 and 2006 are not
necessarily indicative of the results to be expected for the full
year.
The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amount of assets and
liabilities as of the dates of the balance sheets and revenues and expenditures
for the periods presented. Actual results could differ from those
estimates.
For
additional information on other significant accounting policies, see Note 1
of
the Consolidated Financial Statements of the Corporation’s 2006 Annual Report on
Form 10-K.
Note
2 – Acquisitions/Disposition
On
May
15, 2007, the Corporation entered into a definitive agreement to acquire
East
Penn Financial Corporation (East Penn Financial) and its wholly owned
subsidiary, East Penn Bank, a $451 million state chartered, FDIC insured
bank,
offering deposit and lending services throughout the Lehigh Valley, PA.
Headquartered and founded in Emmaus, PA in 1990, East Penn Financial has
nine
banking offices located in Lehigh, Northampton and Berks Counties. The total
value of the transaction at the agreement date, if it closed, is estimated
at
$92.7 million or approximately $14.50 per share of East Penn Financial stock,
although actual value will depend on several factors, including the price
of the
Corporation’s stock, but will not be less than $13.52 per share ($86.3 million)
or greater than $15.48 per share ($99.1 million). Under terms of the Merger
Agreement, each shareholder of East Penn Financial may elect to receive either
cash only or the Corporation’s shares only for each share of East Penn Financial
stock, but may receive a combination of both in the aggregate for all East
Penn
Financial shares the shareholder owns. The amount of final per share
consideration is based on a formula that is determined by the average per
share
value of the Corporation’s stock during the twenty day period ending eleven days
prior to closing. The consideration is subject to election and allocation
procedures designed to provide that the cash portion is $50.3 million but
in any
event not greater than 60% of the dollar value of the merger consideration.
The
parties have agreed that the allocation of the Corporation’s common stock and
cash will be such that the East Penn Financial shareholders will not recognize
gain or loss for federal income tax purposes on those East Penn Financial
shares
that are exchanged for the Corporation’s common stock in the merger. On November
1, 2007, the shareholders of East Penn Financial approved and adopted the
Merger
Agreement as amended August 29, 2007. The Corporation has received all necessary
regulatory approvals for completion of the merger, subject only to receiving
final clearance from the Office of the Comptroller of the Currency to consummate
the merger of East Penn Financial Corporation’s wholly owned bank subsidiary,
East Penn Bank, with and into Harleysville National Corporation’s wholly owned
national bank subsidiary, Harleysville National Bank and Trust Company. The
merger is currently expected to be effective on or about November 16,
2007.
On
March 1,
2007, the Cornerstone Companies, a subsidiary of the Bank, completed a selected
asset purchase of McPherson Enterprises and related entities (McPherson),
registered investment advisors specializing in estate and succession planning
and life insurance for high-net-worth construction and aggregate business owners
and families throughout the United States. Located in Towson, Maryland,
McPherson became a part of the Cornerstone Companies, a component of the Bank’s
Millennium Wealth Management division. The Bank paid $1.5 million in cash.
Estimated goodwill and identifiable intangibles of approximately $1.5 million
were recorded in connection with the asset purchase. Management is in the
process of evaluating and finalizing the identifiable intangible assets and
purchase accounting adjustments.
On
April
14, 2006, the Bank sold its existing credit card portfolio to Elan Financial
Services, a national credit card issuer and established an agent issuing
relationship with Elan Financial Services. Under the agreement, credit cards
for
the Bank are issued under the Harleysville National Bank name. The Bank sold
$15.3 million in credit card receivables resulting in a gain in the second
quarter of 2006 from the sale of these credit cards, net of federal income
taxes, of approximately $939,000 or $.03 per diluted share. The Bank
Note
2 – Acquisitions/Disposition –
Continued
continues
to earn certain fees from ongoing portfolio activity.
The sale agreement stipulated that any credit card accounts delinquent over
30
days, overlimit accounts and petitioned bankruptcies would be guaranteed by
the
Bank for a period of one year. Of the $15.3 million in credit card receivables
sold, $529,000 was sold with full recourse which was the total potential
recourse exposure at the time of the sale. During the second quarter of 2006,
the Bank recorded a recourse liability of $371,000 which was the entire recourse
liability recorded. This estimate was based on our historic losses as
experienced on similar credit card receivables. The Bank was subject to the
full
recourse
obligations
for a period of one year. At June 30, 2007, the total potential recourse
exposure was reduced to $0 with the expiration of the one-
year
recourse period. The Corporation’s actual loss experience approximated the
initial reserve.
Note
3 – Goodwill and Other Intangibles
Goodwill
and identifiable intangibles were $45.1 million and $4.5 million, respectively
at September 30, 2007, and $44.0 million and $4.7 million, respectively at
December 31, 2006. The carrying amounts of goodwill by business segment at
September 30, 2007 and December 31, 2006 for Community Banking was $31.6 million
for both periods and for Wealth Management was $13.5 million and $12.4 million,
respectively. Effective March 1, 2007, the Bank completed the selected asset
purchase of McPherson Enterprises and related entities including estimated
goodwill of approximately $1.1 million and customer relationship intangibles
of
approximately $375,000 (with an estimated weighted average amortization period
of 10 years) allocated to the Wealth Management segment.
Management
performed its annual review of goodwill at June 30, 2007 in accordance with
SFAS
No. 142 and determined there was no impairment of goodwill and other
identifiable intangible assets.
The
gross
carrying value and accumulated amortization related to core deposit intangibles
and other identifiable intangibles at September 30, 2007 and December 31, 2006
are presented below:
|
|
September 30,
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
|
Gross
Carrying Amount
|
|
Accumulated
Amortization
|
|
Gross
Carrying Amount
|
|
|
Accumulated
Amortization
|
|
|
|
(Dollars in thousands)
|
|
Core
deposit intangibles
|
|
$
|
1,929
|
|
|
$
|
908
|
|
|
$
|
1,929
|
|
|
$
|
733
|
|
|
Other
identifiable intangibles
|
|
|
4,288
|
|
|
|
806
|
|
|
|
3,913
|
|
|
|
448
|
|
|
Total
|
|
$
|
6,217
|
|
|
$
|
1,714
|
|
|
$
|
5,842
|
|
|
$
|
1,181
|
|
The
remaining
weighted average amortization period of core deposit and other identifiable
intangibles is approximately seven years. The amortization of core deposit
intangibles allocated to the Community Banking segment were $56,000 and $62,000
for the third quarter of 2007 and 2006, respectively and $175,000 and $185,000
for the nine months ended September 30, 2007 and 2006, respectively.
Amortization of identifiable intangibles related to the Wealth Management
segment totaled $121,000 and $114,000 for the third quarter of 2007 and 2006,
respectively and $358,000 and $336,000 for the nine months ended September
30,
2007 and 2006, respectively. The Corporation estimates that aggregate
amortization expense for core deposit and other identifiable intangibles will
be
$710,000, $709,000, $709,000, $709,000 and $596,000 for 2007, 2008, 2009, 2010
and 2011, respectively.
Mortgage
servicing rights of $2.7 million and $2.6 million at September 30, 2007 and
December 31, 2006, respectively, are included on the Corporation’s balance sheet
in other intangible assets.
Note
4 – Trust Preferred Subordinated Debentures
On
August
22, 2007, HNC Statutory Trust IV (Trust IV), a newly formed Delaware statutory
trust affiliate of the Corporation, issued $22.5 million of fixed/floating
rate
trust preferred securities which represent undivided beneficial interests in
the
assets of Trust IV. Trust IV issued mandatory redeemable preferred stock to
investors and loaned the proceeds to the Corporation for general corporate
purposes including funding of the East Penn Financial Corporation acquisition
anticipated to close in the fourth quarter of 2007. Trust IV holds, as its
sole
asset, a subordinated debenture in the amount of $23.2 million issued by the
Corporation on August 22, 2007. Trust IV qualifies as a variable interest entity
under FASB Interpretation 46 (FIN 46), “Consolidation of Variable Interest
Entities.” The trust preferred securities require quarterly distributions by
Trust IV to the holders of the trust preferred securities at a fixed rate equal
to 6.35% through October 2012 and then will be payable at a variable interest
rate equal to the three-month London Interbank Offered Rate (LIBOR) plus 1.28%
per annum. The trust preferred securities must be redeemed upon maturity of
the
subordinated debentures on October 30, 2037. The Corporation may redeem the
debentures, in whole but not in part, at any time within 90 days at the
specified special event redemption price following the occurrence of a capital
disqualification event, an investment company event or a tax event as set forth
in the indentures relating to the trust preferred securities and in each case
subject to regulatory approval if required. The Corporation also may redeem
the
debentures, in whole or in part, at the stated optional redemption date of
October 30, 2012 and quarterly thereafter, subject to regulatory approval if
required. The optional redemption price is equal to 100% of the principal amount
of the debentures being redeemed plus accrued and unpaid interest on the
debentures to the redemption date.
Note
5 - Pension Plan
The
Corporation has a non-contributory defined benefit pension plan covering
substantially all employees. The plan’s benefits are based on years
of service and the employee’s average compensation during any five consecutive
years within the ten-year period preceding retirement.
The
Corporation has not made any contributions to its pension plan during the first
nine months of 2007. The components of net periodic defined benefit pension
expense and other amounts recognized in other comprehensive income for the
nine
months ended September 30, 2007 and 2006 are as follows:
|
(Dollars
in thousands)
|
|
Nine
Months Ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
Net
periodic benefit cost
|
|
|
|
|
|
|
|
Service
cost
|
|
$
|
875
|
|
|
$
|
780
|
|
|
Interest
cost
|
|
|
512
|
|
|
|
491
|
|
|
Expected
return on plan assets
|
|
|
(450
|
)
|
|
|
(413
|
)
|
|
Amortization
of net actuarial loss
|
|
|
57
|
|
|
|
88
|
|
|
Net
periodic benefit expense
|
|
$
|
994
|
|
|
$
|
946
|
|
At
December 31, 2006, the Corporation adopted SFAS No. 158, “Employers’ Accounting
for Defined Benefit Pension and Other Postretirement Plans” and recognized as a
component of accumulated other comprehensive income (OCI), net of tax, the
net
loss and transition asset that had not been included in the net periodic benefit
cost of its pension plan for $1.5 million. However, the $1.5 million
transition amount was included in OCI for 2006 rather than as an adjustment
of
the December 31, 2006 balance of accumulated OCI. Therefore, OCI, net of tax
for
2006 reported as $2.5 million in the Corporation’s 2006 Form 10-K should be
increased by $1.5 million to $4.0 million with total comprehensive income of
$43.4 million. The Corporation has determined that the error is not material
and
will provide the corrected tabular disclosures of comprehensive income upon
filing of the 2007 Form 10-K.
Note
6
–
Stock-Based Compensation
The
Corporation has four shareholder approved fixed stock option plans that allow
the Corporation to grant options up to an aggregate of 3,797,861 shares of
common stock to key employees and directors. At September 30, 2007,
2,527,303
stock options had been granted under the stock
option plans. The options have a term of ten years when issued and typically
vest over a five-year period. The exercise price of each option is the market
price of the Corporation’s stock on the date of grant. Additionally, at
September 30, 2007, the Corporation has an additional 328,327 granted stock
options as a result of the Millennium Bank acquisition completed in 2004. The
options have a term of ten years and are exercisable at prices ranging from
$9.25 to $13.81.
The
Corporation recognizes compensation expense for stock options in accordance
with
SFAS 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)) adopted at January
1, 2006 under the modified prospective application method of transition. Prior
to January 1, 2006, the Corporation followed SFAS 123 and APB 25 with
pro
forma
disclosures of net income and earnings per share, as if the fair
value-based method of accounting defined in SFAS 123 had been applied. The
Corporation recognizes compensation expense for the portion of outstanding
awards at January 1, 2006 for which the requisite service has not yet been
rendered, based on the grant-date fair value of those awards calculated under
SFAS 123 for pro forma disclosures. For grants subject to a service condition
that were awarded on or after January 1, 2006, the Corporation utilizes the
Black-Scholes option-pricing model (as used under SFAS 123) to estimate the
fair
value of each option on the date of grant. For grants subject to a market
condition that were awarded in 2007, the Corporation utilizes a Monte Carlo
simulation to estimate the fair value and determine the derived service period.
Compensation is recognized over the derived service period with any unrecognized
compensation cost immediately recognized when the market condition is
met.
During
the third quarter of 2007, the Corporation granted stock options which were
subject to a market condition. These awards vest when the Corporation’s common
stock reaches targeted average trading prices for 30 days within five years
from
the grant date. Vesting cannot commence before six months from the grant date.
The term and exercise price of the options are the same as previously mentioned.
The fair value and derived service period (the median period in which the market
condition is met) were determined using a Monte Carlo simulation with the
following assumptions: weighted average dividend yield of 4.59% based on
historical data, weighted-average expected volatility of 32.19% based on
historical data, risk-free rate of 4.54% to 5.17%, weighted average expected
life of 6.04 years and a uniform post-vesting exercise rate (mid-point of
vesting and contractual term).
For
the
nine months ended September 30, 2006, all options awarded were subject to a
service condition. The fair value of these options were estimated on the date
of
grant using the Black-Scholes option-pricing model with the following
weighted-average assumptions based on historical data: weighted-average dividend
yield of 3.52%; weighted-average expected volatility of 32.19%; weighted average
risk-free interest rate of 4.64% (4.42% to 5.08%) and a weighted-average
expected life of 7.28 years.
Expected
volatility is based on the historical volatility of the Corporation’s stock over
the expected life of the grant. The risk-free rate for periods within the
expected life of the option is based on the U.S. Treasury strip rate in effect
at the time of the grant. The life of the option is based on historical factors
which include the contractual term, vesting period, exercise behavior and
employee terminations.
Note
6
–
Stock-Based Compensation
–
Continued
In
accordance with SFAS 123(R), stock-based compensation expense for the nine
months ended September 30, 2007 and 2006 is based on awards that are ultimately
expected to vest and therefore has been reduced for estimated forfeitures.
The
Corporation estimates forfeitures using historical data based upon the groups
identified by management. Stock-based compensation expense was $68,000 and
$65,000, net of tax for the third quarter of 2007 and $97,000 and $93,000,
net
of tax for the third quarter of 2006. Stock-based compensation expense was
$201,000 and $192,000, net of tax for the nine-month period ending September
30,
2007 and $345,000 and $315,000, net of tax for the nine months ended September
30, 2006.
A
summary
of option activity under the Corporation’s stock option plans as of September
30, 2007, and changes during the nine months ended September 30, 2007 is
presented in the following table. The number of shares and weighted-average
share information have been adjusted to reflect stock dividends.
|
Options
|
|
Shares
|
|
|
Weighted-Average
Exercise Price
|
|
|
Weighted-Average
Remaining Contractual Term
(in
years)
|
|
|
Aggregate
Intrinsic
Value
(in
thousands)
|
|
|
Outstanding
at January 1, 2007
|
|
|
1,157,484
|
|
|
$
|
15.60
|
|
|
|
|
|
|
|
|
Granted
|
|
|
25,000
|
|
|
|
14.49
|
|
|
|
|
|
|
|
|
Exercised
|
|
|
(57,135
|
)
|
|
|
9.34
|
|
|
|
|
|
|
|
|
Forfeited
(unvested)
|
|
|
(7,264
|
)
|
|
|
22.27
|
|
|
|
|
|
|
|
|
Cancelled
(vested)
|
|
|
(7,315
|
)
|
|
|
24.98
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding
at September 30, 2007
|
|
|
1,110,770
|
|
|
$
|
15.79
|
|
|
|
4.82
|
|
|
$
|
3,744
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exercisable
at September 30, 2007
|
|
|
967,040
|
|
|
$
|
15.03
|
|
|
|
4.34
|
|
|
$
|
3,709
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The
weighted-average grant-date fair value of options granted during the nine months
ended September 30, 2007 and 2006 was $3.08 and $5.23, respectively. The total
intrinsic value of options exercised during the nine months ended September
30,
2007 and 2006 was $398,000 and $4.3 million, respectively.
Intrinsic value is
measured using the fair market value price of the Corporation’s common stock
less the applicable exercise price.
A
summary
of the status of the Corporation’s nonvested shares as of September 30, 2007 is
presented below:
|
Nonvested
Shares
|
|
Shares
|
|
|
Weighted-Average
Grant-Date
Fair Value
|
|
|
|
|
|
|
|
|
|
|
Nonvested
at January 1, 2007
|
|
|
131,610
|
|
|
$
|
6.15
|
|
|
|
|
|
|
|
|
|
|
|
|
Granted
|
|
|
25,000
|
|
|
|
3.08
|
|
|
|
|
|
|
|
|
|
|
|
|
Vested
|
|
|
(5,615
|
)
|
|
|
6.07
|
|
|
|
|
|
|
|
|
|
|
|
|
Forfeited
|
|
|
(7,264
|
)
|
|
|
6.16
|
|
|
|
|
|
|
|
|
|
|
|
|
Nonvested
at September 30, 2007
|
|
|
143,731
|
|
|
$
|
5.70
|
|
As
of
September 30, 2007, there was a total of $607,000 of unrecognized compensation
cost related to nonvested awards under stock option plans. This cost is expected
to be recognized over a weighted-average period of 1.3 years. The total fair
value of shares vested during the nine months ended September 30, 2007 and
2006
was $34,000 and $90,000, respectively.
Note
7
-
Earnings Per Share
Basic
earnings per share exclude dilution and are computed by dividing income
available to common shareholders by the weighted average common shares
outstanding during the period. Diluted earnings per share take into account
the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised and converted into common stock. All weighted
average, actual shares and per share information in these financial statements
have been adjusted retroactively for the effect of stock dividends.
The
calculations of basic earnings per share and diluted earnings per share are
as
follows:
|
|
|
Three
Months Ended
September
30,
|
|
Nine
Months Ended
September
30,
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars
in thousands, except per share data)
|
|
2007
|
|
|
2006
|
|
|
2007
|
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic
earnings per share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income available to common shareholders
|
|
$
|
7,201
|
|
|
$
|
7,907
|
|
|
$
|
20,414
|
|
|
$
|
26,143
|
|
|
Weighted
average common shares outstanding
|
|
|
28,881,006
|
|
|
|
29,011,903
|
|
|
|
28,930,073
|
|
|
|
28,940,119
|
|
|
Basic
earnings per share
|
|
$
|
.25
|
|
|
$
|
.27
|
|
|
$
|
.71
|
|
|
$
|
.90
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted
earnings per share
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
income available to common shareholders
and
assumed conversions
|
|
$
|
7,201
|
|
|
$
|
7,907
|
|
|
$
|
20,414
|
|
|
$
|
26,143
|
|
|
Weighted
average common shares outstanding
|
|
|
28,881,006
|
|
|
|
29,011,903
|
|
|
|
28,930,073
|
|
|
|
28,940,119
|
|
|
Dilutive
potential common shares
(1),
(2)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
diluted weighted average common shares outstanding
|
|
|
29,107,274
|
|
|
|
29,384,310
|
|
|
|
29,183,811
|
|
|
|
29,373,646
|
|
|
Diluted
earnings per share
|
|
$
|
.25
|
|
|
$
|
.27
|
|
|
$
|
.70
|
|
|
$
|
.89
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1)
|
Includes
incremental shares from assumed conversions of stock
options.
|
|
(2)
|
Antidilutive
options have been excluded in the computation of diluted earnings
per
share because the options’ exercise prices were greater than the average
market price of the common stock. For the three months ended September
30,
2007 and 2006, there were 479,896 antidilutive options at an average
price
of $23.46 and 417,456 antidilutive options at an average price of
$24.50,
respectively. For the nine months ended September 30, 2007 and 2006,
there
were 465,425 antidilutive options at an average price of $23.66 and
417,456 antidilutive options at an average price of $24.50,
respectively.
|
Note
8 – Comprehensive Income
The
components of other comprehensive income are as follows:
|
Comprehensive
Income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
Before
tax
|
|
|
Tax
Benefit
|
|
|
Net
of tax
|
|
|
Nine
months ended September 30, 2007
|
|
Amount
|
|
|
(Expense)
|
|
|
Amount
|
|
|
Net
unrealized losses on available for sale securities:
|
|
|
|
|
|
|
|
|
|
|
Net
unrealized holding losses arising during period
|
|
$
|
(2,320
|
)
|
|
$
|
812
|
|
|
$
|
(1,508
|
)
|
|
Less
reclassification adjustment for net gains realized in net
income
|
|
|
475
|
|
|
|
(166
|
)
|
|
|
309
|
|
|
Net
unrealized losses
|
|
|
(2,795
|
)
|
|
|
978
|
|
|
|
(1,817
|
)
|
|
Change
in fair value of derivatives used for cash flow hedges
|
|
|
(611
|
)
|
|
|
214
|
|
|
|
(397
|
)
|
|
Other
comprehensive loss, net
|
|
$
|
(3,406
|
)
|
|
$
|
1,192
|
|
|
$
|
(2,214
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
Before
tax
|
|
|
Tax
Benefit
|
|
|
Net
of tax
|
|
|
Nine
months ended September 30, 2006
|
|
Amount
|
|
|
(Expense)
|
|
|
Amount
|
|
|
Net
unrealized gains on available for sale securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
unrealized holding gains arising during period
|
|
$
|
2,035
|
|
|
$
|
(712
|
)
|
|
$
|
1,323
|
|
|
Less
reclassification adjustment for net gains realized in net
income
|
|
|
–
|
|
|
|
–
|
|
|
|
–
|
|
|
Net
unrealized gains
|
|
|
2,035
|
|
|
|
(712
|
)
|
|
|
1,323
|
|
|
Change
in fair value of derivatives used for cash flow hedges
|
|
|
(144
|
)
|
|
|
50
|
|
|
|
(94
|
)
|
|
Amortization
of unrealized loss on termination of cash flow hedge
|
|
|
137
|
|
|
|
(48
|
)
|
|
|
89
|
|
|
Other
comprehensive income, net
|
|
$
|
2,028
|
|
|
$
|
(710
|
)
|
|
$
|
1,318
|
|
Note
9 – Segment Information
The
Corporation operates two main lines of business along with several other
operating segments. SFAS No. 131, “Disclosures about Segments of an Enterprise
and Related Information,” establishes standards for public business enterprises
to report information about operating segments. Operating segments are
components of an enterprise, which are evaluated regularly by the chief
operating decision-maker in deciding how to allocate and assess resources and
performance. The Corporation’s chief operating decision-maker is the President
and Chief Executive Officer. The Corporation has applied the aggregation
criteria set forth in SFAS No. 131 for operating segments establishing two
reportable segments: Community Banking and Wealth Management.
The
Community Banking segment provides financial services to consumers, businesses
and governmental units primarily in southeastern Pennsylvania. These services
include full-service banking, comprised of accepting time and demand deposits,
making secured and unsecured commercial loans, mortgages, consumer loans, and
other banking services. The treasury function income is included in the
Community Banking segment, as the majority of effort of this function is related
to this segment. Primary sources of income include net interest income and
service fees on deposit accounts. Expenses include costs to manage credit and
interest rate risk, personnel, and branch operational and technical
support.
The
Wealth Management segment includes: trust and investment management services,
providing investment management, trust and fiduciary services, estate settlement
and executor services, financial planning, and retirement plan and institutional
investment services; and the Cornerstone Companies, registered investment
advisors for high net worth, privately held business owners, wealthy families
and institutional clients. Major revenue component sources include investment
management and advisory fees, trust fees, estate and tax planning fees,
brokerage fees, and insurance related fees. Expenses primarily consist of
personnel and support charges. Additionally, the Wealth Management
segment includes an inter-segment credit related to trust deposits which are
maintained within the Community Banking segment using a transfer pricing
methodology.
The
Corporation has also identified several other operating segments. These
operating segments within the Corporation’s operations do not have similar
characteristics to the Community Banking or Wealth Management segments and
do
not meet the quantitative thresholds requiring separate disclosure. These
non-reportable segments include HNC Reinsurance Company, HNC Financial Company,
and the parent holding company and are included in the “Other”
category.
Information
about reportable segments and reconciliation of the information to the
consolidated financial statements follows:
|
(Dollars
in thousands)
|
|
Community
Banking
|
|
|
Wealth Management
|
|
|
All
Other
|
|
|
Consolidated
Totals
|
|
|
Three
Months Ended September 30, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income (expense)
|
|
$
|
21,348
|
|
|
$
|
117
|
|
|
$
|
(601
|
)
|
|
$
|
20,864
|
|
|
Provision
for loan losses
|
|
|
2,525
|
|
|
|
-
|
|
|
|
-
|
|
|
|
2,525
|
|
|
Noninterest
income
|
|
|
5,111
|
|
|
|
4,530
|
|
|
|
124
|
|
|
|
9,765
|
|
|
Noninterest
expense
|
|
|
14,960
|
|
|
|
3,747
|
|
|
|
149
|
|
|
|
18,856
|
|
|
Income
(loss) before income taxes (benefit)
|
|
|
8,974
|
|
|
|
900
|
|
|
|
(626
|
)
|
|
|
9,248
|
|
|
Income
taxes (benefit)
|
|
|
1,974
|
|
|
|
332
|
|
|
|
(259
|
)
|
|
|
2,047
|
|
|
Net
income (loss)
|
|
$
|
7,000
|
|
|
$
|
568
|
|
|
$
|
(367
|
)
|
|
$
|
7,201
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
Months Ended September 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income (expense)
|
|
$
|
21,060
|
|
|
$
|
118
|
|
|
$
|
(564
|
)
|
|
$
|
20,614
|
|
|
Provision
for loan losses
|
|
|
900
|
|
|
|
-
|
|
|
|
-
|
|
|
|
900
|
|
|
Noninterest
income
|
|
|
4,738
|
|
|
|
3,377
|
|
|
|
171
|
|
|
|
8,286
|
|
|
Noninterest
expense
|
|
|
14,108
|
|
|
|
3,141
|
|
|
|
311
|
|
|
|
17,560
|
|
|
Income
(loss) before income taxes (benefit)
|
|
|
10,790
|
|
|
|
354
|
|
|
|
(704
|
)
|
|
|
10,440
|
|
|
Income
taxes (benefit)
|
|
|
2,698
|
|
|
|
132
|
|
|
|
(297
|
)
|
|
|
2,533
|
|
|
Net
income (loss)
|
|
$
|
8,092
|
|
|
$
|
222
|
|
|
$
|
(407
|
)
|
|
$
|
7,907
|
|
Note
9 – Segment Information – Continued
|
(Dollars
in thousands)
|
|
Community
Banking
|
|
|
Wealth Management
|
|
|
All
Other
|
|
|
Consolidated
Totals
|
|
|
Nine
Months Ended September 30, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income (expense)
|
|
$
|
62,188
|
|
|
$
|
334
|
|
|
$
|
(1,666
|
)
|
|
$
|
60,856
|
|
|
Provision
for loan losses
|
|
|
6,075
|
|
|
|
-
|
|
|
|
-
|
|
|
|
6,075
|
|
|
Noninterest
income
|
|
|
15,021
|
|
|
|
13,631
|
|
|
|
515
|
|
|
|
29,167
|
|
|
Noninterest
expense
|
|
|
46,005
|
|
|
|
11,001
|
|
|
|
770
|
|
|
|
57,776
|
|
|
Income
(loss) before income taxes (benefit)
|
|
|
25,129
|
|
|
|
2,964
|
|
|
|
(1,921
|
)
|
|
|
26,172
|
|
|
Income
taxes (benefit)
|
|
|
5,409
|
|
|
|
1,154
|
|
|
|
(805
|
)
|
|
|
5,758
|
|
|
Net
income (loss)
|
|
$
|
19,720
|
|
|
$
|
1,810
|
|
|
$
|
(1,116
|
)
|
|
$
|
20,414
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
$
|
3,321,817
|
|
|
$
|
22,341
|
|
|
$
|
36,361
|
|
|
$
|
3,380,519
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine
Months Ended September 30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
interest income (expense)
|
|
$
|
64,495
|
|
|
$
|
383
|
|
|
$
|
(1,517
|
)
|
|
$
|
63,361
|
|
|
Provision
for loan losses
|
|
|
3,000
|
|
|
|
-
|
|
|
|
-
|
|
|
|
3,000
|
|
|
Noninterest
income
|
|
|
15,208
|
|
|
|
11,374
|
|
|
|
560
|
|
|
|
27,142
|
|
|
Noninterest
expense
|
|
|
41,783
|
|
|
|
9,691
|
|
|
|
889
|
|
|
|
52,363
|
|
|
Income
(loss) before income taxes (benefit)
|
|
|
34,920
|
|
|
|
2,066
|
|
|
|
(1,846
|
)
|
|
|
35,140
|
|
|
Income
taxes (benefit)
|
|
|
8,899
|
|
|
|
864
|
|
|
|
(766
|
)
|
|
|
8,997
|
|
|
Net
income (loss)
|
|
$
|
26,021
|
|
|
$
|
1,202
|
|
|
$
|
(1,080
|
)
|
|
$
|
26,143
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Assets
|
|
$
|
3,310,306
|
|
|
$
|
18,706
|
|
|
$
|
33,991
|
|
|
$
|
3,363,003
|
|
The
accounting policies of the segments are the same as those described in the
summary of significant accounting policies disclosed in the Corporation’s Annual
Report on Form 10-K for the year ended December 31, 2006. Consolidating
adjustments reflecting certain eliminations of inter-segment revenues, cash
and
investment in subsidiaries are included in the “All Other” segment.
Note
10 – Financial Instruments with Off-Balance Sheet Risk
The
Bank
is a party to financial instruments with off-balance-sheet risk in the normal
course of business to meet the financing needs of its customers. These financial
instruments include commitments to extend credit and standby letters of credit.
Such financial instruments are recorded in the financial statements when they
become payable. Those instruments involve, to varying degrees, elements of
credit and interest rate risk in excess of the amount recognized in the
consolidated balance sheets. The contract or notional amounts of those
instruments reflect the extent of involvement the Bank has in particular classes
of financial instruments.
The
Bank’s maximum exposure to credit loss in the event of nonperformance by the
other party to the financial instrument for commitments to extend credit and
standby letters of credit is represented by the contractual or notional amounts
of those instruments. The Bank uses the same stringent credit policies in
extending these commitments as they do for recorded financial instruments and
controls exposure to loss through credit approval and monitoring procedures.
These commitments often expire without being drawn upon and often are secured
with appropriate collateral; therefore, the total commitment amount does not
necessarily represent the actual risk of loss or future cash
requirements.
The
approximate contract amounts are as follows:
|
Commitments
|
|
Total
Amount Committed at
|
|
|
(Dollars
in thousands)
|
|
|
|
|
December
31, 2006
|
|
|
|
|
|
|
|
|
|
|
Financial
instruments whose contract amounts represent credit risk:
|
|
|
|
|
|
|
|
Commitments
to extend
credit
|
|
$
|
748,254
|
|
|
$
|
753,825
|
|
|
Standby
letters of credit and
financial guarantees written
|
|
|
22,864
|
|
|
|
25,960
|
|
|
Financial
instruments whose notional or contract amounts exceed the amount
of credit
risk:
|
|
|
|
|
|
|
|
|
|
Interest
rate swap
agreements
|
|
|
58,928
|
|
|
|
59,750
|
|
|
Interest
rate cap
agreements
|
|
|
200,000
|
|
|
|
—
|
|
Note
10 – Financial Instruments with Off-Balance Sheet Risk –
Continued
At
September 30, 2007, the Corporation had cash flow hedges in the form of interest
rate swaps with a notional amount of $45.0 million that have the effect of
converting the rates on money market deposit accounts to a fixed-rate cost
of
funds. This strategy will cause the Bank to recognize, in a rising rate
environment, a larger interest rate spread than it otherwise would have without
the swaps in effect. In addition, the Corporation had cash flow hedges with
a
notional amount of $10.0 million that have the effect of converting variable
debt to a fixed rate. For these swaps, the Corporation recognized net interest
income of $73,000 and $134,000 for the three months ended September 30, 2007
and
2006, respectively and $325,000 and $311,000 of net interest income for the
nine
months ended September 30, 2007 and 2006, respectively. During the first quarter
of 2005, the Corporation terminated a cash flow hedge with a notional value
of
$25.0 million. The gross loss related to the termination of this swap was
$310,000 which was amortized through October 2006 in accordance with SFAS No.
133 “Accounting for Derivative Instruments and Hedging Activities.” The
Corporation amortized into net interest income $46,000 for the third quarter
of
2006 and $136,000 for the nine months ended September 30, 2006 related to this
swap. Periodically, the Corporation may enter into fair value hedges to limit
the exposure to changes in the fair value of loan assets. At September 30,
2007,
the Corporation had fair value hedges in the form of interest rate swaps with
a
notional amount of $3.9 million. For these swaps the Corporation recognized
net
interest income of $17,000 and $63,000 for the three and nine months ended
September 30, 2007, respectively (which includes $17,000 and $55,000 for the
respective periods related to two terminated swaps with notional amounts
totaling $3.9 million that were terminated during 2007) and no impact to
earnings for the first nine months of 2006. At September 30, 2007, the
Corporation had swap agreements with a positive fair value of 68,000 and with
a
negative fair value of $234,000. At December 31, 2006, the Corporation had
swap
agreements with a positive fair value of $545,000 and with a negative fair
value
of $21,000. There was no hedge ineffectiveness recognized during the first
nine
months of 2007 and no hedge ineffectiveness was recognized during the first
nine
months of 2006.
During
March 2007, the Corporation purchased one and three month Treasury bill interest
rate cap agreements with notional amounts totaling $200 million to limit its
exposure on variable rate now deposit accounts. The initial premium related
to
these caps was $73,000 which is being amortized to interest expense over the
life of the cap based on the cap market value. The Corporation recognized
amortization of $361 for the nine months ended September 30, 2007. At September
30, 2007, these caps, designated as cash flow hedges, had a positive fair value
of $4,000 with no impact to earnings for the first nine months of 2007. The
caps
mature in March 2009.
The
Bank
also had commitments with customers to extend mortgage loans at a specified
rate
at September 30, 2007 and December 31, 2006 of $2.0 million and $2.3 million,
respectively and commitments to sell mortgage loans at a specified rate at
September 30, 2007 and December 31, 2006 of $842,000 and $792,000, respectively.
The commitments are accounted for as a derivative and recorded at fair value.
The Bank estimates the fair value of these commitments by comparing the
secondary market price at the reporting date to the price specified in the
contract to extend or sell the loan initiated at the time of the loan
commitment. At September 30, 2007, the Corporation had commitments with a
positive fair value of $23,000 which was recorded as other income. At December
31, 2006, the Corporation had commitments with a positive fair value of $15,000
and a negative fair value of $3,000.
During
April 2006, the Bank sold its existing credit card portfolio of $15.3 million.
The sale agreement stipulated that any credit card accounts delinquent over
30
days, overlimit accounts and petitioned bankruptcies would be guaranteed by
the
Bank for a period of one year. Of the $15.3 million in credit card receivables
sold, $529,000 was sold with full recourse which was the total potential
recourse exposure at the time of the sale. During the second quarter of 2006,
the Bank recorded a recourse liability of $371,000 which was the entire recourse
liability recorded. This estimate was based on our historic losses as
experienced on similar credit card receivables. The Bank was subject to the
full
recourse obligations for a period of one year. At June 30, 2007, the total
potential recourse exposure was reduced to $0 with the expiration of the
one-year recourse period. The Corporation’s actual loss experience approximated
the initial reserve.
During
December 2004 and January 2005, the Bank sold lease financing receivables of
$10.5 million. Of these leases, $1.2 million were sold with full recourse and
the remaining leases were sold subject to recourse with a maximum exposure
of
ten percent of the outstanding receivable. The total recourse exposure at the
time of the sale of the leases was $2.0 million. During the first quarter of
2005, the Bank recorded a recourse liability of $216,000 which was the entire
recourse liability recorded. This estimate was based on our historic losses
as
experienced on similar lease financing receivables. After the first anniversary
of the sale agreement, and on a quarterly basis thereafter, upon written request
by the Bank, the purchaser will review the portfolio performance and may reduce
the total exposure to an amount equal to ten percent of the outstanding net
book
value. The Bank will be subject to the full and partial recourse obligations
until all the lease financing receivables have been paid or otherwise been
terminated and all equipment has been sold or disposed of. The final lease
payment is due in 2010. The outstanding balance of these sold leases at
September 30, 2007 was $1.4 million with a total recourse exposure of $287,000
and a current recourse liability of $29,000.
Note
11 – Contingent Liabilities
During
the second quarter of 2007, the Corporation, as a result of a recent internal
audit, reported a defalcation in the amount of approximately $578,000 at one
of
its branches. The Corporation maintains insurance coverage for this type of
risk
with a deductible of $100,000. This claim constituted a covered loss and as
such
the total loss recognized was the amount of the deductible of $100,000 pre-tax
or $65,000, net of income taxes during the second quarter of 2007. The
Corporation received the insurance claim proceeds of $478,000 during the third
quarter of 2007.
Note
12 – Recent Accounting Pronouncements
In
April
2007, the Financial Accounting Standards Board (FASB) issued FSP No. FIN 39-1,
Amendment of FASB Interpretation No. 39, “Offsetting of Amounts Related to
Certain Contracts.” FIN 39-1 permits a reporting entity that is party to a
master netting arrangement to offset the receivable or payable recognized upon
payment or receipt of cash collateral against the fair value amounts recognized
against derivative instruments that had been offset under the same master
netting arrangement. This FSP also replaces the terms “conditional contracts”
and “exchange contracts” with the broader term “derivative instruments.” FIN
39-1 applies to fiscal years beginning after November 15, 2007. A reporting
entity also must recognize the effects of initial adoption as a change in
accounting principle through retrospective application for all periods
presented, unless it is impracticable to do so. The Corporation is in the
process of assessing the impact of the adoption of this statement on the
Corporation’s financial statements.
In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
Financial Assets and Financial Liabilities
¾
Including
an
amendment of FASB Statement No. 115.” SFAS 159 permits entities to choose to
measure many financial instruments and certain other items at fair
value. SFAS 159 provides entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. The statement also establishes presentation and disclosure
requirements. The entity shall report the effect of the first re-measurement
to
fair value as a cumulative-effective adjustment to the opening balance of
retained earnings. At each subsequent reporting date, unrealized gains and
losses on items for which the fair value option has been elected will be
reported in earnings. The fair value option may be applied instrument by
instrument, with a few exceptions, is irrevocable and is applied only to entire
instruments. Most of the provisions of SFAS 159 apply only to entities that
elect the fair value option. However, the amendment to SFAS 115, “Accounting for
Certain Investments in Debt and Equity Securities,” applies to all entities with
available-for-sale and trading securities. If the fair value option is elected
for any available-for-sale or held-to-maturity securities at the effective
date,
the cumulative unrealized gains and losses at that date shall be included in
the
cumulative-effect adjustment. SFAS 159 is effective as of the beginning of
an
entity’s first fiscal year that begins after November 15, 2007. Early adoption
is permitted as of the beginning of a fiscal year that begins on or before
November 15, 2007, provided that the entity also elects to apply the provisions
of SFAS 157, “Fair Value Measurements.” The Corporation is in the process of
assessing the impact of the adoption of this statement on the Corporation’s
financial statements.
In
June,
2006, the FASB issued FASB Interpretation No. 48
,
“Accounting for Uncertainty
in Income Taxes – an interpretation of FASB
Statement No. 109.” FIN 48 clarifies the accounting and reporting for income
taxes where interpretation of the tax law may be uncertain.
FIN 48 prescribes a
recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on de-recognition, classification, interest and penalties, accounting
in interim periods, disclosure, and transition. FIN 48 applies to fiscal years
beginning after December 15, 2006. The Corporation adopted the provisions of
FIN
48 on January 1, 2007. As required by Interpretation 48, which clarifies
Statement 109, “Accounting for Income Taxes,” the Corporation recognizes the
financial statement benefit of a tax position only after determining that the
relevant tax authority would more likely than not sustain the position following
an audit. For tax positions meeting the more-likely-than-notthreshold, the
amount recognized in the financial statements is the largest benefit that has
a
greater than 50 percent likelihood of being realized upon settlement with the
relevant tax authority. At the adoption date, the Corporation applied FIN 48
to
all tax positions for which the statute of limitations remained open. The
Corporation has analyzed filing positions in all of the federal and state
jurisdictions where it is required to file income tax returns, as well as all
open tax years in these jurisdictions.
As
of
January 1, 2007, the Corporation has $158,000 of unrecognized tax benefits,
which if recognized, would favorably affect the Corporation’s effective tax
rate. The Corporation did not record a cumulative effect adjustment related
to
the adoption of FIN 48. There have been no material changes in unrecognized
tax
benefits since January 1, 2007.
The
Corporation’s policy for recording interest and penalties associated with audits
is to record such items as a component of income before income taxes. Penalties
are recorded in other expenses, net, and interest paid or received is recorded
in interest expense or interest income, respectively, in the statement of
income. As of September 30, 2007, interest accrued was $30,000 and no penalties
have been accrued.
The
Corporation is subject to income taxes in the U.S. federal jurisdiction, and
various states and foreign jurisdictions. Tax regulations within each
jurisdiction are subject to the interpretation of the related tax laws and
regulations and require significant judgment to apply. With few exceptions,
the
Corporation is no longer subject to U.S. federal, state and local, or non-U.S.
income tax examinations by tax authorities for the years before
2004.
In
May
2007, the FASB issued FIN 48-1, “Definition of Settlement in FIN 48” to provide
guidance on how an enterprise should determine whether a tax position is
effectively settled for the purpose of recognizing previously unrecognized
tax
benefits. FSP FIN 48-1 is effective retroactively to January 1, 2007. The
implementation of this standard did not have any impact on the Corporation’s
consolidated financial position or results of operations.
Note
13 – Subsequent Event
On
October 31, 2007, the Corporation announced it will be changing the structure
of
its retirement programs by terminating the defined benefit pension plan and
enhancing the 401(k) defined contribution savings plan effective January 1,
2008. The Corporation will freeze the pension plan at the current benefit levels
as of December 31, 2007, at which time the accrual of future benefits for
eligible employees will cease. All retirement benefits earned in the pension
plan as of December 31, 2007, will be preserved and all participants will become
fully vested in their benefit. All eligible employees will begin receiving
a
company funded contribution in the 401(k) plan equal to 2% of eligible earnings.
The Corporation is still in the process of reviewing the impact on its
consolidated financial statements, but anticipates it will record a one-time
pre-tax charge related to the pension plan curtailment of approximately $1.5
million in the fourth quarter of 2007. The Corporation expects the plan changes
will result in retirement-related expense savings of approximately $600,000
for
2008, based on the current 2007 pension assumptions.
Item
2.
MANAGEMENT'S
DISCUSSION AND ANALYSIS OF
RESULTS
OF OPERATIONS AND FINANCIAL CONDITION
The
following is management’s discussion and analysis of the significant changes in
the results of operations, capital resources and liquidity presented in its
accompanying consolidated financial statements for Harleysville National
Corporation (the Corporation) and its wholly owned subsidiaries-Harleysville
National Bank (the Bank), HNC Financial Company and HNC Reinsurance Company.
The
Corporation’s consolidated financial condition and results of operations consist
almost entirely of the Bank’s financial condition and results of operations.
Current performance does not guarantee, and may not be indicative, of similar
performance in the future. These are unaudited financial statements and, as
such, are subject to year-end audit review.
In
addition to historical information, this Form 10-Q contains forward-looking
statements within the meaning of the Private Securities Litigation Reform Act
of
1995. We have made forward-looking statements in this report, and in documents
that we incorporate by reference, that are subject to risks and uncertainties.
Forward-looking statements include the information concerning possible or
assumed future results of operations of the Corporation and its subsidiaries.
When we use words such as “believes,” “expects,” “anticipates,” “may,”
“estimates,” or “intends” or similar expressions, we are making forward-looking
statements. Forward-looking statements are representative only as of the date
they are made, and the Corporation undertakes no obligation to update any
forward-looking statement.
Shareholders
should note that many factors, some of which are discussed elsewhere in this
report and in the documents that we incorporate by reference, could affect
the
future financial results of the Corporation and its subsidiaries and could
cause
those results to differ materially from those expressed or implied in our
forward-looking statements contained or incorporated by reference in this
document
.
These factors
include but are not limited to those described in Item 1A, “Risk Factors” in the
Corporation’s 2006 Annual Report on Form 10-K and in this Form
10-Q.
Critical
Accounting Estimates
The
accounting and reporting policies of the Corporation and its subsidiaries
conform to accounting principles generally accepted in the United States and
general practices with the financial services industry. The Corporation’s
significant accounting policies are described in Note 1 of the consolidated
financial statements in this Form 10-Q and in the Corporation’s 2006 Annual
Report on Form 10-K and are essential in understanding Management’s Discussion
and Analysis of Results of Operations and Financial Condition. In applying
accounting policies and preparing the consolidated financial statements,
management is required to make estimates and assumptions that affect the
reported amount of assets and liabilities as of the dates of the balance sheets
and revenues and expenditures for the periods presented. Therefore, actual
results could differ significantly from those estimates. Judgments and
assumptions required by management, which have, or could have a material impact
on the Corporation’s financial condition or results of operations are considered
critical accounting estimates. The following is a summary of the policies the
Corporation recognizes as involving critical accounting estimates: Allowance
for
Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based
Compensation, Unrealized Gains and Losses on Debt Securities Available for
Sale,
and Deferred Taxes.
Allowance
for Loan Losses: The Corporation maintains an allowance for loan losses at
a
level management believes is sufficient to absorb estimated probable credit
losses. Management’s determination of the adequacy of the allowance is based on
periodic evaluations of the loan portfolio and other relevant factors. However,
this evaluation is inherently subjective as it requires significant estimates
by
management. Consideration is given to a variety of factors in establishing
these
estimates including historical losses, current and anticipated economic
conditions, diversification of the loan portfolio, delinquency statistics,
results of internal loan reviews, borrowers’ perceived financial and management
strengths, the adequacy of underlying collateral, the dependence on collateral,
or the strength of the present value of future cash flows and other relevant
factors. These factors may be susceptible to significant change. To the extent
actual outcomes differ from management estimates, additional provisions for
loan
losses may be required which may adversely affect the Corporation’s results of
operations in the future.
Goodwill
and Other Intangible Asset Impairment: Goodwill and other intangible assets
are
reviewed for potential impairment on an annual basis, or more often if events
or
circumstances indicate that there may be impairment, in accordance with SFAS
No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144,
“Accounting for the Impairment or Disposal of Long-Lived Assets.” Goodwill is
tested for impairment at the reporting unit level and an impairment loss is
recorded to the extent that the carrying amount of goodwill exceeds its implied
fair value. The Corporation employs general industry practices in evaluating
the
fair value of its goodwill and other intangible assets. The Corporation
calculates the fair value using a combination of the following valuation
methods: dividend discount analysis under the income approach, which calculates
the present value of all excess cash flows plus the present value of a terminal
value and price/earnings multiple under the market approach. Management
performed its annual review of goodwill and other identifiable intangibles
at
June 30, 2007 and determined there was no impairment of goodwill or other
identifiable intangibles.
No assurance can be
given
that future impairment tests will not result in a charge to
earnings.
Stock-based
Compensation: The Corporation recognizes compensation expense for stock options
in accordance with SFAS 123 (revised 2004), “Share-Based Payment” (SFAS 123R))
adopted at January 1, 2006 under the modified prospective application method
of
transition. The expense of the option is generally measured at fair value at
the
grant date with compensation expense recognized over the service period, which
is usually the vesting period. The Corporation utilizes the Black-Scholes
option-pricing model (as used under SFAS 123) to estimate the fair value of
each
option on the date of grant. The Black-Scholes model takes into consideration
the exercise price and expected life of the options, the current price of the
underlying stock and its expected volatility, the expected dividends on the
stock and the current risk-free interest rate for the expected life of the
option. The Corporation’s estimate of the fair value of a stock option is based
on expectations derived from historical experience and may not necessarily
equate to its market value when fully vested. In accordance with SFAS 123(R),
the Corporation estimates the number of options for which the requisite service
is expected to be rendered.
Unrealized
Gains and Losses on Securities Available for Sale: The Corporation receives
estimated fair values of debt securities from independent valuation services
and
brokers. In developing these fair values, the valuation services and brokers
use
estimates of cash flows based on historical performance of similar instruments
in similar rate environments. Debt securities available for sale are mostly
comprised of mortgage-backed securities as well as tax-exempt municipal bonds
and U.S. government agency securities. The Corporation uses various indicators
in determining whether a security is other-than-temporarily impaired, including
for equity securities, if the market value is below its cost for an extended
period of time with low expectation of recovery or for debt securities, when
it
is probable that the contractual interest and principal will not be collected.
The debt securities are monitored for changes in credit ratings. Adverse changes
in credit ratings would affect the estimated cash flows of the underlying
collateral or issuer. The unrealized losses associated with the securities
portfolio, that management has the ability and intent to hold, are not
considered to be other-than temporary as of September 30, 2007 because the
unrealized losses are related to changes in interest rates and do not affect
the
expected cash flows of the underlying collateral or issuer. The Corporation
recognized a permanent impairment charge of $55,000 during the three months
ended September 30, 2007 as a result of an equity holding in a financial
institution which was purchased by another institution at a lower than cost
share price. The sale is expected to close in the first quarter of
2008.
Deferred
Taxes: The Corporation recognizes deferred tax assets and liabilities for the
future effects of temporary differences, net operating loss carryforwards,
and
tax credits. Deferred tax assets are subject to management’s judgment based upon
available evidence that future realizations are likely. If management determines
that the Corporation may not be able to realize some or all of the net deferred
tax asset in the future, a charge to income tax expense may be required to
reduce the value of the net deferred tax asset to the expected realizable
value.
The
Corporation has not substantively changed its application of the foregoing
policies, and there have been no material changes in assumptions or estimation
techniques used as compared to prior periods.
Financial
Overview
For
the
third quarter of 2007, the Corporation’s diluted earnings per share was $.25
compared to $.27 for the third quarter of 2006. Net income was $7.2 million
for
the third quarter of 2007 compared to $7.9 million during the same period in
2006.
For
the
nine months ended September 30, 2007, diluted earnings per share was $.70 as
compared to $.89 in the comparable period of 2006. Net income for the nine-month
period ended September 30, 2007, was $20.4 million compared to $26.1 million
during the first nine months of 2006. The reduction in earnings for the first
nine months of 2007 as compared to the same period in 2006 was reflective of
the
lower net interest income due to the net interest margin compression and higher
salaries and benefits expense as well as an increase in the provision for loan
losses as a result of decreased quality of the loan portfolio and
charge-offs.
Earnings
growth was difficult for the Corporation during the quarter. However, the
Corporation continued to report higher levels of noninterest income with wealth
management up 34.2% and bank service charges increasing 17.6% during the third
quarter of 2007 over the comparable period in 2006. The Corporation achieved
loan growth of $61.5 million or 3.0% primarily from commercial and consumer
loans as compared to September 30, 2006. The Corporation recognized some credit
deterioration in the quarter and management continues to be concerned with
overall credit quality.
The
Corporation’s consolidated total assets were $3.4 billion at September 30, 2007,
remaining level with total assets reported at September 30, 2006. Loans
increased by $61.5 million or 3.0% over September 30, 2006 mainly due to growth
in real estate loans, including both construction and consumer as well as
commercial and industrial loans. Total deposits decreased $83.9 million or
3.2%
to $2.54 billion at September 30, 2007 from $2.63 billion at September 30,
2006
principally attributable to a decline in checking and regular savings accounts
partially offset by growth in money market accounts. Total assets at September
30, 2007 were $130.7 million higher compared to December 31, 2006 with loan
growth of $48.4 million or 2.4%, an increase in cash and investments of $71.4
million and an increase in premises and equipment of $6.6 million mainly from
several new office locations including the new operations center building in
Harleysville and three new branch openings. Total deposits were up $27.5 million
or 1.1% in comparison to December 31, 2006.
For
the
three months ended September 30, 2007, the annualized return on average
shareholders’ equity and the annualized return on average assets were 9.86% and
0.86%, respectively. For the same period in 2006, the annualized return on
average shareholders’ equity was 11.10% and the annualized return on average
assets was 0.96%. The decrease in these ratios during 2007 was primarily the
result of lower net income.
Nonperforming
assets (including nonaccrual loans, loans 90 days or more past due and net
assets in foreclosure) were 0.46% of total assets at September 30, 2007,
compared to 0.54% at December 31, 2006, and 0.39% at September 30, 2006. The
decrease in nonperforming assets at September 30, 2007, in relation to December
31, 2006, of $2.0 million was mainly due to a lower level of commercial real
estate loans 90 days past due. The increase of nonperforming assets in relation
to September 30, 2006 of $2.5 million was largely due to a higher level of
nonaccrual residential mortgage loans and commercial loans partially offset
by a
lower level of loans 90 days past due in all loan categories.
The loan loss provision
increased $1.6 million and $3.1 million during the three and nine-month periods
ending September 30, 2007, respectively, compared to the same periods in 2006
as
a result of decreased quality of the loan portfolio and charge-offs during
2007.
The charge-offs were principally related to real estate construction loans
for
one borrower which were disposed of subsequent to September 30, 2007. Management
has dedicated more resources to resolve troubled credits including an increased
focus on earlier identification of potential problem loans and a more active
approach to managing the level of criticized loans that have not reached
nonaccrual status.
On
March
1, 2007, the Cornerstone Companies, a subsidiary of the Bank, completed a
selected asset purchase of McPherson Enterprises and related entities
(McPherson), registered investment advisors specializing in estate and
succession planning and life insurance for high-net-worth construction and
aggregate business owners and families throughout the United States. McPherson
became a part of the Cornerstone Companies, a component of the Bank’s Millennium
Wealth Management division. The acquisition is part of the Corporation’s plan to
continue to build its fee-based services businesses.
On
May
15, 2007, the Corporation entered into a definitive agreement to acquire
East
Penn Financial Corporation (East Penn Financial) and its wholly owned
subsidiary, East Penn Bank, a $451 million state chartered, FDIC insured
bank,
offering deposit and lending services throughout the Lehigh Valley, PA.
Headquartered and founded in Emmaus, PA in 1990, East Penn Financial has
nine
banking offices located in Lehigh, Northampton and Berks Counties. The total
value of the transaction at the agreement date, if it closed, is estimated
at
$92.7 million or approximately $14.50 per share of East Penn Financial stock,
although actual value will depend on several factors, including the price
of the
Corporation’s stock, but will not be less than $13.52 per share ($86.3 million)
or greater than $15.48 per share ($99.1 million). On November 1, 2007, the
shareholders of East Penn Financial approved and adopted the Merger Agreement
as
amended August 29, 2007. The Corporation has received all necessary regulatory
approvals for completion of the merger, subject only to receiving final
clearance from the Office of the Comptroller of the Currency to consummate
the
merger of East Penn Financial Corporation’s wholly owned bank subsidiary, East
Penn Bank, with and into Harleysville National Corporation’s wholly owned
national bank subsidiary, Harleysville National Bank and Trust Company. The
merger is currently expected to be effective on or about November 16, 2007.
The
transaction is expected to be accretive to the Corporation’s earnings per share
in the first full calendar year following the consummation. As part of the
agreement, East Penn Financial will continue to operate under the East Penn
name
and logo, and will become a division of Harleysville National Bank, the
Corporation’s banking subsidiary. Nine of Harleysville National Bank’s existing
branches will also be transferred to the East Penn division including those
in
Lehigh, Carbon, Monroe, and Northampton Counties.
Results
of Operations
Net
income is affected by five major elements: (1) net interest income, or the
difference between interest income earned on loans and investments and interest
expense paid on deposits and borrowed funds; (2) the provision for loan losses,
or the amount added to the allowance for loan losses to provide reserves for
inherent losses on loans; (3) noninterest income, which is made up primarily
of
certain fees, wealth management income and gains and losses from sales of
securities or other transactions; (4) noninterest expense, which consists
primarily of salaries, employee benefits and other operating expenses; and
(5)
income taxes. Each of these major elements will be reviewed in more detail
in
the following discussion.
Net
Interest Income
Net
interest income on a tax equivalent basis in the third quarter of 2007 increased
$237,000 or 1.1% from the same period in 2006 and decreased $2.5 million or
3.8%
from the nine-month period ending September 30, 2006. The year-to-date decrease
during 2007 was mainly attributable to the continued increase in customer
deposit costs which have outpaced yield increases in loans and
investments.
The
rate
volume variance analysis in the table below, which is computed on a
tax-equivalent basis (tax rate of 35%), analyzes changes in net interest income
for the three months ended September 30, 2007 compared to September 30, 2006
by
their volume and rate components. The change attributable to both volume and
rate has been allocated proportionately.
Table
1—Analysis of Changes in Net Interest Income—Fully Taxable-Equivalent
Basis
|
|
|
Three
Months Ended
September
30, 2007 compared to
September
30, 2006
|
|
|
Nine
Month Ended
September
30, 2007 compared to
September
30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
|
Due
to change in:
|
|
|
Total
|
|
|
Due
to change in:
|
|
|
|
|
Change
|
|
|
Volume
|
|
|
Rate
|
|
|
Change
|
|
|
Volume
|
|
|
Rate
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Increase
(decrease) in interest income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment
securities *
|
|
$
|
1,343
|
|
|
$
|
207
|
|
|
$
|
1,136
|
|
|
$
|
3,685
|
|
|
$
|
393
|
|
|
$
|
3,292
|
|
|
Federal
funds sold and deposits in banks
|
|
|
(566
|
)
|
|
|
(417
|
)
|
|
|
(149
|
)
|
|
|
46
|
|
|
|
14
|
|
|
|
32
|
|
|
Loans
*
|
|
|
2,271
|
|
|
|
1,118
|
|
|
|
1,153
|
|
|
|
7,375
|
|
|
|
3,243
|
|
|
|
4,132
|
|
|
Total
|
|
|
3,048
|
|
|
|
908
|
|
|
|
2,140
|
|
|
|
11,106
|
|
|
|
3,650
|
|
|
|
7,456
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Increase
(decrease) in interest expense:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Savings
and money market deposits
|
|
|
1,646
|
|
|
|
490
|
|
|
|
1,156
|
|
|
|
10,151
|
|
|
|
2,764
|
|
|
|
7,387
|
|
|
Time
deposits
|
|
|
(80
|
)
|
|
|
(889
|
)
|
|
|
809
|
|
|
|
2,329
|
|
|
|
(1,115
|
)
|
|
|
3,444
|
|
|
Borrowed
funds
|
|
|
1,245
|
|
|
|
1,140
|
|
|
|
105
|
|
|
|
1,173
|
|
|
|
450
|
|
|
|
723
|
|
|
Total
|
|
|
2,811
|
|
|
|
741
|
|
|
|
2,070
|
|
|
|
13,653
|
|
|
|
2,099
|
|
|
|
11,554
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net
increase (decrease) in net interest income
|
|
$
|
237
|
|
|
$
|
167
|
|
|
$
|
70
|
|
|
$
|
(2,547
|
)
|
|
$
|
1,551
|
|
|
$
|
(4,098
|
)
|
|
*Tax
equivalent basis using a tax rate of 35%, net
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The
following table presents the major asset and liability categories on an average
basis for the periods presented, along with interest income and expense, and
key
rates and yields.
Table
2—Average Balance Sheets and Interest Rates
¾
Fully
Taxable-Equivalent Basis
|
(Dollars
in thousands)
|
|
Three
Months Ended September 30,
|
|
|
Three
Months Ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
Average
|
|
|
Average
|
|
|
|
|
|
Average
|
|
|
Assets
|
|
Balance
|
|
|
Interest
|
|
|
Rate
|
|
|
Balance
|
|
|
Interest
|
|
|
Rate
|
|
|
Earning
assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
investments
|
|
$
|
669,051
|
|
|
$
|
8,769
|
|
|
|
5.20
|
%
|
|
$
|
661,976
|
|
|
$
|
7,538
|
|
|
|
4.52
|
%
|
|
Nontaxable
investments
(1)
|
|
|
264,621
|
|
|
|
4,004
|
|
|
|
6.00
|
|
|
|
255,127
|
|
|
|
3,892
|
|
|
|
6.05
|
|
|
Total
investment securities
|
|
|
933,672
|
|
|
|
12,773
|
|
|
|
5.43
|
|
|
|
917,103
|
|
|
|
11,430
|
|
|
|
4.94
|
|
|
Federal
funds sold and deposits in banks
|
|
|
57,841
|
|
|
|
661
|
|
|
|
4.53
|
|
|
|
92,878
|
|
|
|
1,227
|
|
|
|
5.24
|
|
|
Loans
(1)
(2)
|
|
|
2,090,440
|
|
|
|
37,094
|
|
|
|
7.04
|
|
|
|
2,027,028
|
|
|
|
34,823
|
|
|
|
6.82
|
|
|
Total
earning assets
|
|
|
3,081,953
|
|
|
|
50,528
|
|
|
|
6.50
|
|
|
|
3,037,009
|
|
|
|
47,480
|
|
|
|
6.20
|
|
|
Noninterest-earning
assets
|
|
|
227,563
|
|
|
|
|
|
|
|
|
|
|
|
216,607
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$
|
3,309,516
|
|
|
|
|
|
|
|
|
|
|
$
|
3,253,616
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
and Shareholders' Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Savings
and money market
|
|
$
|
1,363,803
|
|
|
|
12,276
|
|
|
|
3.57
|
|
|
$
|
1,305,618
|
|
|
|
10,630
|
|
|
|
3.23
|
|
|
Time
|
|
|
801,334
|
|
|
|
9,652
|
|
|
|
4.78
|
|
|
|
878,493
|
|
|
|
9,732
|
|
|
|
4.40
|
|
|
Total
interest-bearing deposits
|
|
|
2,165,137
|
|
|
|
21,928
|
|
|
|
4.02
|
|
|
|
2,184,111
|
|
|
|
20,362
|
|
|
|
3.70
|
|
|
Borrowed
funds
|
|
|
501,752
|
|
|
|
6,230
|
|
|
|
4.93
|
|
|
|
409,583
|
|
|
|
4,985
|
|
|
|
4.83
|
|
|
Total
interest bearing liabilities
|
|
|
2,666,889
|
|
|
|
28,158
|
|
|
|
4.19
|
|
|
|
2,593,694
|
|
|
|
25,347
|
|
|
|
3.88
|
|
|
Noninterest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
312,123
|
|
|
|
|
|
|
|
|
|
|
|
334,847
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
40,676
|
|
|
|
|
|
|
|
|
|
|
|
42,397
|
|
|
|
|
|
|
|
|
|
|
Total
noninterest-bearing liabilities
|
|
|
352,799
|
|
|
|
|
|
|
|
|
|
|
|
377,244
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities
|
|
|
3,019,688
|
|
|
|
|
|
|
|
|
|
|
|
2,970,938
|
|
|
|
|
|
|
|
|
|
|
Shareholders'
equity
|
|
|
289,828
|
|
|
|
|
|
|
|
|
|
|
|
282,678
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and shareholders' equity
|
|
$
|
3,309,516
|
|
|
|
|
|
|
|
|
|
|
$
|
3,253,616
|
|
|
|
|
|
|
|
|
|
|
Net
interest spread
|
|
|
|
|
|
|
|
|
|
|
2.31
|
|
|
|
|
|
|
|
|
|
|
|
2.32
|
|
|
Effect
of noninterest-bearing sources
|
|
|
|
|
|
|
|
|
|
|
0.57
|
|
|
|
|
|
|
|
|
|
|
|
0.57
|
|
|
Net
interest income/margin on earning assets
|
|
|
|
|
|
$
|
22,370
|
|
|
|
2.88
|
%
|
|
|
|
|
|
$
|
22,133
|
|
|
|
2.89
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less
tax equivalent adjustment
|
|
|
|
|
|
|
1,506
|
|
|
|
|
|
|
|
|
|
|
|
1,519
|
|
|
|
|
|
|
Net
interest income
|
|
|
|
|
|
$
|
20,864
|
|
|
|
|
|
|
|
|
|
|
$
|
20,614
|
|
|
|
|
|
|
(Dollars
in thousands)
|
|
Nine
Months Ended September 30,
|
|
|
Nine
Months Ended September 30,
|
|
|
|
|
2007
|
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
Average
|
|
|
Average
|
|
|
|
|
|
Average
|
|
|
Assets
|
|
Balance
|
|
|
Interest
|
|
|
Rate
|
|
|
Balance
|
|
|
Interest
|
|
|
Rate
|
|
|
Earning
assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable
investments
|
|
$
|
676,787
|
|
|
$
|
25,821
|
|
|
|
5.10
|
%
|
|
$
|
675,138
|
|
|
$
|
22,412
|
|
|
|
4.44
|
%
|
|
Nontaxable
investments
(1)
|
|
|
261,458
|
|
|
|
11,849
|
|
|
|
6.06
|
|
|
|
252,447
|
|
|
|
11,573
|
|
|
|
6.13
|
|
|
Total
investment securities
|
|
|
938,245
|
|
|
|
37,670
|
|
|
|
5.37
|
|
|
|
927,585
|
|
|
|
33,985
|
|
|
|
4.90
|
|
|
Federal
funds sold and deposits in banks
|
|
|
67,548
|
|
|
|
2,553
|
|
|
|
5.05
|
|
|
|
67,181
|
|
|
|
2,507
|
|
|
|
4.99
|
|
|
Loans
(1)
(2)
|
|
|
2,070,931
|
|
|
|
107,708
|
|
|
|
6.95
|
|
|
|
2,007,650
|
|
|
|
100,333
|
|
|
|
6.68
|
|
|
Total
earning assets
|
|
|
3,076,724
|
|
|
|
147,931
|
|
|
|
6.43
|
|
|
|
3,002,416
|
|
|
|
136,825
|
|
|
|
6.09
|
|
|
Noninterest-earning
assets
|
|
|
221,173
|
|
|
|
|
|
|
|
|
|
|
|
209,946
|
|
|
|
|
|
|
|
|
|
|
Total
assets
|
|
$
|
3,297,897
|
|
|
|
|
|
|
|
|
|
|
$
|
3,212,362
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Liabilities
and Shareholders' Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing
deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Savings
and money market
|
|
$
|
1,385,133
|
|
|
|
37,212
|
|
|
|
3.59
|
|
|
$
|
1,264,577
|
|
|
|
27,061
|
|
|
|
2.86
|
|
|
Time
|
|
|
806,638
|
|
|
|
28,670
|
|
|
|
4.75
|
|
|
|
841,242
|
|
|
|
26,341
|
|
|
|
4.19
|
|
|
Total
interest-bearing deposits
|
|
|
2,191,771
|
|
|
|
65,882
|
|
|
|
4.02
|
|
|
|
2,105,819
|
|
|
|
53,402
|
|
|
|
3.39
|
|
|
Borrowed
funds
|
|
|
458,523
|
|
|
|
16,690
|
|
|
|
4.87
|
|
|
|
445,688
|
|
|
|
15,517
|
|
|
|
4.65
|
|
|
Total
interest bearing liabilities
|
|
|
2,650,294
|
|
|
|
82,572
|
|
|
|
4.17
|
|
|
|
2,551,507
|
|
|
|
68,919
|
|
|
|
3.61
|
|
|
Noninterest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand
deposits
|
|
|
311,491
|
|
|
|
|
|
|
|
|
|
|
|
338,709
|
|
|
|
|
|
|
|
|
|
|
Other
liabilities
|
|
|
43,915
|
|
|
|
|
|
|
|
|
|
|
|
42,918
|
|
|
|
|
|
|
|
|
|
|
Total
noninterest-bearing liabilities
|
|
|
355,406
|
|
|
|
|
|
|
|
|
|
|
|
381,627
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities
|
|
|
3,005,700
|
|
|
|
|
|
|
|
|
|
|
|
2,933,134
|
|
|
|
|
|
|
|
|
|
|
Shareholders'
equity
|
|
|
292,197
|
|
|
|
|
|
|
|
|
|
|
|
279,228
|
|
|
|
|
|
|
|
|
|
|
Total
liabilities and shareholders' equity
|
|
$
|
3,297,897
|
|
|
|
|
|
|
|
|
|
|
$
|
3,212,362
|
|
|
|
|
|
|
|
|
|
|
Net
interest spread
|
|
|
|
|
|
|
|
|
|
|
2.26
|
|
|
|
|
|
|
|
|
|
|
|
2.48
|
|
|
Effect
of noninterest-bearing sources
|
|
|
|
|
|
|
|
|
|
|
0.58
|
|
|
|
|
|
|
|
|
|
|
|
0.54
|
|
|
Net
interest income/margin on earning assets
|
|
|
|
|
|
$
|
65,359
|
|
|
|
2.84
|
%
|
|
|
|
|
|
$
|
67,906
|
|
|
|
3.02
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less
tax equivalent adjustment
|
|
|
|
|
|
|
4,503
|
|
|
|
|
|
|
|
|
|
|
|
4,545
|
|
|
|
|
|
|
Net
interest income
|
|
|
|
|
|
$
|
60,856
|
|
|
|
|
|
|
|
|
|
|
$
|
63,361
|
|
|
|
|
|
|
(1)
|
The
interest earned on nontaxable investment securities and loans is
shown on
a tax equivalent basis, net of deductions (tax rate of
35%).
|
|
(2)
|
Nonaccrual
loans have been included in the appropriate average loan balance
category,
but interest on nonaccrual loans has not been included for purposes
of
determining interest income.
|
Interest
income on a tax equivalent basis in the third quarter of 2007 increased $3.0
million, or 6.4% over the same period in 2006. This increase was primarily
due
to higher average rates earned on loans and investment securities of 22 basis
points and 49 basis points, respectively, as well as increases in average loans
of $63.4 million, or 3.1%. The growth in average loans during 2007 was mainly
attributable to higher levels of new commercial and industrial originations
and
real estate loan originations, including both construction and consumer,
partially offset by a lower level of real estate refinancing loans due to the
higher interest rate environment. Interest expense increased $2.8 million or
11.1% during the third quarter of 2007 versus the comparable period in 2006
mainly attributed to higher deposit rates as well as an increase in average
borrowings of $92.2 million, or 22.5%. The average rate paid on deposits during
the third quarter of 2007 of 4.02% was 32 basis points higher compared to the
same period in 2006 due to higher rates on most deposit products. Average
interest-bearing deposits were down slightly by $19.0 million or 1.0%, due
to
reductions in time deposits and savings accounts offset by growth in
interest-bearing checking and money market accounts. The Corporation has placed
more emphasis on lower rate deposit products in an effort to improve the net
interest margin. The increase in average borrowings was mainly due to a higher
level of long-term securities sold under agreement and overnight borrowings
offset in part by long-term Federal Home Loan Bank maturities
.
Net
Interest Margin
The
net
interest margin for the third and second quarters of 2007 was 2.88% and 2.82%,
respectively, compared to 2.89% for the third quarter of 2006. Customer deposit
costs have continued to outpace yield increases in loans and investments,
resulting in a lower net interest margin compared to the third quarter of 2006,
partially offset by an increase in loan prepayment penalties during the third
quarter of 2007.
Interest
Rate Sensitivity Analysis
In
the
normal course of conducting business activities, the Corporation is exposed
to
market risk, principally interest rate risk through the operations of its
banking subsidiary. Interest rate risk arises from market driven fluctuations
in
interest rates that affect cash flows, income, expense and value of financial
instruments.
The
Corporation actively manages its interest rate sensitivity positions. The
objectives of interest rate risk management are to control exposure of net
interest income to risks associated with interest rate movements and to achieve
consistent growth in net interest income. The Asset/Liability Committee, using
policies and procedures approved by the Corporation’s Board of Directors, is
responsible for managing the rate sensitivity position. The Corporation manages
interest rate sensitivity by changing the mix and repricing characteristics
of
its assets and liabilities through the management of its investment securities
portfolio, its offering of loan and deposit terms and through borrowings from
the Federal Home Loan Bank of Pittsburgh (the FHLB). The nature of the
Corporation’s current operations is such that it is not subject to foreign
currency exchange or commodity price risk.
The
Corporation only utilizes derivative instruments for asset/liability management.
These transactions involve both credit and market risk. The notional amounts
are
amounts on which calculations and payments are based. The notional amounts
do
not represent direct credit exposures. Direct credit exposure is limited to
the
net difference between the calculated amounts to be received and paid, if any.
Interest rate swaps are contracts in which a series of interest-rate flows
(fixed and floating) are exchanged over a prescribed period. The
notional amounts on which the interest payments are based are not exchanged.
Interest rate caps are purchased contracts that limit the exposure from the
repricing of liabilities in a rising rate environment.
At
September 30, 2007, the Corporation had cash flow hedges in the form of interest
rate swaps with a notional amount of $45.0 million that have the effect of
converting the rates on money market deposit accounts to a fixed-rate cost
of
funds. This strategy will cause the Bank to recognize, in a rising rate
environment, a larger interest rate spread than it otherwise would have without
the swaps in effect. In addition, the Corporation had cash flow hedges with
a
notional amount of $10.0 million that have the effect of converting variable
debt to a fixed rate. For these swaps, the Corporation recognized net interest
income of $73,000 and $134,000 for the three months ended September 30, 2007
and
2006, respectively and $325,000 and $311,000 of net interest income for the
nine
months ended September 30, 2007 and 2006, respectively. During the first quarter
of 2005, the Corporation terminated a cash flow hedge with a notional value
of
$25.0 million. The gross loss related to the termination of this swap was
$310,000 which was amortized through October 2006 in accordance with SFAS No.
133 “Accounting for Derivative Instruments and Hedging Activities.” The
Corporation amortized into net interest income $46,000 for the third quarter
of
2006 and $136,000 for the nine months ended September 30, 2006 related to this
swap. Periodically, the Corporation may enter into fair value hedges to limit
the exposure to changes in the fair value of loan assets. At September 30,
2007,
the Corporation had fair value hedges in the form of interest rate swaps with
a
notional amount of $3.9 million. For these swaps the Corporation recognized
net
interest income of $17,000 and $63,000 for the three and nine months ended
September 30, 2007, respectively (which includes $17,000 and $55,000 for the
respective periods related to two terminated swaps with notional amounts
totaling $3.9 million that were terminated during 2007) and no impact to
earnings for the first nine months of 2006. At September 30, 2007, the
Corporation had swap agreements with a positive fair value of 68,000 and with
a
negative fair value of $234,000. At December 31, 2006, the Corporation had
swap
agreements with a positive fair value of $545,000 and with a negative fair
value
of $21,000. There was no hedge ineffectiveness recognized during the first
nine
months of 2007 and no hedge ineffectiveness was recognized during the first
nine
months of 2006.
During
March 2007, the Corporation purchased one and three month Treasury bill interest
rate cap agreements with notional amounts totaling $200 million to limit its
exposure on variable rate now deposit accounts. The initial premium related
to
these caps was $73,000 which is being amortized to interest expense over the
life of the cap based on the cap market value. The Corporation recognized
amortization of $361 for the nine months ended September 30, 2007. At September
30, 2007, these caps, designated as cash flow hedges, had a positive fair value
of $4,000 with no impact to earnings for the first nine months of 2007. The
caps
mature in March 2009.
The
Corporation uses three principal reports to measure interest rate risk: (1)
asset/liability simulation reports; (2) gap analysis reports; and (3) net
interest margin reports. Management also simulates possible economic conditions
and interest rate scenarios in order to quantify the impact on net interest
income. The effect that changing interest rates have on the Corporation’s net
interest income is simulated by increasing and decreasing interest rates. This
simulation is known as rate shocking. The results of the September 30, 2007
net
interest income rate shock simulations show that the Corporation is within
guidelines set by the Corporation’s Asset/Liability Policy when rates increase
or decrease 100 or 200 basis points.
The
report below forecasts changes in the Corporation’s market value of equity under
alternative interest rate environments as of September 30, 2007. The market
value of equity is defined as the net present value of the Corporation’s
existing assets and liabilities. The Corporation is within guidelines set by
the
Corporation’s Asset/Liability Policy for the percentage change in the market
value of equity.
Table
3—Market Value of Equity
|
|
|
|
|
|
Change
in
|
|
|
|
|
|
Asset/Liability
|
|
|
|
|
Market
Value
|
|
|
Market
Value
|
|
|
Percentage
|
|
|
Approved
|
|
|
(Dollars
in thousands)
|
|
of
Equity
|
|
|
Of
Equity
|
|
|
Change
|
|
|
Percent
Change
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
+300
Basis Points
|
|
$
|
385,843
|
|
|
$
|
(95,415
|
)
|
|
|
-19.83
|
%
|
|
|
+/-35
|
%
|
|
+200
Basis Points
|
|
|
418,445
|
|
|
|
(62,813
|
)
|
|
|
-13.05
|
%
|
|
|
+/-
25
|
|
|
+100
Basis Points
|
|
|
451,359
|
|
|
|
(29,899
|
)
|
|
|
-6.21
|
%
|
|
|
+/-
15
|
|
|
Flat
Rate
|
|
|
481,258
|
|
|
|
-
|
|
|
|
0.00
|
%
|
|
|
|
|
|
-100
Basis Points
|
|
|
487,681
|
|
|
|
6,423
|
|
|
|
1.33
|
%
|
|
|
+/-
15
|
|
|
-200
Basis Points
|
|
|
474,521
|
|
|
|
(6,737
|
)
|
|
|
-1.40
|
%
|
|
|
+/-
25
|
|
|
-300
Basis Points
|
|
|
460,311
|
|
|
|
(20,947
|
)
|
|
|
-4.35
|
%
|
|
|
+/-
35
|
|
In
the
event the Corporation should experience a mismatch in its desired gap ranges
or
an excessive decline in their market value of equity resulting from changes
in
interest rates, it has a number of options that it could use to remedy the
mismatch. The Corporation could restructure its investment portfolio through
the
sale or purchase of securities with more favorable repricing attributes. It
could also emphasize growth in loan products with appropriate maturities or
repricing attributes, or attract deposits or obtain borrowings with desired
maturities.
Provision
for Loan Losses
The
Corporation uses the reserve method of accounting for loan losses. The balance
in the allowance for loan and lease losses is determined based on management’s
review and evaluation of the loan portfolio in relation to past loss experience,
the size and composition of the portfolio, current economic events and
conditions, and other pertinent factors, including management’s assumptions as
to future delinquencies, recoveries and losses. Increases to the allowance
for
loan and lease losses are made by charges to the provision for loan losses.
Credit exposures deemed to be uncollectible are charged against the allowance
for loan losses. Recoveries of previously charged-off amounts are credited
to
the allowance for loan losses.
While
management considers the allowance for loan losses to be adequate based on
information currently available, future additions to the allowance may be
necessary due to changes in economic conditions or management’s assumptions as
to future delinquencies, recoveries and losses and management’s intent with
regard to the disposition of loans. In addition, the Office of the Comptroller
of the Currency (the OCC), as an integral part of their examination process,
periodically reviews the Corporation’s allowance for loan losses. The OCC may
require the Corporation to recognize additions to the allowance for loan losses
based on their judgments about information available to them at the time of
their examination.
The
Corporation performs periodic evaluations of the allowance for loan losses
that
include both historical, internal and external factors. The actual allocation
of
reserve is a function of the application of these factors to arrive at a reserve
for each portfolio type. Management assigns credit ratings and individual
factors to individual groups of loans. Changes in concentrations and quality
are
captured in the analytical metrics used in the calculation of the reserve.
The
components of the allowance for credit losses consist of both historical losses
and estimates. Management bases its recognition and estimation of each allowance
component on certain observable data that it believes is the most reflective
of
the underlying loan losses being estimated. The observable data and accompanying
analysis is directionally consistent, based upon trends, with the resulting
component amount for the allowance for loan losses. The Corporation’s allowance
for loan losses components includes the following: historical loss estimation
by
loan product type and by risk rating within each product type, payment (past
due) status, industry concentrations, internal and external variables such
as
economic conditions, credit policy and underwriting changes and results of
the
loan review process. The Corporation’s historical loss component is the most
significant component of the allowance for loan losses, and all other allowance
components are based on the inherent loss attributes that management believes
exist within the total portfolio that are not captured in the historical loss
component.
The
historical loss components of the allowance represent the results of analyses
of
historical charge-offs and recoveries within pools of homogeneous loans, within
each risk rating and broken down further by segment, within the portfolio.
Criticized assets are further assessed based on trends, expressed as
percentages, relative to delinquency, risk rating and nonaccrual, by credit
product.
The
historical loss components of the allowance for commercial and industrial loans
and commercial real estate loans (collectively “commercial loans”) are based
principally on current risk ratings, historical loss rates adjusted, by
adjusting the risk window, to reflect current events and conditions, as well
as
analyses of other factors that may have affected the collectibility of loans.
All commercial loans with an outstanding balance over $500,000 are subject
to
review on an annual basis. Samples of commercial loans with a “pass” rating are
individually reviewed annually. Commercial loans that management determines
to
be potential problem loans are individually reviewed at a minimum annually.
The
review is accomplished via Watchlist Memorandum, and is designed to determine
whether such loans are individually impaired, with impairment measured by
reference to the collateral coverage and/or debt service coverage. Consumer
credit and residential real estate reviews are limited to those loans reflecting
delinquent payment status. Homogeneous loan pools, including consumer and 1-4
family residential mortgages are not subject to individual review but are
evaluated utilizing risk factors such as concentration of one borrower group.
The historical loss component of the allowance for these loans is based
principally on loan payment status, retail classification and historical loss
rates, adjusted by altering the risk window, to reflect current events and
conditions.
The
industry concentration component is recognized as a possible factor in the
estimation of loan losses. Two industries represent possible concentrations:
commercial real estate and consumer loans relying on residential home equity.
No
specific loss-related observable data is recognized by management currently,
therefore no specific factor is calculated in the reserve solely for the impact
of these concentrations, although management continues to carefully consider
relevant data for possible future sources of observable data.
The
historic loss model includes a
judgmental component (environmental factors) that reflects management’s belief
that there are additional inherent credit losses based on loss attributes not
adequately captured in the lagging indicators.
The environmental factors
are based
upon management’s review of trends in the Corporation’s primary market area as
well as regional and national economic trends. Management utilizes various
economic factors that could impact borrowers’ future ability to make loan
payments such as changes in the interest rate environment, product supply
shortages, negative industry specific events. Management utilizes relevant
articles from newspapers and other publications that describe the economic
events affecting specific geographic areas and other published economic reports
and data.
Furthermore,
given that past-performance indicators may not adequately capture current risk
levels, allowing for a real-time adjustment enhances the validity of the loss
recognition process. There are many credit risk management reports that are
synthesized by credit risk management staff to assess the direction of credit
risk and its instant effect on losses. It is important to continue to use
experiential data to confirm risk as measurable losses will continue to manifest
themselves at higher than normal levels even after the economic cycle has begun
an upward swing and lagging indicators begin to show improvement. The judgmental
component is allocated to the specific segments of the portfolio based on the
historic loss component
.
The
loan
loss provision increased $1.6 million and $3.1 million during the three and
nine-month periods ending September 30, 2007, respectively, compared to the
same
periods in 2006 as a result of decreased quality of the loan portfolio and
charge-offs during 2007.
N
et loans charged-off
increased
$3.0 million for the first nine months of 2007 compared to the same period
in
2006 principally from charge-offs related to real estate construction loans
for
one borrower which were disposed of subsequent to September 30, 2007 through
a
sale of the collateral.
The
profile of our customer base has remained relatively constant and we believe
that the current deterioration in credit quality has been caused by the economic
pressures being felt by our borrowers. We have experienced a similar decline
in
the past and expect that we could experience a similar decline in future
economic cycles.
A
summary
of the activity in the allowance for loan losses is as follows:
Table
4—Allowance for Loans Losses
|
|
|
Nine
Months Ended
|
|
|
|
|
September
30,
|
|
|
(Dollars
in thousands)
|
|
2007
|
|
|
2006
|
|
|
|
|
|
|
|
|
|
|
Average
loans
|
|
$
|
2,070,931
|
|
|
$
|
2,007,650
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance,
beginning of period
|
|
|
21,154
|
|
|
|
19,865
|
|
|
Loans
charged off:
|
|
|
|
|
|
|
|
|
|
Real
estate
|
|
|
2,987
|
|
|
|
483
|
|
|
Commercial
and industrial
|
|
|
819
|
|
|
|
469
|
|
|
Consumer
|
|
|
1,178
|
|
|
|
1,253
|
|
|
Lease
financing
|
|
|
51
|
|
|
|
18
|
|
|
Total
loans charged off
|
|
|
5,035
|
|
|
|
2,223
|
|
|
Recoveries:
|
|
|
|
|
|
|
|
|
|
Real
estate
|
|
|
67
|
|
|
|
114
|
|
|
Commercial
and industrial
|
|
|
136
|
|
|
|
48
|
|
|
Consumer
|
|
|
207
|
|
|
|
412
|
|
|
Lease
financing
|
|
|
18
|
|
|
|
87
|
|
|
Total
recoveries
|
|
|
428
|
|
|
|
661
|
|
|
Net
loans charged off
|
|
|
4,607
|
|
|
|
1,562
|
|
|
Provision
for loan losses
|
|
|
6,075
|
|
|
|
3,000
|
|
|
Allowance,
end of period
|
|
$
|
22,622
|
|
|
$
|
21,303
|
|
|
Ratio
of net charge offs to average
|
|
|
|
|
|
|
|
|
|
loans
outstanding (annualized)
|
|
|
0.30
|
%
|
|
|
0.10
|
%
|
|
|
|
|
|
|
|
|
|
|
The
following table sets forth an allocation of the allowance for loan losses by
loan category. The specific allocations in any particular category may be
reallocated in the future to reflect then current conditions. Accordingly,
management considers the entire allowance to be available to absorb losses
in
any category.
Table
5—Allocation of the Allowance for Loan Losses by Loan Type
The
factors affecting the allocation of the allowance during the nine-month period
ended September 30, 2007 were changes in credit quality resulting from increases
in criticized real estate construction loans. The allocation of the allowance
for real estate loans at September 30, 2007 increased $1.4 million from December
31, 2006 primarily due to an increase in criticized real estate construction
loans for one borrower totaling $8.5 million. The loan is part of a syndicated
credit for a local borrower that has been negatively affected by a decline
in
home sales. There were no material changes in the allocation of the allowance
for commercial and industrial loans, consumer loans and lease financing at
September 30, 2007 compared to December 31, 2006. There were no significant
changes in the estimation methods and assumptions including environmental
factors, loan concentrations or terms that impacted the allowance during the
first nine months of 2007. The interest rate environment as well as weakening
in
the commercial real estate market has moderately increased our allowance
allocation in concert with the historical trends. It is expected that the
negative trends in the real estate industry will continue to affect credit
quality for the remainder of 2007 and into 2008. The growth in the loan
portfolio and the change in the mix will result in an adjustment to the amount
of the allowance allocated to each category based upon historical loss trends
and other factors.
The
following table sets forth an allocation of the allowance for loan losses by
category. The specific allocations in any particular category may be reallocated
in the future to reflect then current conditions. Accordingly, management
considers the entire allowance to be available to absorb losses in any
category.
|
|
|
September
30, 2007
|
|
|
December
31, 2006
|
|
|
|
|
|
|
|
Percent
of
|
|
|
|
|
|
Percent
of
|
|
|
(Dollars
in thousands)
|
|
Amount
|
|
|
Allowance
|
|
|
Amount
|
|
|
Allowance
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate
|
|
$
|
9,298
|
|
|
|
41
|
%
|
|
$
|
7,918
|
|
|
|
38
|
%
|
|
Commercial
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
and
industrial
|
|
|
9,227
|
|
|
|
41
|
%
|
|
|
9,119
|
|
|
|
43
|
%
|
|
Consumer
|
|
|
4,060
|
|
|
|
18
|
%
|
|
|
4,041
|
|
|
|
19
|
%
|
|
Lease
financing
|
|
|
37
|
|
|
|
-
|
%
|
|
|
76
|
|
|
|
-
|
%
|
|
Total
|
|
$
|
22,622
|
|
|
|
100
|
%
|
|
$
|
21,154
|
|
|
|
100
|
%
|
Nonperforming
Assets
Nonperforming
assets (including nonaccruing loans, net assets in foreclosure and loans past
due 90 days or more past due) were 0.46% of total assets at September 30, 2007,
compared to .054% at December 31, 2006, and 0.39% at September 30, 2006. The
decrease in nonperforming assets at September 30, 2007, in relation to December
31, 2006, of $2.0 million was mainly due to a lower level of commercial real
estate loans 90 days past due. The increase of nonperforming assets in relation
to September 30, 2006 of $2.5 million was largely due to a higher level of
residential mortgage loans and commercial and industrial loans on nonaccrual
of
interest partially offset by a lower level of loans 90 days past due in all
loan
categories. The expectation of continued economic pressures resulting in
deterioration of credit quality has caused us to provide more resources to
resolve troubled credits including an increased focus on earlier identification
of potential problem loans and a more active approach to managing the level
of
criticized loans that have not reached nonaccrual status.
Foreclosed
assets are carried at the lower of cost (lesser of carrying value of asset
or
fair value at date of acquisition) or estimated fair value. Efforts to liquidate
assets acquired in foreclosure proceed as quickly as potential buyers can be
located and legal constraints permit. Loans past due 90 days or more and still
accruing interest are loans that are generally well secured and are in the
process of collection.
The
following table presents information concerning nonperforming assets.
Nonperforming assets include loans that are in nonaccrual status or 90 days
or
more past due and loans that are in the process of foreclosure.
Table
6—Nonperforming Assets
|
(Dollars
in thousands)
|
|
September
30, 2007
|
|
|
December
31, 2006
|
|
|
September
30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nonaccrual
loans
|
|
$
|
14,507
|
|
|
$
|
15,201
|
|
|
$
|
10,806
|
|
|
Loans
90 days or more past due
|
|
|
1,119
|
|
|
|
2,444
|
|
|
|
2,262
|
|
|
Total
nonperforming
loans
|
|
|
15,626
|
|
|
|
17,645
|
|
|
|
13,068
|
|
|
Net
assets in foreclosure
|
|
|
28
|
|
|
|
–
|
|
|
|
87
|
|
|
Total
nonperforming
assets
|
|
$
|
15,654
|
|
|
$
|
17,645
|
|
|
$
|
13,155
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Allowance
for loan losses to nonperforming loans
|
|
|
144.8
|
%
|
|
|
119.9
|
%
|
|
|
163.0
|
%
|
|
Nonperforming
loans to total net loans
|
|
|
0.75
|
%
|
|
|
0.87
|
%
|
|
|
0.65
|
%
|
|
Allowance
for loan and lease losses to total loans
|
|
|
1.08
|
%
|
|
|
1.03
|
%
|
|
|
1.05
|
%
|
|
Nonperforming
assets to total assets
|
|
|
0.46
|
%
|
|
|
0.54
|
%
|
|
|
0.39
|
%
|
Locally
located real estate, most with acceptable loan to value ratios, secures many
of
the nonperforming loans.
The
following table presents information concerning impaired loans. Impaired loans
are loans for which it is probable that all principal and interest will not
be
collected according to the contractual terms of the loan agreement. Impaired
loans are included in the nonaccrual loan total. Impaired loans increased $1.7
million at September 30, 2007 from December 31, 2006 mostly due to residential
mortgage loans.
Table
7—Impaired Loans
|
(Dollars
in thousands)
|
|
September
30, 2007
|
|
|
December
31, 2006
|
|
|
September
30, 2006
|
|
|
|
|
|
|
|
|
|
|
|
Impaired
Loans
|
|
$
|
5,604
|
|
|
$
|
3,946
|
|
|
$
|
3,260
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average
year-to-date impaired loans
|
|
$
|
7,613
|
|
|
$
|
3,222
|
|
|
$
|
3,027
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Impaired
loans with specific loss allowances
|
|
$
|
5,604
|
|
|
$
|
3,946
|
|
|
$
|
3,260
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Loss
allowances reserved on impaired loans
|
|
$
|
1,320
|
|
|
$
|
678
|
|
|
$
|
483
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Year-to-date
income recognized on impaired loans
|
|
$
|
31
|
|
|
$
|
60
|
|
|
$
|
50
|
The
Bank’s policy for interest income recognition on impaired loans is to recognize
income under the cash basis when the loans are both current and the collateral
on the loan is sufficient to cover the outstanding obligation to the Bank.
The
Bank will not recognize income if these factors do not exist.
Noninterest
Income
Noninterest
income of $9.8 million for the third quarter of 2007 reflects an increase of
$1.5 million or 17.8% from the third quarter of 2006. Wealth management income
rose $1.2 million or 34.2% during the third quarter of 2007 over the comparable
quarter in 2006, primarily driven by a higher level of life insurance and
advisory business at Cornerstone as well as growth in trust assets. Major
revenue component sources of wealth management income include investment
management and advisory fees, trust fees, estate and tax planning fees,
brokerage fees, and insurance related fees. The Bank also experienced an
increase in deposit service charges of $368,000 during the third quarter of
2007
over the prior year comparable period mainly from return check and overdraft
fees. For the nine-month period ended September 30, 2007, noninterest income
was
$29.2 million, an increase of $2.0 million or 7.5% over the same period in
2006.
This increase was primarily due to the previously aforementioned increases
in
wealth management income and service charges on deposits with year-to-date
increases of $2.3 million and $812,000, respectively, partially offset by the
$1.4 million pre-tax gain on the sale of the credit card portfolio during 2006.
In addition, gains on sales of investment securities for the nine months ended
September 30, 2007 were $475,000. The net security gains were primarily the
result of the sale of mortgage-backed securities and municipal bonds. During
the
comparable period in 2006, there were no investment securities gains
recognized.
Noninterest
Expense
Noninterest
expense of $18.9 million for the third quarter of 2007 increased $1.3 million
or
7.4% from the third quarter of 2006 and increased $5.4 million or 10.3% for
the
nine months ended September 30, 2007, over the comparable period in 2006.
Salaries and benefits expense rose $248,000 during the third quarter of 2007
and
$2.9 million during the first nine months of 2007 from the comparable periods
in
2006, primarily due to higher staffing levels resulting from new branch
openings, increased incentives associated with higher wealth management revenue
and higher cost of medical benefits partially offset by non-recurring
compensation and severance charges mainly related to the former Chief Executive
Officer’s contract during 2006. Occupancy expense increased $352,000 and
$687,000 for the three and nine months ended September 30, 2007 over the same
periods in 2006 mostly due to several new office locations including the new
operations center building in Harleysville and three new branch openings along
with additional increases in rent. During the second quarter of 2007, the
Corporation placed the newly constructed operations building located in
Harleysville into service. Depreciation expense for the three and nine-month
periods ending September 30, 2007 related to the operations building was
approximately $104,000 and $186,000, respectively with total depreciation
expense for 2007 currently estimated at approximately $290,000. The remaining
estimated contract billings and allocation among asset categories may alter
this
projected number. Other expense increased $716,000 and $1.6 million for the
three and nine months ended September 30, 2007, respectively over the comparable
periods in 2006, mainly as a result of increased computer software costs and
professional and consulting expenses as well as lower deferred loan origination
costs resulting from lower loan volume.
Income
Taxes
The
effective income tax rates for the three and nine months ended September 30,
2007 were 22.1% and 22.0%, respectively, versus the applicable federal statutory
rate of 35%. The effective income tax rates for the three and nine months ended
September 30, 2006 were 24.3% and 25.6%, respectively. The Corporation’s
effective rates during 2007 and 2006 were lower than the statutory tax rate
primarily as a result of tax-exempt income earned from state and municipal
securities and loans and bank-owned life insurance. The effective rate for
the
first nine months of 2007 was lower than the same period in 2006 primarily
due
to the lower level of net income during the first nine months of
2007.
Balance
Sheet Analysis
Total
assets at September 30, 2007 of $3.4 billion increased $130.7 million compared
to December 31, 2006 with loan growth of $48.4 million, or 2.4%, an increase
in
cash and investments of $71.4 million and an increase in premises and equipment
of $6.6 million. The growth in loans took place primarily in the real estate
portfolio. The increase in premises and equipment resulted mainly from several
new office locations including the new operations center building in
Harleysville and three new branch openings.
The balance of investment
securities available for sale at September 30, 2007 of $870.3 million increased
$17.2 million compared to December 31, 2006 primarily as a result of net
additional purchases of mortgage-backed securities.
The increase in
goodwill of $1.1 million was related to the selected asset purchase of McPherson
during the first quarter of 2007 and allocated to the Wealth Management
segment.
Total
deposits of $2.54 billion at September 30, 2007 increased $27.5 million, or
1.1%
from $2.52 billion at December 31, 2006. Growth in money market accounts of
$64.5 million and time deposits of $53.3 million was partially offset by
reductions in interest-bearing checking accounts of $45.3 million and savings
accounts of $26.5 million.
Total
borrowings increased $112.7 million to $502.2 million at September 30, 2007
from
$389.5 million at December 31, 2006. The increase was the mainly the result
of
advances of $105.0 million in long-term securities sold under agreements to
repurchase at attractive market yields to help fund the loan and investment
portfolio growth partially offset by $35.0 million in net maturities of
long-term Federal Home Loan Bank borrowings. In addition, the Corporation issued
$23.2 million of fixed/floating rate trust preferred subordinated debentures
during the third quarter of 2007. The proceeds are to be used for general
corporate purposes including funding of the East Penn Financial Corporation
acquisition expected to close in the fourth quarter of 2007.
Capital
Capital
formation is important to the Corporation's well being and future growth.
Capital for the period ending September 30, 2007 was $294.4 million, remaining
level with the capital balance at December 31, 2006. Increases in capital from
the retention of the Corporation’s earnings were offset by cash dividends paid
to shareholders as well as an increase in the accumulated other comprehensive
loss related to investment securities. Management believes that the
Corporation's current capital and liquidity positions are adequate to support
its operations. Management is not aware of any recommendations by any regulatory
authority, which, if it were to be implemented, would have a material effect
on
the Corporation's capital.
Table
8—Regulatory Capital
|
(Dollars
in thousands)
|
|
|
|
|
|
|
|
For
Capital
Adequacy
Purposes
|
|
|
To
Be Well Capitalized
Under
Prompt Corrective
Action
Program
|
|
|
As
of September 30, 2007
|
|
Actual
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
Capital (to risk weighted assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
$
|
348,156
|
|
|
|
13.04
|
%
|
|
$
|
213,578
|
|
|
|
8.00
|
%
|
|
$
|
266,973
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
284,066
|
|
|
|
10.70
|
%
|
|
|
212,467
|
|
|
|
8.00
|
%
|
|
|
265,584
|
|
|
|
10
|
%
|
|
Tier
1 Capital (to risk weighted assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
|
325,434
|
|
|
|
12.19
|
%
|
|
|
106,789
|
|
|
|
4.00
|
%
|
|
|
160,184
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
261,344
|
|
|
|
9.84
|
%
|
|
|
106,233
|
|
|
|
4.00
|
%
|
|
|
159,350
|
|
|
|
6
|
%
|
|
Tier
1 Capital (to average assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
|
325,434
|
|
|
|
9.98
|
%
|
|
|
130,412
|
|
|
|
4.00
|
%
|
|
|
163,014
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
261,344
|
|
|
|
8.10
|
%
|
|
|
128,982
|
|
|
|
4.00
|
%
|
|
|
161,227
|
|
|
|
5
|
%
|
|
(Dollars
in thousands)
|
|
|
|
|
|
|
|
For
Capital
Adequacy
Purposes
|
|
|
To
Be Well Capitalized
Under
Prompt Corrective
Action
Program
|
|
|
As
of December 31, 2006
|
|
Actual
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
|
Amount
|
|
|
Ratio
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
Capital (to risk weighted assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
$
|
323,622
|
|
|
|
12.58
|
%
|
|
$
|
205,814
|
|
|
|
8.00
|
%
|
|
$
|
257,268
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
279,513
|
|
|
|
10.93
|
%
|
|
|
204,529
|
|
|
|
8.00
|
%
|
|
|
255,661
|
|
|
|
10
|
%
|
|
Tier
1 Capital (to risk weighted assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
|
302,368
|
|
|
|
11.75
|
%
|
|
|
102,907
|
|
|
|
4.00
|
%
|
|
|
154,361
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
258,259
|
|
|
|
10.10
|
%
|
|
|
102,264
|
|
|
|
4.00
|
%
|
|
|
153,397
|
|
|
|
6
|
%
|
|
Tier
1 Capital (to average assets):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Corporation
|
|
|
302,368
|
|
|
|
9.36
|
%
|
|
|
129,242
|
|
|
|
4.00
|
%
|
|
|
161,553
|
|
|
|
-
|
|
|
Harleysville
National Bank
|
|
|
258,259
|
|
|
|
8.08
|
%
|
|
|
127,877
|
|
|
|
4.00
|
%
|
|
|
159,846
|
|
|
|
5
|
%
|
Pursuant
to the federal regulators’ risk-based capital adequacy guidelines, the
components of capital are called Tier 1 and Tier 2 capital. For the Corporation,
Tier 1 capital is generally common stockholder’s equity and retained earnings
adjusted to exclude disallowed goodwill and identifiable intangibles as well
as
the inclusion of qualifying trust preferred securities. Tier 2 capital is the
allowance for loan losses. The minimum for the Tier 1 ratio is 4.0% and the
total capital ratio (Tier 1 plus Tier 2 capital divided by risk-adjusted assets)
minimum is 8.0%. At September 30, 2007, the Corporation’s Tier 1 risk-adjusted
capital ratio was 12.19%
,
and the total risk-adjusted capital
ratio was 13.04%, both well above the regulatory requirements. The risk-based
capital ratios of the Bank also exceeded regulatory requirements at September
30, 2007. The higher risk-based capital ratios of the Corporation at
September 30, 2007 compared to December 31, 2006 were primarily
attributable to the increase in Tier 1 capital from the issuance of $23.2
million of trust preferred subordinated debentures during the third quarter
of
2007.
The
leverage ratio consists of Tier 1 capital divided by quarterly average total
assets, excluding goodwill and identifiable intangibles. Banking organizations
are expected to have ratios from 4% to 5%, depending upon their particular
condition and growth plans. Higher leverage ratios could be required by the
particular circumstances or risk profile of a given banking organization. The
Corporation’s leverage ratios were 9.98% at September 30, 2007 and 9.36% at
December 31, 2006.
The higher
leverage
ratio of the Corporation at September 30, 2007 was mainly due to the
increase in Tier 1 capital from the issuance of $23.2 million of trust preferred
subordinated debentures during the third quarter of 2007.
The
year-to-date September 30, 2007 cash dividend per share of $.60 was 9.1% higher
than the cash dividend for the same period in 2006 of $.55. The proportion
of
net income paid out in dividends for the first nine months of 2007 was 85.0%,
compared to 61.2% for the same period in 2006, the increase mainly resulting
from lower net income during the first nine months of 2007. Activity in both
the
Corporation’s dividend reinvestment and stock purchase plan did not have a
material impact on capital during the first nine months of 2007.
Liquidity
Liquidity
is a measure of the ability of the Corporation to meet its current cash needs
and obligations on a timely basis. For a bank, liquidity provides the means
to
meet the day-to-day demands of deposit customers and the needs of borrowing
customers. Generally, the Bank arranges its mix of cash, money market
investments, investment securities and loans in order to match the volatility,
seasonality, interest sensitivity and growth trends of its deposit funds. The
Corporation’s decisions with regard to liquidity are based on projections of
potential sources and uses of funds for the next 120 days under the
Corporation’s asset/liability model.
The
resulting projections as of September 30, 2007 show the potential sources of
funds exceeding the potential uses of funds. The accuracy of this prediction
can
be affected by limitations inherent in the model and by the occurrence of future
events not anticipated when the projections were made. The Corporation has
external sources of funds which can be drawn upon when funds are required.
A
source of external liquidity is an available line of credit with the FHLB.
As of
September 30, 2007, the Bank had borrowings outstanding with the FHLB of $204.8
million, all of which were long-term and pledged investment securities available
for sale of $718.9 million and held to maturity of $58.8 million. At September
30, 2007, the Bank had unused lines of credit at the FHLB of $208.5 million
and
unused federal funds lines of credit of $195.0 million.
In addition,
the
Corporation’s funding sources include investment and loan portfolio cash flows,
fed funds sold and short-term investments, as well as access to the brokered
certificate of deposit market and repurchase agreement borrowings.
The
Corporation could also increase its liquidity through its pricing on
certificates of deposit products.
The Corporation
believes it has adequate funding sources to maintain sufficient liquidity under
varying business conditions.
There
are
no known trends or any known demands, commitments, events or uncertainties
that
will result in, or that are reasonably likely to result in liquidity increasing
or decreasing in any material way, although a significant portion of the
Corporation’s time deposits mature within the next twelve months. In the event
that additional funds are required, the Corporation believes its short-term
liquidity is adequate as outlined above.
Other
Information
Pending
Legislation
Management
is not aware of any other current specific recommendations by regulatory
authorities or proposed legislation which, if they were implemented, would
have
a material adverse effect upon the liquidity, capital resources, or results
of
operations, although the general cost of compliance with numerous and multiple
federal and state laws and regulations does have, and in the future may have,
a
negative impact on the Corporation’s results of operations.
Effects
of Inflation
Inflation
has some impact on the Corporation and the Bank’s operating costs. Unlike many
industrial companies, however, substantially all of the Bank’s assets and
liabilities are monetary in nature. As a result, interest rates have a more
significant impact on the Corporation’s and the Bank’s performance than the
general level of inflation. Over short periods of time, interest rates may
not
necessarily move in the same direction or in the same magnitude as prices of
goods and services.
Effect
of Government Monetary Policies
The
earnings of the Corporation are and will be affected by domestic economic
conditions and the monetary and fiscal policies of the United States government
and its agencies. An important function of the Federal Reserve is to regulate
the money supply and interest rates. Among the instruments used to implement
those objectives are open market operations in United States government
securities and changes in reserve requirements against member bank deposits.
These instruments are used in varying combinations to influence overall growth
and distribution of bank loans, investments and deposits, and their use may
also
affect rates charged on loans or paid for deposits.
The
Bank
is a member of the Federal Reserve and, therefore, the policies and regulations
of the Federal Reserve have a significant effect on its deposits, loans and
investment growth, as well as the rate of interest earned and paid, and are
expected to affect the Bank’s operations in the future. The effect of such
policies and regulations upon the future business and earnings of the
Corporation and the Bank cannot be predicted.
Environmental
Regulations
There
are
several federal and state statutes, which regulate the obligations and
liabilities of financial institutions pertaining to environmental issues. In
addition to the potential for attachment of liability resulting from its own
actions, a bank may be held liable under certain circumstances for the actions
of its borrowers, or third parties, when such actions result in environmental
problems on properties that collateralize loans held by the bank. Further,
the
liability has the potential to far exceed the original amount of a loan issued
by the bank. Currently, neither the Corporation nor the Bank are a party to
any
pending legal proceeding pursuant to any environmental statute, nor are the
Corporation and the Bank aware of any circumstances that may give rise to
liability under any such statute.
Branching
During
the second quarter of 2007, the Corporation opened new branches in Warminster,
Bucks County and East Norriton, Montgomery County. The Corporation relocated
its
Blue Bell office in Montgomery County during July 2007. In addition, the Bank
plans to add retail branches in Warrington, Bucks County, Conshohocken and
Flourtown, Montgomery County and Whitehall, Lehigh County in 2008. These plans
are subject to change as management continues to evaluate its market and its
business needs. The Corporation continues to evaluate potential new branch
sites
that are contiguous to our current service area and will expand the Bank’s
market area and market share of loans and deposits.