Alliance Financial 10-K 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Commission file number 0-15366
ALLIANCE FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
Registrants telephone number including area code: (315) 475-4478
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class: Common Stock, $1.00 par value per share
Name of each exchange on which registered: The NASDAQ Stock Market LLC
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes No X
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.
Yes No X
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes X No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X]
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of accelerated filer, large accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer [ ] Accelerated Filer [X] Non-accelerated filer [ ] Smaller Reporting Company [ ]
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X
As of June 30, 2007, the aggregate market value of the voting stock held by nonaffiliates of the registrant was $119.0 million based on the closing sale price as reported on the NASDAQ Global Market.
The number of outstanding shares of the Registrants common stock, $1 par value per share, on March 7, 2008 was 4,652,385 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the proxy statement for the annual shareholders meeting to be held on May 13, 2008 (the Proxy Statement) are incorporated by reference in Part III of this Annual Report on Form 10-K.
Exhibit index is located on page 68 of 70.
TABLE OF CONTENTS
FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED
DECEMBER 31, 2007
ALLIANCE FINANCIAL CORPORATION
This Annual Report on Form 10-K contains certain forward-looking statements with respect to the financial condition, results of operations and business of Alliance Financial Corporation and its subsidiaries. These forward-looking statements include: statements of our goals, intentions and expectations; statements regarding our business plans and prospects and growth and operating strategies; estimates of our risks and future costs and benefits. These forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: an increase in competitive pressure in the banking industry; changes in the interest rate environment which may reduce margins; changes in the regulatory environment; general economic conditions, both nationally and regionally, resulting, among other things, in a deterioration in credit quality; changes in business conditions and inflation; changes in the securities markets; changes in technology used in the banking business; our ability to maintain and increase market share and control expenses; the possibility that our investment management business will fail to perform as currently anticipated; and other factors detailed from time to time in our SEC filings.
Item 1 Business
The Company files annual reports, quarterly reports, proxy statements and other documents with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that the Company files with the SEC at the SECs Public Reference Room at 100 F. Street, N.E., Room 1580, Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains a website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The public can obtain any documents that the Company files with the SEC at www.sec.gov.
The Company also makes available free of charge through its website (www.alliancebankna.com) the Companys Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the SEC.
Alliance Financial Corporation (the Company or Alliance) is a New York corporation and a registered financial holding company formed on November 25, 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc., which were incorporated May 30, 1986 and October 31, 1984, respectively. The Company is the holding company of Alliance Bank, N.A. (the Bank), which was formed as the result of the merger of First National Bank of Cortland and Oneida Valley National Bank in 1999.
The Bank provides financial services from 29 customer service facilities in the New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a Trust Administration Center in Buffalo, NY. Primary services include commercial, retail and municipal banking, consumer finance, mortgage financing and servicing, and trust and investment management services. The Bank has a substantially wholly-owned subsidiary, Alliance Preferred Funding Corp., which is engaged in residential real estate activity, and a wholly-owned subsidiary, Alliance Leasing, Inc., which is engaged in commercial leasing activity in over thirty states.
The Companys administrative offices are located on the 18th Floor, AXA Tower II, 120 Madison St., Syracuse, New York. Banking services are provided at the administrative offices as well as at the Companys 29 customer service facilities.
On February 18, 2005, the Bank acquired a portfolio of personal trust accounts and related assets under management from HSBC, USA, N.A. The Bank assumed the successor trustee role from HSBC on approximately 1,800 personal trust accounts and further assumed approximately $560 million in assets under management. Combined with its existing trust business the Bank now manages approximately $970 million of related investment assets.
On October 6, 2006, Alliance completed its acquisition of Bridge Street Financial, Inc. (Bridge Street) and its wholly-owned subsidiaries, Oswego County National Bank (OCNB) and Ladds Agency Inc. (Ladds), an insurance agency. In connection with the acquisition, Alliance issued approximately 1,292,000 shares of common stock valued at $38.1 million, and paid cash of $13.2 million for total merger consideration of $51.3 million. At the time of the acquisition, Bridge Street had $219.3 million in assets, $148.3 million in gross loans, and $169.2 million in deposits. In the acquisition, Bridge Street was merged into Alliance, Ladds became a wholly-owned subsidiary of Alliance, and Oswego County National Bank was merged into the Bank.
The Company formed Alliance Financial Capital Trust I and Alliance Financial Capital Trust II (collectively Capital Trusts) for the purpose of issuing corporation-obligated mandatorily redeemable capital securities to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of the Company.
At December 31, 2007, the Company had 335 full-time equivalent employees. The Companys employees are not presently represented by any collective bargaining group. The Company considers its employee relations to be good.
The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank System, and its deposits are insured by the Federal Deposit Insurance Corporation up to applicable limits.
The Company offers full-service banking with a broad range of financial products to meet the needs of its commercial, retail, government, and investment management customers. Depository account services include interest and non-interest-bearing checking accounts, money market accounts, savings accounts, time deposit accounts, and individual retirement accounts. The Companys lending activities include the making of residential and commercial mortgage loans, business lines of credit, working capital facilities and business term loans, as well as installment loans, home equity loans, and personal lines of credit to individuals. Trust and investment management services include personal trust, employee benefit trust, investment management, custodial, and financial planning. Through UVEST Financial Services, member NASD/SIPC, the Bank provides financial counseling and brokerage services. The Company also offers safe deposit boxes, travelers checks, money orders, wire transfers, collection services, drive-up banking facilities, 24-hour night depositories, automated teller machines, 24-hour telephone banking, and on-line internet banking. Commercial equipment leasing services are offered through Alliance Leasing, Inc., a subsidiary of the Bank. Personal and commercial insurance products are offered on an agency basis through Ladds Agency, Inc., a multi-line insurance agency.
The Companys business is extremely competitive. The Company competes not only with other commercial banks but also with other financial institutions such as thrifts, credit unions, money market and mutual funds, insurance agencies and companies, brokerage firms, and a variety of other financial services companies.
Supervision and Regulation
The following discussion summarizes some of the laws and regulations applicable to bank holding companies and national banks and provides certain specific information relevant to the Company. This regulatory framework primarily is intended for the protection of depositors and the deposit insurance funds that insure bank deposits, and not for the protection of shareholders or creditors of bank holding companies and banks. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Moreover, Congress, state legislatures and regulatory agencies frequently propose changes to the law and regulations affecting the banking industry. The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to accurately predict. A change in the statutes, regulations, or regulatory policies applicable to the Company or its subsidiaries may have a material adverse effect on their business.
The Company is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and elected to become a financial holding company on June 21, 2006. As such, it is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (the Federal Reserve Board). The Bank Holding Company Act and other federal laws subject bank and financial holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. A bank holding company that qualifies as a financial holding company can expand into a wide variety of services that are financial in nature, if its subsidiary depository institution is well-managed, well-capitalized and has received at least a satisfactory rating on its last CRA examination. Services that have been deemed to be financial in nature include securities underwriting, dealing and market making, sponsoring mutual funds and investment companies, insurance underwriting and agency activities and merchant banking. The Bank Holding Company Act requires every financial holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by financial holding companies, the Federal Reserve Board is required to consider the financial and managerial resources and future prospects of the financial holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors. The Change in Bank Control Act prohibits a person or group of persons from acquiring control of a financial holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Companys outstanding common stock, or otherwise obtaining control or a controlling influence over the Company.
The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their nonbanking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates.
Under Federal Reserve Board policy, a holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. The Federal Reserve Board may charge the holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. Any capital loans by the Company to its subsidiary bank would be subordinate in right of payment to depositors and to certain other indebtedness of the subsidiary bank.
The Companys ability to pay dividends to its shareholders is primarily dependent on the ability of the Bank, the Companys bank subsidiary, to pay dividends to the Company. The ability of both the Company and the Bank to pay dividends is limited by federal statutes, regulations and policies. For example, it is the policy of the Federal Reserve Board that holding companies should pay cash dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the holding companys expected future needs and financial condition. The policy provides that holding companies should not maintain a level of cash dividends that undermines the holding companys ability to serve as a source of strength to its banking subsidiaries. Furthermore, the Bank must obtain regulatory approval for the payment of dividends if the total of all dividends declared in any calendar year would exceed the total of the Banks net profits, as defined by applicable regulations, for that year, combined with its retained net profits for the preceding two years. The Bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts, as defined by applicable regulations.
The Federal Reserve Board has established risk-based capital guidelines that are applicable to financial holding companies. The guidelines established a framework intended to make regulatory capital requirements more sensitive to differences in risk profiles among banking organizations and take off-balance sheet exposures into explicit account in assessing capital adequacy. The Federal Reserve Board guidelines define the components of capital, categorize assets into different risk classes, and include certain off-balance sheet items in the calculation of risk-weighted assets. At least half of the total capital must be comprised of common equity, retained earnings and a limited amount of perpetual preferred stock, less goodwill (Tier 1 capital). Banking organizations that are subject to the guidelines are required to maintain a ratio of Tier 1 capital to risk-weighted assets of at least 4.00% and a ratio of total capital to risk-weighted assets of at least 8.00%. The appropriate regulatory authority may set higher capital requirements when an organizations particular circumstances warrant. The remainder (Tier 2 capital) may consist of a limited amount of subordinated debt, limited-life preferred stock, certain other instruments and a limited amount of loan and lease loss reserves. The sum of Tier 1 capital and Tier 2 capital is total risk-based capital. The Companys Tier 1 and total risk-based capital ratios as of December 31, 2007 were 10.6% and 11.6%, respectively.
In addition, the Federal Reserve Board has established a minimum leverage ratio of Tier 1 capital to quarterly average assets less goodwill (Tier 1 leverage ratio) of 3.00% for financial holding companies that meet certain specified criteria, including that they have the highest regulatory rating. All other financial holding companies are required to maintain a Tier 1 leverage ratio of 3.00% plus an additional layer of at least 100 to 200 basis points. The Companys Tier 1 leverage ratio as of December 31, 2007 was 7.5%, which exceeded its regulatory requirement of 4.00%. The guidelines provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.
The Gramm-Leach-Bliley Act (Gramm-Leach) permits, subject to certain conditions, combinations among banks, securities firms and insurance companies. Under Gramm-Leach, bank holding companies are permitted to offer their customers virtually any type of financial service including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking. In order to engage in these additional financial activities, a financial holding company must qualify and register with the Federal Reserve Board, as the Company has, as a financial holding company by meeting certain higher standards for capital adequacy and management, with heavy penalties for noncompliance. Gramm-Leach establishes that the federal banking agencies will regulate the banking activities of financial holding companies and banks financial subsidiaries, the U.S. Securities and Exchange Commission will regulate their securities activities and state insurance regulators will regulate their insurance activities. Bank holding companies that wish to engage in expanded activities but do not wish to become financial holding companies may elect to establish financial subsidiaries, which are subsidiaries of national banks with expanded powers. Gramm-Leach permits financial subsidiaries to engage in the same types of activities permissible for nonbank subsidiaries of financial holding companies, with the exception of merchant banking, insurance and annuity underwriting and real estate investment and development. Merchant banking may be permitted after a five-year waiting period under certain regulatory circumstances. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers nonpublic, personal information.
Transactions between the holding company and its subsidiary bank are subject to Section 23A of the Federal Reserve Act and to the requirements of Regulation W. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act and to the requirements of Regulation W, which generally require that certain transactions between the holding company and its affiliates be on terms substantially the same, or at least as favorable to the banks, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as insiders) contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.
As a national bank, the Bank is subject to primary supervision, regulation, and examination by the Office of the Comptroller of the Currency (OCC) and secondary regulation by the FDIC and the Federal Reserve Board. The Bank is subject to federal statutes and regulations that significantly affect its business and activities. The Bank must file reports with its regulators concerning its activities and financial condition and obtain regulatory approval to enter into certain transactions. Other applicable statutes and regulations relate to insurance of deposits, allowable investments, loans, acceptance of deposits, trust activities, mergers, consolidations, payment of dividends, capital requirements, reserves against deposits, establishment of branches and certain other facilities, limitations on loans to one borrower and loans to affiliated persons, and other aspects of the business of banks. In addition, federal legislation has instructed federal agencies to adopt standards or guidelines governing banks internal controls, information systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits, asset quality, earnings and capital, and other matters. Regulatory authorities have broad flexibility to initiate proceedings designed to prohibit banks from engaging in unsafe and unsound banking practices.
The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially revised the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statutes. Among other things, federal banking regulators are required to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA identifies the following capital categories for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Rules adopted by the federal banking agencies under FDICIA provide that an institution is deemed to be well capitalized if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure. FDICIA imposes progressively more restrictive constraints on operation, management, and capital distributions, depending on the capital category in which an institution is classified. At December 31, 2007, the Company and the Bank were in the well-capitalized category, based on the ratios and guidelines noted above.
The Bank must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications pay assessments at higher rates than institutions that pose a lower risk. An institutions risk classification is assigned based on its capital level and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. Under FDIC regulations, no FDIC-insured bank can accept brokered deposits unless it is well-capitalized, or is adequately capitalized and receives a waiver from the FDIC. In addition, these regulations prohibit any bank that is not well-capitalized from paying an interest rate on brokered deposits in excess of three-quarters of one percentage point over certain prevailing market rates.
The Federal Deposit Insurance Reform Act of 2005 was signed into law on February 8, 2006, and gives the FDIC increased flexibility in assessing premiums on banks and savings associations, including the Bank, to pay for deposit insurance and in managing its deposit insurance reserves. The reform legislation provides a credit to all insured institutions, based on the amount of their insured deposits at year-end 1996, to offset the premiums that they may be assessed; combines the BIF and SAIF to form a single Deposit Insurance Fund; increase deposit insurance to $250,000 for Individual Retirement Accounts; and authorizes inflation-based increases in deposit insurance on other accounts every 5 years, beginning in 2011. The FDIC also is directed to conduct studies regarding further deposit insurance reform.
The Community Reinvestment Act of 1977 (CRA) and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a banks record in meeting the needs of its service area when considering applications regarding establishing branches, mergers or other bank or branch acquisitions. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 requires federal banking agencies to make public a rating of a banks performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction.
The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. These laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The bank must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations. The Check Clearing for the 21st Century Act (Check 21 Act or the Act), which became effective on October 28, 2004, creates a new negotiable instrument, called a substitute check, which banks are required to accept as the legal equivalent of a paper check if it meets the requirements of the Act. The Act is designed to facilitate check truncation, to foster innovation in the check payment system, and to improve the payment system by shortening processing times and reducing the volume of paper checks.
The earnings of the Company are significantly affected by the monetary and fiscal policies of governmental authorities, including the Federal Reserve Board. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open-market operations in U.S. Government securities and federal funds, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, and the interest rates charged on loans and paid for deposits. The Federal Reserve Board frequently uses these instruments of monetary policy, especially its open-market operations and the discount rate, to influence the level of interest rates and to affect the strength of the economy, the level of inflation or the price of the dollar in foreign exchange markets. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banking institutions in the past and are expected to continue to do so in the future. It is not possible to predict the nature of future changes in monetary and fiscal policies, or the effect that they may have on the Companys business and earnings.
Pursuant to Title V of Gramm-Leach, federal banking regulators adopted rules that limit the ability of banks and other financial institutions to disclose nonpublic information about consumers to nonaffiliated third parties. These limitations require disclosure of privacy policies to consumers and, in some circumstances, allow consumers to prevent disclosure of certain personal information to a nonaffiliated third party. Under these rules, financial institutions must provide: initial notices to customers about their privacy policies, describing the conditions under which they may disclose nonpublic personal information to nonaffiliated third parties and affiliates, annual notices of their privacy policies to current customers, and a reasonable method for customers to opt out of disclosures to nonaffiliated third parties.
As part of the USA Patriot Act of 2001, signed into law on October 26, 2001, Congress adopted the International Money Laundering Abatement and Financial Anti-Terrorism Act of 2001 (IMLAFATA). IMLAFATA authorizes the Secretary of the Treasury, in consultation with the heads of other government agencies, to adopt special measures applicable to banks, bank holding companies, or other financial institutions. Pursuant to this statute, the Department of the Treasury has issued a number of regulations relating to enhanced recordkeeping and reporting requirements for certain financial transactions that are of primary money laundering concern, due diligence requirements concerning the beneficial ownership of certain types of accounts, and restrictions or prohibitions on certain types of accounts with foreign financial institutions. Covered financial institutions also are barred from dealing with foreign shell banks. In addition, IMLAFATA expands the circumstances under which funds in a bank account may be forfeited and requires covered financial institutions to respond under certain circumstances to requests for information from federal banking agencies within 120 hours. These regulations were also adopted during 2002 to implement minimum standards to verify customer identity, to encourage cooperation among financial institutions, federal banking agencies, and law enforcement authorities regarding possible money laundering or terrorist activities, to prohibit the anonymous use of concentration accounts, and to require all covered financial institutions to have in place a Bank Secrecy Act compliance program. IMLAFATA also amends the Bank Holding Company Act and the Bank Merger Act to require federal banking agencies to consider the effectiveness of a financial institutions anti-money laundering activities when reviewing an application under these acts.
The Bank has in place a Bank Secrecy Act compliance program, and engages in very few transactions of any kind with foreign financial institutions or foreign persons.
On July 30, 2002, the President signed into law the Sarbanes-Oxley Act of 2002 (the Act), implementing legislative reforms intended to address corporate and accounting fraud. In addition to the establishment of a new accounting oversight board that enforces auditing, quality control and independence standards and is funded by fees from all publicly traded companies, the law restricts provision of both auditing and consulting services by accounting firms. To ensure auditor independence, any non-audit services being provided to an audit client require pre-approval by the issuers audit committee members. In addition, the audit partners must be rotated. The Act requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the SEC, subject to civil and criminal penalties if they knowingly or willfully violate this certification requirement. In addition, under the Act, legal counsel is required to report evidence of a material violation of the securities laws or a breach of fiduciary duty by a company to its chief executive officer or its chief financial officer, and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.
Longer prison terms and increased penalties are also applied to corporate executives who violate federal securities laws, the period during which certain types of suits can be brought against a company or its officers has been extended, and bonuses issued to top executives prior to restatement of a companys financial statements are subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan blackout periods, and loans to company executives are restricted. The Act accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in ownership in a companys securities within two business days of the change.
The Act also prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent public or certified accountant engaged in the audit of the companys financial statements for the purpose of rendering the financial statements materially misleading. The Act also requires the SEC to prescribe rules requiring inclusion of an internal control report and assessment by management in the annual report to stockholders. In addition, the Act requires that each financial report required to be prepared in accordance with (or reconciled to) accounting principles generally accepted in the United States of America and filed with the SEC reflect all material correcting adjustments that are identified by a registered public accounting firm in accordance with accounting principles generally accepted in the United States of America and the rules and regulations of the SEC.
As directed by Section 302(a) of the Act, the Companys chief executive officer and chief financial officer are each required to certify that the Companys quarterly and annual reports do not contain any untrue statement of a material fact. The Act imposes several requirements, including having these officers certify that: they are responsible for establishing, maintaining and regularly evaluating the effectiveness of the Companys internal controls; they have made certain disclosures to the Companys auditors and the audit committee of the Board of Directors about the Companys internal controls; and they have included information in the Companys quarterly and annual reports about their evaluation and whether there have been significant changes in the Companys internal controls or in other factors that could significantly affect internal controls during the last quarter.
In 1970, the U. S. Congress enacted the Fair Credit Reporting Act (the FCRA) in order to ensure the confidentiality, accuracy, relevancy and proper utilization of consumer credit report information. Under the framework of the FCRA, the United States has developed a highly advanced and efficient credit reporting system. The information contained in that broad system is used by financial institutions, retailers and other creditors of every size in making a wide variety of decisions regarding financial transactions. Employers and law enforcement agencies have also made wide use of the information collected and maintained in databases made possible by the FCRA. The FCRA affirmatively preempts state law in a number of areas, including the ability of entities affiliated by common ownership to share and exchange information freely, and the requirements on credit bureaus to reinvestigate the contents of reports in response to consumer complaints, among others. By its terms, the preemption provisions of the FCRA were to terminate as of December 31, 2003. With the enactment of the Fair and Accurate Transactions Act (FACT Act) in late 2003, the preemption provisions of FCRA were extended, although the FACT Act imposes additional requirements on entities that gather and share consumer credit information. The FACT Act required the Federal Reserve Board and the Federal Trade Commission to issue final regulations within nine months of the effective date of the Act. A series of regulations and announcements have been promulgated, including a joint FTC/FRB announcement of effective dates for FCRA amendments, the FTCs Free Credit Report rule, revisions to the FTCs FACT Act Rules, the FTCs final rules on identity
theft and proof of identity, the FTCs final regulation on consumer information and records disposal, the FTCs final summaries and notices and a final rule on prescreen notices.
On March 1, 2005 the Federal Reserve Board issued a final rule that allows the continued inclusion of trust preferred securities in the Tier 1 capital of bank holding companies. Trust preferred securities, however, will be subject to stricter quantitative limits. The rule provides that trust preferred securities, together with other restricted core capital elements, can be included in a bank holding companys Tier 1 capital up to one-third of the sum of core capital elements, including restricted core capital elements, as defined in the rule. At December 31, 2007, the Companys trust preferred securities comprised 21.8% of the sum of the Companys core capital elements.
Item 1A Risk Factors
There are risks inherent to the Companys business. The material risks and uncertainties that management believes affect the Company are described below. The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties that management is not aware of or focused on or that management currently deems immaterial may also impair the Companys business operations. This report is qualified in its entirety by these risk factors. If any of the following risks actually occur, the Companys financial condition and results of operations could be materially and adversely affected.
The Company is Subject to Interest Rate Risk
The Companys earnings and cash flows are largely dependent upon its net interest income. Net interest income is the difference between interest income earned on interest-earning assets such as loans and securities and interest expense paid on interest-bearing liabilities such as deposits and borrowed funds. Interest rates are highly sensitive to many factors that are beyond the Companys control, including general economic and credit market conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, could influence not only the interest the Company receives on loans and securities and the amount of interest it pays on deposits and borrowings, but such changes could also affect (i) the Companys ability to originate loans and obtain deposits, (ii) the fair value of the Companys financial assets and liabilities, and (iii) the average duration of the Companys mortgage-backed securities portfolio. If the interest rates paid on deposits and other borrowings increase at a faster rate than the interest rates received on loans and other investments, the Companys net interest income, and therefore earnings, could be adversely affected. Earnings could also be adversely affected if the interest rates received on loans and other investments fall more quickly than the interest rates paid on deposits and other borrowings.
Although management believes it has implemented effective asset and liability management strategies to reduce the potential effects of changes in interest rates on the Companys results of operations, any substantial, unexpected, prolonged change in market interest rates could have a material adverse effect on the Companys financial condition and results of operations. See the section captioned Net Interest Income in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 7A, Quantitative and Qualitative Disclosure About Market Risk located elsewhere in this report for further discussion related to the Companys management of interest rate risk.
The Company is Subject to Lending Risk
There are inherent risks associated with the Companys lending activities. These risks include, among other things, the impact of changes in interest rates and changes in the economic or credit market conditions in the markets where the Company operates as well as the State of New York and the entire United States. Increases in interest rates and/or weakening economic or credit market conditions could adversely impact the ability of borrowers to repay outstanding loans or the value of the collateral securing these loans. The Company is also subject to various laws and regulations that affect its lending activities. Failure to comply with applicable laws and regulations could subject the Company to regulatory enforcement action that could result in the assessment of significant civil money penalties against the Company.
As of December 31, 2007, approximately 39.1% of the Companys loan and lease portfolio consisted of commercial loans and leases net of unearned income. These types of loans are generally viewed as having more risk of default than conventional residential real estate loans or most consumer loans. Commercial loans are also typically larger than residential real estate loans and consumer loans. Because the Companys loan portfolio contains a significant number of commercial loans with relatively large balances, the deterioration of one or a few of these loans could cause a significant increase in non-performing loans. An increase in nonperforming loans could result in a net loss of earnings from these loans, an increase in the provision for loan losses and an increase in loan charge-offs, all of which could have a material adverse effect on the Companys financial condition and results of operations. See the section captioned Loans and Leases in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to commercial loans and leases.
The Companys Allowance for Credit Losses May Be Insufficient
The Company maintains an allowance for credit losses, which is a reserve established through a provision for credit losses charged to expense, that represents managements best estimate of probable losses incurred within the existing portfolio of loans and leases. The allowance is necessary to provide for estimated credit losses and risks inherent in the loan and lease portfolio. The level of the allowance reflects managements continuing evaluation of industry concentrations; specific credit risks; loan loss experience; current loan and lease portfolio quality; present economic, political and regulatory conditions and unidentified losses inherent in the current loan portfolio. The determination of the appropriate level of the allowance for credit losses inherently involves a significant degree of subjectivity and requires the Company to make estimates of current credit risks, all of which may undergo material changes. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of the Companys control, may require an increase in the allowance for credit losses. In addition, bank regulatory agencies
periodically review the Companys allowance for credit losses and may require an increase in the provision for credit losses or the recognition of further loan charge-offs, based on judgments different than those of management. In addition, if charge-offs in future periods exceed the allowance for credit losses, the Company will need additional provisions to increase the allowance for credit losses. These increases in the allowance for credit losses will result in a decrease in net income and, possibly, capital, and may have a material adverse affect on the Companys financial condition and results of operations. See the section captioned Asset Quality and the Allowance for Credit Losses in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations located elsewhere in this report for further discussion related to the Companys process for determining the appropriate level of the allowance for credit losses.
The Companys Profitability Depends Significantly on Economic Conditions in Central New York
The Companys success depends significantly on the general economic conditions of Central New York and the specific local markets in which the Company operates. Unlike larger national or other regional banks that are more geographically diversified, the Company provides banking and financial services to customers primarily in the Central New York counties of Cortland, Erie, Madison, Oneida, Onondaga and Oswego. The local economic conditions in these areas have a significant impact on the demand for the Companys products and services as well as the ability of the Companys customers to repay loans, the value of the collateral securing loans and the stability of the Companys deposit funding sources. A significant decline in general economic conditions, caused by inflation, recession, acts of terrorism, outbreak of hostilities or other international or domestic occurrences, unemployment, changes in securities or credit markets or other factors could impact these local economic conditions and, in turn, have a material adverse effect on the Companys financial condition and results of operations.
The Company Operates In a Highly Competitive Industry and Market Area
The Company faces substantial competition in all areas of its operations from a variety of different competitors, many of which are larger and may have more financial resources. Such competitors primarily include national, regional, and community banks within the various markets where the Company operates. Additionally, various out-of-state banks continue to enter or have announced plans to enter the market areas in which the Company currently operates. The Company also faces competition from many other types of financial institutions, including, without limitation, savings and loans, credit unions, finance companies, brokerage firms, insurance companies, factoring companies and other financial intermediaries. The financial services industry could become even more competitive as a result of legislative, regulatory and technological changes and continued consolidation. Banks, securities firms and insurance companies can merge under the umbrella of a financial holding company, which can offer virtually any type of financial service, including banking, securities underwriting, insurance (both agency and underwriting) and merchant banking. Also, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic transfer and automatic payment systems. Many of the Companys competitors have fewer regulatory constraints and may have lower cost structures. Additionally, due to their size, many competitors may be able to achieve economies of scale and, as a result, may offer a broader range of products and services as well as better pricing for those products and services than the Company can. The Companys ability to compete successfully depends on a number of factors, including, among other things:
Failure to perform in any of these areas could significantly weaken the Companys competitive position, which could adversely affect the Companys growth and profitability, which, in turn, could have a material adverse effect on the Companys financial condition and results of operations.
The Company Is Subject To Extensive Government Regulation and Supervision
The Company, primarily through its subsidiary bank, is subject to extensive federal regulation and supervision. Banking regulations are primarily intended to protect depositors funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect the Companys lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject the Company to additional costs, limit the types of financial services and products the Company may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on the Companys business, financial condition and results of operations. While the Company has policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. See the section captioned Supervision and Regulation in Item 1. Business, which is located elsewhere in this report.
The Companys Controls and Procedures May Fail or Be Circumvented
Management regularly reviews and updates the Companys internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Companys controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect on the Companys business, results of operations and financial condition.
New Lines of Business or New Products and Services May Subject the Company to Additional Risks
From time to time, the Company may implement new lines of business or offer new products and services within existing lines of business. There are substantial risks and uncertainties associated with these efforts, particularly in instances where the markets are not fully developed. In developing and marketing new lines of business and/or new products and services the Company may invest significant time and resources. Initial timetables for the introduction and development of new lines of business and/or new products or services may not be achieved and price and profitability targets may not prove feasible. External factors, such as compliance with regulations, competitive alternatives, and shifting market preferences, may also impact the successful implementation of a new line of business or a new product or service. Furthermore, any new line of business and/or new product or service could have a significant impact on the effectiveness of the Companys system of internal controls. Failure to successfully manage these risks in the development and implementation of new lines of business or new products or services could have a material adverse effect on the Companys business, results of operations and financial condition.
The Company Relies on Dividends from Its Subsidiary for Most of Its Revenue
The Company is a separate and distinct legal entity from its subsidiaries. It receives substantially all of its revenue from dividends from the Bank. These dividends are the principal source of funds to pay dividends on the Companys common stock and interest and principal on the Companys debt. Various federal and/or state laws and regulations limit the amount of dividends that the Bank may pay to the Company. Also, the Companys right to participate in a distribution of assets upon a subsidiarys liquidation or reorganization is subject to the prior claims of the subsidiarys creditors. In the event the Bank is unable to pay dividends to the Company, the Company may not be able to service debt, pay obligations or pay dividends on the Companys common stock.
The inability to receive dividends from the Bank could have a material adverse affect on the Companys business, financial condition and results of operations. See the section captioned Supervision and Regulation in Item 1. Business and Note 17 Dividends and Restrictions in the notes to consolidated financial statements included in Item 8. Financial Statements and Supplementary Data, which are located elsewhere in this report.
The Company May Not Be Able To Attract and Retain Skilled People
The Companys success depends, in large part, on its ability to attract and retain key people. Competition for the best people in most activities engaged in by the Company can be intense and the Company may not be able to hire people or to retain them. The unexpected loss of services of one or more of the Companys key personnel could have a material adverse impact on the Companys business because of their skills, knowledge of the Companys market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
The Companys Information Systems May Experience an Interruption Or Breach In Security
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in the Companys customer relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that any such failures, interruptions or security breaches will not occur or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Companys information systems could damage the Companys reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose the Company to civil litigation and possible financial liability, any of which could have a material adverse effect on the Companys financial condition and results of operations.
The Company Continually Encounters Technological Change
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Companys future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Companys operations. Many of the Companys competitors have substantially greater resources to invest in technological enhancements. The Company may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to its customers. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Companys business and, in turn, the Companys financial condition and results of operations.
Severe Weather, Natural Disasters, Acts of War or Terrorism and Other External Events Could Significantly Impact the Companys Business
Severe weather, natural disasters, acts of war or terrorism and other adverse external events could have a significant impact on the Companys ability to conduct business. Such events could affect the stability of the Companys deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Although management has established disaster recovery policies and procedures, the occurrence of any such event could have a material adverse effect on the Companys business, which, in turn, could have a material adverse effect on the Companys financial condition and results of operations.
The Companys Articles of Incorporation, By-Laws and Shareholder Rights Plan As Well As Certain Banking Laws May Have an Anti-Takeover Effect
Provisions of the Companys articles of incorporation and by-laws, federal banking laws, including regulatory approval requirements, and the Companys stock purchase rights plan could make it more difficult for a third party to acquire the Company, even if doing so would be perceived to be beneficial to the Companys stockholders. The combination of these provisions effectively inhibits a non-negotiated merger or other business combination, which, in turn, could adversely affect the market price of the Companys common stock.
Item 2 Properties
The Company conducts business in Central New York State through 29 banking offices and two administrative centers. The Company leases its corporate administrative center, located in Syracuse, NY. Eleven banking offices and one of the administrative centers are subject to leases and/or land leases. The other banking offices and administrative center are owned.
Item 3 Legal Proceedings
In December 1998, the Oneida Indian Nation (The Nation) and the U.S. Justice Department filed a motion to amend a long-standing land claim against the State of New York to include a class of 20,000 unnamed defendants who own real property in Madison County and Oneida County. An additional motion sought to include the Company as a representative of a class of landowners. On September 25, 2000, the United States District Court of the Northern District of New York rendered a decision denying the motion to include the landowners as a group, and thus, excluding the Company and many of its borrowers from the litigation. The State of New York, the County of Madison and the County of Oneida remain as defendants in the litigation. This ruling may be appealed by The Nation, and does not prevent The Nation from suing landowners individually, in which case the litigation could involve assets of the Company. On May 21, 2007, the U.S. District Court issued a decision dismissing the possessory land claims. The Courts decision has been appealed by the Nation. Although management cannot predict the timing of the resolution of this matter, it continues to believe that this matter will be resolved without adversely affecting the Company.
The Company and its subsidiaries are subject to various claims, legal proceedings and matters that arise in the ordinary course of business. In managements opinion, no pending action, if adversely decided, would materially affect the Companys financial condition.
Item 4 Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of the Companys security holders during the fourth quarter of the year ended December 31, 2007.
Item 5 Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Common Stock Data
The common stock of the Company is listed on the NASDAQ Global Market under the symbol ALNC. Market makers for the stock include Keefe, Bruyette & Woods, Inc. and Sandler ONeill & Partners, L.P There were 927 shareholders of record as of December 31, 2007. The following table presents stock prices for the Company for 2007 and 2006. Stock prices below are based on daily high and low closing prices for the quarter, as reported on the NASDAQ Global Market.
Registrar and Transfer Agent
American Stock Transfer & Trust Company
59 Maiden Lane
New York, NY 10038
Automatic Dividend Reinvestment Plan
The Company has an automatic dividend reinvestment plan. This plan is administered by American Stock Transfer and Trust Company, as agent. It offers a convenient way for shareholders to increase their investment in the Company. The plan enables certain shareholders to reinvest cash dividends on all or part of their common stock in additional shares of the Companys common stock without paying brokerage commissions or service charges. Shareholders who are interested in this program may receive a Plan Prospectus and enrollment card by calling ASTC Dividend Reinvestment at 1-800-278-4353, or writing to the following address:
American Stock Transfer & Trust Company
59 Maiden Lane
New York, NY 10038
The Company has historically paid regular quarterly cash dividends on its common stock, and the Board of Directors presently intends to continue the payment of regular quarterly cash dividends, subject to the need for those funds for debt service and other purposes. However, because substantially all of the funds available for the payment of dividends are derived from the Bank, future dividends will depend upon the earnings of the Bank, its financial condition and its need for funds. Furthermore, there are a number of federal banking policies and regulations that restrict the Companys ability to pay dividends. In particular, because the Bank is a depository institution whose deposits are insured by the FDIC, it may not pay dividends or distribute capital assets if it is in default on any assessment due the FDIC. Also, as a national bank, the Bank is subject to OCC regulations which impose certain minimum capital requirements that would affect the amount of cash available for distribution to the Company. In addition, under Federal Reserve policy, the Company is required to maintain adequate regulatory capital, is expected to serve as a source of financial strength to the Bank and to commit resources to support the Bank. These policies and regulations may have the effect of reducing the amount of dividends that the Company can declare to its shareholders.
On November 27, 2007, the Company announced that its Board of Directors had authorized the repurchase of up to 3% of the Companys outstanding common stock, or approximately 143,500 shares, over a 12-month period. The following table provides information with respect to repurchases of the Companys common stock in accordance with the repurchase plan during the fourth quarter ended December 31, 2007.
Stock Performance Graph
The graph below matches Alliance Financial Corporations cumulative 5-year total shareholder return on common stock with the cumulative total returns of the Russell 3000 index and the SNL Bank NASDAQ index. The graph tracks the performance of a $100 investment in our common stock and in each of the indexes (with the reinvestment of all dividends) from 12/31/2002 to 12/31/2007.
Five-Year Comparative Summary
(1) Cash dividends declared per share divided by diluted earnings per share.
(1) Averages presented are daily averages
(2) Non-interest income (net of realized gains and losses on securities and lease prepayment gain) divided by the sum of net interest income and non-interest income (net of realized gains and losses on securities and lease prepayment gain)
(3) Non-interest expense divided by the sum of net interest income and non-interest income (net of realized gains and losses on securities and lease prepayment gain)
(4) Tax equivalent net interest income divided by average earning assets
Summarized quarterly financial information for the years ended December 31, 2007 and 2006 is as follows:
Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations
The following section presents highlight information from management to assist with understanding the consolidated financial condition and results of operations of Alliance Financial Corporation and its subsidiaries (combined, the Company), during the year ended December 31, 2007 and the preceding two years. The consolidated financial statements and related notes, included elsewhere in this annual report on Form 10-K should be read in conjunction with the discussions in this section. The matters discussed in this section contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Statements made that are not historical facts are forward-looking and are based on estimates, forecasts and assumptions involving risks and uncertainties that could cause actual results or outcomes to differ materially from those expressed in the forward-looking statements. The risks and uncertainties referred to above include, but are not limited to those described under Forward-Looking Statements and Risk Factors in Items 1 and 1A, respectively of this Form 10-K.
2007 Highlights and Overview
Our results of operations are dependent primarily on net interest income, which is the difference between the income earned on our loans and leases and securities and our cost of funds, consisting of the interest paid on deposits and borrowings. Results of operations are also affected by the provision for credit losses, securities and loan sale activities, loan servicing activities, service charges and fees collected on our deposit accounts, income collected from trust and investment advisory services and the income earned on our investment in bank-owned life insurance. Our expenses primarily consist of salaries and employee benefits, occupancy and equipment expense, marketing expense, professional services, technology expense, amortization of intangible assets, other expense and income tax expense. Results of operations are also significantly affected by general economic and competitive conditions, particularly changes in interest rates, inflation, government policies and the actions of regulatory authorities.
Average Balance Sheet
The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon. Interest income and yield information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Non-accrual loans have been included in the average balances. Securities are shown at average amortized cost.
The following table sets forth the dollar volume of increase (decrease) in interest income and interest expense resulting from changes in the volume of earning assets and interest-bearing liabilities, and from changes in rates. Volume changes are computed by multiplying the volume difference by the prior years rate. Rate changes are computed by multiplying the rate difference by the prior years balance. The change in interest due to both rate and volume has been allocated proportionally between the volume and rate variances.
Comparison of Operating Results for the Years Ended December 31, 2007 and 2006
Net income for 2007 was $9.5 million, an increase of $2.2 million, or 29.6%, compared to net income of $7.3 million in 2006. Diluted earnings per share was $1.98 in 2007, an increase of 5.3%, or $0.10 per share, compared to $1.88 per share in 2006.
The increases in net income and diluted earnings per share are due largely to the impact of the acquisition of Bridge Street in October 2006. The acquisition was also the primary factor behind increases in net interest income, non-interest income and non-interest expense. The provision for credit losses increased in 2007 due primarily to increases in charge-offs, delinquencies and a general softening of economic and credit conditions in 2007.
Net Interest Income
Net interest income increased $4.8 million or 17.2% due primarily to a $168.6 million increase in average interest earning assets. The increase in average earning assets resulted primarily from the Bridge Street acquisition and secondarily from organic growth, particularly in our lease portfolio.
The net interest margin on a tax-equivalent basis was 3.02% in 2007 and 2006, as an increase in the Companys cost of funds of 32 basis points in 2007 was substantially offset by a 30 basis point increase in tax-equivalent earning asset yields.
Loans and leases comprised 76.7% of average earning assets in 2007, compared with 73.5% in 2006. The higher proportion of earning assets in loans and leases, combined with general upward repricing of the Companys earning-assets in the higher interest rate environment of much of 2007, contributed to an increase in the Companys tax-equivalent earning asset yield to 6.36% in 2007, compared with 6.06% in 2006.
The Companys cost of funds was 3.78% in 2007, compared with 3.46% in 2006 due to generally higher market interest rates in 2007 and to the effect of significant competition for deposits in our market, which increased the cost of retaining existing deposits and attracting new deposits.
Recent reductions in the federal funds rate by the Federal Reserve along with a weakening of national economic conditions have driven short-term market interest rates lower late in 2007 and into 2008. Both the Companys earning-assets yields and its cost of funds have begun to decline as a result. In the current interest rate environment, our cost of funds is expected to decline more quickly than our earning-assets yield in the near term as a larger segment of our interest-bearing liabilities compared with our earning assets mature or have rate resets in the next six months. The current low level of short-term market interest rates and the Companys ability in the current interest rate environment to reduce our offering rates on many of our deposit products is expected to favorably impact the Companys net interest margin in the first quarter of 2008. The magnitude of the potential improvement in our net interest margin, and its duration will be significantly impacted by a number of factors including competition for deposits, the Companys liquidity position and the levels of market interest rates.
The Companys non-interest income is comprised of service charges on deposits, fees from investment management and brokerage services, mortgage banking operations that include gains from sales and income from servicing, and other recurring operating income fees from normal banking operations, along with non-core components that primarily consist of net gains or losses from sales of investment securities.
The following table sets forth certain information on non-interest income for the years indicated:
Total non-interest income increased $3.6 million or 20.2% in 2007 due primarily to the effect of the full-year impact in 2007 of the Bridge Street acquisition. In addition, organic growth in customer service charges and transaction fees, due in large part to increased customer transaction volumes and greater utilization of debit cards for consumer purchases contributed to the increases in service charges on deposit accounts and card related fees.
Investment management income increased in 2007 due to an increase in assets under management resulting from generally higher equity market returns in 2007 and the acquisition of new customers and related assets under management. Rental income from operating leases decreased due to the Companys planned reduction of operating lease activity.
Approximately 60% of the increase in other non-interest income was comprised of non-recurring items, including a $283,000 gain on a prepayment of certain equipment leases. The balance of the increase in other non-interest income resulted primarily from increases in mortgage servicing fees and miscellaneous customer fees.
Non-interest income comprised 39.3% of total revenue (non-interest income, net of realized gains and losses on securities and lease prepayment, and net interest income) in 2007 compared with 39.0% in 2006.
The following table sets forth certain information on operating expenses for the years indicated:
Total non-interest expenses increased $3.8 million or 11.1% in 2007, with increases in all categories, except marketing, resulting primarily from the incremental costs associated with the operation of the Bridge Street branches and the Ladds insurance agency, the costs
associated with processing the increased volume of customer transactions due to the Bridge Street acquisition and amortization of intangible assets recorded in connection with the acquisition.
Non-interest expenses in 2006 included integration and closing costs of the acquisition totaling approximately $1.1 million, including salaries and benefits of approximately $350,000, stationery expense of $130,000, and professional fees of $585,000.
The Companys efficiency ratio was 70.4% in 2007, compared with 74.6% in 2006.
Income Tax Expense
The Companys effective tax rate was 23.2% in 2007 and 19.4% in 2006. The increase in the effective tax rate in 2007 compared with 2006 is primarily attributable to lower non-taxable interest and life insurance income relative to total pre-tax income. A reconciliation of the effective tax rate to the statutory tax rate is included in Note 11 to the consolidated financial statements.
Comparison of Operating Results for the Years Ended December 31, 2006 and 2005
Net income for 2006 was $7.3 million, a decrease of $196,000, or 2.6%, compared to net income of $7.5 million in 2005. Diluted earnings per share were $1.88 in 2006, down 8.3%, or $0.17 per share, compared to $2.05 per share in 2005. The decline in diluted earnings per share resulted primarily from the issuance of 1,292,000 shares of common stock in connection with the acquisition combined with incremental earnings from the acquisition being substantially offset by integration and closing costs.
In 2006, a 12.2% increase in average interest earning assets offset a 25 basis point decrease in our net interest margin compared with 2005 caused largely by the flat yield curve throughout 2006, resulting in a modest 3.0% increase in net interest income. Non-interest income increased $3.5 million compared with 2005, resulting largely from our expanded investment management business and higher service charges, while operating expenses increased $2.5 million due in large part to the acquisition of Bridge Street and the associated integration and closing costs. The provision for credit losses increased $2.3 million in 2006 compared with 2005 due to the growth and changing mix of our loan and lease portfolio and to a higher level of charge-offs in 2006, including two relationships totaling $951,000 which were charged off in the first half of 2006.
Net Interest Income
Net interest income totaled $27.7 million in 2006, compared to $26.9 million in 2005, reflecting the favorable impact of the increase in average earning assets, which offset the effect of a lower net interest margin in 2006. Average earning assets increased $106.9 million in 2006, due largely to organic growth in our leasing and indirect loan portfolios, which increased $54.2 million and $32.2 million, respectively. The rest of our earning asset growth resulted from a combination of new loan originations and from assets acquired from Bridge Street.
The net interest margin compression in 2006 was primarily the result of rising short-term market interest rates that increased the Banks cost of funds on a large percentage of its interest-bearing liabilities with short-term maturity or variable interest rate characteristics. Also, a persistently flat yield curve provided less benefit to the yields on a significant percentage of the Companys interest earning assets that have a pricing correlation with intermediate and longer-term market interest rates, and that rose less than short-term rates during the year.
Higher short-term interest rates and the persistently flat yield curve and periods of yield curve inversions in 2006, along with highly competitive deposit pricing and customer preference for higher yielding time deposits over savings and money market accounts negatively impacted our net interest margin in 2006. An increase in our earning asset yield of 59 basis points in 2006 compared with 2005 was offset by an increase in our cost of funds of 98 basis points over the same period. The net interest margin on a tax-equivalent basis was 3.02% in 2006, compared with 3.27% in 2005.
Average loans and leases (net of unearned income) increased to 73.5% of average earning assets in 2006 from 66.8% in 2005. The mix of our loan and lease portfolio also changed somewhat as a result of the strong growth in our leasing and indirect lending portfolios. Leases accounted for 12.5% of average loans and leases in 2006 compared with 6.2% in 2005.
The following table sets forth certain information on non-interest income for the years indicated:
Total non-interest income increased $3.5 million or 24.4% in 2006. The increase in investment management income compared with 2005 resulted from the timing of the acquisition of approximately $560 million of trust assets under management from HSBC, USA N.A., which closed in February 2005, and also to higher trust fees resulting from the positive returns on assets in 2006.
Service charges on deposit accounts increased primarily from the impact of changes we made to certain transaction fees in the fourth quarter of 2005, and also to fees earned on accounts acquired from Bridge Street.
Card related fees increased in 2006 due primarily to higher customer debit card utilization and fees earned on former Bridge Street accounts. Insurance agency income represents revenue from the insurance subsidiary acquired in the Bridge Street transaction. Rental income from leases decreased in 2006 due to the declining balance in our operating lease portfolio.
Other non-interest income increased $462,000 in 2006 compared with 2005, with approximately $168,000 resulting from non-operating items. The balance of the increase in other non-interest income resulted primarily from increases in mortgage servicing fees and miscellaneous customer fees.
Non-interest income (excluding loss on sales of securities) comprised 39.0% of revenue in 2006 up from 34.6% in 2005.
The following table sets forth certain information on operating expenses for the years indicated:
Total non-interest expenses increased $2.5 million or 8.1% in 2006. The increase in non-interest expense was due in large part to the acquisition of Bridge Street, except as noted below. Merger and conversion expenses totaled approximately $1.1 million in the fourth quarter of 2006, and were primarily in professional fees, salaries and benefits, communications expense, stationery and supplies expense.
Salaries and benefits decreased in 2006 due primarily to efficiencies gained through the implementation of a new staffing model in the first quarter of 2006 being partially offset by salaries and benefits for employees of Bridge Street in the fourth quarter of 2006.
Occupancy and equipment expense increased in 2006 due to a write-down of $174,000 on bank-owned property reclassified to assets held for sale in the fourth quarter and to expenses associated with properties acquired from Bridge Street. Also contributing to the increase were occupancy costs relating to additional branches in operation during the period.
Increases in communication expense, stationery and supplies, marketing and professional fees resulted largely from acquisition and conversion related activities. Also included in professional fees in 2006 was approximately $228,000 in consulting fees paid in the first quarter related to the personnel staffing model project.
Amortization of intangible assets increased in 2006 as a result of amortization of intangible assets established in connection with the Bridge Street acquisition.
Other operating expenses increased $651,000 or 18.0% due largely to higher ATM processing fees and other miscellaneous expenses resulting primarily from increases in customer account and transaction volumes from organic growth and customers acquired from Bridge Street. In addition, director fees increased $231,000 or 67.5% for the year due to an increase in the number of meetings in 2006 primarily related to the acquisition of Bridge Street and corporate governance matters, and an increase in the amount of earnings on directors deferred compensation which is tied to the book value of Alliance common stock.
The Companys efficiency ratio was 74.6% in 2006, compared with 76.1% in 2005.
Income Tax Expense
The Companys effective tax rate was 19.4% in 2006 and 22.3% 2005. The decrease in the effective tax rate in 2006 compared with 2005 is primarily attributable to increased non-taxable interest and life insurance income relative to total pre-tax income. This increase resulted from the level of non-taxable investments obtained in the Bridge Street acquisition.
Comparison of Financial Condition at December 31, 2007 and December 31, 2006
Total assets increased $34.3 million or 2.7% in 2007, to $1.3 billion at December 31, 2007. Securities available-for-sale increased $18.7 million or 7.4%, and total loans and leases, net of unearned income, increased $13.1 million or 1.5% in 2007.
The securities portfolio is designed to provide a favorable total return utilizing low-risk, high-quality securities while at the same time assisting in meeting the liquidity needs of the Banks loan and deposit operations, and supporting the Companys interest risk objectives. Our securities portfolio is predominately comprised of investment grade mortgage-backed securities, securities issued by U.S. government sponsored corporations and municipal securities. Our mortgage-backed securities portfolio is comprised of pass-through securities guaranteed by either Fannie Mae, Freddie Mac or Ginnie Mae, and does not include any securities backed by subprime or other high-risk mortgages. The decrease in unrealized losses on available-for-sale securities resulted primarily from changes in market conditions and interest rates during the period. The Company classifies the majority of its securities as available-for-sale. The Company does not engage in securities trading or derivatives activities in carrying out its investment strategies.
The following table sets forth the amortized cost and market value for the Companys available-for-sale securities portfolio:
The following table sets forth as of December 31, 2007, the maturities and the weighted-average yields of the Companys debt securities, which have been calculated on the basis of the cost, weighted for scheduled maturity of each security, and adjusted to a fully tax-equivalent basis:
Loans and Leases
The loan and lease portfolio is the largest component of the Banks earning assets and accounts for the greatest portion of total interest income. The Bank provides a full range of credit products through its branch network, its commercial department and its leasing subsidiary. Consistent with the focus on providing community banking services, the Bank generally does not attempt to diversify geographically by making a significant amount of loans to borrowers outside of the primary service area. Loans are internally generated and the majority of the lending activity takes place in the New York State counties of Cortland, Madison, Onondaga, Oneida, and Oswego. In addition, the Bank originates indirect auto loans in the western counties of New York State. The Banks leasing subsidiary originates the majority of its leases through reputable, well-established middle market leasing companies, and through vendor and direct customer relationships. The leases are underwritten using our commercial credit standards, and the collateral securing the leases is generally readily marketable. The business is conducted in over 30 states.
Total loans and leases, net of unearned income and deferred costs, increased $14.1 million or 1.6% in 2007.
Residential mortgages increased $21.3 million or 8.5% in 2007. The growth in residential mortgages has come entirely from conventional mortgages originated in our local markets as the result of our planned expansion of our mortgage origination operations. The Company does not originate sub-prime, Alt-A, negative amortizing or other higher risk residential mortgages.
Commercial loans decreased $6.5 million or 2.9% in 2007. Prepayments of several commercial relationships totaling more than $13 million in 2007, a $4.4 million decrease in line of credit utilization during the year, along with scheduled amortization of the portfolio offset otherwise modest new volume in 2007. The prepayments occurred in part as a result of the Companys decision not to offer certain aggressive rate and credit terms that would have been necessary to retain these relationships. Commercial loan growth will continue to be a challenge for the foreseeable future as a result of the soft economic growth in our markets and significant competition among financial institutions.
The rate of growth in our commercial lease and indirect loan portfolios slowed considerably in 2007 compared with 2006 as we intentionally slowed our origination volumes as part of our ongoing portfolio diversification management.
The following table sets forth the composition of the Banks loan and lease portfolio at the dates indicated:
The following table shows the amount of loans and leases outstanding as of December 31, 2007, which, based on remaining scheduled payments of principal, are due in the periods indicated:
The following table sets forth the sensitivity to changes in interest rates as of December 31, 2007:
Asset Quality and the Allowance for Credit Losses
The following table represents information concerning the aggregate amount of non-performing assets:
Loans and leases past due 30 days or more, which generally includes nonperforming and potential problem loans, totaled $16.4 million or 1.83% of total loans and leases at December 31, 2007, compared with $16.3 million or 1.85% at December 31, 2006. Delinquencies at December 31, 2006 were impacted, in part, by the acquisition of the Bridge Street loan portfolio.
Non-performing assets, defined as non-accruing loans and leases plus loans and leases 90 days or more past due, along with other real estate owned and other repossessed assets as of December 31, 2007 were $6.9 million, up $4.3 million or 162.8%, compared to December 31, 2006. Residential mortgage loans on non-accrual status increased $820,000 in 2007 due primarily to a change in how the Company accounts for mortgages past due 90 days or more. Residential mortgages are now placed on non-accrual status when they reach 90 days past due, whereas the Companys practice prior to 2007 was to continue to accrue interest beyond 90 days past due if the loan was in the process of collection and no loss was anticipated. As a result of this change, accruing loans and leases delinquent 90 days or more decreased $751,000 in 2007.
Commercial loans on non-accrual status increased $3.7 million in 2007. Approximately $2.8 million or 74% of the increase relates to two commercial credits that were placed on non-accrual status in 2007. One relationship totaling $1.6 million at December 31, 2007 (net of a charge-off of $285,000) was placed on non-accrual status in the fourth quarter of 2007. In addition to the $285,000 charge-off, the Company allocated $259,000 of the allowance for credit losses as of the end of 2007 to this relationship, reflecting our internal risk rating of this loan. The Company is continuing to actively manage the liquidation of the remaining collateral for this loan. The other large credit placed on non-accrual status in 2007 is a short-term commercial loan totaling $1.2 million. The Company allocated $299,000 of the allowance for credit losses as of December 31, 2007, reflecting our risk rating of this relationship. The rest of the increase in non-accrual commercial loans in 2007 is comprised of 22 loans with an average balance of $170,000.
As a recurring part of its portfolio management program, the Company has identified approximately $5.4 million in potential problem loans at December 31, 2007, as compared to $6.7 million at December 31, 2006. The average balance of such potential problem loans was $208,000 and $267,000 at December 31, 2007 and December 31, 2006, respectively. Potential problem loans are loans that are currently performing, but where the borrowers operating performance or other relevant factors could result in potential credit problems, and are typically classified by our loan rating system as substandard. At December 31, 2007, potential problem loans primarily consisted of commercial real estate and commercial loans. There can be no assurance that additional loans will not become nonperforming, require restructuring, or require increased provision for loan losses.
The Bank has a loan and lease monitoring program that it believes appropriately evaluates non-performing loans and leases and the loan and lease portfolio in general. The loan and lease review program continually audits the loan and lease portfolio to confirm managements loan and lease risk rating system, and tracks problem loans and leases to ensure compliance with loan and lease policy underwriting guidelines, and to evaluate the adequacy of the allowance for credit losses.
The Banks policy is to place a loan or lease on non-accrual status and recognize income on a cash basis when a loan or lease is more than 90 days past due, unless in the opinion of management, the loan or lease is well secured and in the process of collection. The impact of interest not recognized on non-accrual loans and leases was $202,000 in 2007, $40,000 in 2006, and $75,000 in 2005. The Bank considers a loan or lease impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally based upon the present value of future cash flows discounted at the historical effective interest rate, except that all collateral-dependent loans and leases are measured for impairment based on fair value of the collateral. As of December 31, 2007, there was $4.2 million in impaired loans for which $1.3 million in related allowance for credit losses was allocated. There were no impaired loans or leases for which specific valuation allowances had been recorded as of December 31, 2006.
The allowance for credit losses represents managements best estimate of probable incurred credit losses in the Banks loan and lease portfolio. Managements quarterly evaluation of the allowance for credit losses is a comprehensive analysis that builds a total reserve by evaluating the risks within each loan and lease type, or pool of similar loans and leases. The Bank uses a general allocation methodology for all residential and consumer loan pools. This methodology estimates a reserve for each pool based on the most recent three-year loss rate, adjusted to reflect the expected impact that current trends regarding loan growth, delinquency, losses, economic conditions, loan concentrations, policy changes and current interest rates are likely to have. For commercial loan and lease pools, the Bank establishes a specific reserve allocation for all loans and leases in excess of $150,000 which are considered to be impaired and which have been risk rated under the Banks risk rating system, as substandard, doubtful or loss. The specific allocation is based on the most recent valuation of the loan or lease collateral. For all other commercial loans and leases, the Bank uses the general allocation methodology that establishes a reserve for each risk rating category. The general allocation methodology for commercial loans and leases considers the same qualitative factors that are considered when evaluating residential mortgage and consumer loan pools. The combination of using both the general and specific allocation methodologies reflects managements best estimate of the probable credit losses in the Banks loan and lease portfolio. Loans and leases are charged against the allowance for credit losses, in accordance with the Banks loan and lease policy, when they are determined by management to be uncollectible. Recoveries on loans and leases previously charged off are credited to the allowance for credit losses when they are received. When management determines that the allowance for credit losses is less than adequate to provide for potential losses, a direct charge is made to operating income.
The following table summarizes changes in the allowance for credit losses arising from loans and leases charged off, recoveries on loans and leases previously charged off and additions to the allowance, which have been charged to expense.
The provision for credit losses was $3.8 million in 2007, compared with $2.5 million in 2006. Net charge-offs were $2.4 million in 2007, compared with $1.7 million in 2006. The increased level of provisions in 2007 is a reflection of generally higher levels of loan delinquencies and charge-offs in 2007, a higher level of classified loans, and managements assessment of the potential impact on the Companys portfolio of macroeconomic factors and credit market conditions affecting the financial institution sector generally. The provision for credit losses as a percentage of net charge-offs was 158% and 145%, respectively, in 2007 and 2006.
The allowance for credit losses was $8.4 million at December 31, 2007, compared with $7.0 million at December 31, 2006. The ratio of the allowance for credit losses to total loans and leases was 0.94% at December 31, 2007, compared with 0.80% at December 31, 2006. The ratio of the allowance for credit losses to nonperforming loans and leases was 126% at December 31, 2007, compared with 266% at December 31, 2006.
The allowance for credit losses has been allocated within the following categories of loans and leases at the dates indicated with the corresponding percent of loans to total loans for each category (dollars in thousands):
The allowance for credit losses is allocated according to the amount deemed to be reasonably necessary to provide for the probable losses within each category of loans and leases. Increases in the amount allocated to the commercial and lease portfolios reflect the higher outstanding balances of these portfolios coupled with the higher inherent risk of these portfolios compared with residential and consumer lending.
The Banks deposits are the Companys primary source of funds. The deposit base is comprised of demand deposit, savings and money market accounts, and time deposits that are primarily provided by individuals, businesses, and local governments within the communities served. The Bank continuously monitors market pricing, competitors rates, and internal interest rate spreads to maintain and promote growth and profitability.
The following table sets forth the composition of the Companys deposits by business line at year-end (dollars in thousands):
Total deposits were $944.2 million at December 31, 2007, an increase of $8.6 million from December 31, 2006. Checking accounts increased $17.2 million in the year ended December 31, 2007 due to a combination of organic deposit growth and the timing and volumes of customer transaction activity. Savings accounts decreased $4.9 million in 2007 due in large part to the movement of retail deposits to higher yielding alternative bank products such as money market and time accounts, as well as to non-bank investment products. Money market accounts increased $13.9 million in 2007 due primarily to a seasonal increase in municipal deposits partially offset by lower retail balances resulting from the movement of rate-sensitive balances to higher yielding alternatives. Time deposits decreased $17.7 million in 2007 as we have elected to not pay the premium rates that would have been necessary to retain certain rate sensitive accounts. We have seen similar trends in deposit balances in 2008 as we have continued to lower our rates in response to the aggressive easing of short-term rates by the Federal Reserve. From September 2007 to February 2008, the Fed has reduced the federal funds target rate 225 basis points. While this has allowed us to reduce our deposit rates which should have a positive effect on our net interest margin, the significantly lower rates available to time accounts with upcoming maturity dates has caused some rate-sensitive customers to more diligently seek out higher yielding alternatives. In our market, such alternatives increasingly include credit unions, which tend to offer higher rates than the Company and most other banks in our market. We expect the intense competition for deposits in our market area will continue for the foreseeable future, which may cause continued outflows of deposits and as a result increase our reliance on wholesale borrowings or require us to increase the rates we pay on deposits.
Time deposits in excess of $100,000, which are more volatile and sensitive to interest rates, totaled $117.0 million at December 31, 2007, representing 27.9% of total time deposits and 12.4% of total deposits. These deposits totaled $127.4 million, representing 29.1% of total time deposits and 13.6% of total deposits at year-end 2006.
The following table indicates the amount of the Companys time deposits of $100,000 or more by time remaining until maturity as of December 31, 2007 (in thousands):
The Bank offers retail repurchase agreements primarily to its larger business customers. Under the terms of the agreements, the Bank sells investment portfolio securities to the customer and agrees to repurchase the securities on the next business day. The Bank uses this arrangement as a deposit alternative for its business customers. As of December 31, 2007, retail repurchase agreement balances amounted to $54.0 million compared to balances of $43.2 million at December 31, 2006. During 2007, the Bank utilized collateralized repurchase agreements with various brokers and advances from the Federal Home Loan Bank of New York (FHLB) as alternative sources of funding and as a liability management tool. At December 31, 2007, the combination of repurchase agreements and FHLB advances were $148.0 million, compared to $136.5 million at December 31, 2006. Detailed information regarding the Companys borrowings is included in Note 8 in the consolidated financial statements section of this report.
Shareholders equity was $115.6 million at December 31, 2007, compared with $109.5 million at December 31, 2006. Net income of $9.5 million was partially offset by dividends of $4.3 million and by the repurchase of 83,930 shares of Alliance common stock totaling $2.3 million. The Company announced in November 2007 that its Board of Directors authorized the repurchase of up to three percent of the Companys outstanding common stock, or approximately 143,500 shares. 52,100 shares were repurchased at an average price of $25.58 per share under this repurchase plan. The balance of 31,830 shares repurchased occurred in the first quarter of 2007 under the Companys previous repurchase plan at an average price of $30.85 per share.
Also impacting shareholders equity in 2007 was a $3.3 million increase in accumulated other comprehensive income from an accumulated loss position of $2.1 million at December 31, 2006. This change resulted primarily from a significant rally in securities prices that changed an unrealized loss position on securities available-for-sale from $998,000 (net of deferred taxes) at December 31, 2006 to unrealized gains of $933,000 (net of deferred taxes) at December 31, 2007. Our mortgage-backed securities portfolio is comprised of pass-through securities guaranteed by either Fannie Mae, Freddie Mac or Ginnie Mae, and does not include any securities backed by subprime or other high-risk mortgages. Further increasing accumulated other comprehensive income in 2007 was the reversal of a $1.0 million liability (net of deferred taxes) upon the amendment in the fourth quarter of the Companys post-retirement medical plan for current employees.
The Companys goal is to maintain a strong capital position, consistent with the risk profile of the Bank, that supports growth and expansion activities while at the same time exceeding regulatory standards. Capital adequacy in the banking industry is evaluated primarily by the use of ratios which measure capital against total assets, as well as against total assets that are weighted based on defined risk characteristics. At December 31, 2007, the Company exceeded all regulatory required minimum capital ratios and met the regulatory definition of a well-capitalized institution. A more comprehensive analysis of regulatory capital requirements, including ratios for the Company, is included in Note 19 in the consolidated financial statements.
Liquidity and Capital Resources
The Companys liquidity is primarily measured by the Banks ability to provide funds to meet loan and lease requests, to accommodate possible outflows of deposits, and to take advantage of market interest rate opportunities. Funding of loan and lease commitments, providing for liability outflows, and management of interest rate fluctuations require continuous analysis in order to match the maturities of specific categories of short-term loans and leases, and investments with specific types of deposits and borrowings. Liquidity is normally considered in terms of the nature and mix of the Banks sources and uses of funds. The Asset Liability Management Committee (ALCO) of the Bank is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. Management believes, as of December 31, 2007, that liquidity as measured by the Bank is in compliance with its policy guidelines.
The Banks principal sources of funds for operations are cash flows generated from earnings, deposits, securities, loan and lease repayments, borrowings from the FHLB, and securities sold under repurchase agreements. During the year ended December 31, 2007, cash and cash equivalents increased by $3.3 million as net cash provided by operating activities and financing activities of $39.1 million exceeded the net cash used in investing activities of $35.8 million. Net cash provided by financing activities reflects a net increase in deposits of $8.6 million and a net increase in borrowings of $22.3 million, partly offset by treasury stock purchases of $2.3 million and cash dividends paid of $4.2 million. Net cash used in investing activities primarily results from a net increase in loans and leases of $16.7 million and a net increase in investment securities of $15.3 million.
As a member of the FHLB, the Bank is eligible to borrow up to an established credit limit against certain residential mortgage loans and investment securities that have been pledged as collateral. As of December 31, 2007, the Banks credit limit with the FHLB was $186.6 million with outstanding borrowings in the amount of $107.7 million.
In December 2003, the Company formed Alliance Financial Capital Trust I, a wholly-owned subsidiary of the Company. The trust was formed for the purpose of issuing $10.0 million of Company-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of the Company. The debentures held by the trust are the sole assets of that trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities have a variable annual coupon rate that resets quarterly based upon three-month LIBOR plus 285 basis points (7.83%). The capital securities have a 30-year maturity and are redeemable at par in January 2009 and any time thereafter.
In September 2006, the Company formed Alliance Financial Capital Trust II, a wholly-owned subsidiary of the Company. The trust was formed for the purpose of issuing $15.0 million of Company-obligated mandatorily redeemable capital securities (the capital securities) to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of the Company. The debentures held by the trust are the sole assets of that trust. Distributions on the capital securities issued by the trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by the trust. The capital securities have a variable annual coupon rate that resets quarterly based upon three-month LIBOR plus 165 basis points (6.64%). The capital securities have a 30-year maturity and are redeemable at par in September 2011 and any time thereafter.
Contractual Obligations, Commitments, and Off-Balance Sheet Arrangements
The Company has various financial obligations, including contractual obligations and commitments that may require future cash payments. The following table presents as of December 31, 2007, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.
The Company did not have any commitments or obligations to its defined benefit pension plan at December 31, 2007 due to the overfunded status of the plan. The Company also has obligations under its post-retirement plan and supplemental executive retirement plans as described in Note 13 to the consolidated financial statements. The supplemental executive retirement and postretirement benefit payments represent actuarially determined future benefit payments to eligible plan participants.
As of December 31, 2007, the liability for uncertain tax positions, excluding associated interest and penalties, was $168,000 pursuant to FASB Interpretation No. 48. This liability represents an estimate of tax positions that the Company has taken in its tax returns which may ultimately not be sustained upon examination by the tax authorities. Since the ultimate amount and timing of any future cash settlements cannot be predicted with reasonable certainty, this estimated liability has been excluded from the contractual obligations table.
Commitments and Off-Balance Sheet Arrangements
In the normal course of business, to meet the financing needs of its customers and to reduce its exposure to fluctuations in interest rates, the Bank is party to financial instruments with off-balance sheet risk, held for purposes other than trading. The financial instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets. The Banks exposure to credit loss in the event of nonperformance by the other party to the financial instrument, for loan commitments and standby letters of credit, is represented by the contractual amount of those instruments, assuming that the amounts are fully advanced and that collateral or other security is of no value. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet loans. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on managements credit evaluation of the borrower. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Commitments to originate loans, unused lines of credit, and un-advanced portions of construction loans are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Many of the commitments are expected to expire without being drawn upon. Therefore, the amounts presented below do not necessarily represent future cash requirements. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance by a customer to a third party. These guarantees are issued primarily to support public and private borrowing arrangements, bond financing, and similar transactions. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.
The following table details the amounts and expected maturities of significant commitments and off-balance sheet arrangements as of December 31, 2007. Further discussion of these commitments and off-balance sheet arrangements is included in Note 16 to the consolidated financial statements.
Application of Critical Accounting Policies
The Companys consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated in good faith by management.
The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for credit losses, accrued income taxes, pensions and post-retirement obligations and the fair value analysis of goodwill and intangible assets to be the accounting areas that require the most subjective and complex judgments, and as such could be the most subject to revision as new information becomes available. Actual results could differ from those estimates.
The allowance for credit losses represents managements estimate of probable incurred loan and lease losses inherent in the loan and lease portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires
significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for credit losses, and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in this report.
The Company estimates its tax expense based on the amount it expects to owe the respective tax authorities. Taxes are discussed in more detail in Note 11 of the consolidated financial statements section of this report. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions, taking into account statutory, judicial and regulatory guidance in the context of the Corporations tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.
The Company utilizes significant estimates and assumptions in determining the fair value of its goodwill and intangible assets for purposes of impairment testing. The valuation requires the use of assumptions, including, among others, discount rates, rates of return on assets, account attrition rates and costs of servicing. Impairment testing for goodwill requires that the fair value of each of our reporting units be compared to the carrying amount of its net assets, including goodwill. Determining the fair value of a reporting unit requires us to use a high degree of subjective judgment. The Company utilizes both market-based valuation multiples and discounted cash flow valuation models that incorporate such variables as revenue growth rates, expense trends, interest rates and terminal values. Based upon an evaluation of key data and market factors, we select the specific variables to be incorporated into the valuation model. Future changes in the economic environment or operations of our reporting units could cause changes to these variables, which could result in impairment being identified.
The valuation of the Companys obligations associated with pension, post-retirement and supplemental executive retirement plans utilize various actuarial assumptions. These assumptions include discount rate, rate of future compensation increases and expected return on plan assets. Specific discussion of the assumptions used by management is discussed in Note 13.
New Accounting Pronouncements
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. This Statement establishes a fair value hierarchy about the assumptions used to measure fair value and clarifies assumptions about risk and the effect of a restriction on the sale or use of an asset. The standard is effective for fiscal years beginning after November 15, 2007. The impact of adoption was not material.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. The standard provides companies with an option to report selected financial assets and liabilities at fair value and establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. The new standard is effective for the Company on January 1, 2008. The Company did not elect the fair value option for any financial assets or financial liabilities as of January 1, 2008.
In September 2006, the FASB Emerging Issues Task Force finalized Issue No. 06-4, Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements. This issue requires that a liability be recorded during the service period when a split-dollar life insurance agreement continues after participants employment or retirement. The required accrued liability will be based on either the post-employment benefit cost for the continuing life insurance or based on the future death benefit depending on the contractual terms of the underlying agreement. This issue is effective for fiscal years beginning after December 15, 2007. The impact of adoption was a cumulative adjustment to retained earnings of $462,000 to record the future death benefit obligation at January 1, 2008.
Item 7A Quantitative and Qualitative Disclosures about Market Risk
Market risk is the risk of loss in a financial instrument arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. The Companys market risk arises principally from interest rate risk in its lending, deposit and borrowing activities. Other types of market risks do not arise in the normal course of the Companys business activities.
The Banks Asset Liability Management Committee (ALCO) is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to interest rate risk. The policies and guidelines established by ALCO are reviewed and approved by the Companys Board of Directors.
Interest rate risk is monitored primarily through the use of two complementary measures: earnings simulation modeling and net present value estimation. Both measures are highly assumption dependent and change regularly as the balance sheet and business mix evolve; however, taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk, the distribution of risk along the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. The key assumptions employed by these measures are analyzed regularly and reviewed by ALCO.
Earnings Simulation Modeling
Net interest income is affected by changes in the absolute level of interest rates and by changes in the shape of the yield curve. In general, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and funding rates, while a steepening of the yield curve would result in increased earnings as investment margins widen. The model requires management to make assumptions about how the balance sheet is likely to evolve though time in different interest rate environments. Loan and deposit growth rate assumptions are derived from historical analysis and managements outlook, as are the assumptions used to project yields and rates for new loans and deposits. Securities portfolio maturities and prepayments are assumed to be reinvested in similar instruments. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds in conjunction with the historical prepayment performance of the Banks loans. Noncontractual deposit growth rates and pricing are modeled on historical patterns. Interest rates of the various assets and liabilities on the balance sheet are assumed to change proportionally, based on their historic relationship to short-term rates. The Banks guidelines for risk management call for preventative measures to be taken if the simulation modeling demonstrates that an instantaneous 2% increase or decrease in short-term rates over the next 12 months would adversely affect net interest income over the same period by more than 15% when compared to the stable rate scenario. At December 31, 2007, based on the results of our simulation model and assuming that management does not take action to alter the outcome, the Bank would expect net interest income to decline 13.3% if short-term interest rates increase by 2%, and increase 6.3% if short-term interest rates decline by 2%. By comparison, at December 31, 2006, based on the results of our simulation model, and assuming that management did not take action to alter the outcome, the Bank expected net interest income to decrease 9.9% if short-term interest rates increase by 2%, and increase 9.1% if short-term interest rates decline by 2%.
Net Present Value Estimation
The Net Present Value of Equity (NPV) measure is used for discerning levels of risk present in the balance sheet that might not be taken into account in the earnings simulation model due to the shorter time horizon used by that model. The NPV of the balance sheet, at a point in time, is defined as the discounted present value of the asset cash flows minus the discounted value of liability cash flows. Interest rate risk analysis using NPV involves changing the interest rates used in determining the cash flows and in discounting the cash flows. The Companys NPV analysis models both an instantaneous 2% increasing and 2% decreasing interest rate scenario comparing the NPV in each scenario to the NPV in the current rate scenario. The resulting percentage change in NPV is an indication of the longer-term repricing risk and options risk embedded in the balance sheet. The NPV measure assumes a static balance sheet versus the growth assumptions that are incorporated into the earnings simulation measure, and an unlimited time horizon instead of the one-year horizon applied in the earnings simulation model. As with earnings simulation modeling, assumptions about the timing and the variability of balance sheet cash flows are critical in NPV analysis. Particularly important are assumptions driving mortgage prepayments in both the loan and investment portfolios, and changes in the noncontractual deposit portfolios. These assumptions are applied consistently in both models. Based on the December 31, 2007 NPV analysis, a 2% instantaneous increase in interest rates was estimated to increase NPV by 1.4%. NPV was estimated to decrease 7.2% if rates immediately declined by 2%. The Companys policy guidelines limit the amount of the estimated decline/increase to 25% in a 2% rate change scenario. By comparison, the December 31, 2006 NPV analysis estimated a 2% instantaneous increase in interest rates would increase NPV by 5.6%. NPV was estimated to decrease 10.09% if rates immediately declined by 2%.
Item 8 Financial Statements and Supplementary Data
MANAGEMENTS REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Companys management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate. The Companys internal control over financial reporting is a process designed under the supervision of the Companys principal executive officer and principal financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Companys financial statements for external reporting purposes in accordance with Unites States generally accepted accounting principles.
Under the supervision and with the participation of management, including the Companys principal executive officer and principal financial officer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting based on the framework in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on its evaluation under that framework, management concluded that the Companys internal control over financial reporting was effective as of December 31, 2007. In addition, based on our assessment, management has determined that there were no material weaknesses in the Companys internal controls over financial reporting.
The Companys internal control over financial reporting as of December 31, 2007 has been audited by Crowe Chizek and Company LLC, an independent registered public accounting firm, as stated in their report appearing herein, which expresses an unqualified opinion on the effectiveness of the Companys internal control over financial reporting as of December 31, 2007.
Syracuse, New York
March 13, 2008
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM ON INTERNAL CONTROL
We have audited Alliance Financial Corporations internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Alliance Financial Corporations management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Managements Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Companys internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Alliance Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Alliance Financial Corporation as of December 31, 2007 and the related consolidated statements of income, changes in shareholders equity, comprehensive income and cash flows for the year then ended and our report dated March 13, 2008 expressed an unqualified opinion on those consolidated financial statements.
Livingston, New Jersey
March 13, 2008
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING
FIRM ON FINANCIAL STATEMENTS
Board of Directors and Shareholders
Alliance Financial Corporation
Syracuse, New York
We have audited the accompanying consolidated balance sheet of Alliance Financial Corporation as of December 31, 2007 and the related consolidated statements of income, changes in shareholders equity, comprehensive income and cash flows for the year then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Alliance Financial Corporation as of December 31, 2006 and 2005 were audited by other auditors whose report dated March 13, 2007 expressed an unqualified opinion on those statements.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Alliance Financial Corporation as of December 31, 2007 and the results of its operations and its cash flows for the year then ended in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Alliance Financial Corporations internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 13, 2008 expressed an unqualified opinion thereon.
Livingston, New Jersey
March 13, 2008
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of Alliance Financial Corporation:
In our opinion, the consolidated balance sheet as of December 31, 2006 and the related consolidated statements of income, changes in shareholders equity, comprehensive income and cash flows for each of two years in the period ended December 31, 2006 present fairly, in all material respects, the financial position of Alliance Financial Corporation and its subsidiaries at December 31, 2006, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2006, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
The accompanying notes are an integral part of the consolidated financial statements.
Nature of Operations
Alliance Financial Corporation (the Company) is a financial holding company which owns and operates Alliance Bank, N.A. (the Bank), Alliance Financial Capital Trust I, Alliance Financial Capital Trust II (collectively the Capital Trusts) and Ladds Agency, Inc., a multi-line insurance agency. The Company provides financial services through its Bank subsidiary from 29 customer service facilities in the New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a Trust Administration Center in Buffalo, NY. Primary services include commercial, retail and municipal banking, consumer finance, mortgage financing and servicing, and investment management services. The Capital Trusts were formed for the purpose of issuing corporation-obligated mandatorily redeemable capital securities to third-party investors and investing the proceeds from the sale of such capital securities solely in junior subordinated debt securities of the Company. The Bank has a substantially wholly-owned subsidiary, Alliance Preferred Funding Corp., which is engaged in residential real estate activity, and a wholly-owned subsidiary, Alliance Leasing, Inc., which is engaged in commercial equipment financing activity in over thirty states.
1. Basis of Presentation and Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries, Alliance Bank, N.A. and Ladds Agency, Inc., after elimination of intercompany accounts and transactions. The Companys wholly-owned subsidiaries, Alliance Financial Capital Trust I and II, qualify as variable interest entities under FASB Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities. However, the Company is not the primary beneficiary and therefore has not consolidated the accounts of Alliance Financial Capital Trust I and II in its consolidated financial statements.
Critical Accounting Estimates and Policies
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 amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management has identified the allowance for credit losses, income taxes, and the carrying value of goodwill and intangible assets to be the accounting areas that require the most subjective and complex judgments, and as such could be the most subject to revision as new information becomes available. Actual results could differ from those estimates.
Risk and Uncertainties
In the normal course of its business, the Company encounters economic and regulatory risks. There are three main components of economic risk: interest rate risk, credit risk and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, from its interest-earning assets. The Companys primary credit risk is the risk of default on the Companys loan and lease portfolio that results from the borrowers inability or unwillingness to make contractually required payments. Market risk reflects potential changes in the value of collateral underlying loans, the fair value of investment securities, and the value of loans held for sale.
The Company is subject to regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loan and lease loss allowances, and operating restrictions resulting from the regulators judgments based on information available to them at the time of their examinations.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks and highly liquid investments with original maturities less than ninety days.
The Company classifies securities as held-to-maturity or available-for-sale at the time of purchase. Held-to-maturity securities are those that the Company has the positive intent and ability to hold to maturity, and are reported at cost, adjusted for amortization of premiums and accretion of discounts. Securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair value, with net unrealized gains and losses reflected as a separate component of accumulated other comprehensive income, net of taxes. None of the Companys securities have been classified as trading securities or held-to-maturity.
Gains and losses on the sale of securities are based on the specific identification method. Premiums and discounts on securities are amortized and accreted into income using the interest method over the life of the security. Securities are reviewed regularly for other than temporary impairment. Where there is other than temporary impairment, the impairment loss is recognized in the consolidated statements of income. Purchases and sales of securities are recognized on a trade-date basis.
1. Basis of Presentation and Significant Accounting Policies (contd.)
Federal Home Loan Bank of New York and Federal Reserve Bank Stock
As a member of the Federal Home Loan Bank of New York (FHLB) and Federal Reserve Bank (FRB), the Company is required to hold stock in the FHLB and FRB. FHLB and FRB stock is carried at cost since there is no readily available market value. The stock cannot be sold, but can be redeemed by the issuer at cost. The stock is periodically evaluated for impairment based on ultimate recovery of par value.
Securities Sold under Agreements to Repurchase
Repurchase agreements are accounted for as collateralized borrowings, and the obligations to repurchase securities sold are reflected as a liability in the balance sheet, since the Company maintains effective control over the transferred securities. The securities underlying the agreements remain in the Companys securities portfolio. The fair value of the collateral provided to a third party is continually monitored, and additional collateral is provided to the third party, or surplus collateral is returned to the Company as deemed appropriate.
Loans Held for Sale and Mortgage Servicing Rights
Mortgage loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or market, as determined by outstanding commitments from investors. Net unrealized losses, if any, are charged to earnings.
Mortgage loans held for sale are generally sold with servicing rights retained. The carrying value of mortgage loans sold is reduced by the amount allocated to the servicing right. Gains and losses on sales of mortgage loans are based on the difference between the selling price and the carrying value of the related loan sold.
Mortgage servicing rights are recognized separately when they are acquired through sales of loans. For sales of mortgage loans prior to January 1, 2007, a portion of the cost of the loan was allocated to the servicing right based on relative fair values. The Company adopted SFAS No. 156 on January 1, 2007, and for sales of mortgage loans beginning in 2007, servicing rights are initially recorded at fair value with the income statement effect recorded in gains on sales of loans. Fair value is based on a valuation model that calculates the present value of estimated future net servicing income. The valuation model incorporates assumptions that market participants would use in estimating future net servicing income, such as the cost to service, the discount rate, the custodial earnings rate, an inflation rate, ancillary income, prepayment speeds and default rates and losses. All classes of servicing assets are subsequently measured using the amortization method which requires servicing rights to be amortized into non-interest income in proportion to, and over the period of, the estimated future net servicing income of the underlying loans.
Servicing assets are evaluated for impairment based upon the fair value of the rights as compared to carrying amount. Impairment is determined by stratifying rights into groupings based on predominant risk characteristics, such as interest rate, loan type and investor type. Impairment is recognized through a valuation allowance for an individual grouping, to the extent that fair value is less than the carrying amount. If the Company later determines that all or a portion of the impairment no longer exists for a particular grouping, a reduction of the allowance may be recorded as an increase to income. The fair values of servicing rights are subject to significant fluctuations as a result of changes in estimated and actual prepayment speeds and default rates and losses.
Servicing fee income which is reported on the income statement as other non-interest income is recorded for fees earned for servicing loans and recorded as income when earned. The amortization of mortgage servicing rights is netted against loans servicing fee income.
Loans and Leases
Loans and leases are stated at unpaid principal balances less the allowance for credit losses, unearned interest income and net deferred loan origination fees and costs. Interest on loans is based upon the principal amount outstanding. Interest on loans is accrued except when in managements opinion the collectibility of interest is doubtful, at which time the accrual of interest on the loan is discontinued. Loan and lease origination fees and certain direct origination costs are deferred and the net amount is amortized as a yield adjustment over the life of the loan or lease.
Operating leases are stated at cost of the equipment less depreciation. Equipment on operating leases is depreciated on a straight-line basis to its estimated residual value over the lease term. Operating lease income is recognized on a straight-line basis over the term of the lease. Lease financings, included in portfolio loans on the consolidated balance sheet consist of direct financing leases of commercial equipment, primarily computers and office equipment, manufacturing equipment, commercial truck and trailers, and medical equipment. Income attributable to finance leases is initially recorded as unearned income and subsequently recognized as finance income at level rates of return over the term of the leases. The recorded residual values of the Companys leased assets are estimated at the inception of the lease to be the expected fair market value of the assets at the end of the lease term. On a quarterly basis, the Company reassesses the realizable value of its lease residual values. In accordance with U.S. generally accepted accounting principles, anticipated increases in specific future residual values are not recognized before realization. Anticipated decreases in specific future residual values that are considered to be other than temporary are recognized immediately.
1. Basis of Presentation and Significant Accounting Policies (contd.)
Allowance for Credit Losses
The allowance for credit losses represents managements best estimate of probable incurred credit losses in the Companys loan portfolio. Managements quarterly evaluation of the allowance for credit losses is a comprehensive analysis that builds a total reserve by evaluating the risks within each loan type, or pool, of similar loans and leases. The Company uses a general allocation methodology for all residential and consumer loan pools. This methodology estimates an allocation for each pool based on the most recent three-year loss rate, adjusted to reflect the expected impact that current trends regarding loan and lease growth, delinquency, losses, economic conditions, loan concentration, policy changes, and current interest rates are likely to have. For commercial loan and lease pools, the Company establishes a specific reserve allocation for all loans and leases classified as being impaired in excess of $150,000, which have been risk rated under the Companys risk rating system as substandard, doubtful, or loss. For all other commercial loans, the Company uses the general allocation methodology that establishes a reserve for each risk rating category. The general allocation methodology for commercial loans and leases considers the same factors that are considered when evaluating residential mortgage and consumer loan pools. The combination of using both the general and specific allocation methodologies reflects managements best estimate of the probable incurred loan and lease losses in the Companys loan portfolio.
A loan or lease is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan or lease agreement. The measurement of impaired loans or leases is generally discounted at the historical effective interest rate, except that all collateral-dependent loans or leases are measured for impairment based on fair value of the collateral.
Loans will be charged off when they are considered a loss regardless of the delinquency status. From a delinquency standpoint, the policy of the Company is to charge off loans when they are 120 days past due unless extenuating circumstances are documented that attest to the ability to collect the loan. Special circumstances to include fraudulent loans and loans in bankruptcy will be charged off no later than 90 days of discovery or within 120 days delinquent, whichever is shorter. In lieu of charging off the entire loan balance, loans with collateral may be written down to the value of the collateral, less cost to sell, if foreclosure or repossession of collateral is assured and in process.
Income Recognition on Impaired and Non-accrual Loans and Leases
Loans and leases, including impaired loans or leases, are generally classified as non-accrual if they are past due as to maturity of payment of principal or interest for a period of more than 90 days unless they are well secured and are in the process of collection. While a loan or lease is classified as non-accrual and the future collectibility of the recorded loan or lease balance is doubtful, collections of interest and principal are generally applied as a reduction to principal outstanding.
Goodwill and Intangible Assets
Goodwill represents the excess of the purchase price over the fair value of net assets acquired for transactions accounted for under the purchase method of accounting for business combinations. Goodwill is not being amortized, but is evaluated at least annually for impairment. Intangible assets resulting from the acquisition of Bridge Street Financial, Inc. in 2006 include core deposit intangibles, customer relationship intangibles and a covenant to not compete. The core deposit intangible and customer list intangible are being amortized over 10 years using an accelerated method. The non-compete covenant is being amortized on a straight-line basis over a period of 3 years based on the agreement. The trust relationship intangible related to the purchase of trust accounts and related assets under management from HSBC, USA, N.A. in 2005 is being amortized over the expected useful life of the relationships acquired. These intangibles are tested for impairment whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable.
Premises, Furniture, and Equipment
Land is carried at cost. Bank premises, furniture, and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are calculated using the straight-line method over the estimated useful lives of the assets. Useful lives range from one year to 10 years for furniture, fixtures and equipment; three to five years for software, hardware, and data handling equipment; and 10 to 39 years for buildings and building improvements. Leasehold improvements are amortized over the term of the respective lease. Maintenance and repairs are charged to operating expenses as incurred. The asset cost and accumulated depreciation are removed from the accounts for assets sold or retired and any resulting gain or loss is included in the determination of the income.
Bank-Owned Life Insurance
The Bank has purchased life insurance policies on certain employees, key executives and directors. Upon adoption of EITF 06-5, which is discussed further below, bank-owned life insurance is recorded at the amount that can be realized under the insurance contract at the balance sheet date, which is the cash surrender value adjusted for other charges or other amounts due that are probable at settlement. Prior to adoption of EITF 06-5, the Bank recorded owned life insurance at its cash surrender value. In September 2006, the FASB Emerging
1. Basis of Presentation and Significant Accounting Policies (contd.)
Issues Task Force finalized Issue No. 06-5, Accounting for Purchases of Life Insurance - Determining the Amount That Could Be Realized in Accordance with FASB Technical Bulletin No. 85-4 (Accounting for Purchases of Life Insurance) (Issue). This Issue requires that a policyholder consider contractual terms of a life insurance policy in determining the amount that could be realized under the insurance contract. It also requires that if the contract provides for a greater surrender value if all individual policies in a group are surrendered at the same time, that the surrender value be determined based on the assumption that policies will be surrendered on an individual basis. Lastly, the Issue requires disclosure when there are contractual restrictions on the Companys ability to surrender a policy. The adoption of EITF 06-5 on January 1, 2007 had no impact on the Banks financial condition or results of operation.
Assets Held for Sale
Assets held for sale are stated at the lower of its carrying amount or fair value less cost to sell. Assets held for sale are reviewed for impairment when events indicate their carrying amount may not be recoverable from future undiscounted cash flows. If impaired, the assets are recorded at fair value. Fair value is determined using observable market data and other unobservable inputs for the asset.
Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. If fair value declines subsequent to foreclosure, a valuation allowance is recorded through expense. Operating costs after acquisition are expensed.
Loan Commitments and Related Financial Instruments
Financial instruments include off-balance sheet credit instruments, such as commitments to make loans and commercial letters of credit, issued to meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded.
Pension expense is the net of service and interest cost, return on plan assets and amortization of gains and losses not immediately recognized. Employee 401(k) and profit sharing plan expense is the amount of matching contributions and employer fixed and discretionary contributions. Deferred compensation and supplemental retirement plan expense allocates the benefits over years of service.
Effective January 1, 2006, the Company adopted provisions of Financial Accounting Standards Board (FASB) Statement No. 123R Share-Based Payment, (FAS 123R) for its share-based compensation plans. The Company previously accounted for these plans under the recognition and measurement principles of Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, (APB 25) and related interpretations and disclosure requirements established by FAS 123, Accounting for Stock-Based Compensation. Under APB 25, because the exercise price of the Companys employee stock options equaled the market price of the underlying stock on the date of the grant, no compensation expense was recorded. The pro forma effects on income for stock options were instead disclosed in a footnote to the financial statements. Expense was recorded in the income statement for restricted stock units.
Under FAS 123R, all share-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense in the income statement over the vesting period. The Company adopted FAS 123R using the modified prospective method. Under this transition method, compensation cost recognized in 2006 includes the cost for all share-based payments granted prior to, but not yet vested as of January 1, 2006. This cost was based on grant-date fair value estimated in accordance with the original provisions of FAS 123. The cost for all share-based awards granted subsequent to January 1, 2006 represented the grant-date fair value that was estimated in accordance with the provisions of FAS 123R. Results for prior periods have not been restated. The effect of adopting the provisions of FAS 123R decreased net income $28,000, net of a tax benefit of $18,000, and reduced basic and diluted earnings per share by $0.01.
The effect on net income and earnings per share in 2005 if the Company had applied the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, to stock option awards granted on Alliance Financial Corporation common stock would decrease net income $35,000 and decrease basic and diluted earnings per share by $0.01.
Earnings Per Common Share
Basic earnings per common share is net income divided by the weighted average number of common shares outstanding during the period. Diluted earnings per common share includes the dilutive effect of additional potential common shares issuable under stock options and restricted stock awards.
1. Basis of Presentation and Significant Accounting Policies (contd.)
Loss contingencies, including claims and legal actions arising in the ordinary course of business, are recorded as liabilities when the likelihood of loss is probable and an amount or range of loss can be reasonably estimated. Management does not believe there now are such matters that will have a material effect on the financial statements.
Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains and losses on securities available for sale and changes in funded status of the pension plan, post-retirement medical plan and supplemental executive retirement plans which are also recognized as separate components of equity.
Provision for income taxes is based on taxes currently payable or refundable and deferred income taxes on temporary differences between the tax basis of assets and liabilities and their reported amount in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.
The Company adopted FASB Interpretation 48, Accounting for Uncertainty in Income Taxes (FIN 48), as of January 1, 2007. A tax position is recognized as a benefit only if it is more likely than not that the tax position would be sustained in a tax examination, with a tax examination being presumed to occur. The amount recognized is the largest amount of tax benefit that is greater than 50% likely of being realized on examination. For tax positions not meeting the more likely than not test, no tax benefit is recorded. The adoption had no affect on the Companys financial statements. The Company accounts for interest and penalties related to uncertain tax positions as part of its provision for federal and state income taxes.
The Companys operations are solely in the financial services industry and include providing to its customers traditional banking, equipment leasing and other financial services including investment management services. The Company operates primarily in the geographical regions of Cortland, Madison, Oneida, Onondaga, and Oswego counties of New York State, and from a Trust Administration Center in Buffalo, NY. In addition, Alliance Leasing conducts business in over thirty states. While the Companys chief decision-makers monitor the revenue streams of the various Company products and services, the segments that could be separated from the Companys primary business of banking do not meet the criteria for separate disclosure. Accordingly, all of the Companys financial service operations are considered by management to be combined in one reportable operating segment.
Investment Assets Under Management
Assets held in fiduciary or agency capacities for customers are not included in the accompanying consolidated statements of condition, since such items are not assets of the Company. Fees associated with providing investment management services are recorded using a method that approximates the accrual basis.
Reclassifications are made to prior years consolidated financial statements, when necessary, to conform to the current years presentation. These reclassifications have no effect on net income as previously reported.
The amortized cost and estimated fair value of securities at December 31 are as follows (in thousands):