Arrow Financial 10-K 2008
Documents found in this filing:
ARROW FINANCIAL CORPORATION
FORM 10-K TABLE OF CONTENTS
*These items are incorporated by reference to the Corporations Proxy Statement for the Annual Meeting of Shareholders to be held April 30, 2008.
NOTE ON TERMINOLOGY
In this Annual Report on Form 10-K, the terms Arrow, the registrant, the company, we, us, and our generally refer to Arrow Financial Corporation and its subsidiaries as a group, except where the context indicates otherwise. Arrow is a two-bank holding company headquartered in Glens Falls, New York. Our banking subsidiaries are Glens Falls National Bank and Trust Company (Glens Falls National) whose main office is located in Glens Falls, New York, and Saratoga National Bank and Trust Company (Saratoga National) whose main office is located in Saratoga Springs, New York. Subsidiaries of Glens Falls National include Capital Financial Group, Inc. (an insurance agency specializing in selling and servicing group health care policies), North Country Investment Advisers, Inc. (a registered investment adviser that provides investment advice to our proprietary mutual funds) and Arrow Properties, Inc., a real estate investment trust (REIT).
At certain points in this Report, our performance is compared with that of our peer group of financial institutions. Unless otherwise specifically stated, this peer group is comprised of the group of 273 domestic bank holding companies with $1 to $3 billion in total consolidated assets as identified in the Federal Reserve Boards Bank Holding Company Performance Report for December 2007, and peer group data has been derived from such Report. This peer group is not, however, identical to either of the peer groups comprising the two bank indices included in the stock performance graphs on pages 11 and 12 of this Report.
The information contained in this Annual Report on Form 10-K contains statements that are not historical in nature but rather are based on our beliefs, assumptions, expectations, estimates and projections about the future. These statements are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and involve a degree of uncertainty and attendant risk. Words such as expects, believes, anticipates, estimates and variations of such words and similar expressions often identify such forward-looking statements. Some of these statements, such as those included in the interest rate sensitivity analysis in Item 7A of this Report, entitled Quantitative and Qualitative Disclosures About Market Risk, are merely presentations of what future performance or changes in future performance would look like based on hypothetical assumptions and on simulation models. Other forward-looking statements are based on our general perceptions of market conditions and trends in activity, both locally and nationally, as well as current management strategies for future operations and development.
Examples of forward-looking statements in this Report are referenced in the table below:
These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to quantify or, in some cases, to identify. In the case of all forward-looking statements, actual outcomes and results may differ materially from what the statements predict or forecast.
Factors that could cause or contribute to such differences include, but are not limited to; unexpected changes in economic and market conditions, including unanticipated fluctuations in interest rates; severe changes in credit markets, including credit insurance markets; new developments in state and federal regulation of financial institutions; enhanced competition from unforeseen sources; new emerging technologies; unexpected loss of key personnel; and similar risks inherent in banking operations or business generally. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to revise or update these forward-looking statements to reflect the occurrence of unanticipated events.
USE OF NON-GAAP FINANCIAL MEASURES
The Securities and Exchange Commission (SEC) has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain non-GAAP financial measures. GAAP is generally accepted accounting principles in the United States of America. Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the companys reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. As a parallel measure with Regulation G, the SEC has provided in Item 10 of its Regulation S-K, that public companies must make the same types of supplemental disclosures whenever they include non-GAAP financial measures in their filings with the SEC. The SEC has exempted from the definition of non-GAAP financial measures certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures or SEC filings, supplemental information is not required. The following measures used in this Report, which although commonly utilized by financial institutions have not been specifically exempted by the SEC, may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them.
Tax-Equivalent Net Interest Income and Net Interest Margin: Net interest income, as a component of the tabular presentation by financial institutions of Selected Financial Information regarding their recently completed operations, is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added back to the net interest income total.
This adjustment is considered helpful in comparing one financial institution's net interest income to that of another institution, to correct any distortion that might otherwise arise from the fact that the two institutions typically will have different proportions of tax-exempt items in their portfolios. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average earning assets. For purposes of this measure as well, tax-equivalent net interest income is generally used by financial institutions, again to provide a better basis of comparison from institution to institution. We follow these practices.
The Efficiency Ratio: Financial institutions often use an "efficiency ratio" as a measure of expense control. The efficiency ratio typically is defined as the ratio of noninterest expense to net interest income and noninterest income. Net interest income as utilized in calculating the efficiency ratio is typically expressed on a tax-equivalent basis. Moreover, most financial institutions, in calculating the efficiency ratio, also adjust both noninterest expense and noninterest income to exclude from these items (as calculated under GAAP) certain component elements, such as intangible asset amortization (deducted from noninterest expense) and securities gains or losses (excluded from noninterest income). We follow these practices.
Item 1. Business
Our holding company, Arrow Financial Corporation, a New York corporation, was incorporated on March 21, 1983 and is registered as a bank holding company within the meaning of the Bank Holding Company Act of 1956. Arrow owns (directly or indirectly) two nationally chartered banks in New York (Glens Falls National and Saratoga National), an insurance agency (Capital Financial Group, Inc.), a registered investment adviser that advises our proprietary mutual funds (North Country Investment Advisers, Inc.), a Real Estate Investment Trust (Arrow Properties, Inc.) and five other non-bank subsidiaries whose operations are insignificant.
The holding companys business consists primarily of the ownership, supervision and control of our two banks. The holding company provides various advisory and administrative services and coordinates the general policies and operation of the banks. There were 448 full-time equivalent employees at December 31, 2007.
We offer a full range of commercial and consumer banking and financial products. Our deposit base consists of deposits derived principally from the communities we serve. We target our lending activities to consumers and small and mid-sized companies in our immediate geographic areas. Through our banks' trust operations, we provide retirement planning, trust and estate administration services for individuals, and pension, profit-sharing and employee benefit plan administration for corporations.
In April 2005, Arrows subsidiary banks acquired from HSBC Bank USA, N.A. (HSBC) three bank branches located within the banks service areas. Glens Falls National acquired two HSBC branches located in Argyle and Salem, New York, and Saratoga National acquired a branch located in Corinth, New York. The banks acquired substantially all deposit liabilities, the physical facilities and certain loans related to the branches. At the closing of the acquisitions, total deposits of the three branches were approximately $62 million and the related loans were approximately $8 million. The acquisition resulted in total intangible assets, including goodwill, of approximately $5.9 million.
In November 2004, Glens Falls National acquired all of the outstanding shares of common stock of Capital Financial Group, Inc. (CFG), an insurance agency headquartered in South Glens Falls, New York, which specializes in group health and life insurance products. The acquisition was structured as a tax-free exchange of Arrows common stock for CFGs common stock. CFGs president and staff continued with CFG after the acquisition. As adjusted for cumulative contingent payments, we recorded the following intangible assets as a result of the acquisition (none of which are deductible for income tax purposes): goodwill ($1.623 million), covenant not to compete ($117 thousand) and portfolio expirations ($686 thousand). The value of the covenant is being amortized over five years and the value of the expirations is being amortized over twenty years. Under the acquisition agreement, we issued 66,630 shares of Arrows common stock at closing. The agreement also provides for annual contingent future payments of Arrow common stock, based upon earnings of CFG, adjusted as provided in the agreement, over a five-year period. We concluded that under criteria established by Statement of Financial Accounting Standards (SFAS) No. 141 Business Combinations, these contingent future payments would be recorded as additional goodwill at the time of payment. The maximum contingent payment over the five-year period is $3.0 million of Arrow stock, valued at the market price on the date of payment. Through December 31, 2007, total contingency payments amounted to $244 thousand (9,380 shares).
In 2000, Glens Falls National formed a subsidiary, North Country Investment Advisers, Inc. (NCIA), which is an investment adviser registered with the U. S. Securities and Exchange Commission. NCIA advises two SEC-registered mutual funds, the North Country Intermediate Bond Fund™ and the North Country Equity Growth Fund™. Currently, the investors in these funds consist primarily of individual, corporate and institutional trust customers of our Banks. However, the funds are also offered on a retail basis at most of the branch locations of our banks.
B. LENDING ACTIVITIES
Arrow engages in a wide range of lending activities, including commercial and industrial lending primarily to small and mid-sized companies; mortgage lending for residential and commercial properties; and consumer installment and home equity financing. We also maintain an active indirect lending program through our sponsorship of primarily automobile dealer programs under which we purchase dealer paper, primarily from dealers that meet pre-established specifications. From time-to-time we have sold a modest portion of our residential real estate loan originations into the secondary market, primarily to the Federal Home Loan Mortgage Corporation (Freddie Mac) and state housing agencies, while normally retaining the servicing rights.
In addition to sales of loans into the secondary market, we have periodically securitized some of the mortgage loans in our portfolio. In the securitized transactions, we sold mortgage loans and concurrently purchased an equivalent amount of guaranteed mortgage-backed securities issued by Freddie Mac, with the sold loans representing the underlying collateral for the pooled securities. We have no contingent liability to unrelated parites under these securitization arrangements. At December 31, 2007, the balance of these securitized loans remaining in our securities portfolio was approximately $3.5 million. In addition to interest earned on loans, we receive facility fees for various types of commercial and industrial credits, and commitment fees for extension of letters of credit and certain types of loans.
Generally, we continue to implement lending strategies and policies that are intended to protect the quality of the loan portfolio, including strong underwriting and collateral control procedures and credit review systems. It is our policy to discontinue the accrual of interest on loans when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of repayment is, in the opinion of management, uncertain (see Part II, Item 7.C.II.c. Risk Elements). Future cash payments on nonaccrual loans may be applied all to principal, although income in some cases may be recognized on a cash basis.
We lend primarily to borrowers within our geographic area. The loan portfolio does not include any foreign loans or any other significant risk concentrations. We do not participate in loan syndications, either as originator or as a participant. Most of the portfolio, in general, is fully collateralized, and many commercial loans are further secured by personal guarantees.
We do not engage in subprime mortgage lending as a business line and we do not extend or purchase so-called negative amortization, option ARMs or negative equity mortgage loans.
C. SUPERVISION AND REGULATION
The following generally describes the laws and regulations to which we are subject. Bank holding companies, banks and their affiliates are extensively regulated under both federal and state law. To the extent that the following information summarizes statutory or regulatory law, it is qualified in its entirety by reference to the particular provisions of the various statutes and regulations. Any change in applicable law may have a material effect on our business and prospects.
Arrow is a registered bank holding company within the meaning of the Bank Holding Company Act of 1956 (BHC Act) and is subject to regulation by the Board of Governors of the Federal Reserve System (FRB). Arrow is not a so-called financial holding company under federal banking law. Additionally, as a bank holding company under New York State law, Arrow is subject to a limited amount of regulation by the New York State Banking Department. Our two subsidiary banks are both nationally chartered banks and are subject to supervision and examination by the Office of the Comptroller of the Currency (OCC). The banks are members of the Federal Reserve System and the deposits of each bank are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation (FDIC). The BHC Act generally prohibits Arrow from engaging, directly or indirectly, in activities other than banking, activities closely related to banking, and certain other financial activities. Under the BHC Act, a bank holding company must obtain FRB approval before acquiring, directly or indirectly, 5% or more of the voting shares of another bank or bank holding company (unless it already owns a majority of such shares). Bank holding companies are able to acquire banks or other bank holding companies located in all 50 states. In addition, 48 of the 50 states permit banks headquartered in other states to establish branches in their states, although in some cases such branching may be achieved only by acquiring existing banks in such states. The Gramm-Leach-Bliley Act, enacted in 1999, authorized bank holding companies to affiliate with a much broader array of other financial institutions than was previously permitted, including insurance companies, investment banks and merchant banks. See Item 1.D., Recent Legislative Developments.
An important area of banking regulation is the federal banking systems promulgation and enforcement of minimum capitalization standards for banks and bank holding companies. The FRB has adopted various "capital adequacy guidelines" for its use in the examination and supervision of bank holding companies. The FRBs risk-based capital guidelines assign risk weightings to all assets and certain off-balance sheet items and establish an 8% minimum ratio of qualified total capital to the aggregate dollar amount of risk-weighted assets (which is almost always less than the dollar amount of such assets without risk weighting). Under the risk-based guidelines, at least half of total capital must consist of "Tier 1" capital, which comprises common equity, retained earnings and a limited amount of permanent preferred stock, less goodwill. Under the FRBs final rule, issued February 28, 2006, trust preferred securities may also qualify as Tier 1 capital, in an amount not to exceed 25% of Tier 1 capital. The final rule limits restricted core capital elements to a percentage of the sum of core capital elements, net of goodwill less any associated deferred tax liability. We issued trust preferred securities in 2003 and 2004 to serve as part of our core capital. Up to half of total capital may consist of so-called "Tier 2" capital, comprising a limited amount of subordinated debt, preferred stock not qualifying as Tier 1 capital, certain other instruments and a limited amount of the allowance for loan losses. The FRBs other important guideline for measuring a bank holding companys capital is the leverage ratio standard, which establishes minimum limits on the ratio of a bank holding company's "Tier 1" capital to total tangible assets (not risk-weighted). For top-rated holding companies, the minimum leverage ratio is 3%, but lower-rated companies may be required to meet substantially greater minimum ratios. Our subsidiary banks are subject to capital requirements similar to the capital requirements applicable at the holding company level described above. Our banks capital requirements have been promulgated by their primary federal regulator, the OCC.
Under applicable law, federal banking regulators are required to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. The regulators have established five capital classifications for banking institutions, the highest being "well-capitalized." Our holding company and both of our subsidiary banks currently qualify as well-capitalized. Under regulations adopted by the federal bank regulators, a banking institution is considered "well-capitalized" if it has a total risk-adjusted capital ratio of 10% or greater, a Tier 1 risk-adjusted capital ratio of 6% or greater and a leverage ratio of 5% or greater and is not subject to any regulatory order or written directive regarding capital maintenance. The year-end 2007 capital ratios of our holding company and our banks are set forth in Part II, Item 7.E. "Capital Resources and Dividends" and in Note 15 Regulatory Matters to the audited financial statements under Part II, Item 8 of this Report.
A holding company's ability to pay dividends or repurchase its outstanding stock, as well as its ability to expand its business through acquisitions of additional banking organizations or permitted non-bank companies, may be restricted if its capital falls below these minimum capitalization ratios or fails to meet other informal capital guidelines that the regulators may apply from time to time to specific banking organizations. In addition to these potential regulatory limitations on payment of dividends, our holding companys ability to pay dividends to our shareholders, and our subsidiary banks ability to pay dividends to our holding company are also subject to various restrictions under applicable corporate laws, including banking laws (affecting our subsidiary banks) and the New York Business Corporation Law (affecting our holding company). The ability of our holding company and banks to pay dividends in the future is, and is expected to continue to be, influenced by regulatory policies, capital guidelines and applicable law.
In cases where banking regulators have significant concerns regarding the financial condition, assets or operations of a bank or bank holding company, the regulators may take enforcement action or impose enforcement orders, formal or informal, against the organization.
D. RECENT LEGISLATIVE DEVELOPMENTS
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 became effective October 17, 2005. The Act addressed many areas of bankruptcy practice, including consumer bankruptcy, general and small business bankruptcy, treatment of tax claims in bankruptcy, ancillary and cross-border cases, financial contract protection amendments to Chapter 12 governing family farmer reorganization, and special protection for patients of a health care business filing for bankruptcy. This Act did not have a significant impact on our earnings or on our efforts to recover collateral on secured loans.
The Sarbanes-Oxley Act, signed into law on July 30, 2002, adopted a number of measures having a significant impact on all publicly-traded companies, including Arrow. Generally, the Act sought to improve the quality of financial reporting of these companies by compelling them to adopt good corporate governance practices and by strengthening the independence of their auditors. The Act placed substantial additional duties on directors, officers, auditors and attorneys of public companies. Among other specific measures, the Act required that chief executive officers and chief financial officers certify to the SEC in the holding companys annual and quarterly reports filed with the SEC regarding the accuracy of its financial statements contained therein and the integrity of its internal controls. The Act also accelerated insiders' reporting requirements for transactions in company securities, restricts certain executive officer and director transactions, imposed obligations on corporate audit committees, and provided for enhanced review of company filings by the SEC. As part of the general effort to improve public company auditing, the Act places limits on consulting services that may be performed by a company's independent auditors by requiring that the companys Audit Committee of the Board of Directors evaluate amounts to determine independence. The Act created a federal public company accounting oversight board (the PCAOB) to set auditing standards, inspect registered public accounting firms, and exercise enforcement powers, subject to oversight by the SEC.
In the wake of the Sarbanes-Oxley Act, the nations stock exchanges, including the exchange on which Arrows stock is listed, the National Association of Securities Dealers, Inc. (NASD), promulgated a wide array of governance standards that must be followed by listed companies. The NASD standards include having a Board of Directors the majority of whose members are independent of management, and having audit, compensation and nomination committees of the Board consisting exclusively of independent directors. We have implemented a variety of corporate governance measures and procedures to comply with Sarbanes-Oxley and the amended NASD listing requirements, although we have always relied on a Board of Directors a majority of whose members are independent and independent Board committees to make important decisions regarding the company.
The USA Patriot Act initially adopted in 2001 and re-adopted by the U.S. Congress in 2006 with certain changes (the Patriot Act), imposes substantial new record-keeping and due diligence obligations on banks and other financial institutions, with a particular focus on detecting and reporting money-laundering transactions involving domestic or international customers. The U.S. Treasury Department has issued and will continue to issue regulations clarifying the Patriot Act's requirements. The Patriot Act requires all financial institutions, including banks, to establish certain anti-money laundering compliance and due diligence programs. The provisions of the Act impose substantial additional costs on all financial institutions, including ours.
In November 1999, Congress enacted the Gramm-Leach-Bliley Act (GLBA), which permitted bank holding companies to engage in a wider range of financial activities. For example, under GLBA bank holding companies may underwrite all types of insurance and annuity products and all types of securities products and mutual funds, and may engage in merchant banking activities. Bank holding companies that wish to engage in these or other financial activities generally must do so through separate financial subsidiaries and may themselves be required to register (and qualify to register) as so-called financial holding companies. A bank holding company that does not register as a financial holding company remains a bank holding company subject to substantially the same regulatory restrictions and permitted activities as applied to bank holding companies prior to GLBA (See Item I.C., Supervision and Regulation, above). We have not as yet elected to become a financial holding company. Also under GLBA, financial institutions have become subject to stringent customer privacy regulations, in addition to the privacy provisions under the Fair Credit Reporting Act Amendment of 2003.
The FDIC collects both insurance premiums on insured deposits and an assessment for the Financing Corporation (FICO) bonds.
The FICO was established by the Competitive Equality Banking Act of 1987, and is a mixed-ownership government corporation whose sole purpose was to issue bonds to insure thrift insitutions. Outstanding FICO bonds, which are 30-year noncallable bonds with a principal amount of approximately $8.1 billion, mature in 2017 through 2019. FICO has assessment authority, separate from the FDIC's authority to assess risk-based premiums for deposit insurance, to collect funds from all FDIC-insured institutions sufficient to pay interest on FICO bonds. The FDIC acts as collection agent for the FICO. Since the first quarter of 2000, all FDIC-insured deposits have been assessed at the same rate by FICO. For 2007, our FICO assessment was approximately $140,000.
In 2007 the FDIC resumed charging financial institutions a premium under the new risk-based assessment system. Under this system, institutions in Risk Category I (the lowest of four risk categories) will pay a rate (based on a formula) of 5 to 7 cents per $100 of assessable deposits. Both of our banks qualified for the 5 cent per $100 assessment rate during 2007.
The Federal Deposit Insurance Reform Act of 2005 allowed "eligible insured depository institutions" to share a one-time assessment credit pool of approximately $4.7 billion. Our credit amounted to $747,000. The credit was available to offset 2007 FDIC insurance premiums, but not to offset the FICO bond assessment, which will continue through 2019. The one-time credit fully offset our FDIC insurance premiums for 2007 and will offset approximately $133 thousand of our 2008 premiums.
Various federal bills that would significantly affect banks are introduced in Congress and the New York State Legislature from time to time. We cannot estimate the likelihood of any currently proposed banking bills being enacted into law, or the ultimate effect that any such potential legislation, if enacted, would have upon our financial condition or operations.
E. STATISTICAL DISCLOSURE (GUIDE 3)
Set forth below is an index identifying the location in this Report of various items of statistical information required to be included in this Report by the SECs industry guide for Bank Holding Companies.
We face intense competition in all markets we serve. Traditional competitors are other local commercial banks, savings banks, savings and loan institutions and credit unions, as well as local offices of major regional and money center banks. Also, non-banking financial organizations, such as consumer finance companies, insurance companies, securities firms, money market and mutual funds and credit card companies offer substantive equivalents of the various loan and financial products and transactional accounts that we offer, even though these non-banking organizations are not subject to the same regulatory restrictions and capital requirements that apply to us. Under federal banking laws, such non-banking financial organizations not only may offer products comparable to those offered by commercial banks, but also may establish or acquire their own commercial banks.
G. EXECUTIVE OFFICERS OF THE REGISTRANT
The names and ages of the executive officers of Arrow and positions held by each are presented in the following table. Officers are elected annually by the Board of Directors.
H. AVAILABLE INFORMATION
Our Internet address is www.arrowfinancial.com. We make available free of charge on or through our Internet website our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports as soon as practicable after we file or furnish them with the SEC pursuant to the Exchange Act. We also make available on the internet website various other documents related to corporate operations, including our Corporate Governance Guidelines, the charters of our principal board committees, and our codes of ethics. We have adopted a financial code of ethics that applies to Arrows chief executive officer, chief financial officer and principal accounting officer and a business code of ethics that applies to all directors, officers and employees.
Item 1A. Risk Factors
Our financial results and the market price of our stock in future periods are subject to risks arising from many factors, including:
If economic conditions worsen or the U.S. experiences a nationwide recession, the companys allowance for loan losses may not be adequate to cover actual losses. Like all financial institutions, we maintain an allowance for loan losses to provide for loan defaults and uncollectibility. Our allowance for loan losses is based on our historical loss experience as well as an evaluation of the risks associated with our loan portfolio, including the size and composition of the portfolio, current economic conditions and geographic concentrations within the portfolio and other factors. For a variety of reasons, including falling home prices nationwide and a general deterioration in U.S. credit markets over the past six months to one year, the rate of growth in the national economy slowed dramatically in the fourth quarter of 2007 and available data suggests that economic conditions may continue to deteriorate in upcoming periods. If the economy in our geographic market area, Northeastern New York State, should deteriorate or enter into a recession state, this may have an adverse impact on our loan portfolio. If the quality of our portfolio should weaken, our allowance for loan losses may not be adequate to cover actual loan losses, and future provisions for loan losses could materially and adversely affect financial results. Moreover, loan portfolio difficulties often accompany difficulties in other areas of our business, including our investment portfolio and growth of our business generally, thereby compounding the negative effects on earnings.
The domestic interest rate environment could negatively affect the companys net interest income. An institutions net interest income is significantly affected by market rates of interest, including short-term and long-term rates and the relationship between the two. Interest rates are highly sensitive to many factors, which are beyond our control, including general economic conditions, policies of various governmental and regulatory agencies such as the Federal Reserve Board, and actions taken by foreign central banks. Like all financial institutions, the Companys balance sheet is affected by fluctuations in interest rates. Volatility in interest rates can also result in the flow of funds away from financial institutions. See the discussion under Changes in Net Interest Income Due to Rate, on page 18 of this Report.
The financial services industry is highly competitive, and competitive pressures could intensify and adversely affect the companys financial results. We operate in a highly competitive industry that could become even more competitive as a result of legislative, regulatory and technological changes and continued entry into the banking business by non-banking companies. Traditionally we compete with other commercial banks, savings and loan associations, mutual savings banks, finance companies, mortgage banking companies, credit unions and investment companies. However, technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks. Many of these new competitors have fewer regulatory constraints and some have lower cost structures.
Changes in accounting standards may materially impact the companys financial statements. From time to time, the Financial Accounting Standards Board (FASB) changes the financial accounting and reporting standards that govern the preparation of our financial statements. These changes can be hard to predict and can materially impact how we record and report our financial condition and results of operations. In some cases, we may be required to apply a new or revised standard retroactively, resulting in changes to previously reported financial statements.
The companys business could suffer if it loses key personnel unexpectedly or fails to provide for an orderly management succession. Our success depends, in large part, on our ability to retain our key personnel for the duration of their expected terms of service, and to arrange for an orderly succession of other, equally skilled personnel. Competition for the best people in our business can be intense. While our Board of Directors actively reviews succession plans, any sudden change at the senior management level may adversely affect our business.
The company relies on other companies to provide key components of the companys business infrastructure. Third-party vendors provide key components of our business infrastructure such as internet connections, network access and mutual fund distribution. These parties are beyond our control, and any problems caused by these third parties, including their not providing us their services or performing such services poorly, could adversely affect our ability to deliver products and services to our customers and conduct our business.
Significant legal actions could subject the company to substantial uninsured liabilities. From time to time we are subject to claims related to our operations. These claims and legal actions, including supervisory actions by our regulators, could involve large monetary claims and significant defense costs. To protect ourselves from the cost of these claims, we maintain insurance coverage in amounts and with deductibles that we believe are appropriate for our operations, but this insurance coverage may not cover all claims against us or may increase substantially in cost. As a result, we may be exposed to significant uninsured liabilities, which could adversely affect our results of operations and financial condition.
The company is exposed to risk of environmental liability when it takes title to properties. In the course of our business, we may foreclose on and take title to real estate, including commercial real estate, and could be subject to environmental liabilities with respect to these properties. We may be held liable for substantial amounts to a government entity or to third parties for property damage, personal injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination or may be required to investigate or clean up hazardous or toxic substances or chemical releases at a property. In addition, if we are the owner or former owner of a contaminated site, we may be subject to common law claims by third parties based on damages and costs resulting from environmental contamination emanating from the property.
The company faces continuing and growing security risks to its own information base and to information on its customers. The computer systems and network infrastructure that we use, are always vulnerable to unforeseen problems, including theft of confidential customer information (identity theft) and interruption of service as a result of fire, natural disasters, explosion or general infrastructure failure. These problems may arise in both our internally developed systems and the systems of our third-party service providers. We constantly assess and attempt to improve our security systems and disaster preparedness, but the risks in these areas are substantially escalating.
The companys stock price can be volatile. Our stock price can fluctuate widely in response to a variety of factors, including: actual or anticipated variations in our operating results; recommendations by securities analysts; significant acquisitions or business combinations; operating and stock price performance of other companies that investors deem comparable to us; new technology used or services offered by our competitors; news reports relating to trends, concerns and other issues in the financial services industry; and changes in government regulations. Many of these factors that may adversely affect our stock price do not directly pertain to our operating results, including general market fluctuations, industry-wide factors and economic and general political conditions and events, including terrorist attacks, economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations.
If the value of real estate in our market area were to decline materially, a significant portion of our loan portfolio could become under-collateralized, which might have a material adverse effect on us. In addition to considering the financial strength and cash flow characteristics of borrowers, we often secure loans with real estate collateral, which in each case provides an alternate source of repayment in the event of default by the borrower. This real property may deteriorate in value during the time the credit is outstanding. If we are required to liquidate the collateral securing a loan to satisfy the debt during a period of reduced real estate values, our earnings and capital could be adversely affected. Our geographic market area experienced real estate price appreciation in the period 2002-2007 but property values in our region have recently leveled off and future declines in property values, of the sort being experienced elsewhere in the U.S. currently, are quite possible.
We are subject to the local economies where we operate, and unfavorable economic conditions in these areas could have a material adverse effect on our financial condition and results of operations. Our success depends upon the growth in population, income levels and deposits in our geographic market area. Unpredictable and unfavorable economic conditions unique to our market area may have an adverse effect on the quality of our loan portfolio and financial performance. As a community bank, we are less able than our larger regional competitors to spread the risk of unfavorable local economic conditions over a larger market area. Moreover, we cannot give any assurances that we will benefit from any unique and favorable economic conditions in our market area, even if they do occur.
We may be adversely affected by government regulation. We are subject to extensive federal and state banking regulations and supervision. Banking regulations are intended primarily to protect our depositors funds and the federal deposit insurance funds, not the companys shareholders. Regulatory requirements affect our lending practices, capital structure, investment practices, dividend policy and growth. Failure to meet minimum capital requirements could result in the imposition of limitations on our operations that would adversely impact our operations and could, if capital levels dropped significantly, result in our being required to cease or scale back our operations. Changes in governing law, regulations or regulatory practices could impose additional costs on us or adversely affect our ability to obtain deposits or make loans and thereby hurt our revenues and profitability.
Item 1.B. Unresolved Staff Comments - None
Item 2. Properties
Our main office is at 250 Glen Street, Glens Falls, New York. The building is owned by us and serves as the main office for Glens Falls National Bank, our principal subsidiary. We own twenty-seven branch offices and lease six others at market rates.
In the opinion of management, the physical properties of our holding company and our subsidiary banks are suitable and adequate. For more information on our properties, see Notes 1, 6 and 22 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.
Item 3. Legal Proceedings
We are not the subject of any material pending legal proceedings, other than ordinary routine litigation occurring in the normal course of our business. On an ongoing basis, we are the subject of or a party to various legal claims, which arise in the normal course of our business. The various pending legal claims against us will not, in the opinion of management based upon consultation with counsel, result in any material liability.
Item 4. Submission of Matters to a Vote of Security Holders
None in the fourth quarter of 2007.
Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity
The common stock of Arrow Financial Corporation is traded on The Nasdaq Stock MarketSM under the symbol AROW.
The high and low prices listed below represent actual sales transactions, as reported by Nasdaq. All stock prices and cash dividends per share have been restated to reflect subsequent stock dividends. On September 28, 2007, we distributed a 3% stock dividend on our outstanding shares of common stock.
The payment of cash dividends by Arrow is at the discretion of its Board of Directors and is dependent upon, among other things, our earnings, financial condition and other factors, including applicable legal and regulatory restrictions. See "Capital Resources and Dividends" in Part II, Item 7.E. of this report.
There were approximately 5,811 holders of record of Arrows common stock at December 31, 2007. Arrow has no other class of stock outstanding.
Equity Compensation Plan Information
The following table sets forth certain information regarding Arrow's equity compensation plans as of December 31, 2007. These equity compensation plans were our 1993 Long Term Incentive Plan ("1993 Stock Plan"), our 1998 Long Term Incentive Plan ("1998 Stock Plan"), our Director, Officer and Employee Stock Purchase Plan ("ESPP") and our Directors' Stock Plan. Consistent with applicable law and regulation, the 1993 Stock Plan and the 1998 Stock Plan were approved by Arrow's shareholders, while the ESPP and the Directors' Plan were not.
(1) Includes 426,477 shares of common stock issuable pursuant to outstanding stock options granted under the 1998 Stock Plan and 93,080 shares of common stock issuable pursuant to outstanding stock options granted under the 1993 Stock Plan.
(2) Under the terms of the 1998 Stock Plan, the ability to issue options or other stock-based awards expired in January 2008. On that date, there remained available for issue but unissued 151,278 shares of common stock. Awards under the 1993 Stock Plan expired in 2003. The Company is submitting a new 2008 Long-Term Incentive Plan for shareholder approval at its 2008 annual meeting of shareholders.
(3) Includes 2,094 shares of common stock available for future issuance under the Directors Stock Plan and 559,671 shares of common stock available for future issuance under the ESPP. The company is preparing to amend the Directors Stock Plan to add 30,000 shares of common stock to the total of authorized shares issuable thereunder; the amendment will be submitted for shareholder approval at the 2008 annual meeting of shareholders.
Description of Non-Shareholder Approved Plans.
Director, Officer and Employee Stock Purchase Plan. The Director, Officer and Employee Stock Purchase Plan was adopted by the Board of Directors in 2000. Under the plan, eligible participants (currently directors, officers, full-time employees and certain retirees) are permitted to acquire shares of common stock at a price that represents a small discount from the current market price of the stock by authorizing regular withholding from their paychecks or, in the case of directors or retirees, regular withdrawals from their bank deposit accounts. Participants may also purchase shares on an ad hoc basis through optional cash contributions. The discount on shares acquired through regular withholdings or withdrawals is 5%. The discounted price only applies to the first $1,000 of a participant's monthly contribution; after that threshold is reached, shares are purchased at 100% of market price. The total number of shares originally authorized for purchase under the Plan, as adjusted, was 775,546 shares. There are maximum and minimum levels for participant contributions, which the Board of Directors may change from time to time.
Directors' Stock Plan. The Directors' Stock Plan was originally adopted by the Board of Directors in 1999. It provides for the automatic issuance of shares of Common Stock to directors of Arrow and its subsidiary banks in lieu of cash director fees otherwise payable to them. The portion of their cash directors fees payable in stock is fixed each year in advance by a vote of the full Board of Directors. The total number of shares authorized for issuance under the Plan, as adjusted through December 31, 2007, is 32,736 shares.
STOCK PERFORMANCE GRAPHS
The following two graphs provide a comparison of the total cumulative return (assuming reinvestment of dividends) for the common stock of Arrow as compared to the Russell 2000 Index, the SNL NASDAQ Bank Index and the SNL Bank $1-$5B Index. The historical information set forth below may not be indicative of future results. The first graph presents the five year period from December 31, 2002 to December 31, 2007 and the second graph presents the ten year period from December 31, 1997 to December 31, 2007.
Source: SNL Financial LC, Charlottesville, VA © 2008
Source: SNL Financial LC, Charlottesville, VA © 2008
Unregistered Sales of Equity Securities
In connection with Arrows acquisition in 2004 of Capital Financial Group, Inc. (CFG), an insurance agency specializing in the sale of group health and life insurance products, Arrow issued 66,630 shares of its common stock to the former sole shareholder of CFG, John Weber, in exchange for Mr. Webers CFG shares. The acquisition agreement contained a post-closing purchase price adjustment provision, under which Arrow would also pay to Mr. Weber, over the 5-year period following closing, additional consideration in the form of additional shares of Arrows common stock, depending on the financial performance of CFG as a subsidiary of Arrow during such period. Under this provision, Arrow issued an additional 9,380 shares to Mr. Weber from 2005 to 2007. All shares issued to Mr. Weber at the original closing and in post-closing adjustments were issued without registration under the Securities Act of 1933, as amended, in reliance upon the exemption for such registration set forth in Section 3(a)(11) of the Act and Rule 147 promulgated by the Securities and Exchange Commission thereunder. This exemption was available because Mr. Weber was and remains a New York resident, and CFG was and remains a New York corporation having substantially all of its assets and business operations in the State of New York.
Issuer Purchases of Equity Securities
The following table presents information about repurchases by us during the three months ended December 31, 2007 of our common stock (our only class of equity securities registered pursuant to Section 12 of the Securities Exchange Act of 1934):
1The total number of shares purchased and the average price paid per share include shares purchased in open market transactions under the Arrow Financial Corporation Automatic Dividend Reinvestment Plan (the DRIP) by the administrator of the DRIP and shares surrendered or deemed surrendered to Arrow by holders of options to acquire Arrow common stock in connection with the exercise of such options. In the months indicated, the listed number of shares purchased included the following numbers of shares purchased through such methods: October 2007 - DRIP purchases (2,388 shares); November 2007 DRIP purchases (4,369 shares), stock options (19,828 shares); December 2007 DRIP purchases (19,078 shares), stock options (3,584 shares). DRIP purchases do not reflect so-called netting transactions, that is, purchases effected within the DRIP itself by the DRIP administrator consisting of monthly acquisitions of shares by purchasing participants who are investing funds in the plan from other selling participants who are withdrawing funds from the plan.
2Includes only those shares acquired by Arrow pursuant to publicly-announced stock repurchase programs. Does not include shares purchased or subject to purchase under the DRIP or any compensatory stock plan. Our only current publicly-announced stock repurchase program is the program approved by the Board of Directors and announced in April 2007 under which the Board authorized a twelve-month maximum cumulative purchase of $6,000,000 in stock.
Item 6. Selected Financial Data
FIVE YEAR SUMMARY OF SELECTED DATA
Arrow Financial Corporation and Subsidiaries
(Dollars In Thousands, Except Per Share Data)
1Share and per share amounts have been adjusted for subsequent stock splits and dividends, including the most recent September
2007 3% stock dividend.
2Tangible book value excludes intangible assets from total equity.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table presents selected quarterly information for the fourth quarter of 2007 and the preceding four quarters:
Selected Quarterly Information:
(Dollars In Thousands, Except Per Share Amounts)
Share and per share amounts have been adjusted for subsequent stock dividends, including the most recent September 2007 3% stock dividend.
1 See Use of Non-GAAP Financial Measures on page 3.
Selected Twelve-Month Information:
(Dollars In Thousands, Except Per Share Amounts)
Share and per share amounts have been adjusted for subsequent stock dividends, including the most recent September 2007 3% stock dividend.
1 See Use of Non-GAAP Financial Measures on page 3.
CRITICAL ACCOUNTING POLICIES
In order to prepare our consolidated financial statements in accordance with accounting principles generally accepted in the United States of America, we were required to make estimates and assumptions that affected the amounts reported in these statements. There are uncertainties inherent in making these estimates and assumptions, which could materially affect our results of operations and financial position. We consider the following to be critical accounting policies:
The allowance for loan losses: The adequacy of the allowance for loan losses is sensitive to changes in current economic conditions that may make it difficult for borrowers to meet their contractual obligations. Any downward trend in the economy, regional or national, may require us to increase the allowance for loan losses resulting in a negative impact on our results of operations and financial condition at the same time that other areas of our operations, including new loan originations and assets under administration in our trust department may also be experiencing negative pressures from the same underlying negative economic conditions.
Liabilities for retirement plans: We have a variety of pension and retirement plans. Liabilities under these plans rely on estimates of future salary increases, numbers of employees and employee retention, discount rates and long-term rates of investment return. Changes in these assumptions due to changes in the financial markets, the economy, our own operations or applicable law and regulation may result in material changes to our liability for postretirement expense, with consequent impact on our results of operations and financial condition.
Valuation allowance for deferred tax assets: SFAS No. 109 Accounting for Income Taxes, requires a reduction in the carrying amount of deferred tax assets by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. Our analysis of the need for a valuation allowance for deferred tax assets is, in part, based on an estimate of future taxable income.
Goodwill: SFAS No. 142 Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at a level of reporting referred to as a reporting unit. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of a reporting unit with its carrying amount, including goodwill. The second step of the goodwill impairment test, used to measure the amount of impairment loss, compares the implied fair value of a reporting units goodwill with the carrying amount of that goodwill.
Other than temporary decline in the value of debt and equity securities: SFAS No. 115 Accounting for Certain Investments in Debt and Equity Securities, requires that, for individual securities classified as either available-for-sale or held-to-maturity, an enterprise shall determine whether a decline in fair value below the amortized cost basis is other than temporary. For example, if it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred. If the decline in fair value is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value as a new cost basis and the amount of the write-down shall be included in current period earnings. A significant economic downturn might result in an other-than-temporary impairment in securities held in our portfolio.
The following discussion and analysis focuses on and reviews our results of operations for each of the years in the three-year period ended December 31, 2007 and our financial condition as of December 31, 2007 and 2006. The discussion below should be read in conjunction with the selected quarterly and annual information set forth above and the consolidated financial statements and other financial data presented elsewhere in this Report. When necessary, prior-year financial information has been reclassified to conform to the current-year presentation.
Summary of 2007 Financial Results
We reported net income of $17.3 million for 2007, an increase of $440 thousand, or 2.6%, compared to 2006. Diluted earnings per share of $1.61 represented an increase of $.08, or 5.2%, from 2006. During 2007, our net interest margin stabilized and net interest income increased from 2006. This followed two successive years of decreasing net interest income and three consecutive years of decreasing net interest margins. Out net interest margin was essentially the same as in 2006, and our increase in net interest income from 2006 to 2007 was attributable to a 2.4% increase in average earning assets.
We recorded a non-cash pre-tax charge in the fourth quarter of 2007 of $600 thousand related to our proportionate share, as a member bank of the Visa credit card organization, of certain estimated litigation costs incurred by Visa U.S.A., Inc. in the quarter. Like other financial institutions that are Visa members, we are obligated to indemnify Visa in connection with certain legal proceedings. While the outcome and amount of potential losses that may be incurred by Visa, and ultimately by its member banks, related to litigation involving Visa and certain of its member banks is inherently uncertain, based on the settlement of the litigation with American Express and our estimate of the fair value of potential losses related to the remaining litigation, we recognized an after-tax charge to fourth quarter earnings of $362 thousand representing a 3.4 cents dilution of earnings per share for the fourth quarter and the year ended December 31, 2007. However, in October 2007, Visa, in connection with a restructuring, issued shares of its common stock to its member banks in contemplation of an initial public offering (IPO) of these and other shares which Visa has indicated is planned for the first half of 2008. Visa has indicated that it intends that payments related to its antitrust litigation matters will be funded from an escrow account to be established with a portion of the proceeds from its IPO, including proceeds allocable to member banks shares. We currently expect that our proportional share of the proceeds of Visas planned IPO in 2008 will exceed the aggregate amount of this charge, and if so, that the income to us in 2008 will exceed the 2007 charge. On February 25, 2008, Visa, Inc. filed an amended Form S-1 registration statement for its Class A common stock public offering with a price range of $37.00 to $42.00 per share, but Visa has not yet set a date for the IPO.
At December 31, 2007, our tangible book value per share (calculated based on shareholders equity reduced by intangible assets including goodwill and other intangible assets) amounted to $9.94, an increase of $.66, or 7.1%, from year-end 2006. Our total shareholders equity at year-end 2007 increased 3.5% over the year-end 2006 level. Major changes to shareholders equity included: i) $17.3 million of net income for the year ii) a $3.7 million net unrealized gain in the valuation allowance for available-for-sale securities, offset by iii) cash dividends of $10.0 million, and iv) repurchases of our own common stock of $7.3 million. As of the last trading day of 2007, the average of our closing bid and asked stock price was $21.43, resulting in a trading multiple of 2.16 to tangible book value.
The Board of Directors declared a quarterly cash dividend of $.24 per share for the fourth quarter of 2007. For the year, total cash dividends (as adjusted for stock dividends) were $.94 compared to $.91 for 2006, an increase of $.03, or 3.3%.
Through year-end 2007, we had experienced an improvement in the credit quality of our loan portfolio; assets continued to demonstrate considerable strength, both as compared to our peer banks and to our historically sound asset quality levels. Nonperforming loans amounted to $2.2 million at December 31, 2007, a decrease of $593 thousand from the prior year-end. The ratio of nonperforming loans to period-end loans was .21% at December 31, 2007, a decrease from .28% one year earlier. Loans charged-off (net of recoveries) against the allowance for loan losses were $390 thousand for 2007, as compared to $789 thousand for the prior year. At year-end 2007, the allowance for loan losses was $12.4 million, representing 1.19% of total loans, down three basis points from 1.22% at the prior year-end.
B. RESULTS OF OPERATIONS
The following analysis of net interest income, the provision for loan losses, noninterest income, noninterest expense and income taxes, highlights the factors that had the greatest impact on our results of operations for 2007 and the prior two years.
I. NET INTEREST INCOME (Tax-equivalent Basis)
Net interest income represents the difference between interest, dividends and fees earned on loans, securities and other earning assets and interest paid on deposits and other sources of funds. Changes in net interest income result from changes in the level and mix of earning assets and sources of funds (volume) and changes in the yields earned and interest rates paid (rate). Net interest margin is the ratio of net interest income to average earning assets. Net interest income may also be described as the product of average earning assets and the net interest margin. As described in the section entitled Use of Non-GAAP Financial Measures on page 3 of the Report we calculate net interest income on a tax-equivalent basis.
CHANGE IN NET INTEREST INCOME
(Dollars In Thousands) (Tax-equivalent Basis)
On a tax-equivalent basis, net interest income was $49.2 million in 2007, an increase of $959 thousand, or 2.0%, from $48.3 million in 2006. This compared to a decrease of $2.3 million, or 4.5%, between 2005 and 2006. Factors contributing to the decrease in net interest income over the three-year period are discussed in the following portions of this Section B.I.
In the following table, net interest income components are presented on a tax-equivalent basis. Changes between periods are attributed to movement in either the average daily balances or average rates for both earning assets and interest-bearing liabilities. Changes attributable to both volume and rate have been allocated proportionately between the categories.
The following table reflects the components of our net interest income, setting forth, for years ended December 31, 2007, 2006 and 2005 (i) average balances of assets, liabilities and shareholders' equity, (ii) interest and dividend income earned on earning assets and interest expense incurred on interest-bearing liabilities, (iii) average yields earned on earning assets and average rates paid on interest-bearing liabilities, (iv) the net interest spread (average yield less average cost) and (v) the net interest margin (yield) on earning assets. Interest income and interest rate information is presented on a tax-equivalent basis (see the discussion under Use of Non-GAAP Financial Measures on page 3 of the Report). The yield on securities available-for-sale is based on the amortized cost of the securities. Nonaccrual loans are included in average loans.
Average Consolidated Balance Sheets and Net Interest Income Analysis
(Tax-equivalent basis using a marginal tax rate of 35%)
(Dollars in Thousands)
CHANGES IN NET INTEREST INCOME DUE TO RATE
After two years of decreases in net interest income, we experienced an increase in net interest income of $959 thousand from 2006 to 2007. An increase in average net earning assets (i.e., changes in volume), had a $1.2 million positive impact on net interest income, which more than offset a $220 thousand negative effect of a one basis point decrease in net interest margin (i.e. changes in rates). We experienced a decrease in net interest income of $2.3 million from 2005 to 2006. Although we experienced an increase in average net earning assets (i.e., changes in volume), which had an $878 thousand positive impact on net interest income, this was more than offset by the negative effect of a decrease in our net interest spread and net interest margin (i.e. changes in rates), which had a negative impact of $3.1 million on net interest income.
Generally, the following items have a major impact on changes in net interest income due to rate: general interest rate changes, the ratio of our rate sensitive assets to rate sensitive liabilities (interest rate sensitivity gap) during periods of interest rate changes, and changes in the level of nonperforming loans.
Impact of Interest Rate Changes 2002 2007
In mid-2003, due to actions by the Federal Reserve (Fed) the federal funds target rate decreased to an almost unprecedented low of 1.00%. In mid-2004, the Federal Reserve Board reversed course and began to increase short-term rates with a series of 25 basis point increases in the targeted federal funds rate, reaching 5.25% by mid-2006. From mid-2006 to fall 2007, the Fed did not take any actions to change short-term rates. In September 2007, however, in response to perceptions of a weakening economy and a loss of liquidity in the short-term credit market, precipitated in large part by problems related to subprime residential real estate lending, the Fed began lowering the federal funds target rate. By the December 2007 meeting of the Board of Governors, the rate had decreased 100 basis points, to 4.25%, and in early 2008, the Fed, in response to continuing liquidity concerns in the credit markets, lowered the federal funds rate by an additional 125 basis points, to 3.00%. We expect to see an immediate impact in the cost of our deposits, which will be followed by a gradual reduction as maturing time deposits reprice. We also expect that our loan yields will decline, but that decrease may not be as severe if mid- to long-term rates do not fall as quickly or to the extent of short-term rates.
Our net interest margin has traditionally been sensitive to and impacted by changes in prevailing market interest rates. The following analysis of the relationship between prevailing rates (and changes in rates) and our net interest margin and net interest income covers the period from 2002 to the present.
An important recent development with regard to the effect of rate changes in our profitability has been the so-called flattening of the yield curve. After the Fed began increasing short-term interest rates in June 2004, the yield curve did not maintain its traditional upward curve but flattened; that is, as short-term rates increased, longer-term rates stayed unchanged or decreased. Therefore, the traditional spread between short-term rates and long-term rates (the upward yield curve) essentially disappeared, i.e., the curve had flattened. Late in 2006 and in early 2007, the yield curve was occasionally inverted, with short-term rates exceeding long-term rates. This flattening of the yield curve was the most significant factor in reducing our net interest income in 2005 and 2006. Only at the end of the second quarter of 2007 did the yield on longer-term securities begin to increase over short-term investments. This was further enhanced when long-term rates held steady after the Fed lowered short-term rates in September 2007.
Nevertheless, longer-term rates were resistant to increases during the period of rising short-term rates, both due to borrower expectations and to a widespread perception in the credit markets of limited risk of default. To the extent these perceptions and expectations are now changing, long-term rates may be expected to remain steady, or perhaps even rise, even though short-term rates have now begun to drop sharply. Thus, the yield curve may be expected to return to a more traditional shape with consequent benefit to company margins. No assurances can be given on this recent development, however, particularly as aggregate levels of borrowing, especially consumer mortgage related borrowings may be expected to diminish.
In addition to the shape of the yield curve, our net interest margin has traditionally been sensitive to and impacted by changes in prevailing market interest rates. Generally, there has been a negative correlation between changes in prevailing interest rates and our net interest margin, especially when rates begin to move in a different direction. When prevailing rates begin to decline, our net interest margin generally increases in immediately ensuing periods, and vice versa, as in each case earning assets reprice more slowly than interest-bearing sources of funds. This was the case for our net interest margin during the 2002 to mid-2003 period, when prevailing market rates were declining and our margin increased, and during the mid-2003 to 2004 period, when the rate decline began to decelerate and rates then reversed and began to increase and our margins experienced a negative effect. In 2005 and 2006, however, as the Feds push to increase prevailing rates matured, our net interest margin continued to suffer as a result of the flattening yield curve. This historical trend too, however, may be expected to benefit our net interest margins in upcoming periods, as deposit rates begin to decline.
The net interest margin for the full year of 2002 was 4.50%. In ensuing years, our margin steadily decreased, during an extended period of increasing short-term interest rates. Our margin reached a low point in the fourth quarter of 2006, at 3.24%. The margin for the first two and last quarter of 2007 was 3.32%. Margin decreased to 3.29% for the third quarter of 2007 primarily due to an increase in seasonal higher-costing municipal deposits. In general, the recovery from the fourth quarter of 2006 was due to the fact that a portion of our earning assets repriced upwards at a rate faster than the rates paid on interest-bearing liabilities. For the year 2007, net interest margin was 3.31%, down one basis point from 2006. The impact of this decrease was $220 thousand on net interest income for the year 2007.
Overall, we expect that the dramatic reduction in short-term interest rates since September 2007 will have a significant impact on our net interest income and net interest margin in future periods.
A discussion of the models we use in projecting the impact on net interest income resulting from possible changes in interest rates vis-à-vis the repricing patterns of our earning assets and interest-bearing liabilities is included later in this report under Item 7.A., Quantitative and Qualitative Disclosures About Market Risk.
CHANGES IN NET INTEREST INCOME DUE TO VOLUME
(Dollars In Thousands)
2006 to 2007:
In general, an increase in average earning assets has a positive impact on net interest income. For 2007, average earning assets increased $35.1 million over 2006, while average paying liabilities only increased $28.3 million. This combination led to a $1.2 million increase in net interest income. (This positive effect was partially offset by the $220 thousand negative effect on net interest income resulting from the changes in rates during the year, discussed above.)
The $35.1 million increase in average earning assets from 2006 to 2007 reflected an increase in average loans of $24.2 million, or 2.4%, a decrease of $2.3 million, or 0.5%, in investment securities and an increase of $13.1 million in the average balance of federal funds. We experienced increases in all major categories within the loan portfolio during 2007, although the average balance of indirect loans (which represented the second largest segment of the loan portfolio) decreased slightly. Indirect loans are primarily auto loans financed through local dealerships where we acquire the dealer paper. Increases in the average balances of other loan categories included: i) commercial and commercial real estate loans (an increase of $11.6 million, or 4.4%), ii) residential real estate loans (an increase of $8.0 million, or 2.5%) and iii) other consumer loans (an increase of $5.5 million, or 10.1%). Although average loans increased by 2.4% in 2007, this was a lower rate of increase than the 5.8% rate experienced in 2006.
The $28.3 million increase in average paying liabilities resulted from a $28.2 million increase in time deposits and a $7.5 million increase in non-maturity deposit balances. These increases were offset in part by a decrease of $7.5 million in the average balance of other borrowed funds.
The fact that average earning assets grew at a faster pace than average paying liabilities was primarily due to a $3.8 million, or 2.1%, increase in the average balance of non-interest bearing demand deposits.
2005 to 2006:
For 2006, average earning assets increased $65.2 million over 2005, while average paying liabilities only increased $52.2 million. This combination led to a $878 thousand increase in net interest income. (However, this positive effect was more than offset by the $3.1 million negative effect on net interest income resulting from the changes in rates during the year, especially the decrease in the net interest margin, discussed above.)
The $65.2 million increase in average earning assets from 2005 to 2006 reflected an increase in average loans of $54.3 million, or 5.8%, an increase of $5.0 million, or 1.1%, in investment securities and an increase of $5.8 million in the average balance of federal funds. We experienced increases in all major categories within the loan portfolio during 2006, although the average balance of indirect loans was modest. Increases in the average balances of other loan categories included: i) commercial and commercial real estate loans (an increase of $33.2 million, or 13.0%), ii) residential real estate loans (an increase of $13.8 million, or 4.6%) and iii) other consumer loans (an increase of $7.1 million, or 14.5%). Although average loans increased by 5.8% in 2006 this was a lower rate of increase than the 8.7% rate experienced in 2005. The only category of loans that grew faster in 2006 than in 2005 was commercial loans, which grew at an 11.6% rate in 2005 versus 14.5% in 2006.
The $52.2 million increase in average paying liabilities between 2005 and 2006 resulted from an $85.3 million increase in time deposits, offset, in part, by a $36.9 million decrease in non-maturity deposit balances. The average balance of other borrowed funds was virtually unchanged. The change in the mix of deposit categories from non-maturity to time deposits is typical during a period of rising rates. The $62 million of deposits acquired in the April 2006 branch acquisition accounted for a portion of the increase in average deposit balances between 2005 and 2006, since these deposits were not included in the average balances for the first three months of 2005.
The fact that average earning assets grew at a faster pace than average paying liabilities was primarily due to a $7.9 million, or 4.6%, increase in the average balance of non-interest bearing demand deposits.
Increases in the volume of loans and deposits, as well as yields and costs by type, are discussed later in this report under Item 7.C. Financial Condition.
II. PROVISION FOR LOAN LOSSES AND ALLOWANCE FOR LOAN LOSSES
We consider our accounting policy relating to the allowance for loan losses to be a critical accounting policy, given the uncertainty involved in evaluating the level of the allowance required to cover credit losses inherent in the loan portfolio, and the material effect that such judgments may have on our results of operations. In addition to the following discussion, see Notes 1 and 5 to the consolidated financial statements, included in Item 8 of this Report.
Through the provision for loan losses, an allowance is maintained that reflects our best estimate of probable incurred loan losses related to specifically identified loans as well as the remaining portfolio. Actual loan losses are charged against this allowance when loans are deemed uncollectible.
We use a two-step process to determine the provision for loans losses and the amount of the allowance for loan losses. We evaluate impaired commercial and commercial real estate loans over $250,000 under SFAS No. 114, Accounting for Creditors for Impairment of a Loan. We evaluate the remainder of the portfolio under SFAS No. 5 Accounting for Contingencies.
At December 31, 2007 we had one loan considered impaired and evaluated under SFAS No. 114. That loan had sufficient collateral and required no specific reserve. See Note 5 to the consolidated financial statements, included in Item 8 of this Report.
Homogenous Loan Pools: Under our SFAS No. 5 analysis, we group homogeneous loans as follows, each with its own estimated loss-rate:
Other commercial and commercial real estate loans,
One to four family residential real estate loans,
Home equity loans,
Indirect loans low risk tiers (based on credit scores),
Indirect loans high risk tiers, and
Other consumer loans.
Within the group of other commercial and commercial real estate loans, we sub-group loans based on our internal system of risk-rating, which is applied to all commercial and commercial real estate loans. We establish loss rates for each of these pools. Furthermore, larger balance loans within the higher risk-ratings are pulled out of their homogenous pools and are evaluated individually.
Estimated losses, under our SFAS No. 5 evaluation, reflect consideration of all significant factors that affect the collectibility of the portfolio as of December 31, 2007. In our evaluation, we do both a quantitative and qualitative analysis of the homogeneous pools.
Quantitative Analysis: Quantitatively, we determined the historical loss rate for each homogeneous loan pool.
During the past five years we have had little charge-off activity on loans secured by residential real estate. Indirect consumer lending represents a significant component of our total loan portfolio and is the only category of loans that has a history of losses that lends itself to a trend analysis. We have had two losses on commercial real estate loans in the past five years. Losses on commercial loans (other than those secured by real estate) are also historically low, but can vary widely from year-to-year; this is the most complex category of loans in our loss analysis.
Our net charge-offs for the past five years have been at historical lows for our company. Annualized net charge-offs have ranged from .04% to .10% of average loans during this period. In prior years this ratio was significantly higher. For example, in the mid-to-late 1990s, the charge-off ratio ranged from .16% to .32% for our company. The ratio for bank holding companies in our peer group was .23% at December 31, 2007, the most recent reporting period. The peer group ratio was also very low, ranging from .13% to .25% in the five preceding years.
Qualitative Analysis: While historical loss experience provides a reasonable starting point for our analysis, historical losses, or even recent trends in losses, do not by themselves form a sufficient basis to determine the appropriate level for the allowance. Therefore, we also considered and adjusted historical loss factors for qualitative and environmental factors that are likely to cause credit losses associated with our existing portfolio. These included:
Changes in the volume and severity of past due, nonaccrual and adversely classified loans
Changes in the nature and volume of the portfolio and in the terms of loans
Changes in the value of the underlying collateral for collateral dependent loans
Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices not considered elsewhere in estimating credit losses
Changes in the quality of the loan review system
Changes in the experience, ability, and depth of lending management and other relevant staff
Changes in international, national, regional, and local economic and business conditions and developments that affect the collectibility of the portfolio
The existence and effect of any concentrations of credit, and changes in the level of such concentrations
The effect of other external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the existing portfolio or pool
For each homogeneous loan pool, we estimate a loss factor expressed in basis points for each of the qualitative factors above, and for historical credit losses. We update and change, if necessary, the loss-rates assigned to various pools based on the analysis of loss trends and the change in qualitative and environmental factors. In order to more accurately estimate probable loan losses, during 2007 we segmented the loan loss reserve pools for our commercial loan portfolio between commercial loans and commercial loans secured by real estate, and updated our loss rates primarily related to criticized commercial loans and indirect consumer loans accounted for under SFAS No. 5. These enhancements did not result in a material change to the provision for loan losses for the year ended December 31, 2007 or in the allowance for loan losses.
From June 2004 to June 2006, the Federal Reserve Bank increased prevailing short-term rates in an effort to slow down national economic growth and check potential increases in the inflation rate. In the last part of 2007, the Federal Reserve Bank began to cut rates in response to the growing liquidity crisis in credit markets and evident slowing of the economy-wide growth. In our market area, however, there was very little impact, by year-end, from these developments in credit markets and the national economy on unemployment rates, job growth and business failures. During the June 2004 to June 2006 period, when short-term rates rose dramatically, long-term rates held steady or even fell. Except for indirect consumer loans, interest rates for most of our borrowers are based on intermediate and long-term rates, especially for residential real estate loans and for commercial loans.
Due to the imprecise nature of the loan loss estimation process and ever changing economic conditions, these risk attributes may not be adequately captured in data related to the formula-based loan loss components used to determine allocations in our analysis of the adequacy of the allowance for loan losses. Management, therefore, has established and maintains an unallocated portion within the allowance for loan losses reflecting the uncertainty of future economic conditions within our market area. The amount of this measurement imprecision allocation was $831 thousand at December 31, 2007, a decrease of $177 thousand, or 18%, compared to the $1.0 million at December 31, 2006. This reduction was primarily due to the improvement in loan quality ratios at December 31, 2007.
SUMMARY OF THE ALLOWANCE AND PROVISION FOR LOAN LOSSES
(Dollars In Thousands) (Loans, Net of Unearned Income)
ALLOCATION OF THE ALLOWANCE FOR LOAN LOSSES
(Dollars in Thousands)
III. NONINTEREST INCOME
The majority of our noninterest income constitutes fee income from services, principally fees and commissions from fiduciary services, deposit account service charges, insurance commissions, computer processing fees and other recurring fee income. Net gains or losses on the sale of securities available-for-sale is another category of noninterest income.
ANALYSIS OF NONINTEREST INCOME
(Dollars In Thousands)
2007 compared to 2006: Total noninterest income increased $507 thousand, or 3.2%, from 2006 to 2007.
For 2007, income from fiduciary activities increased $490 thousand, or 9.6%, from 2006. Most of the increase resulted from an increase in assets under administration and management. At year-end 2007, the market value of assets under trust administration and investment management amounted to $961.2 million, an increase of $54.7 million, or 6.0%, from year-end 2006.
Income from fiduciary activities includes income from funds under investment management in the North Country Funds, specifically the North Country Equity Growth Fund (NCEGX) and the North Country Intermediate Bond Fund (NCBDX), both of which are advised by our registered investment adviser subsidiary, North Country Investment Advisers, Inc. On a combined basis, these funds had a market value of $207.1 million and $176.1 million at December 31, 2007 and 2006, respectively. The funds were introduced in March 2001. Most of the dollars invested in these funds are derived from retirement and pension plan accounts of which our banks serve as trustee, but our North Country Funds also are offered on a retail basis through an arrangement with UVEST Financial Services Group, Inc., a third-party registered broker/dealer that provides securities brokerage services to our customers from several of our bank branches. Included as an investor in the North Country Funds is our companys pension plan, which owned shares in the funds with a market value of approximately $17.5 million at December 31, 2007 and $17.0 million at 2006.
Fees for other services to customers include deposit account service charges, debit card processing fees, merchant bankcard processing fees, safe deposit box fees and loan servicing fees. These fees amounted to $8.1 million in 2007, an increase of $176 thousand, or 2.2%, from 2006. The increase was primarily attributable to increases in rental income from our third-party provider of securities brokerage services and from our merchant bankcard and debit card activity fee income.
The following table presents sales and purchases within the available-for-sale portfolio during 2007.
2007 Investment Sales and Purchases
In November 2004, we acquired Capital Financial Group, Inc., a local insurance agency specializing in the sale of group health and life insurance. See the more detailed discussion of the acquisition on page 4 of this Report. Insurance commission income was $1.7 million for 2005, the first full year of income from this business and increased to $1.8 million in 2006 and $1.9 million in 2007.
Other operating income includes net gains on the sale of loans and other real estate owned as well as other miscellaneous revenues. For 2007, other operating income decreased $362 thousand, or 33.5%, from 2006. In 2006, we sold, at market price, a parcel of land that we had earlier purchased to serve as premises for a new branch. The sale of land resulted in a gain of $227 thousand. We subsequently entered into an agreement with Stewarts Shops Corp., the buyer, to lease from them a portion of the building they constructed on the parcel of land to serve as a bank branch. In years prior to 2007, other operating income included data processing servicing fee income received from one unaffiliated upstate New York bank. However, this arrangement came to an end in the second quarter of 2007, following the acquisition of that institution by an unrelated company. This represented a reduction in fee income of $56 thousand for the comparative period.
2006 compared to 2005: Total noninterest income increased $833 thousand, or 5.6%, from 2005 to 2006.
For 2006, income from fiduciary activities increased $406 thousand, or 8.7%, from 2005. Most of the increase reflected a similar increase in assets under administration and management. At year-end 2006, the market value of assets under trust administration and investment management amounted to $906.5 million, an increase of $92.8 million, or 11.4%, from year-end 2005.
Income from fiduciary activities includes income from funds under investment management in the North Country Funds. On a combined basis, these funds had a market value of $176.1 million and $153.0 million at December 31, 2006 and 2005, respectively. Included as an investor in the North Country Funds is our companys pension plan, which owned shares in the funds with a market value of approximately $17.0 million at December 31, 2006 and $16.8 million at year-end 2005.
Fees for other services to customers include deposit account service charges, debit card processing fees, merchant bankcard processing fees, safe deposit box fees and loan servicing fees. These fees amounted to $8.0 million in 2006, an increase of $582 thousand, or 7.9%, from 2005. The increase was primarily attributable to an increase in deposit account service charges as a result of an increase in our retail product fee structure. We also experienced increases in
rental income from our third-party provider of securities brokerage services and on our merchant bankcard activities.
In 2006 total other income included net securities losses of $102 thousand on the sale of $44.1 million of securities available-for-sale. The primary purpose of the sales was to extend and restructure the maturities of the portfolio by selling certain investments with shorter remaining maturities. The following table presents sales and purchases within the available-for-sale portfolio during 2006.
2006 Investment Sales and Purchases
Insurance commission income for 2005, at $1.7 million, represented the first full year of income from this business. For 2006, insurance commission income increased to $1.8 million.
Other operating income includes net gains on the sale of loans and other real estate owned, if any, as well as other miscellaneous revenues. For 2006, other operating income increased $225 thousand, or 26.3%, from 2005. In 2006, we sold, at market price, a parcel of land that we had earlier purchased to serve as premises for a new branch. The sale resulted in a gain of $227 thousand. We subsequently entered into an agreement with Stewarts Shops Corp., the buyer, to lease from them a portion of the building they constructed on the parcel of land to serve as a bank branch.
IV. NONINTEREST EXPENSE
Noninterest expense is a means of measuring the delivery cost of services, products and business activities of a company. The key components of noninterest expense are presented in the following table.
ANALYSIS OF NONINTEREST EXPENSE
(Dollars In Thousands)
2007 compared to 2006: Noninterest expense for 2007 amounted to $37.9 million, an increase of $1.1 million, or 3.1%, from 2006. One comparative measure of operating expenses for financial institutions is the efficiency ratio. The efficiency ratio (a ratio where lower is better) is calculated as the ratio of noninterest expense to the sum of tax equivalent net interest income and other income. Excluded from the calculation are intangible asset amortization and any net securities gains or losses. The efficiency ratio might be considered a non-GAAP financial measure but is generally utilized by banks and bank analysts to assess an institutions performance. See the discussion on Use of Non-GAAP Financial Measures on page 3 of this Report. For 2007, the efficiency ratio for Arrow was 57.3%, an increase from the 2006 ratio of 56.7%. Our 2007 ratio, however, still compared favorably to the ratio for our peer group of 64.6% as of December 31, 2007. For information on the calculation of our efficiency ratios on a quarterly and annual basis, see pages 14 and 15 of this Report.
Salaries and employee benefits expense decreased $672 thousand, or 3.0%, from 2006 to 2007. Salary expense increased $246 thousand, or 1.5%, from 2006, due primarily to normal merit increases and to staff increases at our new branches. Employee benefits, however, decreased $918 thousand, or 15.2% from 2006 to 2007. This was primarily attributable to decreases in post-retirement benefits and incentive compensation expenses. The ratio of total personnel expense (salaries and employee benefits) to average assets was 1.37% for 2007, 22 basis points less than the annualized ratio for our peer group of 1.59% at December 31, 2007.
Occupancy expense increased $140 thousand, or 4.6%, from 2006 to 2007. A portion of the increase was attributable to increased costs for our new branches. Furniture and equipment expense increased by $44 thousand, or 1.5%, from 2006 to 2007.
Other operating expense increased from 2006 to 2007, by $1.6 million, or 18.6%. The most significant component of the increase was the $600 reserve for the Visa U.S.A. litigation costs (see page 16). Other increases were spread among a variety of categories, including marketing and third party computer processing fees.
2006 compared to 2005: Noninterest expense for 2006 amounted to $36.8 million, an increase of $1.6 million, or 4.6%, from 2005. One comparative measure of operating expenses for financial institutions is the efficiency ratio, which is the ratio of other expense to the sum of tax equivalent net interest income and other income. Excluded from the calculation are intangible asset amortization and any net securities gains or losses. The efficiency ratio might be considered a non-GAAP financial measure but is generally utilized by banks and bank analysts to assess an institutions performance. See the discussion on Use of Non-GAAP Financial Measures on page 3 of this Report. For 2006, the efficiency ratio for Arrow was 56.7%, an increase from the 2005 ratio of 53.5%. Our 2006 ratio, however, still compared favorably to the ratio for our peer group of 61.3% as of December 31, 2006. For information on the calculation of our efficiency ratios on a quarterly and annual basis, see pages 14 and 15 of this Report.
Salaries and employee benefits expense increased $1.4 million, or 6.8%, from 2005 to 2006. The increase in salary expense for 2006 was 4.7% over 2005, due primarily to normal merit increases and to staff increases resulting from the acquisition of new branches in April 2005 (which staff increases were only included in 2005 expenses for nine months). Employee benefits increased 12.7% from 2005 to 2006. This was primarily attributable to increases in health insurance and post-retirement benefits. The ratio of total personnel expense (salaries and employee benefits) to average assets was 1.45% for 2006, 14 basis points less than the annualized ratio for our peer group of 1.59% at December 31, 2006.
Occupancy expense increased $144 thousand, or 4.9%, from 2005 to 2006. Most of the increase was attributable to increased costs for utilities and the fact that the three branches acquired in 2005 were only included in 2005 expense for nine months of 2005. Furniture and equipment expense increased by $96 thousand, or 3.3%, from 2005 to 2006.
Other operating expense actually decreased from 2005 to 2006, by $25 thousand, or 0.3%. Legal, advertising and supplies expenses decreased in 2006 from 2005 levels, which were enhanced by one-time expenses in 2005 for the branch acquisition, while other areas of other operating expenses experienced normal increases or fluctuations.
V. INCOME TAXES
The following table sets forth our provision for income taxes and effective tax rates for the periods presented.
INCOME TAXES AND EFFECTIVE RATES
(Dollars in Thousands)
The provisions for federal and state income taxes amounted to $6.8 million, $7.1 million and $8.1 million for 2007, 2006 and 2005, respectively. The effective income tax rates for 2007, 2006 and 2005 were 28.2%, 29.7% and 30.3%, respectively, with the decreasing rate in recent periods reflecting an increase in the ratio of tax-exempt income to income before taxes.
C. FINANCIAL CONDITION
I. INVESTMENT PORTFOLIO
Investment securities are classified as held-to-maturity, trading, or available-for-sale, depending on the purposes for which such securities were acquired and are being held. Securities held-to-maturity are debt securities that the company has both the positive intent and ability to hold to maturity; such securities are stated at amortized cost. Debt and equity securities that are bought and held principally for the purpose of sale in the near term are classified as trading securities and are reported at fair value with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity or trading securities are classified as available-for-sale and are reported at fair value with unrealized gains and losses excluded from earnings and reported net of taxes in accumulated other comprehensive income or loss. At December 31, 2007, 2006 and 2005, we held no trading securities. Set forth below is certain information about our securities available-for-sale portfolio and securities held-to-maturity portfolio.
The following table sets forth the carrying value of our securities available-for-sale portfolio at year-end 2007, 2006 and 2005.
In all periods, other mortgage-backed securities consisted of solely of agency mortgage pass-through securities. Pass-through securities provide to the investor monthly portions of principal and interest pursuant to the contractual obligations of the underlying mortgages. Collateralized mortgage obligations (CMOs) separate the repayments into two or more components (tranches), where each tranche has a separate estimated life and yield. Our practice has been to purchase pass-through securities and CMOs that are guaranteed by federal agencies and tranches of CMOs with shorter maturities. Included in corporate and other debt securities are highly rated corporate bonds and commercial paper. At year-end 2007, approximately $9.6 million, or 84.2%, of the listed amount of mutual funds and equity securities consisted of required holdings of stock of the Federal Reserve Bank of New York and the Federal Home Loan Bank of New York.
The following table sets forth the maturities of our securities available-for-sale portfolio as of December 31, 2007. CMOs and other mortgage-backed securities are included in the table based on their expected average lives. Mutual funds and equity securities, which have no stated maturity, are included in the after 10-years category.
MATURITIES OF SECURITIES AVAILABLE-FOR-SALE
The following table sets forth the tax-equivalent yields of our securities available-for-sale portfolio at December 31, 2007.
YIELDS ON SECURITIES AVAILABLE-FOR-SALE
(Fully Tax-Equivalent Basis)
The yields on debt securities shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the amortized cost of the securities at December 31, 2007. Yields on obligations of states and municipalities exempt from federal taxation were computed on a fully tax-equivalent basis using a marginal tax rate of 35%. Dividend earnings derived from equity securities were adjusted to reflect applicable federal income tax exclusions.
At December 31, 2007 and 2006, the weighted average maturity was 3.3 and 2.8 years, respectively, for debt securities in the available-for-sale portfolio. At December 31, 2007, the net unrealized losses on securities available-for-sale amounted to $61 thousand. The net unrealized gain or loss on such securities, net of tax, is reflected in accumulated other comprehensive income/loss.
The unrealized loss was $6.2 million at December 31, 2006. The net unrealized loss at year-end 2006 was primarily attributable to the decreased fair value of the debt securities (primarily fixed rate) portfolios resulting from an increase in prevailing interest rates, chiefly short-term rates. Conversely, the decrease from 2006 to 2007 was primarily attributable to a decline in market yields during 2007.
For further information regarding our portfolio of securities available-for-sale, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.
The following table sets forth the carrying value of our portfolio of securities held-to-maturity (consisting exclusively of state and municipal obligations) at December 31 of each of the last three years.
For information regarding the fair value of our portfolio of securities held-to-maturity at December 31, 2007, see Note 3 to the Consolidated Financial Statements contained in Part II, Item 8 of this Report.
The following table sets forth the maturities of our portfolio of securities held-to-maturity as of December 31, 2007.
MATURITIES OF SECURITIES HELD-TO-MATURITY
The following table sets forth the tax-equivalent yields of our portfolio of securities held-to-maturity at December 31, 2007.
YIELDS ON SECURITIES HELD-TO-MATURITY
(Fully Tax-Equivalent Basis)
The yields shown in the table above are calculated by dividing annual interest, including accretion of discounts and amortization of premiums, by the carrying value of the securities at December 31, 2007. Yields on obligations of states and municipalities exempt from federal taxation (which constituted the entire portfolio) were computed on a fully tax-equivalent basis using a marginal tax rate of 35%.
During 2007, 2006 and 2005, we sold no securities from the held-to-maturity portfolio. The weighted-average maturity of the held-to-maturity portfolio was 4.8 years and 4.5 years at December 31, 2007 and 2006, respectively.
II. LOAN PORTFOLIO
The amounts and respective percentages of loans outstanding represented by each principal category on the dates indicated were as follows:
a. Types of Loans
(Dollars In Thousands)
No Subprime Mortgage Activities: During the second half of 2007, the U.S. experienced significant disruption and volatility in its financial and capital markets. A major cause of the disruption was a collapse of residential real estate values across much of the U.S., which in turn triggered widespread defaults on subprime mortgage loans and steep devaluations of portfolios containing these loans and securities collateralized by them. Many lending institutions suffered sizable charge-offs and losses in the second half of 2007. We did not.
We have never engaged in subprime mortgage lending as a business line and we have never acquired any subprime mortgage loans. On occasion we may have made a loan to a borrower having a FICO score of 660 or below or have had extensions of credit outstanding to borrowers who have developed credit problems after origination resulting in deterioration of their FICO scores. We also on occasion have extended community development loans to borrowers whose creditworthiness is below our normal standards as part of the community support program we have developed in fulfillment of our statutorily-mandated duty to support low- and moderate-income neighborhoods within our service area. However, we are a prime lender and apply prime lending standards.
Residential Real Estate Loans: In recent years, residential real estate and home equity loans have represented the largest segment of our loan portfolio. Residential mortgage demand has been moderate since 2004, after a period in the preceding years when demand was high. However, during 2004 and 2005 and the first quarter of 2006, we sold many of our 30-year, fixed-rate mortgage originations, while retaining the servicing. By the end of the first quarter of 2006, as yields on longer-term residential real estate loans began to rise, we stopped selling our 30-year mortgage originations and decided to retain them in our portfolio. During 2007, the $53.6 million of new residential real estate loan originations more than offset normal principal amortization on the pre-existing loans in the segment. We expect that, if we continue to retain all or most originations, we will be able to maintain the current level of residential real estate loans and may experience some continued growth. However, if the demand for residential real estate loans in our service area decreases, due to mortgage rate increases or a softening of the local real estate market or the economy generally, our portfolio also may decrease, which may negatively impact our financial performance, and if the economy or local real estate market suffers a major downturn, the quality of our residential loan portfolio and our financial condition itself may be damaged.
Indirect Loans: For several years prior to 2003, indirect consumer loans (consisting principally of auto loans financed through local dealerships where we acquire the dealer paper) was the largest segment of our loan portfolio. For much of this period, indirect consumer loans were the fastest growing segment of our loan portfolio, both in terms of absolute dollar amount and as a percentage of the overall portfolio. In the ensuing five years, this segment of the portfolio fluctuated in size, with periods of expansion followed by contraction. Generally, over the period the segment experienced little growth in absolute terms and decreased as a percentage of the overall portfolio. This change in indirect loan totals was largely the result of aggressive campaigns of zero rate and other subsidized financing by auto manufacturers, commencing late 2001 and recurring periodically in the years since then. During the fourth quarter of 2002 and for the first two quarters of 2003, the indirect portfolio experienced a small amount of growth, but the level flattened in the third quarter of 2003 and declined during the fourth quarter of 2003 and the first half of 2004 before rising slightly during the second half of 2004.
At the end of the first quarter of 2005, we experienced an increase in indirect loans, which continued throughout the second and third quarters of 2005, for a variety of factors, including the decision by the automobile manufacturers to be less aggressive with their subsidized financing programs. In the fourth quarter of 2005, however, indirect loan balances declined by 4.3%, measured at quarter-end (although the average balance for the fourth quarter was slightly higher than the average balance for the third quarter).
During the first three quarters of 2006, we elected not to compete aggressively in the indirect loan sector, in the face of a resurgence of extremely low rates being offered by automobile manufacturers. As a result, principal amortization and prepayments exceeded our originations and indirect balances decreased. In the fourth quarter of 2006 and the first three quarters of 2007, however, we saw our indirect loan balances increase. Even though indirect balances fell during the fourth quarter of 2007, our indirect loan total at December 31, 2007 was $6.7 million above the prior year-end total.
At December 31, 2007, indirect loans continued to represent the second largest category of loans in our portfolio and a significant component of our business. However, if auto manufacturers and their finance affiliates persist in marketing heavily subsidized financing programs, our indirect loan portfolio is likely to continue to experience rate pressure and limited, if any, overall growth as a percentage of the total portfolio. Moreover, as noted above for residential real estate loans, if the national or regional economy weakens in upcoming periods, we may experience a weakened demand for indirect loans and possibly a weakened quality within the portfolio, which could negatively impact our financial performance.
Commercial, Commercial Real Estate and Construction and Land Development Loans: We have experienced strong to moderate demand for commercial loans for the past several years, and thus commercial and commercial real estate loan balances have grown significantly, both in dollar amount and as a percentage of the overall loan portfolio. This pattern continued during 2007 as these loan balances grew $6.8 million, or 2.5%, from December 31, 2006. Substantially all commercial and commercial real estate loans in our portfolio are extended to businesses or borrowers located in our regional market. Many of the loans in the commercial portfolio have variable rates tied to prime, FHLB or U.S. Treasury indices.
The following table indicates the changing mix in our loan portfolio by including the quarterly average balances for our significant loan products for the past five quarters. The remaining quarter-by-quarter tables present the percentage of total loans represented by each category and the annualized tax-equivalent yield of each category.
Quarterly Average Loan Balances
(Dollars In Thousands)
Percentage of Total Quarterly Average Loans
Quarterly Tax-Equivalent Yield on Loans
In general, the yield (tax-equivalent interest income divided by average loans) on our loan portfolio and other earning assets has been impacted by changes in prevailing interest rates, as previously discussed on in this Report on page 19 under the heading "Impact of Interest Rate Changes 2002 - 2007." We expect that such will continue to be the case; that is, that loan yields will continue to rise and fall with changes in prevailing market rates, although the timing and degree of responsiveness will continue to be influenced by a variety of other factors, including the makeup of the loan portfolio, the shape of the yield curve, consumer expectations and preferences and the rate at which the portfolio expands.
Additionally, there is a significant amount of cash flow from normal amortization and prepayments in all loan categories, and this cash flow reprices at current rates as new loans are generated at the current yields.
As noted in the earlier discussion, during a period of change in prevailing rates, we generally experience a time lag between the impact of the change on our deposit portfolio (which is felt relatively quickly) and the impact of the change on our loan portfolio (which occurs more slowly). The consequence of this time lag is a positive impact on the net interest margin during the beginning of the rate decline period, and a negative impact on the margin at the beginning of a rate increase period.
As we discussed in the prior review of net interest income, during the period from mid-2004 to mid-2006, the Federal Reserve Bank increase the targeted federal funds rate from 1.00% to 5.25%, in an effort to dampen inflationary pressures and unrestrained borrowing. During this period of rate increase, the time-lag between repricing of our deposits and the repricing of loan balances was especially lengthy; in some sectors of the portfolio, the repricing upward of loan rates was not completed before the Fed began decreasing rates in the last four months of 2007. Thus, for our company as for any commercial banks, the return to a decreasing interest rate environment, while it may relieve some of the recent extreme pressures on our net interest margins, may not have quite the positive impact on margins and net interest income that would normally be experienced in periods where spreads are typically wider before the rate decline commences.
The following table indicates the respective maturities and interest rate structure of our commercial, financial and agricultural loans and real estate - construction loans at December 31, 2007. For purposes of determining relevant maturities, loans are assumed to mature at (but not before) their scheduled repayment dates as required by contractual terms. Demand loans and overdrafts are included in the Within 1 Year maturity category. Most of the real estate - construction loans are made with a commitment for permanent financing, whether extended by us or unrelated third parties. The maturity distribution below reflects the final maturity of the permanent financing.
b. Maturities and Sensitivities of Loans to Changes in Interest Rates
COMMITMENTS AND LINES OF CREDIT
Stand-by letters of credit represent extensions of credit granted in the normal course of business, which are not reflected in the financial statements at a given date because the commitments are not funded at that time. As of December 31, 2007, our total contingent liability for standby letters of credit amounted to $3.2 million. In addition to these instruments, we also have issued lines of credit to customers, including home equity lines of credit, commitments for residential and commercial construction loans and other personal and commercial lines of credit, which also may be unfunded or only partially funded from time to time. Commercial lines, generally issued for a period of one year, are usually extended to provide for the working capital requirements of the borrower. At December 31, 2007, we had outstanding unfunded loan commitments in the aggregate amount of approximately $175.7 million.
c. Risk Elements
1. Nonaccrual, Past Due and Restructured Loans
The amounts of nonaccrual, past due and restructured loans for the past five years are presented in the table on page 22 under the heading Summary of the Allowance and Provision for Loan Losses.
We designate loans as nonaccrual when the payment of interest and/or principal is due and unpaid for a designated period (generally 90 days) or when the likelihood of the full repayment of principal and interest is, in the opinion of management, uncertain. Under the Uniform Retail Credit Classification and Account Management Policy established by banking regulators, fixed-maturity consumer loans must generally be charged-off no later than when 120 days past due. Loans secured with non-real estate collateral in the process of collection are charged-down to the value of the collateral, less cost to sell. Open-end credits, residential real estate loans and commercial loans are evaluated for charge-off on a loan-by-loan basis when placed on nonaccrual status. We had no material commitments to lend additional funds on outstanding nonaccrual loans at December 31, 2007. Loans past due 90 days or more and still accruing interest are those loans which were contractually past due 90 days or more but because of expected repayments, were still accruing interest.
The balance of loans 30-89 days past due totaled $8.5 million at December 31, 2007 and represented 0.82% of loans outstanding at that date, as compared to approximately $6.0 million, or 0.60% of loans at December 31, 2006. These non-current loans at December 31, 2007 were composed of approximately $5.2 million of consumer loans, principally indirect motor vehicle loans, $1.4 million of residential real estate loans and $1.9 million of commercial loans.
SFAS No. 114 requires that all impaired loans, except for large groups of smaller-balance homogeneous loans, be measured based on (i) the present value of expected future cash flows discounted at the loan's effective interest rate, (ii) the loan's observable market price or (iii) the fair value of the collateral, less cost to sell, if the loan is collateral dependent. We apply the provisions of SFAS No. 114 to all impaired commercial and commercial real estate loans over $250 thousand, and to all restructured loans. Allowances for losses for the remaining smaller-balance loans are evaluated under SFAS No. 5. Under the provisions of SFAS No. 114, we determine impairment for collateralized loans based on fair value of the collateral less estimated cost to sell. For other loans, impairment is determined by comparing the recorded value of the loan to the present value of the expected cash flows, discounted at the loans effective interest rate. We determine the interest income recognition method for impaired loans on a loan-by-loan basis. Based upon the borrowers payment histories and cash flow projections, interest recognition methods include full accrual or cash basis.
During 2007, one commercial loan was considered impaired under SFAS No. 114 with an average recorded investment of $733 thousand. At year-end 2007, the balance of impaired loans consisted of that one loan with a balance of $759 thousand which had no related reserve.
At December 31, 2007, nonperforming loans amounted to $2.2 million, a decrease of $593 thousand, or 21.4%, from the balance at year-end 2006. Total nonperforming loans at year-end 2007 represented .21% of period-end loans, a decrease from .28% at year-end 2006. The ratio of nonperforming loans to average loans for our peer group at December 31, 2007 was 1.05%, up from .56% at December 31, 2006.
During 2007, income recognized on year-end balances of nonaccrual loans was $70 thousand. Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $162 thousand.
During 2006, two commercial loans were considered impaired under SFAS No. 114 with an average recorded investment of $341 thousand. At year-end 2006, the balance of impaired loans consisted of one loan with a balance of $708 thousand which had no related reserve.
At December 31, 2006, nonperforming loans amounted to $2.8 million, an increase of $529 thousand, or 23.5%, from the balance at year-end 2005. Total nonperforming loans at year-end 2006 represented .28% of period-end loans, an increase from .23% at year-end 2005. The ratio of nonperforming loans to average loans for our peer group at December 31, 2006 was .56%.
During 2006, income recognized on year-end balances of nonaccrual loans was $126 thousand. Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $160 thousand.
During 2005, one commercial loan was considered impaired under SFAS No. 114 with an average recorded investment of $512 thousand. At year-end 2005, the balance of the loan was $512 thousand and it had a related reserve of $96 thousand.
At December 31, 2005, nonperforming loans amounted to $2.2 million, an increase of $139 thousand, or 6.6%, from the balance at year-end 2004. Total nonperforming loans at year-end 2005 represented .23% of period-end loans, a decrease from .24% at year-end 2004. The ratio of nonperforming loans to average loans for our peer group at December 31, 2005 was .52%.
During 2005, income recognized on year-end balances of nonaccrual loans was $81 thousand. Income that would have been recognized during that period on nonaccrual loans, if such loans had been current in accordance with their original terms and had been outstanding throughout the period (or since origination if held for part of the period) was $156 thousand.
2. Potential Problem Loans
On at least a quarterly basis, we apply an internal credit quality rating system to commercial loans that are either past due or fully performing but exhibit certain characteristics that could reflect a potential weakness. Loans are placed on nonaccrual status when the likely amount of future principal and interest payments are expected to be less than the contractual amounts, even if such loans are not 90 days past due.
Periodically we review the loan portfolio for evidence of potential problem loans. Potential problem loans are loans that are currently performing in accordance with contractual terms, but where known information about possible credit problems of the borrower causes doubt about the ability of the borrower to comply with the loan payment terms and may result in disclosure of such loans as nonperforming at some time in the future. Through our on-going credit monitoring, we consider loans which, in our internal classification system, are classified as substandard but continue to accrue interest to be potential problem loans. At December 31, 2007 we identified 35 commercial relationships totaling $25.3 million as potential problem loans. At December 31, 2006 we identified 23 commercial relationships totaling $13.6 million as potential problem loans. Factors such as payment history, value of supporting collateral, and personal or government guarantees led us to conclude that the current risk exposure on these loans did not warrant accounting for the loans as nonperforming. Although in a performing status as of year-end, these loans exhibited certain risk factors, which have the potential to cause them to become nonperforming at some point in the future.
The overall level of our performing loans that demonstrate characteristics of potential weakness from time-to-time is for the most part dependent on economic conditions in northeastern New York State.
3. Foreign Outstandings - None
4. Loan Concentrations
The loan portfolio is well diversified. There are no concentrations of credit that exceed 10% of the portfolio, other than the general categories reported in the preceding Section C.II.a. of this Item 7. For further discussion, see Note 26 to the Consolidated Financial Statements in Part II, Item 8 of this Report.
5. Other Real Estate Owned and Repossessed Assets
Other real estate owned (OREO) consists of real property acquired in foreclosure. OREO is carried at the lower of (i) fair value less estimated cost to sell or (ii) the recorded investment in the loan at the date of foreclosure, or cost. We establish allowances for OREO losses, which are established and monitored on a property-by-property basis and reflect our ongoing estimate of the property's estimated fair value less costs to sell (when such amount is less than cost). For all periods, all OREO was held for sale. Repossessed assets for each of the five years in the table below consist almost entirely of motor vehicles.
Distribution of OREO and Repossessed Assets
(Net of Allowance) (In Thousands)
The following table summarizes changes in the net carrying amount of OREO for each of the periods presented.
Schedule of Changes in OREO
(Net of Allowance) (In Thousands)
There was no allowance for OREO losses at year-end 2007, 2006 or 2005. We started 2007 with two properties in OREO. During the year we acquired two more and sold three, ending the year with just one property. We started 2006 with no properties in OREO. During the year we acquired one commercial and one residential property, which remained unsold at year-end. We started 2005 with no properties in OREO. During the year we acquired and sold four properties, ending the year with no properties in OREO.
We started 2004 with no properties in OREO. During 2004, we did not acquire or sell any real estate acquired through foreclosure. We started 2003 with $51 thousand in OREO. During 2003, we acquired one property for $10 thousand through foreclosure. Also during the year, we sold two properties with a carrying amount of $61 thousand for a net gain of $12 thousand.
III. SUMMARY OF LOAN LOSS EXPERIENCE
The information required in this section is presented in the discussion of the Provision for Loan Losses and Allowance for Loan Losses in Part II Item 7.B.II. beginning on page 20 of this Report, including:
Charge-offs and Recoveries by loan type
Factors that led to the amount of the Provision for Loan Losses
Allocation of the Allowance for Loan Losses by loan type
The percent of loans in each loan category is presented in the table of loan types in the preceding section on page 28 of this report.
The following table sets forth the average balances of and average rates paid on deposits for the periods indicated.
AVERAGE DEPOSIT BALANCES
Years Ended December 31,
(Dollars In Thousands)
During 2007, average deposit balances increased by $39.5 million, or 3.4%, over the average for 2006. The increase was primarily generated from our pre-existing branch network, although we did open two new branches in 2007; a new branch in Plattsburgh in the beginning of 2007 and another in the Saratoga Springs area in April of 2007.
During 2006, average deposit balances increased by $56.4 million, or 5.1%, over the average for 2005. Early in April 2005 we acquired approximately $62 million of deposit balances in our acquisition of three branches from HSBC. The inclusion of these acquired deposits in our average deposit balances for only part of the 2005 year, versus the entire 2006 year, accounted for approximately $16 million of the increase in average balances. The remaining increase was generated from our pre-existing branch network, and we opened a new branch in the Saratoga Springs area in January of 2006.
During 2005, average deposit balances increased by $63.1 million, or 6.0%, over the average for 2004. The acquisition of balances in the HSBC branch purchase transaction accounted for approximately $45 million of the increase in average balances between the years. The remaining increase was generated from our pre-existing branch network.
We did not sell or close any branches during the covered period, 2005-2007.
The following table presents the quarterly average balance by deposit type for each of the most recent five quarters.
Quarterly Average Deposit Balances (Dollars In Thousands)
Fluctuations in balances of our NOW accounts and time deposits of $100,000 or more are largely the result of municipal deposit fluctuations. Municipal deposits on average represent 15% to 20% of our total deposits. Municipal deposits are typically placed in NOW accounts and time deposits of short duration. Many of our municipal deposit relationships are subject to annual renewal, by formal or informal agreements.
In general, there is a seasonal pattern to municipal deposits starting with a low point during July and August. Account balances tend to increase throughout the fall and into the winter months from tax deposits and receive an additional boost at the end of March from the electronic deposit of state funds. In addition to these seasonal fluctuations within types of accounts, the overall level of municipal deposit balances fluctuates from year-to-year as some municipalities move their accounts in and out of our banks due to competitive factors. Often, the balances of municipal deposits at the end of a quarter are not representative of the average balances for that quarter.
Overall our deposit balances generally followed a pattern of flat to slightly decreased levels in the first calendar quarter, increasing totals in the second and third quarters, and continued increases in the fourth quarter, but moderating slightly at year-end. Our deposit experience in 2007 followed this pattern. In the first quarter, the average balance decreased $2.3 million, or 0.2%, from the fourth quarter of 2006, but rebounded in the second quarter with a $13.7 million, or 1.2%, increase in average balances over the first quarter of 2007. Average deposit balances for the third quarter of 2007 increased by $19.1 million, or 1.6%, over the second quarter of 2007. The increase was primarily attributable to an increase in municipal balances, but non-municipal balances also increased during the quarter.
During the fourth quarter of 2007, the average balance increased as expected, by $17.4 million, reflecting the significant increase in interest-bearing demand deposits attributable to the seasonal increase in municipal deposits. However, by the fourth quarter period-end, municipal deposit balances were only $3.83 million higher than the balance at September 30, 2007.
During the uninterrupted period of declining interest rates from May 2000 through the first half of 2004, we experienced a trend (typical for financial institutions) where maturing time deposits were transferred to non-maturity interest-bearing transaction accounts. This period of declining rates ended in June 2004 as the Fed initiated a series of seventeen 25 basis point increases in prevailing rates extending through June 2006.
As a result of this rising short-term rate environment commencing in mid-2004, we began to experience a reversal of the prior trend in deposit account migration as our customers, including municipal accounts, started to transfer some of their non-maturity balances back into time deposits. At December 31, 2007 time deposits represented 35.7% of total deposits, up from 22.5% at June 30, 2004. This ratio did not reach the high-water mark for recent years of 40.8% at June 30, 2000. As prevailing market rates began decreasing in the last four months of 2007, we saw the beginnings of a migration out of time deposits and back to non-maturity accounts. The total quarterly average balances as a percentage of total deposits are illustrated in the table below.
Time deposits of $100,000 or more are to a large extent comprised of municipal deposits and are obtained on a competitive bid basis.
In general, rates paid by us on various types of deposit accounts are influenced by the rates being offered or paid by our competitors, which in turn are influenced by prevailing interest rates in the economy as impacted from time to time by the actions of the Federal Reserve Bank. There typically is a time lag between the Federal Reserves actions undertaken to influence rates and the actual repricing of our deposit liabilities, although this lag is normally shorter than the lag between Federal Reserve actions and the repricing of our loans and other earning assets.
As a result of the Federal Reserve rate decreases in the 2001 through mid-2004 period, we experienced a decrease in the cost of deposits throughout the period. The cost of deposits during the second quarter of 2005 was at its lowest point in many years. After the Federal Reserve Bank began a protracted series of rate increases in June 2004, our cost of deposits continued to fall in the third quarter of 2004 as maturing time deposits were still repricing at lower rates. From the fourth quarter of 2004 through the second quarter of 2007, however, our average cost of deposits increased each quarter. This trend began to reverse itself in the past two quarters and we expect that our cost of deposits will continue to fall as long as the Federal Reserve Bank continues a policy of further rate decreases to stimulate the economy in 2008.
V. TIME DEPOSITS OF $100,000 OR MORE
The maturities of time deposits of $100,000 or more at December 31, 2007 are presented below. (In Thousands)
Our liquidity is measured by our ability to raise cash when we need it at a reasonable cost. We must be capable of meeting expected and unexpected obligations to our customers at any time. Given the uncertain nature of customer demands as well as the need to maximize earnings, we must have available reasonably priced sources of funds, on- and off-balance sheet, that can be accessed quickly in time of need.
Securities available-for-sale represent a primary source of our balance sheet cash flow. Certain investment securities are selected at purchase as available-for-sale based on their marketability and collateral value, as well as their yield and maturity. Our securities available-for-sale portfolio was $338.1 million at year-end 2007. Maturing loans in our portfolio also represent a steady source of balance sheet cash flow.
In addition to liquidity arising from balance sheet cash flows, we have supplemented liquidity with additional off-balance sheet sources such as federal funds lines of credit and credit lines with the Federal Home Loan Bank (FHLB). We have established federal funds lines of credit with three correspondent banks totaling $30 million. The average balance throughout 2007 was only $18 thousand and there was no period-end balance. We have established overnight and 30 day term lines of credit with the FHLB; each of these lines provided for a maximum borrowing line of $122.1 million at December 31, 2007. We borrowed only occasionally from the overnight line of credit with the FHLB during 2007. The average balance throughout 2007 was $285 thousand and there was no period-end balance. If advanced, such lines of credit are collateralized by mortgage-backed securities, loans and FHLB stock. The balance in other short-term borrowings at December 31, 2007 consisted entirely of treasury, tax and loan balances at the Federal Reserve Bank of New York.
In addition, we have identified wholesale and retail repurchase agreements and brokered certificates of deposit as appropriate off-balance sheet sources of funding accessible in relatively short time periods. Also, Glens Falls National has established a borrowing facility with the Federal Reserve Bank of New York, pledging certain consumer loans as collateral for potential discount window advances. At December 31, 2007, the amount available under this facility was $148.6 million, but there were no advances then outstanding. We measure and monitor our basic liquidity as a ratio of liquid assets to short-term liabilities, both with and without the availability of borrowing arrangements. Based on the level of cash flows from our investment securities portfolio, particularly mortgage-backed securities, and from maturing loans in our portfolio, our stable core deposit base and our significant borrowing capacity, we believe that our liquidity is sufficient to meet any reasonably likely events or occurrences.
E. CAPITAL RESOURCES AND DIVIDENDS
Shareholders' equity was $122.3 million at December 31, 2007, an increase of $4.1 million, or 3.5%, from the prior year-end. The most significant changes to shareholders equity include, net income of $17.3 million and net unrealized gains in the valuation allowance for available-for-sale securities ($3.7 million, net of tax) which were only partially offset by: i) cash dividends ($10.0 million), ii) repurchases of our own common stock ($7.3 million) and, iii) our guarantee of a $1.5 million loan to our Employee Stock Ownership Plan (ESOP) which requires a reduction in shareholders equity for the shares acquired with loan proceeds that have not yet been allocated to employees.
In each of 2004 and 2003, we enhanced our regulatory capital by issuing $10 million of capital securities in private placements with institutional investors, utilizing a subsidiary Delaware business trust for that purpose. These trust preferred securities were reflected as Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts on our consolidated balance sheets as of December 31, 2007 and 2006. These securities have certain features that make them an attractive funding vehicle. Under the Federal Reserves regulatory capital guidelines discussed below, trust preferred securities may qualify as Tier 1 capital, in an amount not to exceed 25% of Tier 1 capital, net of goodwill less any associated deferred tax liability. Both of our issues or trust preferred securities qualify as Tier 1 regulatory capital.
The maintenance of appropriate capital levels is a management priority. Overall capital adequacy is monitored on an ongoing basis by management and reviewed regularly by the Board of Directors. Our principal capital planning goal is to provide an adequate return to shareholders while retaining a sufficient base to provide for future expansion and comply with all regulatory standards.
One set of regulatory capital guidelines applicable to our holding company and subsidiary banks are the so-called risk-based capital measures. Under these measures, as established by federal bank regulators, the minimum ratio of "Tier 1" capital to risk-weighted assets is 4.0% and the minimum ratio of total capital to risk-weighted assets is 8.0%. For Arrow, Tier 1 capital is comprised of common shareholders' equity and the trust preferred securities issued by our two unconsolidated subsidiaries (see the second previous paragraph), less intangible assets. Total capital for the risk-based capital guidelines, includes Tier 1 capital plus other qualifying regulatory capital, including a portion of our allowance for loan losses.
In addition to the risk-based capital measures, the federal bank regulatory agencies require banks and bank holding companies to satisfy another capital guideline, the Tier 1 leverage ratio (Tier 1 capital to quarterly average assets less intangible assets). The minimum Tier 1 leverage ratio is 3.0% for the most highly rated institutions. The guidelines provide that other institutions should maintain a Tier 1 leverage ratio that is at least 1.0% to 2.0% higher than the 3.0% minimum level for top-rated institutions.
The table below sets forth the capital ratios of our holding company and subsidiary banks, Glens Falls National and Saratoga National, as of December 31, 2007:
At December 31, 2007 our holding company and both banks exceeded the minimum capital ratios established by the regulatory guidelines, and qualified as "well-capitalized", the highest category, in the capital classification scheme set by federal bank regulatory agencies (see the further discussion under "Supervision and Regulation" in Part I Item 1.C. of this Report).
The source of funds for the payment of shareholder dividends by our holding company consists primarily of dividends declared and paid to the holding company by our bank subsidiaries. In addition to regulatory constrictions on payments of dividends, there are statutory limitations applicable to the payment of dividends by our bank subsidiaries. As of December 31, 2007, under this statutory limitation, the maximum amount that could have been paid by the bank subsidiaries to the holding company, without special regulatory approval, was approximately $19.0 million. The ability of our holding company and our banks to pay dividends in the future is and will continue to be influenced by regulatory policies, capital guidelines and applicable laws.
See Part II, Item 5, "Market for the Registrant's Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities" for a recent history of our cash dividend payments.
F. OFF-BALANCE SHEET ARRANGEMENTS
In the normal course of operations, we may engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions may be used by us for general corporate purposes or for customer needs. Corporate purpose transactions may be used to help manage credit, interest rate, and liquidity risk or to optimize capital. Customer transactions may be used to manage customers' requests for funding.
We have no off-balance sheet arrangements that are reasonably likely to have a material current or future effect on our financial condition, revenues or expenses, results of operations, liquidity or capital expenditures.
G. CONTRACTUAL OBLIGATIONS (In Thousands)
1 See Note 11 to the Consolidated Financial Statements in Item 8 of this Report for additional information on Federal Home Loan Bank Advances, including call provisions.
2 See Note 12 to the Consolidated Financial Statements in Item 8 of this Report for additional information on Junior Subordinated Obligations Issued to Unconsolidated Subsidiary Trusts.
3 See Note 22 to the Consolidated Financial Statements in Item 8 of this Report for additional information on our Operating Lease Obligations.
4 See Note 16 to the Consolidated Financial Statements in Item 8 of this Report for additional information on our Retirement Plans.
H. FOURTH QUARTER RESULTS
We reported net income of $4.5 million for the fourth quarter of 2007, an increase of $186 thousand, or 4.3%, from the fourth quarter of 2006. Diluted earnings per common share for the fourth quarter of 2007 was $.42, an increase of $.03, or 7.7%, from the $.39 amount for the fourth quarter of 2006. The net increase in earnings was primarily attributable to the following: (i) an $858 thousand increase in tax-equivalent net interest income, (ii) a $75 thousand decrease in the provision for loan losses, (iii) a $43 thousand increase in noninterest income, (iv) a $653 thousand increase in noninterest expense, including a $600 thousand expense incurred by our banks, as Visa member banks, relating to members obligation to indemnify Visa USA, Inc. for losses recognized by it in the fourth quarter of 2007 in connection with antitrust litigation against Visa, and (v) a $46 thousand decrease in the provision for income taxes. The factors contributing to these quarter-to-quarter changes are included in the discussion of the year-to-year changes elsewhere in this Report.
SELECTED FOURTH QUARTER FINANCIAL INFORMATION
(Dollars In Thousands, Except Per Share Amounts)
1 Share and Per Share amounts have been restated for the September 2007 3% stock dividend.
2 Net Interest Margin is the ratio of tax-equivalent net interest income to average earning assets. (See Use of Non-GAAP Financial
Measures on page 3).
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
In addition to credit risk in our loan portfolio and liquidity risk, discussed earlier, our business activities also generate market risk. Market risk is the possibility that changes in future market rates (interest rates) or prices (fees for products and services) will make our position less valuable. The ongoing monitoring and management of risk is an important component of our asset/liability management process, which is governed by policies that are reviewed and approved annually by the Board of Directors. The Board of Directors delegates responsibility for carrying out asset/liability oversight and control to managements Asset/Liability Committee (ALCO). In this capacity ALCO develops guidelines and strategies impacting our asset/liability profile based upon estimated market risk sensitivity, policy limits and overall market interest rate levels and trends. We have not made use of derivatives, such as interest rate swaps, in our risk management process.
Interest rate risk is the most significant market risk affecting us. Interest rate risk is the exposure of our net interest income to changes in interest rates. Interest rate risk is directly related to the different maturities and repricing characteristics of interest-bearing assets and liabilities, as well as to the risk of prepayment of loans and early withdrawal of time deposits, and the fact that the speed and magnitude of responses to interest rate changes varies by product.
The ALCO utilizes the results of a detailed and dynamic simulation model to quantify the estimated exposure of net interest income to sustained interest rate changes. While ALCO routinely monitors simulated net interest income sensitivity over a rolling two-year horizon, it also utilizes additional tools to monitor potential longer-term interest rate risk.
The simulation model attempts to capture the impact of changing interest rates on the interest income received and interest expense paid on all interest-sensitive assets and liabilities reflected on our consolidated balance sheet. This sensitivity analysis is compared to ALCO policy limits which specify a maximum tolerance level for net interest income exposure over a one year horizon, assuming no balance sheet growth and a 200 basis point upward and downward shift in interest rates, and a repricing of interest-bearing assets and liabilities at their earliest reasonably predictable repricing dates. A parallel and pro rata shift in rates over a 12 month period is assumed. Applying the simulation model analysis as of December 31, 2007, a 200 basis point increase in interest rates demonstrated a 3.3% decrease in net interest income, and a 200 basis point decrease in interest rates demonstrated a 0.5% decrease in net interest income. These amounts were within our ALCO policy limits. Historically there has existed an inverse relationship between changes in prevailing rates and our net interest income, reflecting the fact that our liabilities and sources of funds generally reprice more quickly than our earning assets.
The preceding sensitivity analysis does not represent a forecast on our part and should not be relied upon as being indicative of expected operating results. As noted elsewhere in this Report, the Federal Reserve Board took certain actions from September 2007 through January 2008 that resulted in a 225 basis point decrease in prevailing rates. We believe that decreases in prevailing interest rates will generally have a short-term positive impact on our net interest margin and net interest income, which would be mitigated or perhaps reversed over the mid- to longer-term. We believe that increases in prevailing rates will generally have a negative impact on our margin and net interest income in the short-term, which would be mitigaged or perhaps reversed over the long-term. In each case, that is, in the case of increasing or decreasing rates, the slope of the yield curve and changes in the slope of the yield curve will also affect net interest income and the net interest margin. We are not able to predict with certainty what the magnitude of these effects would be.
The hypothetical estimates underlying the sensitivity analysis are based upon numerous assumptions including: the nature and timing of changes in interest rates including yield curve shape, prepayments on loans and securities, deposit decay rates, pricing decisions on loans and deposits, reinvestment/replacement of asset and liability cash flows, and others. While assumptions are developed based upon current economic and local market conditions, we cannot make any assurance as to the predictive nature of these assumptions including how customer preferences or competitor influences might change.
Also, as market conditions vary from those assumed in the sensitivity analysis, actual results will differ due to: prepayment/refinancing levels likely deviating from those assumed, the varying impact of interest rate changes on caps or floors on adjustable rate assets, the potential effect of changing debt service levels on customers with adjustable rate loans, depositor early withdrawals and product preference changes, unanticipated shifts in the yield curve and other internal/external variables. Furthermore, the sensitivity analysis does not reflect actions that ALCO might take in responding to or anticipating changes in interest rates.
Item 8. Financial Statements and Supplementary Data
The following audited consolidated financial statements and unaudited supplementary data are submitted herewith:
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
as of December 31, 2007 and 2006
Consolidated Statements of Income
for the Years Ended December 31, 2007, 2006 and 2005
Consolidated Statements of Changes in Shareholders' Equity
for the Years Ended December 31, 2007, 2006 and 2005
Consolidated Statements of Cash Flows
for the Years Ended December 31, 2007, 2006 and 2005
Notes to Consolidated Financial Statements
Supplementary Data: (Unaudited)
Summary of Quarterly Financial Data for the Years Ended December 31, 2007 and 2006
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
of Arrow Financial Corporation:
We have audited the accompanying consolidated balance sheets of Arrow Financial Corporation and subsidiaries (the Company) as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in shareholders equity and cash flows for each of the years in the three-year period ended December 31, 2007. These consolidated financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits 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 audits provide 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 Arrow Financial Corporation and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007, 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 Companys 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), and our report dated March 6, 2008, expressed an unqualified opinion on the effectiveness of the Companys internal control over financial reporting.
/s/ KPMG LLP
Albany, New York
March 6, 2008
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
of Arrow Financial Corporation:
We have audited Arrow Financial Corporations (the Company) internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).The Companys 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. 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, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's 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 company's 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, Arrow Financial Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on criteria established in Internal ControlIntegrated 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 sheets of Arrow Financial Corporation and subsidiaries as of December 31, 2007 and 2006, and the related consolidated statements of income, changes in shareholders equity, and cash flows for each of the years in the three-year period ended December 31, 2007, and our report dated March 6, 2008 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
Albany, New York
March 6, 2008
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Dollars in Thousands)
See Notes to Consolidated Financial Statements.
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, Except Per Share Amounts)
All share and per share amounts have been adjusted for the 2007 3% stock dividend.
See Notes to Consolidated Financial Statements.
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY
(In Thousands, Except Share and Per Share Amounts)
(Continued on Next Page)
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY, Continued
(In Thousands, Except Share and Per Share Amounts)
(Continued on Next Page)
ARROW FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS EQUITY, Continued
(In Thousands, Except Share and Per Share Amounts)
Per share amounts and share data have been adjusted for subsequent stock splits and dividends, including the most recent 2007 3% stock dividend.
Included in the shares issued for the stock dividend in 2007 were treasury shares of 116,690 and unallocated ESOP shares of 3,201.
See Notes to Consolidated Financial Statements.