Consolidated
total assets were $3.9 billion at December 31, 2007, an increase of 20.1% or
$653.2 million over $3.2 billion in total assets reported at December 31, 2006.
On November 16, 2007, the Corporation completed its acquisition of East Penn
Financial and its subsidiary, East Penn Bank. At the acquisition date, East Penn
Financial had approximately $451.1 million in assets, $337.7 million in loans
and $382.7 million in deposits.
The return
on average shareholders equity was 8.91% in 2007 compared to 13.98% in 2006.
The return on average assets was 0.79% in 2007 compared to 1.22% in 2006. The
decrease in these ratios during 2007 was primarily the result of lower net
income.
Loans
increased $413.5 million and deposits increased $468.2 million. Adjusted for the
East Penn Financial acquisition, organic loan growth was approximately $81.9
million or 4.0% and deposit growth was approximately $63.5 million or
2.5%.
Net interest
income on a tax-equivalent basis decreased $698,000, or .8%, for the year ending
December 31, 2007, over the prior year. The net interest margin for 2007 was
2.82% compared to 2.95% for 2006. The decline in the net interest margin was
mainly attributable to the increased customer deposit costs which outpaced yield
increases in loans and investments.
Nonperforming assets increased $4.3 million to $22.0 million at December
31, 2007 from $17.6 million at the end of 2006. However, nonperforming assets as
a percentage of total assets remained relatively stable at 0.56% compared to
0.54% at the end of 2006. The provision for loan losses increased $6.4 million
mostly as a result of decreased quality of the loan portfolio. Net charge-offs
increased by $4.7 million during 2007 over 2006 largely related to one large
real estate loan charge-off and four other unrelated commercial and industrial
loans.
Noninterest
income decreased $2.0 million or 4.4% during 2007 over 2006, although wealth
management fee income rose $3.9 million or 26.1% and service charges on deposits
increased $1.7 million or 21.1%. During 2007, the Corporation recognized gains
from sale-leaseback transactions of $2.8 million, while during 2006 the
Corporation recognized gains on the sale of the Honesdale branch and credit card
portfolio of $10.7 million and $1.4 million, respectively.
Noninterest
expenses were up $10.5 million or 14.9% in 2007 as compared to 2006. Driving
these increases were salaries and benefits expenses primarily due to higher
staffing levels resulting from new branch openings and the East Penn
acquisition. In addition, occupancy expenses increased due to several new office
locations including the new operations center building in Harleysville and four
new branch openings as well as the addition of the East Penn branches. Other
expenses increased due to a one-time pre-tax charge of $1.9 million related to
the pension plan curtailment and increased professional and consulting fees. The
Corporation changed the structure of its retirement programs by announcing its
intention to terminate the defined benefit pension plan while enhancing the
401(k) defined contribution savings plan. Going forward, management anticipates
that pension and 401(k) expenses will be reduced by approximately $600,000
annually.
Acquisitions/Dispositions
Effective
November 16, 2007, the Corporation completed its acquisition of East Penn
Financial. Under the terms of the Agreement and Plan of Merger dated as of May
15, 2007, as amended August 29, 2007, East Penn Financial was acquired by
Harleysville National Corporation and East Penn Financials wholly owned
subsidiary, East Penn Bank, a $451 million state chartered, FDIC insured bank
offering deposit and lending services throughout the Lehigh Valley, PA merged
with and into the Bank. Headquartered and founded in Emmaus, PA in 1990, East
Penn Bank, had nine banking offices located in Lehigh, Northampton and Berks
Counties. The acquisition expands the branch network that the Corporation has in
the Lehigh Valley and its opportunity to provide East Penn customers with a
broader mix of products and services. As part of the merger agreement, East Penn
Bank continues to operate under the East Penn name and logo, and has become a
division of the Bank. Nine of the Banks existing branches were transferred to
the East Penn division including those in Lehigh, Carbon, Monroe, and
Northampton Counties. The Corporation acquired 100% of the outstanding shares of
East Penn Financial for a total purchase price of $91.3 million. The transaction
was accounted for in accordance with SFAS No. 141, Business Combinations. In
connection therewith, 2,890,125 East Penn Financial shares were exchanged for
2,432,771 shares of the Corporations common stock and 3,444,229 East Penn
Financial shares were exchanged for cash consideration totaling $49.9
million.
23
East Penn Financial stock options of
136,906 were exchanged for cash consideration of $792,000 and options of 29,092
were exchanged to acquire 25,480 shares of the Corporations common stock
options. The allocation of the Corporations common stock and cash was such that
the East Penn Financial shareholders did not recognize gain or loss for federal
income tax purposes on those East Penn Financial shares that were exchanged for
the Corporations common stock in the merger. East Penn Financials results of
operations are included in the Corporations results from the date of
acquisition, November 16, 2007. The transaction is expected to be accretive to
the Corporations earnings for the fiscal year of 2008.
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 Banks Millennium Wealth Management
division. The acquisition is part of the Corporations plan to continue to build
its fee-based services businesses. The consideration for the transaction was
$1.5 million in cash.
Effective
January 1, 2006, the Bank completed its acquisition of the Cornerstone
Companies, registered investment advisors for high net worth, privately held
business owners, wealthy families and institutional clients. Located in the
Lehigh Valley, Pennsylvania, the firm serves clients throughout Pennsylvania and
other mid-Atlantic states. The transaction was accounted for using the purchase
method of accounting. The purchase price consisted of $15.0 million in cash paid
at closing and a contingent payment of up to $7.0 million to be paid
post-closing. The contingent payment is based upon the Cornerstone Companies
meeting certain minimum operating results during a five-year earn-out period
with a maximum payout of $7.0 million over this period. For 2007 and 2006, the
minimum operating results were met resulting in earn-out payments totaling $2.2
million which was recorded as additional goodwill. At December 31, 2007, the
remaining maximum payout is $4.8 million through 2010. The Cornerstone Companies
results of operations are included in the Corporations results from the
effective date of the acquisition, January 1, 2006.
On December
27, 2007, the Bank settled and closed an agreement to sell fifteen properties to
affiliates of American Realty Capital, LLC (ARC) in a sale-leaseback
transaction. The properties are located throughout Berks, Bucks, Lehigh,
Montgomery, Northampton, and Carbon counties. Under the leases, the Bank will
continue to utilize the properties in the normal course of business. Lease
payments on each property are institution-quality, triple net leases with an
initial annual aggregate base rent of $3.0 million with annual rent escalations
equal to the lower of CPI-U (Consumer Price Index for all Urban Consumers) or
2.0 percent commencing in the second year of the lease term. As tenant, the Bank
will be fully responsible for all costs associated with the operation, repair
and maintenance of the properties during the lease terms and will be recorded as
occupancy expense. The agreement provides that each lease will have a term of 15
years, commencing on the closing date for the Agreement. The agreement also
contains options to renew for periods aggregating up to 45 years. Under certain
circumstances these renewal options are subject to revocation by the lessor. The
Bank received net proceeds of $38.2 million and recorded a gain on sale from the
transaction of $2.3 million (pre-tax) representing a portion of the total gain
of $18.9 million. The remaining gain will be deferred and amortized through a
reduction of occupancy expense over the 15-year term of the leases an annual
amount of $1.1 million. The Corporation also completed a separate sale-leaseback
of office in October 2007 receiving net proceeds of $1.5 million with a
recognized pre-tax gain of $473,000. The deferred gain of $552,000 will be
amortized over the 10-year term of the lease. This strategic initiative will
help the Corporation translate a large non-earning asset into an earning asset
in the form of loans, which can help bolster earnings and increase
liquidity.
For a
five-year summary of financial information, see Item 6, Selected Financial
Data, which is incorporated herein by reference.
For
quarterly information for 2007 and 2006, see Item 7, Managements Discussion
and Analysis of Financial Condition and Results of OperationsFourth Quarter
2007 Results, and Table 16, Selected Quarterly Financial Data, which are
incorporated herein by reference.
24
Investment Securities
SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities requires
that debt and equity securities classified as available for sale be reported at
fair value, with unrealized gains and losses excluded from earnings and reported
in other comprehensive income. The net effect of unrealized gains or losses,
caused by marking an available for sale portfolio to market, causes fluctuations
in the level of shareholders equity and equity-related financial ratios as
market interest rates cause the fair value of fixed-rate securities to
fluctuate.
Investment
securities increased 7.8% to $982.9 million at December 31, 2007 from $911.9
million at December 31, 2006. The investment securities available for sale
increased $72.6 million and the investment securities held to maturity decreased
$1.5 million. The majority of the increase in available for sale securities is
due to the securities acquired from East Penn Financial of $66.2 million at
November 16, 2007. During 2007, $186.2 million of securities available for sale
were sold which generated a pre-tax gain of $1.1 million. The securities sold
consisted primarily of bullet and callable agency, tax-exempt municipal and
mortgage-backed securities. In comparison, $110.8 million of securities
available for sale were sold in 2006 which generated a pretax loss of
$674,000.
The
following table shows the carrying value of the Corporations investment
securities available for sale and held to maturity:
Table 1Investment Portfolio
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
|
(Dollars in thousands)
|
Investment securities available for sale:
|
|
|
|
|
|
|
|
|
|
Obligations of other U.S. government agencies and
corporations
|
|
$
|
98,734
|
|
$
|
119,956
|
|
$
|
157,396
|
Obligations of states and political subdivisions
|
|
|
228,436
|
|
|
201,643
|
|
|
173,845
|
Mortgage-backed securities
|
|
|
515,989
|
|
|
476,107
|
|
|
467,568
|
Other securities
|
|
|
82,409
|
|
|
55,304
|
|
|
42,844
|
Total investment securities available for
sale
|
|
$
|
925,568
|
|
$
|
853,010
|
|
$
|
841,653
|
Investment securities held to maturity:
|
|
|
|
|
|
|
|
|
|
Obligations of other U.S. government agencies and
corporations
|
|
$
|
3,868
|
|
$
|
3,856
|
|
$
|
3,843
|
Obligations of states and political subdivisions
|
|
|
53,479
|
|
|
55,023
|
|
|
55,712
|
Total investment securities held to maturity
|
|
$
|
57,347
|
|
$
|
58,879
|
|
$
|
59,555
|
The maturity
analysis of investment securities including the weighted average yield for each
category as of December 31, 2007 is as follows. Actual maturities may differ
from contractual maturities because issuers and borrowers may have the right to
call or prepay obligations with or without call or prepayment
penalties.
25
Table 2Maturity and
Tax-Equivalent Yield Analysis of Investment Securities
|
|
December 31, 2007
|
|
|
|
|
|
|
Due after
|
|
Due after
|
|
|
|
|
|
|
|
|
|
|
Due in 1 year
|
|
1
year through
|
|
5
years through
|
|
Due after
|
|
|
|
|
|
|
or less
|
|
5 years
|
|
10 years
|
|
10 years
|
|
Total
|
|
|
(Dollars in thousands)
|
Investment securities available for sale:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Obligations of other
U.S. government
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
agencies and corporations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
$
|
13,693
|
|
|
$
|
34,942
|
|
|
$
|
47,092
|
|
|
$
|
3,007
|
|
|
$
|
98,734
|
|
Weighted average yield
|
|
|
3.72
|
%
|
|
|
4.46
|
%
|
|
|
6.67
|
%
|
|
|
5.20
|
%
|
|
|
5.48
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.8 years
|
|
Obligations of states
and political
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
subdivisions:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
|
|
|
|
|
415
|
|
|
|
52,489
|
|
|
|
175,532
|
|
|
|
228,436
|
|
Weighted average yield(1)
|
|
|
|
%
|
|
|
5.15
|
%
|
|
|
5.85
|
%
|
|
|
6.28
|
%
|
|
|
6.18
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
6.1 years
|
|
Mortgage-backed
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
|
837
|
|
|
|
19,566
|
|
|
|
65,027
|
|
|
|
430,559
|
|
|
|
515,989
|
|
Weighted average yield
|
|
|
3.42
|
%
|
|
|
4.05
|
%
|
|
|
4.69
|
%
|
|
|
5.33
|
%
|
|
|
5.20
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
5.7 years
|
|
Other debt
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
|
6,532
|
|
|
|
7,921
|
|
|
|
2,000
|
|
|
|
36,927
|
|
|
|
53,380
|
|
Weighted average yield
|
|
|
4.11
|
%
|
|
|
5.14
|
%
|
|
|
4.23
|
%
|
|
|
6.20
|
%
|
|
|
5.71
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
18.3 years
|
|
Equity
securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
29,029
|
|
Weighted average yield
|
|
|
|
%
|
|
|
|
%
|
|
|
|
%
|
|
|
|
%
|
|
|
5.47
|
%
|
Total
investment securities available for
sale:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Fair value
|
|
$
|
21,062
|
|
|
$
|
62,844
|
|
|
$
|
166,608
|
|
|
$
|
646,025
|
|
|
$
|
925,568
|
|
Weighted average
yield
|
|
|
3.83
|
%
|
|
|
4.42
|
%
|
|
|
5.56
|
%
|
|
|
5.64
|
%
|
|
|
5.51
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
6.3
years
|
|
Investment securities held to maturity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Obligations of other
U.S. government
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
agencies and corporations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortized cost
|
|
$
|
|
|
|
$
|
|
|
|
|
|
|
|
$
|
3,868
|
|
|
$
|
3,868
|
|
Weighted average yield
|
|
|
|
%
|
|
|
|
%
|
|
|
|
%
|
|
|
5.42
|
%
|
|
|
5.42
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
10.5 years
|
|
Obligations of states
and political
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
subdivisions:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortized Cost
|
|
|
|
|
|
|
|
|
|
|
3,598
|
|
|
|
49,881
|
|
|
|
53,479
|
|
Weighted average yield(1)
|
|
|
|
%
|
|
|
|
%
|
|
|
6.02
|
%
|
|
|
6.69
|
%
|
|
|
6.65
|
%
|
Weighted average maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
2.7 years
|
|
Total investment
securities held to
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
maturity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortized Cost
|
|
$
|
|
|
|
$
|
|
|
|
$
|
3,598
|
|
|
$
|
53,749
|
|
|
$
|
57,347
|
|
Weighted average yield
|
|
|
|
%
|
|
|
|
%
|
|
|
6.02
|
%
|
|
|
6.60
|
%
|
|
|
6.56
|
%
|
Weighted average
maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.2 years
|
|
____________________
(1)
|
Weighted average yield on
nontaxable investment securities is shown on a tax equivalent basis (tax
rate of 35%).
|
26
Loans
Loans
increased $413.5 million in 2007. The acquisition of East Penn Financial
accounted for $337.7 million as of November 16, 2007. Organic growth was
approximately $81.9 million, or 4.0%. At the acquisition date, East Penn
Financial included $58.7 million in real estate loans, $239.0 million in
commercial loans, and $40.0 million in consumer loans. The growth in commercial
loans and real estate loans was mainly due to the emphasis on owner-operated
businesses and owner occupied commercial mortgage loans in its primary market.
The growth in consumer loans was mainly due to marketing efforts. In addition,
there was also a shift from variable rate home equity lines to fixed rate, fixed
payment home equity loans. The planned reduction in lease financing was due to
run-off. One of the Banks strategic objectives is to increase its loan to
deposit ratio by growing its loan portfolio at a faster pace than its deposits.
Loans increased $61.9 million, or 3.1% in 2006, primarily attributed to growth
in commercial and industrial, commercial real estate and residential mortgage
loans.
The following table shows the
composition of the Banks loans, net of deferred costs:
Table 3Composition of Loan
Portfolio
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
2004
|
|
2003
|
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
Amount
|
|
of Loans
|
|
Amount
|
|
of Loans
|
|
Amount
|
|
of Loans
|
|
Amount
|
|
of Loans
|
|
Amount
|
|
of Loans
|
|
|
(Dollars in thousands)
|
Real
estate
|
|
$
|
959,064
|
|
39
|
%
|
|
$
|
845,880
|
|
41
|
%
|
|
$
|
791,358
|
|
40
|
%
|
|
$
|
693,468
|
|
37
|
%
|
|
$
|
498,135
|
|
35
|
%
|
Commercial
and industrial
|
|
|
730,144
|
|
30
|
%
|
|
|
507,899
|
|
25
|
%
|
|
|
479,238
|
|
24
|
%
|
|
|
473,514
|
|
26
|
%
|
|
|
385,554
|
|
27
|
%
|
Consumer
|
|
|
769,051
|
|
31
|
%
|
|
|
685,988
|
|
34
|
%
|
|
|
697,373
|
|
35
|
%
|
|
|
645,718
|
|
35
|
%
|
|
|
463,492
|
|
34
|
%
|
Lease
financing
|
|
|
2,564
|
|
|
%
|
|
|
7,588
|
|
|
%
|
|
|
17,524
|
|
1
|
%
|
|
|
33,102
|
|
2
|
%
|
|
|
61,210
|
|
4
|
%
|
Total
|
|
$
|
2,460,823
|
|
100
|
%
|
|
$
|
2,047,355
|
|
100
|
%
|
|
$
|
1,985,493
|
|
100
|
%
|
|
$
|
1,845,802
|
|
100
|
%
|
|
$
|
1,408,391
|
|
100
|
%
|
The
following table details outstanding loans by type as of December 31, 2007, in
terms of contractual maturity date:
Table 4Selected Loan
Maturity Data
|
|
December 31, 2007
|
|
|
|
|
|
Due after
|
|
|
|
|
|
|
|
|
Due in
|
|
1
year
|
|
Due after
|
|
|
|
|
|
1 year or less
|
|
through 5 years
|
|
5 years
|
|
Total
|
|
|
(Dollars in thousands)
|
Real
estate
|
|
$
|
183,969
|
|
$
|
508,448
|
|
$
|
266,647
|
|
$
|
959,064
|
Commercial and
industrial
|
|
|
162,486
|
|
|
235,321
|
|
|
332,337
|
|
|
730,144
|
Consumer
|
|
|
224,034
|
|
|
219,506
|
|
|
325,511
|
|
|
769,051
|
Lease
financing
|
|
|
2,220
|
|
|
344
|
|
|
|
|
|
2,564
|
Total
|
|
$
|
572,709
|
|
$
|
963,619
|
|
$
|
924,495
|
|
$
|
2,460,823
|
Loans with variable or floating
interest
rates
|
|
$
|
364,868
|
|
$
|
260,155
|
|
$
|
338,674
|
|
$
|
963,697
|
Loans
with fixed predetermined interest rates
|
|
|
207,841
|
|
|
703,464
|
|
|
585,821
|
|
|
1,497,126
|
Total
|
|
$
|
572,709
|
|
$
|
963,619
|
|
$
|
924,495
|
|
$
|
2,460,823
|
The Bank had
no concentration of loans to individual borrowers which exceeded 10% of total
loans at December 31, 2007 and 2006. The Bank actively monitors the risk of loan
concentration. The Bank had no foreign loans, and the impact of nonaccrual and
delinquent loans on total interest income was not material.
27
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. A loan
is generally classified as nonaccrual when principal or interest has
consistently been in default for a period of 90 days or more, when there has
been deterioration in the financial condition of the borrower, or payment in
full of principal or interest is not expected. Delinquent loans past due 90 days
or more and still accruing interest are loans that are generally well-secured
and expected to be restored to a current status in the near future.
Nonperforming assets (including nonaccrual loans, loans 90 days or more
past due and net assets in foreclosure) were 0.56% of total assets at December
31, 2007, compared to 0.54% at December 31, 2006 and 0.27% at December 31, 2005.
The ratio of nonperforming loans to total net loans was 0.90% at December 31,
2007, compared to 0.87% at December 31, 2006 and 0.42% at December 31,
2005.
Nonaccruing loans increased $5.9
million to $21.1 million at December 31, 2007, as compared to December 31, 2006.
The higher level of nonaccruing loans was mainly due to an increase in
nonaccrual commercial construction, home equity revolving and installment loans
during 2007 offset by a decrease in non-accrual commercial mortgages.
Nonaccruing loans increased $7.7 million to $15.2 million at December 31, 2006,
as compared to December 31, 2005. The increase in nonaccruing loans was
principally due to an increase in non-accrual commercial mortgage loans during
2006. The Banks policy for interest income recognition on nonaccrual 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. During
2007, interest accrued on nonaccruing loans and not recognized as interest
income was $982,000 and interest paid on nonaccruing loans of $331,000 was
recognized as interest income. During 2006, interest accrued on nonaccruing
loans and not recognized as interest income was $788,000 and interest paid on
nonaccruing loans of $191,000 was recognized as interest income. During 2005,
interest accrued on nonaccruing loans and not recognized as interest income was
$310,000, and interest paid on nonaccruing loans of $250,000 was recognized as
interest income.
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. As of December 31, 2007,
loans past due 90 days or more and still accruing interest were $857,000,
compared to $2.4 million at December 31, 2006 and $846,000 at December 31, 2005.
The lower level of loans past due 90 days or more at December 31, 2007 from
December 31, 2006 was primarily in the commercial loans, commercial mortgages,
home equity revolving lines and home equity installment loans. The higher level
of loans past due 90 days or more at December 31, 2006 compared to December 31,
2005 was primarily in the commercial and residential real estate loan
portfolio.
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.
Net assets
in foreclosure at December 31, 2007 were $28,000. There were no net assets in
foreclosure at December 31, 2006 and $29,000 at December 31, 2005. Efforts to
liquidate assets acquired in foreclosure proceed as quickly as potential buyers
can be located and legal constraints permit. Foreclosed assets are carried at
the lower of cost (lesser of carrying value of the asset or fair value at date
of acquisition) or estimated fair value.
28
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 5Nonperforming
Assets
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
2004
|
|
2003
|
|
|
(Dollars in thousands)
|
Nonaccrual loans
|
|
$
|
21,091
|
|
|
$
|
15,201
|
|
|
$
|
7,493
|
|
|
$
|
4,705
|
|
|
$
|
3,343
|
|
Loans 90 days or more
past due
|
|
|
857
|
|
|
|
2,444
|
|
|
|
846
|
|
|
|
981
|
|
|
|
1,164
|
|
Total nonperforming loans
|
|
|
21,948
|
|
|
|
17,645
|
|
|
|
8,339
|
|
|
|
5,686
|
|
|
|
4,507
|
|
Net assets in
foreclosure
|
|
|
28
|
|
|
|
-
|
|
|
|
29
|
|
|
|
370
|
|
|
|
935
|
|
Total nonperforming assets
|
|
$
|
21,976
|
|
|
$
|
17,645
|
|
|
$
|
8,368
|
|
|
$
|
6,056
|
|
|
$
|
5,442
|
|
Allowance for loan losses to
nonperforming
loans
|
|
|
124.5
|
%
|
|
|
119.9
|
%
|
|
|
238.2
|
%
|
|
|
324.6
|
%
|
|
|
371.7
|
%
|
Nonperforming loans to total loans
|
|
|
0.90
|
%
|
|
|
0.87
|
%
|
|
|
0.42
|
%
|
|
|
0.31
|
%
|
|
|
0.32
|
%
|
Allowance for loan
losses to total loans
|
|
|
1.11
|
%
|
|
|
1.03
|
%
|
|
|
1.00
|
%
|
|
|
1.00
|
%
|
|
|
1.19
|
%
|
Nonperforming assets to total assets
|
|
|
0.56
|
%
|
|
|
0.54
|
%
|
|
|
0.27
|
%
|
|
|
0.20
|
%
|
|
|
0.22
|
%
|
Locally
located real estate, most with acceptable loan to value ratios, secures many of
the nonperforming loans.
Allowance for Loan Losses
The
Corporation uses the reserve method of accounting for loan losses. The balance
in the allowance for loan losses is determined based on managements 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 managements assumptions as to future
delinquencies, recoveries and losses. Increases to the allowance for loan 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 managements assumptions as
to future delinquencies, recoveries and losses and managements intent with
regard to the disposition of loans. In addition, the OCC, as an integral part of
their examination process, periodically reviews the Corporations 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 Corporations 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 Corporations 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.
29
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
managements 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 managements review of trends in the
Corporations 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 and 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
provision for loan losses increased $6.4 million during 2007 compared to 2006
mostly as a result of a decrease in the quality of the loan portfolio which
caused an increase in the amount of the required reserve. Net loans charged-off
increased $4.7 million for 2007 compared to 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 and four
unrelated commercial and industrial loans. 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. The provision for
loan losses for 2006 reflected an increase of $799,000 compared to the 2005
primarily due to inherent risk related to loan growth and the increase in
non-performing loans of $9.3 million.
30
The
allowance for loan losses increased $6.2 million, or 29.2%, to $27.3 million at
December 31, 2007 as compared to December 31, 2006. The increase in the
allowance was primarily due to the addition of the East Penn Financial loan loss
reserve in November 2007 as well as the inherent risk related to loan growth and
the increase in nonperforming loans of $4.3 million. The allowance for loan
losses increased $1.3 million, or 6.5%, to $21.2 million at December 31, 2006
from December 31, 2005. The increase in the allowance was mainly due to inherent
risk related to loan growth and the increase in nonperforming loans of $9.3
million.
A summary of the activity in the
allowance for loan losses is as follows:
Table 6Allowance for Loan
Losses
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
2004
|
|
2003
|
|
|
(Dollars in thousands)
|
Average loans
|
|
$
|
2,123,170
|
|
|
$
|
2,014,420
|
|
|
$
|
1,900,023
|
|
|
$
|
1,625,419
|
|
|
$
|
1,354,127
|
|
Allowance, beginning of
year
|
|
$
|
21,154
|
|
|
$
|
19,865
|
|
|
$
|
18,455
|
|
|
$
|
16,753
|
|
|
$
|
17,190
|
|
Loans
charged off:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real estate
|
|
|
4,847
|
|
|
|
1,047
|
|
|
|
383
|
|
|
|
208
|
|
|
|
1,311
|
|
Commercial and industrial
|
|
|
1,551
|
|
|
|
1,141
|
|
|
|
353
|
|
|
|
522
|
|
|
|
515
|
|
Consumer
|
|
|
1,693
|
|
|
|
1,481
|
|
|
|
2,123
|
|
|
|
1,921
|
|
|
|
2,173
|
|
Lease financing
|
|
|
51
|
|
|
|
42
|
|
|
|
188
|
|
|
|
883
|
|
|
|
556
|
|
Total
loans charged off
|
|
|
8,142
|
|
|
|
3,711
|
|
|
|
3,047
|
|
|
|
3,534
|
|
|
|
4,555
|
|
Recoveries:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real estate
|
|
|
72
|
|
|
|
138
|
|
|
|
326
|
|
|
|
307
|
|
|
|
80
|
|
Commercial and industrial
|
|
|
142
|
|
|
|
55
|
|
|
|
66
|
|
|
|
58
|
|
|
|
33
|
|
Consumer
|
|
|
283
|
|
|
|
519
|
|
|
|
586
|
|
|
|
496
|
|
|
|
685
|
|
Lease financing
|
|
|
19
|
|
|
|
88
|
|
|
|
78
|
|
|
|
143
|
|
|
|
120
|
|
Total
recoveries
|
|
|
516
|
|
|
|
800
|
|
|
|
1,056
|
|
|
|
1,004
|
|
|
|
918
|
|
Net
loans charged off
|
|
|
7,626
|
|
|
|
2,911
|
|
|
|
1,991
|
|
|
|
2,530
|
|
|
|
3,637
|
|
Reserve from East Penn
Financial
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
acquisition
|
|
|
3,250
|
|
|
|
|
|
|
|
|
|
|
|
1,677
|
|
|
|
|
|
Provision for loan losses
|
|
|
10,550
|
|
|
|
4,200
|
|
|
|
3,401
|
|
|
|
2,555
|
|
|
|
3,200
|
|
Allowance, end of year
|
|
$
|
27,328
|
|
|
$
|
21,154
|
|
|
$
|
19,865
|
|
|
$
|
18,455
|
|
|
$
|
16,753
|
|
Ratio
of net charge offs to average
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
loans outstanding
|
|
|
0.36
|
%
|
|
|
0.14
|
%
|
|
|
0.10
|
%
|
|
|
0.16
|
%
|
|
|
0.27
|
%
|
The factors
affecting the allocation of the allowance during 2007 were changes in credit
quality resulting from increases in criticized real estate construction loans
and increases in loan volume from the East Penn Financial acquisition. The
allocation of the allowance for real estate loans at December 31, 2007 increased
$2.6 million as compared to December 31, 2006 principally due to an increase in
criticized real estate construction loans including a loan for one borrower
totaling $7.8 million. The loan is part of a syndicated credit for a local
borrower that has been negatively affected by a decline in home sales. The
allocation of the allowance for commercial and industrial loans at December 31,
2007 increased $3.2 million from December 31, 2006 mostly due to an increase in
commercial loan volume from the East Penn Financial acquisition. In addition,
the allocation of the allowance for consumer loans at December 31, 2007
increased $444,000 primarily due to the increased level of consumer loans
related to the East Penn acquisition. There was no material changes in the
allocation of the allowance for lease financing at December 31, 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 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.
31
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.
Table 7Allocation of the
Allowance for Loan Losses by Loan Type
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
2004
|
|
2003
|
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
Percent
|
|
|
|
|
|
of
|
|
|
|
|
of
|
|
|
|
|
of
|
|
|
|
|
of
|
|
|
|
|
of
|
|
|
Amount
|
|
Allowance
|
|
Amount
|
|
Allowance
|
|
Amount
|
|
Allowance
|
|
Amount
|
|
Allowance
|
|
Amount
|
|
Allowance
|
|
|
(Dollars in thousands)
|
Real
estate
|
|
$
|
10,491
|
|
38
|
%
|
|
$
|
7,918
|
|
38
|
%
|
|
$
|
6,422
|
|
32
|
%
|
|
$
|
4,923
|
|
27
|
%
|
|
$
|
3,919
|
|
23
|
%
|
Commercial and
industrial
|
|
|
12,340
|
|
45
|
%
|
|
|
9,119
|
|
43
|
%
|
|
|
8,534
|
|
43
|
%
|
|
|
7,456
|
|
40
|
%
|
|
|
6,840
|
|
41
|
%
|
Consumer
|
|
|
4,485
|
|
17
|
%
|
|
|
4,041
|
|
19
|
%
|
|
|
4,596
|
|
23
|
%
|
|
|
5,515
|
|
30
|
%
|
|
|
4,990
|
|
30
|
%
|
Lease
financing
|
|
|
12
|
|
|
%
|
|
|
76
|
|
|
%
|
|
|
313
|
|
2
|
%
|
|
|
561
|
|
3
|
%
|
|
|
1,004
|
|
6
|
%
|
Total
|
|
$
|
27,328
|
|
100
|
%
|
|
$
|
21,154
|
|
100
|
%
|
|
$
|
19,865
|
|
100
|
%
|
|
$
|
18,455
|
|
100
|
%
|
|
$
|
16,753
|
|
100
|
%
|
Investment in Bank
The
Corporation acquired an investment in Berkshire Bancorp, the holding company of
Berkshire Bank, through the East Penn Financial acquisition. As of December 31,
2007, the total investment in Berkshire Bancorp, Inc. was $2.6 million
represented by 543,783 shares, resulting in a 17.97% ownership in consideration
of the combined ownership of the Corporation, its directors and officers. The
Corporation is considered to be a passive investor under a Crown X Agreement
which imposes certain restrictions on the Corporation. The Corporation is
entitled to purchase additional share of common stock from Berkshire Bank up to
24.9% of the outstanding shares of common stock at any time up to July 3, 2013
at an exercise price of $4.10, which is adjusted for stock splits. The
investment is included in other assets at its cost basis.
Deposits and Borrowings
Deposits and
borrowings are the primary funding sources of the Corporation. Core deposits
increased 7.1%, or $118.1 million, to $1.8 billion at December 31, 2007, up from
$1.7 billion at December 31, 2006. This growth is due to $185.2 million acquired
from East Penn Financial at November 16, 2007 and an organic decrease of
approximately $67.2 million. Total deposits increased $468.2 million, or 18.6%
for the same period, which was primarily attributable to deposits associated
with the acquisition of East Penn Financial of $382.7 million at acquisition
date and growth in time deposits. The Corporation continued its emphasis on
government banking to provide additional funding sources through relationships
with municipalities and school districts resulting in both interest-bearing
checking accounts and large time deposits.
Deposit Structure
The
following table is a distribution of average balances and average rates paid on
the deposit categories for the last three years:
Table 8Average Deposits
|
|
December 31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
|
|
(Dollars in thousands)
|
Demandnoninterest-bearing
|
|
$
|
312,011
|
|
|
%
|
|
$
|
333,406
|
|
|
%
|
|
$
|
335,962
|
|
|
%
|
Demandinterest-bearing
|
|
|
517,520
|
|
3.52
|
%
|
|
|
450,256
|
|
3.24
|
%
|
|
|
351,071
|
|
1.64
|
%
|
Money
market and savings
|
|
|
864,062
|
|
3.45
|
%
|
|
|
836,940
|
|
2.91
|
%
|
|
|
889,332
|
|
1.86
|
%
|
Time
deposits
|
|
|
863,953
|
|
4.78
|
%
|
|
|
848,912
|
|
4.29
|
%
|
|
|
683,466
|
|
3.56
|
%
|
Total interest-bearing deposits
|
|
$
|
2,245,535
|
|
3.98
|
%
|
|
$
|
2,136,108
|
|
3.53
|
%
|
|
$
|
1,923,869
|
|
2.42
|
%
|
Total deposits
|
|
$
|
2,557,546
|
|
|
|
|
$
|
2,469,514
|
|
|
|
|
$
|
2,259,831
|
|
|
|
32
The maturity
distribution of certificates of deposit of $100,000 and over as of December 31,
2007 is as follows:
Table 9Maturity
Distribution of Certificates of Deposit $100,000 and Over
|
|
(Dollars
|
|
|
in thousands)
|
Three
months or less
|
|
$
|
185,640
|
Over three months to
six months
|
|
|
88,555
|
Over
six months to twelve months
|
|
|
95,583
|
Over twelve
months
|
|
|
113,902
|
Total
|
|
$
|
483,680
|
Borrowings
Borrowings
increased $118.8 million to $508.3 at December 31, 2007 from $389.5 million at
December 31, 2006. The Corporation decreased long term debt with the Federal
Home Loan Bank by $23.0 million while increasing long-term securities sold under
agreement to repurchase by $105.0 million. Subordinated debt increased to $83.0
million at December 31, 2007. The Corporation completed a private placement of
$22.5 million in aggregate principal amount of fixed/floating rate preferred
securities (subordinated debt) through a newly formed Delaware Trust affiliate
HNC Statutory Trust IV on August 22, 2007. The Corporation acquired $8.2 million
of subordinated debt from East Penn Financial on November 16, 2007.
Borrowings
decreased $49.7 million to $389.5 million at December 31, 2006 from $439.2
million at December 31, 2005. The decrease was the result of reductions of $58.0
million in long-term Federal Home Loan Bank (FHLB) borrowings offset in part by
increases of $8.3 million in short-term borrowings.
The Bank,
pursuant to a designated cash management agreement, utilizes securities sold
under agreements to repurchase as vehicles for customers sweep and term
investment products. Securitization under these cash management agreements are
in U.S. Treasury Securities and obligations of states and political subdivisions
securities. Securities sold under agreements to repurchase are generally
overnight transactions. These securities are held in a third-party custodians
account, designated by the Bank under a written custodial agreement that
explicitly recognizes the Banks interest in the securities.
Table 10Securities Sold
under Agreements to Repurchase
|
|
At or for the year ended December
31,
|
Securities sold under agreements to
repurchase(1):
|
|
|
2007
|
|
2006
|
|
2005
|
|
|
(Dollars in thousands)
|
Balance at year-end
|
|
$
|
101,493
|
|
|
$
|
96,840
|
|
|
$
|
88,118
|
|
Weighted
average rate at year-end
|
|
|
3.60
|
%
|
|
|
4.61
|
%
|
|
|
3.45
|
%
|
Maximum month-end balance
|
|
$
|
105,205
|
|
|
$
|
100,944
|
|
|
$
|
155,239
|
|
Average
balance during the year
|
|
$
|
121,392
|
|
|
$
|
128,185
|
|
|
$
|
102,722
|
|
Weighted average rate during the year
|
|
|
4.46
|
%
|
|
|
4.37
|
%
|
|
|
2.64
|
%
|
____________________
(1)
|
Excludes
long-term securities sold under agreements to repurchase with private
entities of $105 million at December 31, 2007
.
|
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 is reviewed in more detail in the following
discussion.
33
Net Interest Income
Net interest
income on a tax equivalent basis in 2007 decreased $698,000, or .8% to $88.5
million, compared to 2006. During 2007, the Corporation experienced higher
deposit costs offset in part by yield increases in loans and investments. Net
interest income on a tax equivalent basis in 2006 decreased $4.3 million, or
4.6% to $89.2 million, in comparison to 2005. The decrease in 2006 was mostly
due to higher deposit rates, partially offset by higher loan rates and loan
volume.
The rate
volume analysis in the following table, which is computed on a tax-equivalent
basis (tax rate of 35%), analyzes changes in net interest income for the last
three years by their volume and rate components. The change attributable to both
volume and rate has been allocated proportionately.
Table 11Analysis of Changes
in Net Interest IncomeFully Taxable-Equivalent Basis
|
|
2007 compared to 2006
|
|
2006 compared to 2005
|
|
|
Net
|
|
Due to Change in
|
|
Net
|
|
Due to Change in
|
|
|
Change
|
|
Volume
|
|
Rate
|
|
Change
|
|
Volume
|
|
Rate
|
|
|
(Dollars in thousands)
|
Increase (decrease) in interest income:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment securities(1)
|
|
$
|
4,935
|
|
|
$
|
953
|
|
|
$
|
3,982
|
|
|
$
|
5,611
|
|
|
$
|
1,019
|
|
|
$
|
4,592
|
|
Federal funds sold and deposits in banks
|
|
|
(477
|
)
|
|
|
(376
|
)
|
|
|
(101
|
)
|
|
|
2,416
|
|
|
|
1,134
|
|
|
|
1,282
|
|
Loans(1)(2)
|
|
|
11,203
|
|
|
|
7,349
|
|
|
|
3,854
|
|
|
|
18,843
|
|
|
|
7,244
|
|
|
|
11,599
|
|
Total
|
|
|
15,661
|
|
|
|
7,926
|
|
|
|
7,735
|
|
|
|
26,870
|
|
|
|
9,397
|
|
|
|
17,473
|
|
Increase (decrease) in
interest expense:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Savings and money market deposits
|
|
|
9,074
|
|
|
|
2,992
|
|
|
|
6,082
|
|
|
|
16,587
|
|
|
|
874
|
|
|
|
15,713
|
|
Time deposits
|
|
|
4,849
|
|
|
|
651
|
|
|
|
4,198
|
|
|
|
12,130
|
|
|
|
6,567
|
|
|
|
5,563
|
|
Borrowed funds
|
|
|
2,436
|
|
|
|
1,730
|
|
|
|
706
|
|
|
|
2,433
|
|
|
|
(881
|
)
|
|
|
3,314
|
|
Total
|
|
|
16,359
|
|
|
|
5,373
|
|
|
|
10,986
|
|
|
|
31,150
|
|
|
|
6,560
|
|
|
|
24,590
|
|
Net (decrease)
increase in interest income
|
|
$
|
(698
|
)
|
|
$
|
2,553
|
|
|
$
|
(3,251
|
)
|
|
$
|
(4,280
|
)
|
|
$
|
2,837
|
|
|
$
|
(7,117
|
)
|
____________________
(1)
|
|
The interest earned on nontaxable
investment securities and loans is shown on a tax-equivalent basis using a
tax rate of 35%, net.
|
|
|
|
(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 2007 increased $15.7 million, or 8.5% to
$200.6 million, in comparison to 2006. The increase was primarily due to higher
average loans of $108.8 million, or 5.4%, and a 19 basis point rise in the
average rates earned on loans. 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 and loans acquired from East Penn Financial, partially offset by a
lower level of real estate refinancing loans due to the higher interest rate
environment. The average yield on investments also increased 42 basis points.
Interest expense increased $16.4 million, to $112.1 million during 2007 mostly
attributed to higher deposit rates and an increase in average deposits of $109.4
million. The average rate paid on deposits during 2007 of 3.98% was 45 basis
points higher compared to 2006 primarily due to higher rates on money market
accounts, interest checking accounts and time deposits accounts. The increase in
average deposits was mostly from growth in interest-bearing checking and money
market accounts as well as deposits acquired from East Penn Financial partially
offset by reductions in savings accounts.
The Corporation has placed more emphasis on lower
rate deposit products in an effort to improve the net interest
margin.
Interest
income on a tax-equivalent basis in 2006 increased $26.9 million, or 17.0% to
$185.0 million, as compared to 2005. The increase was primarily due to higher
average loans of $114.4 million, or 6.0%, and a 59 basis point rise in the
average rates earned on loans. The average yield on investments also increased
50 basis points. Interest expense increased $31.2 million, to $95.8 million
during 2006 mostly attributed to higher deposit and borrowing rates. The average
rate paid on deposits during 2006 of 3.53% was 111 basis points higher compared
to 2005 primarily due to higher rates on most deposit products. These higher
rates resulted from the continued increase in short-term rates during 2006. The
average rate paid on borrowings for 2006 of 4.69% was 75 basis points higher
than 2005 mainly due to an increase in short-term borrowing rates.
34
Net Interest Margin
The 2007 net
interest margin of 2.82% was lower than the net interest margins for 2006 and
2005 of 2.95% and 3.27%, respectively. The decline in the net interest margin
during 2007 and 2006 was mainly attributable to the increased customer deposit
costs which outpaced yield increases in loans and investments.
During 2007,
the Corporation continued to manage its balance sheet in an effort to position
it for the inverted yield curve and subsequent falling rates scenario. The
Corporation sold securities with lower fixed rates and longer average lives and
purchased securities with higher yields to take advantage of specific market
sectors and more stable cash flows. As a result, the balance sheet is better
positioned to mitigate market risk.
The table
below 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 12Average Balance
Sheets and Interest RatesFully Taxable-Equivalent Basis
|
|
Year Ended December
31,
|
|
|
2007
|
|
2006
|
|
2005
|
|
|
Average
|
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
|
|
Average
|
|
|
|
|
|
|
|
|
Balance
|
|
Interest
|
|
Rate
|
|
Balance
|
|
Interest
|
|
Rate
|
|
Balance
|
|
Interest
|
|
Rate
|
|
|
(Dollars in thousands)
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Earning
Assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment securities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Taxable investments
|
|
$
|
681,788
|
|
$
|
34,803
|
|
5.10
|
%
|
|
$
|
672,648
|
|
$
|
30,296
|
|
4.50
|
%
|
|
$
|
648,630
|
|
$
|
23,923
|
|
3.69
|
%
|
Nontaxable investments(1)
|
|
|
262,676
|
|
|
15,849
|
|
6.03
|
|
|
|
252,987
|
|
|
15,421
|
|
6.10
|
|
|
|
254,433
|
|
|
16,183
|
|
6.36
|
|
Total investment securities
|
|
|
944,464
|
|
|
50,652
|
|
5.36
|
|
|
|
925,635
|
|
|
45,717
|
|
4.94
|
|
|
|
903,063
|
|
|
40,106
|
|
4.44
|
|
Federal funds sold and deposits
in
banks
|
|
|
72,087
|
|
|
3,576
|
|
4.96
|
|
|
|
79,670
|
|
|
4,053
|
|
5.09
|
|
|
|
51,740
|
|
|
1,637
|
|
3.16
|
|
Loans(1)(2)
|
|
|
2,123,170
|
|
|
146,400
|
|
6.90
|
|
|
|
2,014,420
|
|
|
135,197
|
|
6.71
|
|
|
|
1,900,023
|
|
|
116,354
|
|
6.12
|
|
Total earning assets
|
|
|
3,139,721
|
|
|
200,628
|
|
6.39
|
|
|
|
3,019,725
|
|
|
184,967
|
|
6.13
|
|
|
|
2,854,826
|
|
|
158,097
|
|
5.54
|
|
Noninterest-earning
assets
|
|
|
231,583
|
|
|
|
|
|
|
|
|
209,499
|
|
|
|
|
|
|
|
|
184,360
|
|
|
|
|
|
|
Total
assets
|
|
$
|
3,371,304
|
|
|
|
|
|
|
|
$
|
3,229,224
|
|
|
|
|
|
|
|
$
|
3,039,186
|
|
|
|
|
|
|
Liabilities and
Shareholders Equity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing deposits:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Savings and money market
|
|
$
|
1,381,582
|
|
|
47,980
|
|
3.47
|
%
|
|
$
|
1,287,196
|
|
|
38,906
|
|
3.02
|
%
|
|
$
|
1,240,403
|
|
|
22,319
|
|
1.80
|
%
|
Time
|
|
|
863,953
|
|
|
41,309
|
|
4.78
|
|
|
|
848,912
|
|
|
36,460
|
|
4.29
|
|
|
|
683,466
|
|
|
24,330
|
|
3.56
|
|
Total interest-bearing deposits
|
|
|
2,245,535
|
|
|
89,289
|
|
3.98
|
|
|
|
2,136,108
|
|
|
75,366
|
|
3.53
|
|
|
|
1,923,869
|
|
|
46,649
|
|
2.42
|
|
Borrowed funds
|
|
|
471,296
|
|
|
22,838
|
|
4.85
|
|
|
|
434,938
|
|
|
20,402
|
|
4.69
|
|
|
|
456,599
|
|
|
17,969
|
|
3.94
|
|
Total interest-bearing liabilities
|
|
|
2,716,831
|
|
|
112,127
|
|
4.13
|
|
|
|
2,571,046
|
|
|
95,768
|
|
3.72
|
|
|
|
2,380,468
|
|
|
64,618
|
|
2.71
|
|
Noninterest-bearing
liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Demand deposits
|
|
|
312,011
|
|
|
|
|
|
|
|
|
333,406
|
|
|
|
|
|
|
|
|
335,962
|
|
|
|
|
|
|
Other liabilities
|
|
|
44,069
|
|
|
|
|
|
|
|
|
42,925
|
|
|
|
|
|
|
|
|
49,782
|
|
|
|
|
|
|
Total noninterest-bearing liabilities
|
|
|
356,080
|
|
|
|
|
|
|
|
|
376,331
|
|
|
|
|
|
|
|
|
385,744
|
|
|
|
|
|
|
Total
liabilities
|
|
|
3,072,911
|
|
|
|
|
|
|
|
|
2,947,377
|
|
|
|
|
|
|
|
|
2,766,212
|
|
|
|
|
|
|
Shareholders equity
|
|
|
298,393
|
|
|
|
|
|
|
|
|
281,847
|
|
|
|
|
|
|
|
|
272,974
|
|
|
|
|
|
|
Total liabilities and shareholders equity
|
|
$
|
3,371,304
|
|
|
|
|
|
|
|
$
|
3,229,224
|
|
|
|
|
|
|
|
$
|
3,039,186
|
|
|
|
|
|
|
Net
interest spread
|
|
|
|
|
|
|
|
2.26
|
|
|
|
|
|
|
|
|
2.41
|
|
|
|
|
|
|
|
|
2.83
|
|
Effect of
noninterest-bearing sources
|
|
|
|
|
|
|
|
0.56
|
|
|
|
|
|
|
|
|
0.54
|
|
|
|
|
|
|
|
|
0.44
|
|
Net interest
income/margin on earning
assets
|
|
|
|
|
$
|
88,501
|
|
2.82
|
%
|
|
|
|
|
$
|
89,199
|
|
2.95
|
%
|
|
|
|
|
$
|
93,479
|
|
3.27
|
%
|
Less tax equivalent
adjustment
|
|
|
|
|
|
6,067
|
|
|
|
|
|
|
|
|
6,026
|
|
|
|
|
|
|
|
|
6,358
|
|
|
|
Net
interest income
|
|
|
|
|
$
|
82,434
|
|
|
|
|
|
|
|
$
|
83,173
|
|
|
|
|
|
|
|
$
|
87,121
|
|
|
|
____________________
(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.
|
35
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 Corporations 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 wholesale
borrowings from several providers, but primarily from the Federal Home Loan
Bank. The nature of the Corporations 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 December
31, 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
$287,000, $442,000 and $69,000 for the years ended December 31, 2007, 2006 and
2005, respectively and estimates that for 2008, $153,000 will be recognized as a
decrease in net interest income. These swaps mature in 2008. 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. For the
years ended December 31, 2006 and 2005, the Corporation amortized into net
interest income $151,000 and $159,000, respectively 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 December 31, 2007, the
Corporation had fair value hedges in the form of interest rate swaps with a
notional amount of $3.9 million. These swaps mature in 2017. The Corporation
recognized net interest income of $59,000 and $7,000 for the years ended
December 31, 2007 and 2006, respectively, which includes $55,000 for 2007
related to two terminated swaps with notional amounts totaling $3.9 million that
were terminated during 2007. At December 31, 2007, the Corporation had swap
agreements with a positive fair value of $10,000 and with a negative fair value
of $366,000. 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 2007, 2006 and 2005.
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
$8,000 for the year ended December 31, 2007 and estimates that for 2008, $46,000
will be recognized as interest expense. At December 31, 2007, these caps,
designated as cash flow hedges, had a positive fair value of $222. The caps
mature in March 2009. During 2007, the Corporation accelerated the
reclassification of an immaterial amount in other comprehensive income to
earnings as a result of variable-rate interest payments becoming probable not to
occur. The accelerated amount was a loss of $7,000 recognized in interest
expense.
36
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. The Corporations interest rate sensitivity, as
measured by the repricing of its interest sensitive assets and liabilities at
December 31, 2007, is presented in the following table. The data in the table
was based in part on assumptions that are regularly reviewed for accuracy. The
table presents data at a single point in time and includes management
assumptions estimating the prepayment rate and the interest rate environment
prevailing at December 31, 2007. The table indicates a liability sensitive
one-year cumulative gap position of 6.76% of total earning assets.
Table 13Contractual
Repricing Data of Interest Sensitive Assets and Liabilities
|
|
December 31, 2007
|
|
|
|
|
|
|
|
|
|
|
After 1 year
|
|
|
|
|
|
|
|
|
|
0
to
|
|
91
to
|
|
through
|
|
Over
|
|
|
|
|
|
90 days
|
|
365 days
|
|
5 years
|
|
5 years
|
|
Total
|
|
|
(Dollars in thousands)
|
Earning assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment
securities
|
|
$
|
123,476
|
|
|
$
|
177,901
|
|
|
$
|
385,265
|
|
|
$
|
296,273
|
|
|
$
|
982,915
|
Federal
funds sold and deposits in banks
|
|
|
135,473
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
135,473
|
Loans
|
|
|
734,454
|
|
|
|
225,436
|
|
|
|
887,746
|
|
|
|
613,187
|
|
|
|
2,460,823
|
Total earning assets
|
|
$
|
993,403
|
|
|
$
|
403,337
|
|
|
$
|
1,273,011
|
|
|
$
|
909,460
|
|
|
$
|
3,579,211
|
Interest-bearing
liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing checking accounts
|
|
$
|
111,130
|
|
|
$
|
140,033
|
|
|
$
|
230,941
|
|
|
$
|
|
|
|
$
|
482,104
|
Money market
funds
|
|
|
92,579
|
|
|
|
224,442
|
|
|
|
479,304
|
|
|
|
|
|
|
|
796,325
|
Savings
accounts
|
|
|
7,284
|
|
|
|
21,852
|
|
|
|
116,545
|
|
|
|
|
|
|
|
145,681
|
Time
deposits
|
|
|
318,651
|
|
|
|
517,317
|
|
|
|
366,538
|
|
|
|
184
|
|
|
|
1,202,690
|
Borrowed funds
|
|
|
157,162
|
|
|
|
52,248
|
|
|
|
243,720
|
|
|
|
55,155
|
|
|
|
508,285
|
Total interest-bearing liabilities
|
|
$
|
686,806
|
|
|
$
|
955,892
|
|
|
$
|
1,437,048
|
|
|
$
|
55,339
|
|
|
$
|
3,135,085
|
Interest rate swaps
|
|
$
|
8,928
|
|
|
$
|
(5,000
|
)
|
|
$
|
|
|
|
$
|
(3,928
|
)
|
|
$
|
|
Incremental
gap
|
|
$
|
315,525
|
|
|
$
|
(557,555
|
)
|
|
$
|
(164,037
|
)
|
|
$
|
850,193
|
|
|
|
|
Cumulative gap(1)
|
|
$
|
315,525
|
|
|
$
|
(242,030
|
)
|
|
$
|
(406,067
|
)
|
|
$
|
444,126
|
|
|
|
|
Cumulative gap as a percentage of earning
assets
|
|
|
8.82
|
%
|
|
|
6.76
|
%
|
|
|
11.35
|
%
|
|
|
12.41
|
%
|
|
|
|
____________________
(1)
|
|
The information is based upon
significant assumptions, including the following: loans and leases are
repaid by contractual maturity and repricing; securities, except
mortgage-backed securities, are repaid according to contractual maturity
adjusted for call features; mortgage-backed security repricing is adjusted
for estimated early paydowns; interest-bearing demand, regular savings,
and money market savings deposits are estimated to exhibit some rate
sensitivity based on managements analysis of deposit withdrawals; and
time deposits are shown in the table based on contractual
maturity.
|
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 Corporations net interest income is simulated by increasing
and decreasing interest rates. This simulation is known as rate shocking. The
results of the December 31, 2007 net interest income rate shock simulations show
that the Corporation is within guidelines set by the Corporations
Asset/Liability Policy when rates increase or decrease 100 or 200 basis
points.
37
The
following table forecasts changes in the Corporations market value of equity
under alternative interest rate environments as of December 31, 2007. The market
value of equity is defined as the net present value of the Corporations
existing assets and liabilities. The Corporation is within guidelines set by the
Corporations Asset/Liability Policy for the percentage change in the market
value of equity.
Table 14Market Value of Equity
|
|
December 31, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
Asset/Liability
|
|
|
|
|
Change in
|
|
|
|
|
|
|
Approved
|
|
|
Market
Value
|
|
Market Value
|
|
Percentage
|
|
Percent
|
|
|
of Equity
|
|
of Equity
|
|
Change
|
|
Change
|
|
|
(Dollars in thousands)
|
+300
Basis Points
|
|
$416,917
|
|
$(116,265
|
)
|
|
|
21.81
|
%
|
|
|
|
+/
35
|
%
|
+200 Basis
Points
|
|
457,103
|
|
(76,079
|
)
|
|
|
14.27
|
|
|
|
|
+/
25
|
|
+100
Basis Points
|
|
497,873
|
|
(35,309
|
)
|
|
|
6.62
|
|
|
|
|
+/
15
|
|
Flat Rate
|
|
533,182
|
|
|
|
|
|
0.00
|
|
|
|
|
|
|
100 Basis Points
|
|
538,758
|
|
5,576
|
|
|
|
1.05
|
|
|
|
|
+/
15
|
|
200 Basis Points
|
|
528,116
|
|
(5,066
|
)
|
|
|
0.95
|
|
|
|
|
+/
25
|
|
300 Basis Points
|
|
517,653
|
|
(15,529
|
)
|
|
|
2.91
|
|
|
|
|
+/
35
|
|
In the event
the Corporation should experience a mismatch in its desired gap ranges or an
excessive decline in its 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
provision for loan losses increased $6.4 million during 2007 compared to 2006
mostly as a result of decreased quality of the loan portfolio. The provision for
loan losses for 2006 reflected an increase of $799,000 compared to the 2005
primarily due to inherent risk related to loan growth and the increase in
non-performing loans of $9.3 million. Total net loans charged off in 2007, 2006
and 2005 were $7.6 million, $2.9 million and $2.0 million, respectively.
Noninterest Income
For the year
ended December 31, 2007, noninterest income was $43.3 million, a decrease of
$2.0 million or 4.4% from 2006. Wealth management fee income rose $3.9 million
or 26.1% during 2007 primarily driven by a higher level of life insurance
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 experienced an increase in deposit service
charges of $1.7 million or 21.1% over the prior year mainly from return check
and overdraft fees and fees from East Penn deposit accounts. During the fourth
quarter of 2007, the Bank recognized a pre-tax gain of $2.3 million on the
sale-leaseback of fifteen bank properties representing a portion of the total
gain of $18.9 million. The remaining gain will be deferred and amortized through
a reduction of occupancy expense over the 15-year term of the leases an annual
amount of approximately $1.1 million. The Corporation also completed a separate
sale-leaseback of office space in October with a recognized pre-tax gain of
$473,000. The deferred gain of $552,000 will be amortized over the 10-year term
of the lease. In addition, gains on sale of investment securities were $1.1
million during 2007 as compared to losses of $674,000 for 2006. The net security
gains during 2007 were primarily the result of the sale of bullet and callable
agency, tax-exempt municipal and mortgage-backed securities. In addition,
noninterest income for 2006 included the pre-tax gains on the sales of the
Banks Honesdale branch and credit card portfolio of $10.7 million and $1.4
million, respectively.
38
Noninterest
income of $45.3 million during 2006 increased $15.4 million compared to 2005.
During 2006, the Bank recognized a pre-tax gain of $10.7 million on the sale of
its Honesdale branch. The sale of this single Wayne County location included
$74.2 million in deposits, as well as approximately $22.5 million in loans and
other assets, and resulted in a net cash payment of $42.5 million. The
acquisition of the Cornerstone Companies was the primary driver of increases in
wealth management income of $8.1 million for the year of 2006 over 2005,
partially offset by the sale of Cumberland Advisors, which was divested in 2005.
In addition, noninterest income for 2006 included the pre-tax gain of $1.4
million on the sale of the Banks $15.3 million credit card portfolio as well as
increases in fee revenue resulting from credit card operations. Losses on sales
of investment securities for 2006 were $674,000 as compared to gains of $4.8
million for 2005. Noninterest income for 2005 included the gains of $690,000 and
$287,000 on the sales of Harleysville National Banks McAdoo branch and
Cumberland Advisors, Inc, respectively.
Noninterest Expense
Noninterest
expense of $81.4 million for the year ended December 31, 2007 increased $10.5
million or 14.9% in comparison to 2006. Salaries and benefits expense rose $4.2
million during 2007 from the previous year, primarily due to higher staffing
levels resulting from new branch openings and the East Penn Financial
acquisition and higher costs of medical benefits. Occupancy expense increased
$1.3 million for the year ended December 31, 2007, over 2006 mostly due to
several new office locations including the new operations center building in
Harleysville and four new branch openings as well as the addition of the East
Penn branches. Other expense increased $5.0 million during 2007 mainly as a
result of the one-time pre-tax charge of $1.9 million related to the pension
plan curtailment, increased professional and consulting expense as well as East
Penn merger costs of approximately $339,000 and lower deferred loan origination
costs resulting from lower loan volume.
Noninterest
expense of $70.9 million during 2006 increased $8.4 million compared to 2005.
Salaries and benefits expense rose $7.2 million for the year of 2006 over 2005,
primarily related to the acquisition of the Cornerstone Companies, partially
offset by the sale of Cumberland Advisors in the second quarter of 2005, higher
staffing levels resulting from growth, increased incentives, non-recurring
compensation and severance charges primarily related to the former Chief
Executive Officers contract, and compensation expense of $440,000 resulting
from recording the Corporations stock option expense in conformance with FAS
123(R), Stock Based Compensation. Occupancy expense increased $494,000 in 2006
over 2005 mostly due to the Cornerstone Companies acquisition and a new branch
opening. Other expense increased $2.0 million during 2006 mainly as a result of
the Cornerstone Companies acquisition including amortization of intangible
assets of $448,000 partially offset by decreased marketing expenses during 2006.
Income Taxes
The
effective income tax rates for 2007, 2006 and 2005 were 21.5%, 26.3% and 24.2%
were less than the applicable federal statutory rate of 35%. The Corporations
effective rates 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, as well as for 2005, the non-taxable gain on the sale
of Cumberland Advisors, Inc. The effective tax rate for 2007 was lower than 2006
and 2005 primarily due to the lower level of net income during 2007.
Capital
Capital
formation is important to the Corporations well being and future growth.
Capital, at the end of 2007, was $339.3 million, an increase of $44.6 million
over the end of 2006. The increase was mainly due to the issuance of $39.1
million in common stock in connection with the acquisition of East Penn
Financial. At December 31, 2006, capital was $294.8 million, an increase of
$21.5 million over December 31, 2005. The increase was primarily the result of
the retention of the Corporations earnings and issuances of stock for stock
options including tax benefits partially offset by dividends paid to the
shareholders. Management believes that the Corporations current capital
position and liquidity position are strong and that its capital position is
adequate to support its operations. Management is not aware of any
recommendation by any regulatory authority, which, if it were to be implemented,
would have a material effect on the Corporations capital.
39
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 stockholders 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 for the
Corporation is the allowance for loan losses. The risk-based capital ratios are
computed by dividing the components of capital by risk-adjusted assets.
Risk-adjusted assets are determined by assigning credit risk-weighting factors
from 0% to 100% to various categories of assets and off-balance sheet financial
instruments. The minimum for the Tier 1 capital 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 December 31, 2007, the Corporations Tier 1 risk-adjusted
capital ratio was 9.79%, and the total risk-adjusted capital ratio was 10.67%,
both well above regulatory requirements. The risk-based capital ratios of the
Bank also exceeded regulatory requirements at the end of 2007. At December 31,
2006, the Corporations Tier 1 risk-adjusted capital ratio was 11.75%, and the
total risk-adjusted capital ratio was 12.58%. The lower risk-based capital
ratios of the Corporation at December 31, 2007 compared to December 31, 2006
were primarily attributable to the increase in risk-weighted assets from the
acquisition of East Penn Financial in November 2007 and due to an increase in
loans and federal funds sold.
To
supplement the risk-based capital adequacy guidelines, the Federal Reserve Board
(FRB) established a leverage ratio guideline. The leverage ratio consists of
Tier 1 capital divided by quarterly average total assets, excluding goodwill and
identifiable intangibles. The minimum leverage ratio guideline is 3% for banking
organizations that do not anticipate significant growth and that have
well-diversified risk, excellent asset quality, high liquidity, good earnings
and, in general, are considered top-rated, strong banking organizations. Other
banking organizations are expected to have ratios of at least 4% or 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 Corporations leverage ratios were 8.72% and
9.36% at December 31, 2007 and 2006, respectively.
The lower leverage ratio of the
Corporation at December 31, 2007 was mainly due to an increase in average assets
from the acquisition of East Penn Financial and increases in average loans and
average federal funds sold.
Under FDIC
regulations, a well capitalized institution must have a leverage ratio of at
least 5%, a Tier 1 risk-based capital ratio of at least 6% and a total
risk-based capital ratio of at least 10% and not be subject to a capital
directive order. To be considered adequately capitalized an institution must
generally have a leverage ratio of at least 4%, a Tier 1 risk-based capital
ratio of at least 4% and a total risk-based capital ratio of at least 8%. An
institution is deemed to be critically under capitalized if it has a tangible
equity ratio of 2% or less. As of December 31, 2007, the Bank is above the
regulatory minimum guidelines and meets the criteria to be categorized as a
well capitalized institution.
The cash
dividends paid during 2007 of $.80 per share was 6.7% higher than the cash
dividends in 2006 of $.75. The proportion of net income paid out in dividends
for 2007 was 88.82%, compared to 55.26% for 2006, the increase mainly resulting
from lower net income during 2007. The dividend payout ratios are in compliance
with regulatory guidelines. Management is focusing on improving and increasing
earnings so that the dividend payout ratio remains within acceptable
limits
.
Activity in both the Corporations dividend reinvestment and stock
purchase plan did not have a material impact on capital during 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
Corporations decisions with regard to liquidity are based on the projections of
potential sources and uses of funds for the next 120 days under the
Corporations asset/liability model.
40
The
resulting projections as of December 31, 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. One source of external liquidity is the available line of credit with
the FHLB. As of December 31, 2007, the Bank had borrowings outstanding with the
FHLB of $216.8 million, all of which were long-term. At December 31, 2007, the
Bank had unused lines of credit at the FHLB of $363.1 million and unused federal
funds lines of credit of $195.0 million.
In
addition, the Corporations
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 has pledged available for sale
investment securities with a carrying value of $699.0 million and held to
maturity securities of $57.3 million. 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
Corporations time deposits mature in 2008. Given the anticipated low rate
environment for much of 2008, we expect to be able to retain most of these
deposits. In the event that additional funds are required, the Corporation
believes its short-term liquidity is adequate as outlined above.
The
following table sets forth contractual obligations and other commitments
representing required and potential cash outflows as of December 31, 2007:
Table 15Contractual
Obligations and Other Commitments
|
|
December 31, 2007
|
|
|
|
|
|
|
|
|
After one
|
|
After three
|
|
|
|
|
|
|
|
|
One year or
|
|
year through
|
|
years through
|
|
After five
|
|
|
Total
|
|
less
|
|
three years
|
|
five years
|
|
years
|
|
|
(Dollars in thousands)
|
Minimum
annual operating leases
|
|
$
|
87,937
|
|
$
|
6,119
|
|
$
|
11,607
|
|
|
$
11,133
|
|
$
|
59,078
|
Remaining contractual maturities
of time
deposits
|
|
|
1,202,690
|
|
|
835,496
|
|
|
335,959
|
|
|
31,049
|
|
|
186
|
Long-term borrowings
|
|
|
321,785
|
|
|
57,035
|
|
|
54,750
|
|
|
160,000
|
|
|
50,000
|
Subordinated
debt
|
|
|
82,992
|
|
|
|
|
|
|
|
|
|
|
|
82,992
|
Unfunded home
equity lines
of credit(1)
|
|
|
326,972
|
|
|
12,978
|
|
|
14,758
|
|
|
20,793
|
|
|
278,443
|
Unfunded other loan
lines of credit
|
|
|
492,892
|
|
|
384,922
|
|
|
57,138
|
|
|
31,885
|
|
|
18,947
|
Unfunded residential mortgages
|
|
|
3,131
|
|
|
3,131
|
|
|
|
|
|
|
|
|
|
Standby letters of
credit
|
|
|
23,473
|
|
|
20,195
|
|
|
1,728
|
|
|
|
|
|
1,550
|
Total
|
|
$
|
2,541,872
|
|
$
|
1,319,876
|
|
$
|
475,940
|
|
|
$254,860
|
|
$
|
491,196
|
____________________
(1)
|
Home equity lines of credit in
the after five years category have no stated
expiration.
|
The Bank
also had commitments with customers to extend mortgage loans at a specified rate
at December 31, 2007 and December 31, 2006 of $3.4 million and $2.3 million,
respectively and commitments to sell mortgage loans at a specified rate at
December 31, 2007 and December 31, 2006 of $2.4 million 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 December 31, 2007, the Corporation had commitments with a
positive fair value of $19,000 and negative fair value of $19,000 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 Corporations actual loss experience approximated
the initial reserve.
41
During
January 2006, the Bank completed its acquisition of the Cornerstone Companies.
The purchase price consisted of $15.0 million in cash paid at closing and a
contingent payment of up to $7.0 million to be paid post-closing. The contingent
payment is based upon the Cornerstone Companies meeting certain minimum
operating results during a five-year earn-out period with a maximum payout of
$7.0 million over this period. For 2006 and 2007, the minimum operating results
were met resulting in earn-out payments totaling $2.2 million which was recorded
as additional goodwill. At December 31, 2007, the remaining maximum payout is
$4.8 million through 2010.
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 December
31, 2007 was $1.0 million with a total recourse exposure of $198,000 and a
current recourse liability of $17,000.
For information on known
uncertainties, see Item 1, Business.
Fourth Quarter 2007 Results (Unaudited)
Net income
for the fourth quarter of 2007 was $6.2 million or $0.20 per diluted share, as
compared to $13.3 million or $0.45 per diluted share for the fourth quarter of
2006.
Net interest
income on a tax equivalent basis in the fourth quarter of 2007 increased $1.8
million, or 8.7%, from the same period in 2006. This increase was mainly
attributable to higher net earning assets from the East Penn Financial
acquisition effective November 16, 2007 and lower interest bearing checking and
money market deposit costs. The net interest margin for the fourth quarter of
2007 of 2.76% remained flat as compared to 2.75% for the fourth quarter of
2006.
Noninterest
income of $14.2 million for the fourth quarter of 2007 decreased $4.0 million
from the comparable period in 2006. Fourth quarter 2007 growth, however, was
achieved over 2006 in wealth management fee income and service charges on
deposits. Wealth management fee income rose $1.5 million or 44.5% primarily
driven by a higher level of life insurance business at Cornerstone as well as
growth in trust assets. Service charges on deposits increased $876,000 or 43.9%
mainly from return check and overdraft fees and fees from East Penn deposit
accounts. During the fourth quarter of 2007, the Corporation recognized gains
from sale-leaseback transactions of $2.8 million and from sales of investment
securities of $657,000, while during 2006 the Corporation recognized a gain on
the sale of the Honesdale branch of $10.7 million and a loss on sale of
investment securities of $674,000.
Noninterest
expense of $23.6 million for the fourth quarter of 2007 increased $5.1 million
from the same period in 2006. Salaries and benefits expense rose $1.3 million
during the fourth quarter of 2007 from the comparable period in 2006, primarily
related to higher staffing levels resulting from new branch openings and the
East Penn acquisition. In addition, occupancy expense increased due to several
new office locations including the new operations center building in
Harleysville and four new branch openings as well as the addition of the East
Penn branches. Other expenses increased mostly due to a one-time pre-tax charge
of $1.9 million related to the pension plan curtailment, merger expenses of
$339,000 and increased professional and consulting fees.
42
The
following is the summarized (unaudited) consolidated quarterly financial data of
the Corporation which, in the opinion of management, reflects all adjustments,
consisting only of normal recurring adjustments, necessary for fair presentation
of the Corporations results of operations: