TWO RIVER BANCORP 10-K 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
For the fiscal year ended December 31, 2006
For the transition period from ________ to _______
Commission file Number: 000-51889
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
The aggregate market value of the registrants common stock held by non-affiliates of the registrant, computed by reference to the price at which the common stock was last sold, or the average bid and asked price of such common stock, as of the last business day of the registrants most recently completed second quarter, is $67,833,350.
As of March 27, 2007, 6,511,582 shares of the registrants common stock were outstanding.
Portions of the registrants definitive Proxy Statement for its 2007 Annual Meeting of Shareholders to be filed by the registrant within 120 days after the end of the registrants most recent fiscal year are incorporated by reference into Part III of this report.
TABLE OF CONTENTS
Item 1. Business.
Community Partners Bancorp
The disclosures set forth in this item are qualified by Item 1A. Risk Factors, the section captioned Forward-looking Statements in Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation and other statements set forth in this report.
Community Partners Bancorp (Community Partners, the Company, we, us and our) is a business corporation organized under the laws of the State of New Jersey in August 2005. The principal place of business of Community Partners is located at 1250 Highway 35 South, Middletown, New Jersey 07748 and its telephone number is (732) 706-9009.
Community Partners was organized to effect the acquisition and become the holding company of two New Jersey chartered commercial banks, Two River Community Bank (Two River), located in Middletown, New Jersey, and The Town Bank (Town Bank), located in Westfield, New Jersey. Throughout this document, we refer to each of Two River and Town Bank as a Bank and we refer to them together as the Banks. At the effective time of the acquisition, each Bank became a wholly-owned subsidiary of Community Partners.
Other than its investment in the Banks, Community Partners currently conducts no other significant business activities. Community Partners may determine to operate its own business or acquire other commercial banks, thrift institutions or bank holding companies, or engage in or acquire such other activities or businesses as may be permitted by applicable law, although it has no present plans or intentions to do so. When we refer to the business conducted by Community Partners in this document, including any lending or other banking activities, we are referring to the business that Community Partners conducts through the Banks.
Subject to regulatory approval and/or consent, it is expected that Community Partners will receive a cash infusion from Two River for working capital and other purposes. Additional financial resources may be available to Community Partners in the future through borrowings, debt or equity financings, or dividends from the Banks or from acquired entities or new businesses. Dividends from either Bank to Community Partners will be subject to regulatory limitations, and other actions by which Community Partners may acquire cash or assets may also be subject to compliance with regulatory restrictions.
As of December 31, 2006, the Company had consolidated assets of $520.5 million, total deposits of $441.9 million and shareholders equity of $68.3 million.
As of December 31, 2006, Community Partners had 113 full-time and 12 part-time employees. The Companys employees are not represented by a union or covered by a collective bargaining agreement. Management of the Company believes that, in general, its employee relations are good.
Two River is a New Jersey state chartered commercial bank which engages in the business of commercial and retail banking. As a community bank, Two River offers a wide range of banking services including demand, savings and time deposits and commercial and consumer/installment loans to small and medium-sized businesses, not-for-profit organizations, professionals and individuals principally in the Monmouth County, New Jersey area. Two River also offers its customers numerous banking products such as safety deposit boxes, a night depository, wire transfers, money orders, travelers checks, automated teller machines, direct deposit, federal payroll tax deposits, telephone and internet banking and merchant card services.
We believe that Two River customers still want to do business with a banker and that they want to feel that they are important to that banker. To accomplish this objective, Two River emphasizes to its employees the importance of delivering exemplary customer service and seeking out opportunities to build further relationships with the Banks customers. Two Rivers deposits are insured by the Bank Insurance Fund of the FDIC up to the statutory limits.
Two River has established a website on the Internet at www.tworiverbank.com.
Town Bank was organized in 1998 as a New Jersey state chartered commercial bank in Westfield, New Jersey by a group of prominent local business and community leaders to provide community banking as an alternative to larger financial institutions. Town Bank commenced operations in October 1998, and conducts business from two banking locations in Westfield. Town Bank provides a wide-range of commercial and consumer banking products and services, including personal and business checking accounts and time deposits, money market accounts and regular savings accounts. Town Banks deposits are insured by the Bank Insurance Fund of the FDIC up to the statutory limits.
Town Bank has established a website on the Internet at www.townbank.com.
Market Analysis and Competition
Our market strategy is focused on delivering to individuals and small and medium-sized businesses exceptional client service and effective financial advice through friendly and personal banking professionals who understand and care about the broad financial needs and objectives of its clients.
Two River operates ten branch offices and an operations center in Monmouth County, New Jersey. Two Rivers principal office is located on the west side of Route 35 South, just to the north of its intersection with New Monmouth Road in Middletown, Monmouth County, New Jersey. Branch offices are located in Atlantic Highlands, Cliffwood, Middletown Township, Navesink, Port Monmouth, Red Bank, Tinton Falls (2), Wall Township, and West Long Branch, New Jersey. Each branch is within 75 miles of the metropolitan areas of both New York City and Philadelphia, with a diverse population and growing economy.
Town Bank operates two branch offices in Westfield, Union County, New Jersey. Town Banks primary trade area includes the town of Westfield as well as the immediately contiguous portions of Clark, Cranford, Fanwood, Garwood, Mountainside and Scotch Plains in Union County, New Jersey. The Westfield area is a bedroom community for New York City, approximately 25 miles to the east, and is easily accessible by major highways or rail.
We expect that for the near future, our primary business will be the ownership of the Banks. Therefore, the competitive conditions to be faced by Community Partners will be those faced by the member Banks. In addition, many banks and other financial institutions have formed, or are in the process of forming, holding companies. It is likely that these holding companies will attempt to acquire commercial banks, thrift institutions or companies engaged in bank-related activities. We are therefore likely to face competition in undertaking any such acquisitions and in operating subsequent to any such acquisitions.
Both Banks face substantial competition for deposits and creditworthy borrowers. They compete with both New Jersey and regionally based commercial banks, savings banks and savings and loan associations, most of which have assets, capital and lending limits greater in amount than of the Banks. Other competitors include money market mutual funds, mortgage bankers, insurance companies, stock brokerage firms, regulated small loan companies, credit unions and issuers of commercial paper and other securities.
Products and Services
The Banks offer a full range of retail and commercial banking services to our customers. This includes a wide variety of business loans and consumer lending products; checking, savings, money market and certificates of deposit; corporate services for businesses and professionals; safe deposit boxes; ACH services; debit card and ATM services; and check deposit pick-up. Other service products include travelers checks, money orders, treasurers checks, and direct deposit facilities. We also offer customers the convenience of a full complement of internet banking services which allow them to check account balances, view account activity, transfer funds, place stop-payment orders, and pay their bills any time of the day or night. Deposits are insured up to applicable legal limits.
The Banks engage in a variety of lending activities, which are primarily categorized as commercial and residential real estate - consumer lending. The strategy is to focus its lending activities on small/medium business customers and retain customers by offering them a wide range of products and personalized service. Commercial and real estate mortgage lending (consisting of commercial real estate, commercial business, construction and other commercial lending) are currently our main lending focus. Sources to fund loans are derived primarily from deposits, although we do occasionally borrow on a short-term basis to fund loan growth or meet deposit outflows.
The Banks presently generate the vast majority of our loans in the State of New Jersey, with a significant portion in Union and Monmouth County. Loans are generated through marketing efforts, its present customers, walk-in customers, referrals, the directors, founders and advisory boards of the member Banks. The Banks have been able to maintain a high overall credit quality through the establishment and adherence to prudent lending policies and practices and sound management. There is an established written loan policy for each of its categories of loans. These loan policies have been adopted by the board of directors of each member Bank and are reviewed annually. Any loan to Bank or Company directors or their affiliates must be reviewed and approved by the Banks board of directors in accordance with the loan policy for such loans as well as applicable state and federal law.
In managing the growth and quality of its loan portfolio, we have focused on: (i) the application of prudent underwriting criteria; (ii) the active involvement by senior management and the Bank board of directors in the loan approval process; (iii) the active monitoring of loans to ensure that repayments are made in a timely manner and early detection of potential problem loans; and (iv) a loan review process by an independent loan review firm, which conducts in-depth reviews of portions of the loan portfolio on a quarterly basis.
Our principal earning assets are loans originated or participated in by the Banks. The risk that certain borrowers will not be able to repay their loans under the existing terms of the loan agreement is inherent in the lending function. Risk elements in a loan portfolio include non-accrual loans, past due and restructured loans, potential problem loans, loan concentrations (by industry or geographically) and other real estate owned, acquired thru foreclosure or a deed in lieu of foreclosure. Because the vast majority of the Banks loans are made to borrowers located in Union and Monmouth County, New Jersey, each loan or group of loans presents a geographical risk and credit risk based upon the condition of the local economy. The local economy is influenced by outside conditions such as housing prices, employment conditions and changes in interest rates.
Our commercial loan portfolio consists primarily of commercial business loans to small and medium sized businesses and individuals for business purposes and commercial real estate loans.
Commercial and industrial loans are usually made to finance the purchase of inventory and new or used equipment or for short-term working capital. Generally, these loans are secured, but these loans are sometimes granted on an unsecured basis. To further enhance its security position, we generally require personal guarantees of principal owners. These loans are made on both a line of credit basis and on a fixed-term basis ranging from one to five years in duration. At December 31, 2006 and December 31, 2005, commercial and industrial loans comprised 24.0% and 25.6%, respectively, of our total loan portfolio.
Commercial real estate loans are made to local commercial, retail and professional firms and individuals for the acquisition of new property or the refinancing of existing property. These loans are typically related to commercial businesses and secured by the underlying real estate used in these businesses or real property of the principals. These loans are generally offered on a fixed or variable rate basis with 5 to 20 year maturities, subject to rate re-adjustments every five years, and a 10 to 20 year amortization schedule. At December 31, 2006 and December 31, 2005, commercial real estate loans comprised 38.0% and 45.3%, respectively, of our total loan portfolio.
Construction and land development loans are made on a short-term basis for both residential and non-residential properties and are secured by land and property. Construction loans are usually for a term of 6 to 12 months. Funds for construction loans are disbursed as phases of construction are completed and after the construction is inspected by an independent third party. At December 31, 2006 and December 31, 2005, construction loans comprised 26.8% and 19.7%, respectively, of our total loan portfolio.
We have established written underwriting guidelines for commercial loans. In granting commercial loans, we look primarily to the borrowers cash flow as the principal source of loan repayment. Collateral and personal guarantees of the principals of the entities to which we lend are consistent with the requirements of our loan policy.
Commercial loans are often larger and may involve greater risks than other types of lending. Since payments on such loans are often dependent on the successful operation of the business involved, repayment of such loans may be more sensitive than other types of loans to adverse conditions in the real estate market or the economy. Construction loans involve the additional risk of non-completion by the borrower. We are also involved with off-balance sheet financial instruments which include collateralized commercial and standby letters of credit meeting the financial needs of their customers. We seek to minimize these risks through its underwriting and monitoring guidelines. There can be no assurances, however, of success in the efforts to minimize these risks.
Residential Real Estate and Consumer Loans
We offer a full range of residential real estate and consumer loans. These loans consist of residential mortgages, home equity lines of credit and loans, personal loans, automobile loans and overdraft protection. Our home equity revolving lines of credit come with a floating interest rate tied to the prime rate with a maximum ratio of loan to value ratio of 80%. Lines of credit are available to qualified applicants in amounts up to $250,000 for up to 15 years. We also offer fixed rate home equity loans in amounts up to $250,000 for a term of up to 15 years. Credit is based on the income and cash flow of the individual borrowers and real estate collateral supporting the mortgage debt. At December 31, 2006 and December 31, 2005, consumer and residential real estate loans comprised 11.2% and 9.3%, respectively, of our total loan portfolio.
As we continue to grow and leverage our capital, we envision that loans will continue to be our principal earning assets. An inherent risk in lending is the borrowers ability to repay the loan under its existing terms. Risk elements in a loan portfolio include non-accrual loans (as defined below), past due and restructured loans, potential problem loans, loan concentrations and other real estate owned, acquired through foreclosure or a deed in lieu of foreclosure.
Non-performing assets include loans that are not accruing interest (non-accruing loans) as a result of principal or interest being in default for a period of 90 days or more and other real estate owned. When a loan is classified as non-accruing, interest accruals cease and all past due interest is reversed and charged against current income. Until the loan becomes current, any payments received from the borrower are applied to outstanding principal unless we determine that the financial condition of the borrower and other factors merit recognition of such payments as interest. At December 31, 2006 and 2005, the Company had no non-accrual loans.
We utilize a risk system, consisting of multiple grading categories, as an analytical tool to assess risk and set appropriate reserves. Along with the risk system, management further evaluates risk characteristics of the loan portfolio under current economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors management feels deserve recognition in establishing an appropriate reserve or reasons which might bear on ultimate collectibility.
In addition, the FDIC has a classification system for problem loans and other lower quality assets, classifying them as substandard, doubtful or loss. A loan is classified as substandard when it is inadequately protected by the current value and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that some loss may occur if the deficiencies are not corrected.
A loan is classified doubtful when it has all the weaknesses inherent in one classified as substandard with the added characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing factors, conditions, and values, highly questionable and improbable. A loan is classified as loss when it is considered uncollectible and of such little value that the assets continuance as an asset on the balance sheet is not warranted.
In addition to non-performing loans and loans past due 90 days or more and still accruing interest categories, we maintain a list of performing loans where management has identified problems which potentially could cause such loans to be placed on non-accrual status in future periods. Loans on this watch list are subject to heightened scrutiny and more frequent review by management. The balance of potential problem loans at December 31, 2006 totaled approximately $17.4 million.
We maintain an allowance for loan losses at a level that we believe is adequate to provide for probable losses inherent in the loan portfolio. Loan losses are charged directly to the allowance when they occur and any recovery is credited to the allowance when realized. Risks from the loan portfolio are analyzed on a continuous basis by loan officers, and periodically by our outside independent loan review auditors, directors on the Loan Committee and the Bank board of directors as a whole.
A risk system, consisting of multiple grading categories, is utilized as an analytical tool to assess risk and set appropriate reserves. Along with the risk system, management further evaluates risk characteristics of the loan portfolio under current and anticipated economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors management feels deserve recognition in establishing an appropriate reserve. These estimates are reviewed at least quarterly, and as adjustments become necessary, they are realized in the periods in which they become known. Additions to the allowance are made by provisions charged to expense and the allowance is reduced by net charge-offs (i.e., loans judged to be uncollectible and charged against the reserve, less any recoveries on such loans).
Although management attempts to maintain the allowance at a level deemed sufficient to cover any losses, future additions to the allowance may be necessary based upon any changes in market conditions. In addition, various regulatory agencies periodically review our allowance for loan losses, and may require us to take additional provisions based on their judgments about information available to them at the time of their examination.
Our investment portfolio consists primarily of obligations of U.S. Government sponsored agencies as well as municipal and government authority bonds, with high grade corporate bonds accounting for less than 10% of the portfolio. Government regulations limit the type and quality of instruments in which the company may invest its funds.
We conduct our asset/liability management through consultation with members of our board of directors, senior management and an outside financial advisor. The asset/liability investment committee, commonly known as an ALCO committee, which is comprised of the president, chief financial officer and certain members of our board of directors. The ALCO committee, in consultation with our board of directors, is responsible for the review of interest rate risk and evaluates future liquidity needs over various time periods.
We have established a written investment policy which is reviewed annually by the ALCO committee and our board of directors. The investment policy identifies investment criteria and states specific objectives in terms of risk, interest rate sensitivity and liquidity and emphasizes the quality, term and marketability of the securities acquired for its investment portfolio.
The ALCO committee is responsible for monitoring the Companys investment portfolio and ensuring that investments comply with the investment policy. The ALCO committee may from time to time consult with investment advisors. Each Bank president and its chief financial officer may purchase or sell securities in accordance with the guidelines of the ALCO committee. Each Banks board of directors reviews the components of the investment portfolio on a monthly basis.
We emphasize relationships with commercial and individual customers and seek to obtain transaction accounts, which are frequently non-interest bearing deposits or lower cost interest bearing checking and money market deposit accounts.
Deposits are the primary source of funds used in lending and other general business purposes. In addition to deposits, we may derive additional funds from principal repayments on loans, the sale of investment securities and borrowing from other financial institutions. Loan amortization payments have historically been a relatively predictable source of funds. The level of deposit liabilities can vary significantly and is influenced by prevailing interest rates, money market conditions, general economic conditions and competition. As another means of funding our growth, we have the option of generating additional capital through the issuance of trust preferred capital securities.
Community Partners deposits consist of checking accounts, savings accounts, money market accounts and certificates of deposit. Deposits are obtained from individuals, partnerships, corporations and unincorporated businesses in the companys market area. We attempt to control the flow of deposits primarily by pricing its accounts to remain generally competitive with other financial institutions in its market area.
Business Growth Strategy
Our plan for growth emphasizes expanding our market presence in the communities located between Union County and Monmouth County, New Jersey by adding strategically located new offices and considering selective acquisitions that would be accretive to earnings within the first full year of combined operations. We believe that this strategy will continue to build shareholder value and increase revenues and earnings per share by creating a larger base of lending and deposit relationships and achieving economies of scale and other efficiencies Our efforts include opening retail banking offices in the Middlesex county area and other attractive markets where we have established lending relationships, as well as exploring opportunities to grow and add other profitable banking-related businesses. We believe that by establishing banking offices and making selective acquisitions in attractive growth markets while providing our customary superior service, our core deposits will naturally increase.
Supervision and Regulation
Two River, Town Bank and Community Partners operate within a system of banking laws and regulations intended to protect bank customers and depositors. These laws and regulations govern the permissible operations and management, activities, reserves, loans and investments of Community Partners, Two River and Town Bank. In addition, Community Partners is subject to federal laws and regulations and the corporate laws and regulations of the state of its incorporation, New Jersey. Two River and Town Bank, New Jersey state chartered banks, are also subject to The New Jersey Banking Act. The following descriptions summarize the key banking and other laws and regulations to which Two River and Town Bank are subject, and to which Community Partners is subject as a registered bank holding company. These descriptions are not intended to be complete and are qualified in their entirety by reference to the full text of the statutes and regulations. Future changes in these laws and regulations, or in the interpretation and application thereof by their administering agencies, cannot be predicted, but could have a material effect on the business and results of Community Partners, Two River and Town Bank.
Community Partners is a bank holding company under the Federal Bank Holding Company Act of 1956, as amended by the 1999 financial modernization legislation known as the Gramm-Leach-Bliley Act, and is subject to the supervision of the Board of Governors of the Federal Reserve System. In general, the Bank Holding Company Act limits the business of bank holding companies to banking, managing or controlling banks, and performing certain servicing activities for subsidiaries and, as a result of the Gramm-Leach-Bliley Act amendments, would permit bank holding companies that are also financial holding companies to engage in any activity, or acquire and retain the shares of any company engaged in any activity, that is either (1) financial in nature or incidental to such financial activity or (2) complementary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. In order for a bank holding company to engage in the broader range of activities that are permitted by the Bank Holding Company Act for bank holding companies that are also financial holding companies, upon satisfaction of certain regulatory criteria, the bank holding company must file a declaration with the Federal Reserve Board that it elects to be a financial holding company. Community Partners does not intend to seek a financial holding company designation at this time, and does not believe that the current decision not to seek a financial holding company designation will adversely affect its ability to compete in its chosen markets. We believe that seeking such a designation for Community Partners would not position it to compete more effectively in the offering of products and services currently offered by the Banks.
Two River and Town Bank are each commercial banks chartered under the laws of the State of New Jersey. As such, they are subject to regulation, supervision and examination by the New Jersey Department of Banking and Insurance, or NJDOBI, and by the Federal Deposit Insurance Corporation, or FDIC. Each of these agencies regulates aspects of activities conducted by the Banks and Community Partners, as discussed below. Neither Bank is a member of the Federal Reserve Bank of New York.
The primary source of cash to pay dividends, if any, to the Companys shareholders and to meet the Companys obligations is dividends paid to the Company by the Banks. Dividend payments by the Banks to the Company are subject to the New Jersey Banking Act of 1948 (the Banking Act) and the Federal Deposit Insurance Act (the FDIA). Under the Banking Act and the FDIA, the Banks may not pay any dividends if after paying the dividend, the Bank would be undercapitalized under applicable capital requirements. In addition to these explicit limitations, the federal regulatory agencies are authorized to prohibit a banking subsidiary or bank holding company from engaging in an unsafe or unsound banking practice. Depending upon the circumstances, the agencies could take the position that paying a dividend would constitute an unsafe or unsound banking practice.
It is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the immediately preceding year and only if prospective earnings retention is consistent with the organizations expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividend that undermines the bank holding companys ability to serve as a source of strength to its banking subsidiary. A bank holding company may not pay dividends when it is insolvent.
Neither Two River nor Town Bank has ever declared any cash dividends and neither entity contemplates the payment of such dividends in the future, except to fund expenses of Community Partners. Community Partners did not pay any cash dividends to shareholders in 2006 and does not contemplate the payment of cash dividends to shareholders in 2007. On July 18, 2006, Community Partners declared a 3% stock dividend, which was paid on September 1, 2006 to shareholders of record as of August 18, 2006.
Transactions with Affiliates
Banking laws and regulations impose certain restrictions on the ability of bank holding companies to borrow from and engage in other transactions with their subsidiary banks. Generally, these restrictions require that any extensions of credit must be secured by designated amounts of specified collateral and are limited to (i) 10% of the banks capital stock and surplus per non-bank affiliated borrower, and (ii) 20% of the banks capital stock and surplus aggregated as to all non-bank affiliated borrowers. In addition, certain transactions with affiliates must be on terms and conditions, including credit standards, at least as favorable to the institution as those prevailing for arms-length transactions.
Liability of Commonly Controlled Institutions and Source of Strength Doctrine
The Federal Deposit Insurance Act contains a cross-guarantee provision that could result in any insured depository institution owned by Community Partners being assessed for losses incurred by the FDIC in connection with assistance provided to, or the failure of, any other insured depository institution owned by Community Partners. Capital loans by a bank holding company to a bank subsidiary are subordinate in right of repayment to deposits and other bank indebtedness. If a bank holding company declares bankruptcy, its bankruptcy trustee must fulfill any commitment made by the bank holding company to sustain the capital of its subsidiary banks.
Our subsidiary banks deposits are insured to applicable limits by the Federal Deposit Insurance Corporation. Although the FDIC is authorized to assess premiums under a risk-based system for such deposit insurance, most insured depository institutions have not been required to pay premiums for the last ten years. The Federal Deposit Insurance Reform Act of 2005 (the Reform Act), which was signed into law on February 15, 2006, has resulted in significant changes to the federal deposit insurance program: (i) effective March 31, 2006, the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) were merged into a new combined fund, called the Deposit Insurance Fund; (ii) the current $100,000 deposit insurance coverage will be indexed for inflation (with adjustments every five years, commencing January 1, 2011); and (iii) deposit insurance coverage for retirement accounts was increased to $250,000 per participant subject to adjustment for inflation. In addition, the Reform Act gave the FDIC greater latitude in setting the assessment rates for insured depository institutions, which could be used to impose minimum assessments.
The FDIC is authorized to set the reserve ratio for the Deposit Insurance Fund annually at between 1.15% and 1.5% of estimated insured deposits. If the Deposit Insurance Funds reserves exceed the designated reserve ratio, the FDIC is required to pay out all or, if the reserve ratio is less than 1.5%, a portion of the excess as a dividend to insured depository institutions based on the percentage of insured deposits held on December 31, 1996 adjusted for subsequently paid premiums. Insured depository institutions that were in existence on December 31, 1996 and paid assessments prior to that date (or their successors) are entitled to a one-time credit against future assessments based on the amount of their assessable deposits on that date. Our subsidiary banks will not be entitled to this credit as neither were in existence as of December 31, 1996.
Pursuant to the Reform Act, the FDIC has determined to maintain the designated reserve ratio at its current 1.25%. The FDIC has also adopted a new risk-based premium system that provides for quarterly assessments based on an insured institutions ranking in one of four risk categories based on their examination ratings and capital ratios. Beginning in 2007, well-capitalized institutions with the CAMELS ratings of 1 or 2 will be grouped in Risk Category I and will be assessed for deposit insurance at an annual rate of between five and seven basis points, with the assessment rate for an individual institution to be determined according to a formula based on a weighted average of the institutions individual CAMEL component ratings plus either five financial ratios or the average ratings of its long-term debt. Institutions in Risk Categories II, III and IV will be assessed at annual rates of 10, 28 and 43 ba sis points, respectively.
In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation (FICO), an agency of the Federal government established to recapitalize the predecessor to the SAIF. The FICO assessment rates, which are determined quarterly, averaged 0.013% of insured deposits in fiscal 2006. These assessments will continue until the FICO bonds mature in 2017.
The Federal Reserve Board and the FDIC have substantially similar risk-based capital and leverage ratio guidelines for banking organizations. These guidelines are intended to ensure that banking organizations have adequate capital given the risk levels of their assets and off-balance sheet financial instruments. Under the risk-based capital and leverage ratio guidelines, assets and off-balance sheet items are assigned to broad risk categories, each with appropriate weights. The resulting capital ratios represent capital as a percentage of total risk-weighted assets and off-balance sheet items. These risk-based capital requirements identify concentration of credit risk, and facilitate management of those risks.
To derive total risk-weighted assets, bank assets are given risk-weights of 0%, 20%, 50% and 100%. In addition, certain off-balance sheet items are converted to asset equivalent amounts to which an appropriate risk-weight will apply. Most loans are assigned to the 100% risk category, except for performing first mortgage loans fully secured by residential property, which carry a 50% risk weighting. Most investment securities (including, primarily, general obligation claims of states or other political subdivisions of the United States) are assigned to the 20% category, except for municipal or state revenue bonds, which have a 50% risk-weight, and direct obligations of the U.S. Treasury or obligations backed by the full faith and credit of the United States government, which have a 0% risk-weight. In converting off-balance sheet items, direct credit substitutes, including general guarantees and standby letters of credit backing financial obligations, are given a 100% risk-weighting. Transaction-related contingencies such as bid bonds, standby letters of credit backing nonfinancial obligations, and undrawn commitments (including commercial credit lines with an initial maturity or more than one year) have a 50% risk weighting. Short-term commercial letters of credit have a 20% risk weighting, and certain short-term unconditionally cancelable commitments have a 0% risk weighting.
Under the capital guidelines, a banking organizations total capital is divided into tiers. Tier I Capital consists of common shareholders equity and qualifying preferred stock, less certain goodwill items and other intangible assets. Not more than 25% of qualifying Tier I capital may consist of trust preferred securities. Tier II Capital consists of hybrid capital instruments, perpetual debt, mandatory convertible debt securities, a limited amount of subordinated debt, and preferred stock that does not qualify as Tier I Capital, plus a limited amount of loan and lease loss allowances and a limited amount of unrealized holding gains on equity securities. Tier III Capital consists of qualifying unsecured subordinated debt. Total Capital is the sum of Tier I, Tier II and Tier III Capital. The sum of Tier II and Tier III Capital may not exceed the amount of Tier I Capital.
Under the Federal Reserve Boards risk-based capital guidelines for bank holding companies, the required minimum ratio of Total Capital (the sum of Tier I, Tier II and Tier III capital) to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) is 8%. The required minimum ratio of Tier I Capital to risk-weighted assets is 4%. At December 31, 2006, Community Partners ratios of Total Capital and Tier 1 Capital to risk-weighted assets were 10.73% and 9.68%, respectively.
The Federal Reserve Board also requires bank holding companies to comply with minimum leverage ratio guidelines. The leverage ratio is the ratio of a bank holding companys Tier I Capital (excluding intangibles) to its total assets (excluding intangibles). Bank holding companies normally must maintain a minimum leverage ratio of 4%, unless the bank holding company has the highest supervisory rating or has implemented the Federal Reserve Boards risk-adjusted measure for market risk, in which case its minimum leverage ratio must be 3%. Banking organizations undergoing significant growth or undertaking acquisitions must maintain even higher capital positions. At December 31, 2006, Community Partners leverage ratio was 8.52%.
The primary federal regulator for each of the Banks, the FDIC, also has implemented risk-based capital guidelines for insured depository institutions. Like the Federal Reserve Boards requirements, the FDICs required minimum ratio of total capital to risk-weighted assets is 8.0%. At least half of the total capital is required to be Tier I Capital. The required minimum ratio of Tier I Capital to risk-weighted assets is 4%. At December 31, 2006, Two Rivers ratios of Total Capital and Tier 1 Capital to risk-weighted assets were 10.54% and 9.55%, respectively. At December 31, 2006, Town Banks ratios of Total Capital and Tier 1 Capital to risk-weighted assets were 11.29% and 10.14%, respectively.
The Federal Deposit Insurance Act requires federal banking regulators to take prompt corrective action with respect to depository institutions that do not meet minimum capital requirements. Failure to meet minimum requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have an adverse material effect on Community Partners financial condition. Under the Prompt Corrective Action Regulations, the Banks must meet specific capital guidelines that involve quantitative measures of their respective assets, liabilities and certain off-balance sheet items as calculated under regulatory accounting practices.
The Prompt Corrective Action Regulations define specific capital categories based on an institutions capital ratios. The capital categories, in declining order, are well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. The Federal Deposit Insurance Act imposes progressively more restrictive constraints on operations, management and capital distributions, depending on the capital category by which the institution is classified. Institutions categorized as undercapitalized or worse may be subject to requirements to file a capital plan with their primary federal regulator, prohibitions on the payment of dividends and management fees, restrictions on asset growth and executive compensation, and increased supervisory monitoring, among other things. Other restrictions may be imposed on the institution by the regulatory agencies, including requirements to raise additional capital, sell assets or sell the entire institution. Once an institution becomes critically undercapitalized, it generally must be placed in receivership or conservatorship within 90 days.
The Prompt Corrective Action Regulations provide that an institution is well capitalized if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier I risk-based capital ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater. The institution also may not be subject to an order, written agreement, capital directive or prompt corrective action directive to meet and maintain a specific level for any capital measure. An institution is adequately capitalized if it has a total risk-based capital ratio of 8.0% or greater, a Tier I risk-based capital ratio of 4.0% or greater, and a leverage ratio of 4.0% or greater (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines), and the institution does not meet the definition of a well-capitalized institution. An institution is deemed undercapitalized if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio of less than 4.0%, or a leverage ratio of less than 4.0% (or a leverage ratio of 3.0% or greater if the institution is rated composite 1 in its most recent report of examination, subject to appropriate federal banking agency guidelines), and the institution does not meet the definition of a significantly undercapitalized or critically undercapitalized institution. An institution is significantly undercapitalized if the institution has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio of less than 3.0%, or a leverage ratio less than 3.0% and the institution does not meet the definition of a critically undercapitalized institution, and is critically undercapitalized if the institution has a ratio of tangible equity to total assets that is equal to or less than 2.0%.
The appropriate federal banking agency may, under certain circumstances, reclassify a well-capitalized insured depository institution as adequately capitalized. The appropriate agency is also permitted to require an adequately capitalized or undercapitalized institution to comply with the supervisory provisions as if the institution were in the next lower category (but not to treat a significantly undercapitalized institution as critically undercapitalized) based on supervisory information other than an institutions capital levels.
At December 31, 2006, Two River and Town Bank were each well capitalized based on the ratios and guidelines noted above. However, the capital categories of these banks are determined solely for the purpose of applying the Prompt Corrective Action Regulations and may not constitute an accurate representation of their overall financial condition or prospects.
Unsafe and Unsound Practices
Notwithstanding its Prompt Corrective Action category dictated by risk-based capital ratios, the Federal Deposit Insurance Act permits the appropriate bank regulatory agency to reclassify an institution if it determines, after notice and a hearing, that the condition of the institution is unsafe or unsound, or if it deems the institution to be engaging in an unsafe or unsound practice. Also, if a federal regulatory agency with jurisdiction over a depository institution believes that the depository institution will engage, is engaging, or has engaged in an unsafe or unsound practice, the regulator may require that the bank cease and desist from such practice, following notice and a hearing on the matter.
The USA PATRIOT Act
On October 26, 2001, the President of the United States signed into law certain comprehensive anti-terrorism legislation known as the USA PATRIOT Act of 2001. Title III of the USA PATRIOT Act substantially broadened the scope of the U.S. anti-money-laundering laws and regulations by imposing significant new compliance and due diligence obligations, creating new crimes and penalties and expanding the extra-territorial jurisdiction of the United States. The U.S. Treasury Department has issued a number of implementing regulations which apply various requirements of the USA PATRIOT Act to financial institutions such as Two River and Town Bank. Those regulations impose new obligations on financial institutions to maintain appropriate policies, procedures and controls to detect, prevent and report money laundering and terrorist financing.
Failure of a financial institution to comply with the USA PATRIOT Acts requirements could have serious legal consequences for an institution and adversely affect its reputation. The banks and Community Partners adopted appropriate policies, procedures and controls to address compliance with the requirements of the USA PATRIOT Act under the existing regulations and each of them will continue to revise and update its policies, procedures and controls to reflect changes required by the Act and by the Treasury Department regulations.
Community Reinvestment Act
The Federal Community Reinvestment Act requires banks to respond to the full range of credit and banking needs within their communities, including the needs of low and moderate-income individuals and areas. A banks failure to address the credit and banking needs of all socio-economic levels within its markets may result in restrictions on growth and expansion opportunities for the bank, including restrictions on new branch openings, relocation, formation of subsidiaries, mergers and acquisitions. In the latest CRA examination report with respect to Two River, dated February 23, 2006, Two River received a rating of Satisfactory. In the latest CRA examination report with respect to Town Bank, dated January 5, 2006, Town Bank received a rating of Satisfactory.
In addition to fostering the development of financial holding companies, the Gramm-Leach-Bliley Act modified laws relating to financial privacy. The new financial privacy provisions generally prohibit financial institutions, including both banks and, following the acquisition, Community Partners, from disclosing or sharing nonpublic personal financial information to third parties for marketing or other purposes not related to transactions, unless customers have an opportunity to opt out of authorizing such disclosure, and have not elected to do so. It has never been the policy of either bank, and it is not expected to be the policy of Community Partners, to release such information except as may be required by law.
Loans to One Borrower
Federal banking laws limit the amount a bank may lend to a single borrower to 15% of the banks capital base, unless the entire amount of the loan is secured by adequate amounts of readily marketable collateral. However, no loan to one borrower may exceed 25% of a banks statutory capital, notwithstanding collateral pledged to secure it.
New Jersey banking law limits the total loans and extensions of credit by a bank to one borrower at one time to 15% of the capital funds of the bank when the loan is not fully secured by collateral having a market value at least equal to the amount of the loans and extensions of credit. Such loans and extensions of credit are limited to 10% of the capital funds of the bank when the total loans and extensions of credit by a bank to one borrower at one time are fully secured by readily available marketable collateral having a market value (as determined by reliable and continuously available price quotations) at least equal to the amount of funds outstanding. If a banks lending limit is less than $500,000, the bank may nevertheless have total loans and extensions of credit outstanding to one borrower at one time not to exceed $500,000.
Depositor Preference Statute
Under federal law, depositors, certain claims for administrative expenses and employee compensation against an insured depository institution are afforded a priority over other general unsecured claims against the institution, in the event of a liquidation or other resolution of the institution by a receiver.
The Gramm-Leach-Bliley Financial Modernization Act of 1999 (the Modernization Act) became effective in early 2000. The Modernization Act:
The Modernization Act modified other financial laws, including laws related to financial privacy and community reinvestment.
The Modernization Act also amends the BHCA and the Bank Merger Act to require the federal banking agencies to consider the effectiveness of a financial institutions anti-money laundering activities when reviewing an application under these acts.
Additional proposals to change the laws and regulations governing the banking and financial services industry are frequently introduced in Congress, in the state legislatures and before the various bank regulatory agencies. The likelihood and timing of any such changes and the impact such changes might have on the Company cannot be determined at this time.
The Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley Act), which became law on July 30, 2002, added new legal requirements affecting corporate governance, accounting and corporate reporting for companies with publicly traded securities.
The Sarbanes-Oxley Act provides for, among other things:
Additionally, Section 404 of the Sarbanes-Oxley Act requires that a public company subject to the reporting requirements of the Exchange Act, include in its annual report (i) a managements report on internal control over financial reporting assessing the companys internal controls, and (ii) an auditors attestation report, completed by the registered public accounting firm that prepares or issues an accountants report which is included in the companys annual report, attesting to the effectiveness of managements internal control assessment. Because we are neither a large accelerated filer nor an accelerated filer, under current rules, we are not required to provide managements report on internal control over financial reporting until we file our annual report for 2007 and compliance with the auditors attestation report requirement is not required until we file our annual report for 2008.
Each of the national stock exchanges, including the Nasdaq Capital Market where our common stock is listed, have implemented corporate governance rules, including rules strengthening director independence requirements for boards, and the adoption of charters for the nominating, corporate governance, and audit committees. The rule changes are intended to, among other things, make the board of directors independent of management and allow shareholders to more easily and efficiently monitor the performance of companies and directors. These increased burdens have increased our legal and accounting fees and the amount of time that our board of directors and management must devote to corporate governance issues.
Overall Impact of New Legislation and Regulations
Various legislative initiatives are from time to time introduced in Congress and in the New Jersey State Legislature. It cannot be predicted whether or to what extent the business and condition of Community Partners, Two River and Town Bank will be affected by new legislation or regulations, and legislation or regulations as yet to be proposed or enacted.
Item 1A. Risk Factors.
Our common stock is speculative in nature and involves a significant degree of risk. The risk factors below are not listed in order of importance.
Changes in interest rates could reduce our income, cash flows and asset values.
Our income and cash flows and the value of our assets depend to a great extent on the difference between the interest rates we earn on interest-earning assets, such as loans and investment securities, and the interest rates we pay on interest-bearing liabilities such as deposits and borrowings. These rates are highly sensitive to many factors which are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Board of Governors of the Federal Reserve System. Changes in monetary policy, including changes in interest rates, will influence not only the interest we receive on our loans and investment securities and the amount of interest we pay on deposits and borrowings but will also affect our ability to originate loans and obtain deposits and the value of our investment portfolio. If the rate of interest we pay on our deposits and other borrowings increases more than the rate of interest we earn on our loans and other investments, our net interest income, and therefore our earnings, could be adversely affected. Our earnings also could be adversely affected if the rates on our loans and other investments fall more quickly than those on our deposits and other borrowings.
Economic conditions either nationally or locally in areas in which our operations are concentrated may adversely affect our business.
Deterioration in local, regional, national or global economic conditions in Middlesex, Monmouth or Union County in New Jersey could cause us to experience a reduction in deposits and new loans, an increase in the number of borrowers who default on their loans and a reduction in the value of the collateral securing their loans, all of which could adversely affect our performance and financial condition. Unlike larger banks that are more geographically diversified, we provide banking and financial services Middlesex, Monmouth or Union County in New Jersey. Therefore, we are particularly vulnerable to adverse local economic conditions.
Competition may decrease our growth or profits.
We face substantial competition in all phases of our operations from a variety of different competitors, including commercial banks, savings and loan associations, mutual savings banks, credit unions, consumer finance companies, factoring companies, leasing companies, insurance companies and money market mutual funds. There is very strong competition among financial services providers in our principal service area. Our competitors may have greater resources, higher lending limits or larger branch systems than we do. Accordingly, they may be able to offer a broader range of products and services as well as better pricing for those products and services than we can.
In addition, some of the financial services organizations with which we compete are not subject to the same degree of regulation as is imposed on federally insured financial institutions. As a result, those non-bank competitors may be able to access funding and provide various services more easily or at less cost than we can, adversely affecting our ability to compete effectively.
We plan to continue to grow rapidly and there are risks associated with rapid growth.
We intend to continue to expand our business and operations to increase deposits and loans. Continued growth may present operating and other problems that could adversely affect our business, financial condition and results of operations. Our growth may place a strain on our administrative, operational, personnel and financial resources and increase demands on our systems and controls. Our ability to manage growth successfully will depend on our ability to attract qualified personnel and maintain cost controls and asset quality while attracting additional loans and deposits on favorable terms, as well as on factors beyond our control, such as economic conditions and interest rate trends. If we grow too quickly and are not able to attract qualified personnel, control costs and maintain asset quality, this continued rapid growth could materially adversely affect our financial performance.
We rely on our management and other key personnel, and the loss of any of them may adversely affect our operations.
We are and will continue to be dependent upon the services of our executive management team. In addition, we will continue to depend on our ability to retain and recruit key commercial loan officers. The unexpected loss of services of any key management personnel or commercial loan officers could have an adverse effect on our business and financial condition because of their skills, knowledge of our market, years of industry experience and the difficulty of promptly finding qualified replacement personnel.
We may fail to achieve sufficient operational integration between the two Banks to make their combination under a single holding company a financial success.
Our success will depend on, among other things, our ability to realize anticipated cost savings and to integrate the operations of Two River and Town Bank in a manner that does not materially disrupt the existing customer relationships of either bank or result in decreased revenues from any loss of customers. If we are not able to successfully achieve these objectives, the anticipated benefits of the acquisition may not be realized fully or at all or may take longer to realize than expected.
Two River and Town Bank have operated, and are continuing to operate, independently. We continue to face significant challenges in consolidating Two River and Town Bank functions, integrating the organizations, procedures and operations in a timely and efficient manner and retaining key Two River and Town Bank personnel. The integration of Two River and Town Bank has been and continues to be costly, complex and time consuming, and our management continues to devote substantial resources and efforts to it.
The ongoing integration process may result in the disruption of each Banks ongoing business or inconsistencies in standards, controls, procedures and policies that adversely affect their ability to maintain relationships with customers, suppliers, employees and others with whom they have business dealings or to achieve the anticipated benefits of the acquisition.
Our financial condition and results of operations would be adversely affected if our allowance for loan losses is not sufficient to absorb actual losses or if we are required to increase our allowance.
Despite our underwriting criteria, we may experience loan delinquencies and losses. In order to absorb losses associated with non-performing loans, we maintain an allowance for loan losses based on, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Determination of the allowance inherently involves a high degree of subjectivity and requires us to make significant estimates of current credit risks and future trends, all of which may undergo material changes. At any time there are likely to be loans in our portfolio that will result in losses but that have not been identified as non-performing or potential problem credits. We cannot be sure that we will be able to identify deteriorating credits before they become non-performing assets or that we will be able to limit losses on those loans that are identified.
We may be required to increase our allowance for loan losses for any of several reasons. State and federal regulators, in reviewing our loan portfolio as part of a regulatory examination, may request that we increase our allowance for loan losses. Changes in economic conditions affecting borrowers, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of our control, may require an increase in our allowance. In addition, if charge-offs in future periods exceed our allowance for loan losses, we will need additional increases in our allowance for loan losses. Any increases in our allowance for loan losses will result in a decrease in our net income and, possibly, our capital, and may materially affect our results of operations in the period in which the allowance is increased.
We may be adversely affected by government regulation.
The banking industry is heavily regulated. Banking regulations are primarily intended to protect the federal deposit insurance funds and depositors, not shareholders. Changes in the laws, regulations, and regulatory practices affecting the banking industry may increase our costs of doing business or otherwise adversely affect us and create competitive advantages for others. Regulations affecting banks and financial services companies undergo continuous change, and we cannot predict the ultimate effect of these changes, which could have a material adverse effect on our profitability or financial condition.
Environmental liability associated with lending activities could result in losses.
In the course of our business, we may foreclose on and take title to properties securing our loans. If hazardous substances were discovered on any of these properties, we could be liable to governmental entities or third parties for the costs of remediation of the hazard, as well as for personal injury and property damage. Many environmental laws can impose liability regardless of whether we knew of, or were responsible for, the contamination. In addition, if we arrange for the disposal of hazardous or toxic substances at another site, we may be liable for the costs of cleaning up and removing those substances from the site even if we neither own nor operate the disposal site. Environmental laws may require us to incur substantial expenses and may materially limit use of properties we acquire through foreclosure, reduce their value or limit our ability to sell them in the event of a default on the loans they secure. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability.
Failure to implement new technologies in our operations may adversely affect our growth or profits.
The market for financial services, including banking services and consumer finance services, is increasingly affected by advances in technology, including developments in telecommunications, data processing, computers, automation, Internet-based banking and telebanking. Our ability to compete successfully in our markets may depend on the extent to which we are able to exploit such technological changes. However, we can provide no assurance that we will be able properly or timely to anticipate or implement such technologies or properly train our staff to use such technologies. Any failure to adapt to new technologies could adversely affect our business, financial condition or operating results.
Item 1B. Unresolved Staff Comments
Item 2. Properties.
The following table provides certain information with respect to properties:
Town Bank has acquired a parcel of vacant land at 245-249 North Avenue in Cranford, New Jersey and has obtained approvals from New Jersey state and federal banking authorities to open a bank branch there. Town Bank is pursuing municipal site plan and other approvals to construct the facility and anticipates opening the location for business in early 2008. Town Bank also leases vacant land in Fanwood, New Jersey for an approved branch location. The landlord has municipal approval to construct a building of approximately 3,000 square feet.
Item 3. Legal Proceedings.
We may be involved, from time to time, as plaintiff or defendant in legal actions arising in the normal course of its business. At December 31, 2006, we were not involved in any material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of the Companys shareholders during the fourth quarter of the fiscal year ended December 31, 2006.
Item 5. Market for Registrants Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities.
The common stock of the Company trades on the Nasdaq Capital Market under the trading symbol CPBC. The following are the high and low sales prices per share prospective from April 4, 2006, the date the Companys common stock began trading on the Nasdaq Capital Market.
(1) Prices have been retroactively adjusted for the 3% stock dividend declared on July 18, 2006 and paid on September 1, 2006 to shareholders of record as of August 18, 2006.
As of March 27, 2007, there were approximately 516 holders of the Companys common stock.
The Company paid a 3% stock dividend on September 1, 2006 to shareholders of record as of August 18, 2006. The Company has never paid a cash dividend and there are no plans to pay a cash dividend at this time. The Company intends to retain its earnings in order to provide capital for the continuing growth of the Banks.
Stock Performance Graph
The following graph compares the performance of the Companys common stock with the performance of the Nasdaq Composite Index and a the Nasdaq Bank Index from April 1, 2006 through December 31, 2006. The graph assumes that $100 was invested on April 1, 2006 in the Companys common stock, the Nasdaq Composite Index and the Nasdaq Bank Index and that all dividends were reinvested.
Item 6. Selected Financial Data.
In connection with our acquisition of Two River and Town Bank, the former Two River shareholders received a majority of the voting rights of the combined entity (Community Partners). Accordingly, Two River is the acquiring company for accounting purposes. Two Rivers assets and liabilities are reported by the Company at Two Rivers historical cost, and the Companys financial statements consist of only Two Rivers for the periods prior to April 1, 2006. Town Banks assets and liabilities were recorded at their respective fair values as of the time of the acquisition as described in Note 2 to the Notes to Consolidated Financial Statements. Operations relating to the business of Town Bank are included in the Companys financial statements only prospectively from April 1, 2006, the date of the transaction. See Note 1 to the Notes to Consolidated Financial Statements on Page F-8.
The following selected financial data should be read in conjunction with the Companys Consolidated Financial Statements and the accompanying notes presented elsewhere herein.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation.
The following managements discussion and analysis of financial condition and results of operation is intended to provide a better understanding of the significant changes and trends relating to the financial condition, results of operations, capital resources, liquidity and interest rate sensitivity of Community Partners Bancorp as of December 31, 2006 and 2005 and for each of the years in the three year period ended December 31, 2006. The following information should be read in conjunction with the audited consolidated financial statements as of and for the period ended December 31, 2006, including the related notes thereto.
When used in this and in future filings by us with the SEC, in our press releases and in oral statements made with the approval of an authorized executive officer of ours, the words or phrases will, will likely result, could, anticipates, believes, continues, expects, plans, will continue, is anticipated, estimated, project or outlook or similar expressions (including confirmations by an authorized executive officer of ours of any such expressions made by a third party with respect to us) are intended to identify forward-looking statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, each of which speak only as of the date made. Such statements are subject to certain risks and uncertainties that could cause actual results to differ materially from historical earnings and those presently anticipated or projected.
Factors that may cause actual results to differ from those results expressed or implied, include, but are not limited to, those listed below under Risk Factors; changes in the direction of the economy nationally or in New Jersey; changes in effective income tax rates; continued relationships with major customers including sources for loans; the ability of customers to repay their obligations; the adequacy of the allowance for loan losses; competition; and the effects of general economic conditions and legal and regulatory barriers and structure. Although management has taken certain steps to mitigate any negative effect of the aforementioned items, significant unfavorable changes could severely impact the assumptions used and have an adverse effect on profitability. Such risks and other aspects of our business and operations are described in Business, Risk Factors and Managements Discussion and Analysis of Financial Condition and Results of Operation. We have no obligation to publicly release the result of any revisions which may be made to any forward-looking statements to reflect anticipated or unanticipated events or circumstances occurring after the date of such statements.
The following discussion is based upon our financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses.
Note 1 to our audited consolidated financial statements for December 31, 2006 contains a summary of the Companys significant accounting policies. Management believes the following critical accounting policies encompass the more significant judgments and estimates used in the preparation of our consolidated financial statements.
Allowance for Loan Losses. Management believes our policy with respect to the methodology for the determination of the allowance for loan losses involves a high degree of complexity and requires management to make difficult and subjective judgments which often require assumptions or estimates about highly uncertain matters. Changes in these judgments, assumptions or estimates could materially impact the results of operations. This critical policy and its application are periodically reviewed with our audit committee and board of directors.
The allowance for loan losses is based upon managements evaluation of the adequacy of the allowance account, including an assessment of known and inherent risks in the portfolio, giving consideration to the size and composition of the loan portfolio, actual loan loss experience, level of delinquencies, detailed analysis of individual loans for which full collectibility may not be assured, the existence and estimated net realizable value of any underlying collateral and guarantees securing the loans, and current economic and market conditions. Although
management utilizes the best information available, the level of the allowance for loan losses remains an estimate that is subject to significant judgment and short term change. Various regulatory agencies may require us and our banking subsidiaries to make additional provisions for loan losses based upon information available to them at the time of their examination. Furthermore, the majority of our loans are secured by real estate in New Jersey, primarily in Monmouth County and Union County. Accordingly, the collectibility of a substantial portion of the carrying value of our loan portfolio is susceptible to changes in local market conditions and may be adversely affected should real estate values decline or the New Jersey and/or our local market areas experience economic shock. Future adjustments to the allowance for loan losses account may be necessary due to economic, operating, regulatory and other conditions beyond our control.
Stock Based Compensation. Prior to January 1, 2006, our stock option plans were accounted for under the recognition and measurement provisions of APB Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees, and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock Based Compensation. No stock-based employee compensation cost was recognized in our statements of income through December 31, 2005, as all options granted under the plans had an exercise price equal to the market value of the underlying common stock on the date of the grant. Statement No. 123(R) replaced Statement No. 123, supersedes APB Opinion No. 25 and requires compensation costs related to share-based payment transactions to be recognized in the financial statements over the period that an employee provides service in exchange for the award. Effective January 1, 2006, we adopted the fair value recognition provisions of FASB Statement No. 123(R), Share Based Payment, using the modified-prospective transition method. Under that transition method, compensation cost recognized after January 1, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested, as of January 1, 2006 based on the grant-date fair value calculated in accordance with the provision of Statement No. 123, and (b) compensation cost for all share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value calculated in accordance with the provision of Statement 123(R). We had no nonvested stock options at December 31, 2005, therefore, the adoption of Statement 123(R) relates only to share-based payments granted after January 1, 2006.
Community Partners did not grant any stock options, restricted stock grants or any other share-based compensation awards during the year ended December 31, 2006. Also, Community Partners did not adopt any new share-based compensation plans during 2006.
Investment Securities Impairment Valuation. Management evaluates securities for other-than temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation. Consideration is given to (1) length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of Two River to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Purchase Accounting for Business Combinations. In June of 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets. These standards eliminated the pooling-of-interests method of accounting (pooling) in favor of purchase accounting. Further, these standards were promulgated to ensure that post-merger financial statements of combined entities are prepared in a manner that best represents the underlying economics of a business combination.
These standards necessitate the application of accounting policies and procedures that entail the use of assumptions, estimates, and judgments that are critical to the presentation of financial information, including the ongoing valuation of intangibles. Goodwill and other intangible assets are reviewed for impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment. The magnitude of the acquisition of Town Bank on our consolidated results suggests that the application of these standards since the date of that acquisition is substantially more critical to the presentation of financial information.
Deferred Tax Assets and Liabilities. We recognize deferred tax assets and liabilities for future tax effects of temporary differences, net operating loss carry forwards and tax credits. Deferred tax assets are subject to managements judgment based upon available evidence that future realization is more likely than not. If management determines that we may be unable to realize all or part of net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.
Effective April 1, 2006, Community Partners acquired all of the shares of capital stock of each of Two River and The Town Bank in exchange for shares of Community Partners common stock, and Two River and Town Bank became wholly-owned subsidiaries of Community Partners. Two River is the acquiring company for accounting purposes and its assets and liabilities are reported by Community Partners at Two Rivers historical cost. Town Banks assets and liabilities were recorded by Community Partners at their respective fair values as of April 1, 2006. Operations relating to the business of Town Bank are included in Community Partners financial statements only prospectively from April 1, 2006. Thus, reported earnings and balance sheet figures of Community Partners prior to April 1, 2006 include those of Two River and do not include those of Town Bank. Current period performance, other than per share amounts and ratio analysis, is not generally comparable to reported results for corresponding prior periods, as a significant portion of the increases in reported earnings and balance sheet figures are due to the inclusion of Town Bank in the periods subsequent to March 31, 2006 but not the prior periods.
For the year ended December 31, 2006, net interest income increased $6.9 million, or 64.5%, to $17.6 million from $10.7 million recorded for the year ended December 31, 2005. Net income totaled $3.7 million for the year ended December 31, 2006 compared to $2.1 million for the year ended December 31, 2005, an increase of $1.6 million or 76.2%. Basic earnings per share were $0.63 for the year ended December 31, 2006 compared to $0.52 per share for the same period in 2005. Diluted earnings per share for the year ended December 31, 2006 amounted to $0.61 compared to $0.49 per diluted share for the year ended December 31, 2005. Our 2006 results were positively affected by the inclusion of Town Banks operations in reported earnings prospectively from April 1, 2006. Included in the consolidated results of operations of Community Partners for 2006 was net income amounting to $1.7 million attributable to the operations of Town Bank.
All per share amounts have been retroactively adjusted to reflect the 3% stock dividend paid by Community Partners on September 1, 2006.
For the year ended December 31, 2005, net interest income increased $2.0 million, or 23.0%, to $10.7 million from $8.7 million recorded for the year ended December 31, 2004. Net income totaled $2.1 million for the year ended December 31, 2005 compared to $1.3 million for the year ended December 31, 2004, an increase of $767 thousand, or 57.9%. Basic earnings per share were $0.52 for the year ended December 31, 2005 compared to $0.35 per share for the same period in 2004. Diluted earnings per share for the year ended December 31, 2005 amounted to $0.49 compared to $0.33 per diluted share for the year ended December 31, 2004.
Total assets increased by $252.2 million, or 94.0% to $520.5 million at December 31, 2006 from $268.3 million at December 31, 2005. The increase in total assets was primarily the result of our acquisition of Town Bank as of April 1, 2006. At March 31, 2006, Town Banks total assets amounted to $208.0 million. The remainder of our growth during 2006 consisted primarily of increased loans outstanding.
The loan portfolio, net of the allowance for loan losses, grew to $412.3 million at December 31, 2006, an increase of $198.4 million, or 92.8% from the December 31, 2005 level of $213.9 million. The allowance for loan losses totaled $4.6 million, or 1.10% of total loans at December 31, 2006 compared to $2.4 million, or 1.10% of loans outstanding at December 31, 2005. Acquired loan growth consists of Town Banks net loans at March 31, 2006 of $137.3 million. Organic loan growth for 2006 was $61.1 million.
Deposits rose to $441.9 million at December 31, 2006 from $236.4 million at December 31, 2005, an increase of $205.5 million, or 86.9%. The increase in deposits is primarily attributable to the acquisition of Town Bank and to a lesser extent the result of gaining market share in our Companys trade area. Town Banks total deposits were $160.8 million at March 31, 2006. Organic deposit growth was $44.7 million for 2006.
The following table provides information on our performance ratios for the dates indicated.
Results of Operations
Our principal source of revenue is net interest income, the difference between interest income on earning assets and interest expense on deposits and borrowings. Interest earning assets consist primarily of loans, investment securities and federal funds sold. Sources to fund interest earning assets consist primarily of deposits and borrowed funds. Our net income is also affected by our provision for loan losses, other income and other expenses. Other income consists primarily of service charges, commissions and fees, while other expenses are comprised of salaries and employee benefits, occupancy costs and other operating expenses.
Year Ended December 31, 2006 Compared to Year Ended December 31, 2005
For the year ended December 31, 2006, net income increased to $3.7 million, or $0.63 per share for basic and $0.61 per share for diluted shares, compared to net income of $2.1 million, or $0.52 per share for basic and $0.49 per share for diluted shares in 2005.
Our net income was primarily due to a $6.9 million, or 64.5%, increase in net interest income. The improvement in net interest income is attributable primarily to the inclusion of Town Banks operating results subsequent to the date of acquisition, and to a lesser extent, to our continued strong growth, which is made possible by establishing a sound foundation through the strategic utilization of our resources. Town Banks net interest income included in our consolidated operations amounted to $6.0 million for 2006.
Non-interest expenses increased $4.3 million, or 52.4%, to $12.5 million for the year ended December 31, 2006 from $8.2 million for the year ended December 31, 2005. Town Banks non-interest expenses amounted to $3.0 million during the period subsequent to the date of acquisition. Additional increases in non-interest expenses resulted as we increased our support staff and deployed other resources in order to continue our strategic plan.
For the year ended December 31, 2006, we recognized net interest income of $17.6 million, as compared to $10.7 million for the year ended December 31, 2005. We achieved this increase by increasing our average balance of interest earning assets by $175.1 million, or 73.2%, to $414.2 million for the year ended December 31, 2006 from $239.1 million for the year ended December 31, 2005 as a result of the acquisition, while our net interest spread and net interest margin declined by 52 basis points and 25 basis points, respectively, to 3.42% and 4.24% for the year ended December 31, 2006 from 3.94% and 4.49% for the year ended December 31, 2005, as a result of increasingly competitive market conditions.
For the year ended December 31, 2006, our total interest income increased to $29.8 million from $14.8 million for the year ended December 31, 2005. This $15.0 million, or 101.4% increase, was driven primarily by increased volume, as volume-related increases in interest income of $11.1 million were further increased by rate-related increases of $3.9 million for the year ended December 31, 2006 as compared to the prior fiscal year. Most of the interest-income increases came from our loan portfolio, which accounted for $10.4 million of the $11.1 million volume-related increase, and $3.5 million of the $3.9 million rate-related increase, as our average loans outstanding increased by $156.1 million, or 79.4%, to $352.7 million for the year ended December 31, 2006 from $196.6 million for the year ended December 31, 2005. The increase in the average balances of interest-earning assets was due primarily to the acquisition of Town Bank and strong organic growth. The average yield on our interest-earning assets increased by 100 basis points to 7.19% for the year ended December 31, 2006 from 6.19% for the prior year. The increase in market interest rates throughout 2005 and 2006 accounted for the improvement in yield.
Total interest expense increased to $12.2 million for the year ended December 31, 2006 period from $4.1 million for the year ended December 31, 2005. This 197.6% increase in interest expense is primarily due to a $143.3 million increase in our average balance of interest-bearing liabilities, which increased to $323.9 million for the year ended December 31, 2006 from $180.6 million for the year ended December 31, 2005. The increase in the average balance of interest-bearing liabilities was due primarily to the acquisition of Town Bank. In addition, faced with steadily increasing interest rates during 2006, we priced and marketed our deposit products in a manner designed to obtain the increased funds we needed for loan growth without significantly shrinking our net interest margin. For the year ended December 31, 2006, the average rate on our interest-bearing liabilities was 3.78% compared to 2.25% in the prior fiscal year. The 153 basis point increase in our interest-bearing liabilities, partially off-set by the 100 basis point increase in our interest-earning assets, resulted in our net interest margin decreasing to 4.24% for the 2006 fiscal year from 4.49% for the 2005 fiscal year.
The following table reflects, for the periods presented, the components of our net interest income, setting forth: (1) average assets, liabilities, and shareholders equity, (2) interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities, (3) average yields earned on interest-earning assets and average rates paid on interest-bearing liabilities, (4) our net interest spread (i.e., the average yield on interest-earning assets less the average rate on interest-bearing liabilities), and (5) our yield on interest-earning assets. There have been no tax equivalent adjustments made to yields.
Analysis of Changes in Net Interest Income
The following table sets forth for the periods indicated the amounts of the total change in net interest income that can be attributed to changes in the volume of interest-bearing assets and liabilities and the amount of the change that can be attributed to changes in interest rates.
Provision for Loan Losses
Our provision for loan losses recorded for the year ended December 31, 2006 was $649,000, compared to $453,000 for the year ended December 31, 2005. The increase in the provision for 2006 was primarily due to higher loan growth and the assumption of Town Banks loan loss provision in 2006 compared to 2005. Loan growth in 2006 was approximately $62 million compared to $40 million in 2005. In addition, the provision reflects managements assessment of economic conditions, credit quality and other risk factors inherent in the loan portfolio. The allowance for loan losses totaled $4.6 million, or 1.10% of total loans at December 31, 2006, compared to $2.4 million, or 1.10% of total loans, at December 31, 2005. The $2.2 million increase in the allowance for loan losses for the year ended December 31, 2006 is a result of the growth of our loan portfolio, which accounted for $649,000 of the increase, and the acquisition of Town Bank, which accounted for $1.5 million of the increase. We will continue to review the need for additions to our allowance for loan losses based upon our review of the loan portfolio, the level of delinquencies and general market and economic conditions.
Non-interest income amounted to $1.5 million for the year ended December 31, 2006, compared to $1.2 million for the year ended December 31, 2005, an increase of $258,000, or 21.0%. The increase was primarily attributable to an increase in service fees on deposits of $189,000, or 40.6%, and an increase in other income of $183,000, or 72.6%. The growth in service fees on deposits reflects the growth in transaction account deposits and activity and the increase in other income reflects increased ATM surcharge fees and a higher level of fees on residential mortgages originated for other institutions. These increases are attributable to our continued growth and the acquisition of Town Bank. Partially off-setting these increases was a reduction in other loan customer service fees, which decreased by $113,000 from $343,000 during 2005 to $230,000 during 2006. The reduction in other loan customer service fees resulted from a reduction in the amount of loan pre-payment penalty fees collected as commercial loan pre-payments and refinancing with other institutions slowed during 2006.
The following table provides a summary of non-interest expense by category for the years ended December 31, 2006 and 2005.
Non-interest expense was $12.5 million for the year ended December 31, 2006, compared to $8.2 million for the year ended December 31, 2005, an increase of $4.3 million, or 52.4%. Salaries and employee benefits increased $2.1 million, or 45.8%, to $6.5 million from $4.5 million primarily as a result of the acquisition of Town Bank, which accounted for $1.4 million of the increase, and additions to staff to support our growth, along with higher salaries and health insurance costs. The number of our full-time equivalent employees increased from 73 at December 31, 2004, to 80 at December 31, 2005, and to 126 at December 31, 2006. Occupancy and equipment expenses, advertising and marketing expenses, insurance and other operating expenses increased by $1.3 million, or 39.9%, due to the general growth of our business and the inclusion of Town Banks operations subsequent to March 31, 2006. Professional fees increased by $283,000, or 148.9%, to $473,000 for the year ended December 31, 2006 from $190,000 for the year ended December 31, 2005 primarily as a result of the formation of the bank holding company, the acquisition of Town Bank and the increased costs of being a public company. Data processing expenses increased by $381,000, or 167.1%, to $609,000 for the year ended December 31, 2006 from $228,000 for the year ended December 31, 2005 as a result of expenses associated with converting Town Bank to the Companys core processing servicer and our general growth. Subsequent to the acquisition of Town Bank as of April 1, 2006, we began amortizing identifiable intangible assets and incurred $287,000 in costs during 2006. At December 31, 2006, the balance of $1.8 million in core deposit intangibles remains to be amortized through March, 2016.
We anticipate continued significant increases in non-interest expense in 2007 and beyond, as we incur costs related to the expansion of our branch system and our lending activities, and ongoing efforts to penetrate our target markets, in addition to other costs associated with the integration of the operations of the two banks and the operation of the Company.
For the year ended December 31, 2006, we recorded $2.2 million in income tax expense, compared to $1.2 million for the year ended December 31, 2005. The increase in income tax expense is due to higher pre-tax income. The effective tax rate for 2006 was 37.1%, compared to 36.9% for 2005.
Year Ended December 31, 2005 Compared to Year Ended December 31, 2004
For the year ended December 31, 2005, net income increased to $2.1 million or $0.52 per share for basic and $0.49 per diluted share, compared to net income of $1.3 million or $0.35 per share for basic and $0.33 per diluted share for the same period in 2004.
The increase in net income was primarily due to a $2.0 million, or 23.0% increase in net interest income. The improvement in net interest income is attributable to our strong growth in 2005.
Net Interest Income
For the year ended December 31, 2005, we recognized net interest income of $10.7 million as compared to $8.7 million for the year ended December 31, 2004. The increase in net interest income for the year ended December 31, 2005, as compared to the year ended December 31, 2004, was largely due to an increase in the average balance of interest earning assets, which increased $40.2 million, or 20.2%, to $239.1 million for the year ended December 31, 2005 from $198.9 million for the year ended December 31, 2004. The increase reflects an increase in average loans outstanding of $42.4 million, or 27.5%, to $196.6 million for the year ended December 31, 2005 from $154.2 million for the year ended December 31, 2004, and an increase in average investment securities of $4.5 million, or 12.4%, to $40.8 million for the year ended December 31, 2005 from $36.3 million for the year ended December 31, 2004, and was partially offset by a decrease of $6.7 million, or 79.8%, in average federal funds sold to $1.7 million for the year ended December 31, 2005 from $8.4 million for the year ended December 31, 2004.
Primarily as a result of the increase in the average balance of interest earning assets, our interest income increased to $14.8 million, or 31%, for the year ended December 31, 2005 from $11.3 million for the year ended December 31, 2004. The improvement in interest income was primarily due to volume-related increases in income from the loan portfolio of $2.7 million and volume-related increases in income of $180,000 in the investment securities portfolio, partially offset by volume-related decreases in income of $86,000 in federal funds sold. In addition to the net volume-related increases, rate-related increases amounting to $779,000 resulted as the average yield on our interest-earning assets increased to 6.19% for the year ended December 31, 2005 from 5.66% for the prior year.
Total interest expense increased 64.0% to $4.1 million for the year ended December 31, 2005 from $2.5 million for the year ended December 31, 2004. The increase in interest expense is primarily related to the increase in the average balance of interest-bearing liabilities, which increased $29.2 million to $180.6 million for the 2005 fiscal year compared to $151.4 million for the 2004 fiscal year. Volume-related increases in interest expense accounted for $518,000 of increased expense and was further increased by $1.0 million attributable to net rate-related increases in interest expense. The volume related increases in interest-bearing liabilities were the result of marketing and pricing decisions made by management in response to the need for cost effective sources of funds, primarily to fund loan growth. These decisions, along with market rate increases on deposits for the year ended December 31, 2005 as compared to the prior fiscal year, resulted in the increase in the cost of interest-bearing liabilities to 2.25% for the year ended December 31, 2005 from 1.67% for year ended December 31, 2004.
Please refer to the Average Balance Sheet in the preceding discussion and the Rate/Volume Analysis comparing the years ended December 31, 2005 and 2004.
Provision for Loan Losses
Our provision for loan losses recorded for the year ended December 31, 2005 was $453,000 compared to $458,000 for the year ended December 31, 2004. The provision is the result of our review of several factors. We had no loan charge-offs during the periods ended December 31, 2005 and December 31, 2004. Loan growth for the year ended December 31, 2005 was approximately $40 million compared to $42 million for the year ended December 31, 2004. The provision also reflects managements assessment of economic conditions, credit quality and other risk factors inherent in the loan portfolio. The allowance for loan losses totaled $2.4 million, or 1.10% of total loans at December 31, 2005, compared to $1.9 million, or 1.10% of total loans, at December 31, 2004.
Non-interest income amounted to $1.2 million for the year ended December 31, 2005, compared to $820,000 for the year ended December 31, 2004, an increase of $408,000, or 49.8%. The increase was primarily attributable to an increase in earnings from investment in life insurance which increased $154,000 to $167,000 for the year ended December 31, 2005 from $13,000 for the year ended December 31, 2004, and increased other income which increased $113,000 to $252,000 for the year ended December 31, 2005 from $139,000 for the year ended December 31, 2004. We invested in $3.5 million of bank-owned life insurance during December 2004, and we recorded an entire year of earnings for the year ended December 31, 2005. The increase in other income during 2005 resulted primarily from fees on residential mortgages originated for other institutions, a service first instituted by the Company during 2005. Service fees on deposits increased $76,000 for the year ended December 31, 2005 compared to the prior year and other loan customer service fees increased $65,000 during the same comparable periods. The growth in service fees on deposits and other loan customer service fees reflects the growth in transaction account deposits and activity and increases in non-interest related loan fees.
The following table provides a summary of non-interest expense by category for the two years ended December 31, 2005 and 2004.
Non-interest expense amounted to $8.2 million for the year ended December 31, 2005, compared to $7.0 million for the year ended December 31, 2004, an increase of $1.2 million, or 17.1%. The increase was due primarily to increases in employee expenses as well as increases in occupancy expenses, equipment expenses and other costs generally attributable to our growth. Of this increase, salary and employee benefits increased $717,000, or 19.0%, and reflected increases in the number of employees from 73 full-time equivalents at December 31, 2004 to 80 full-time equivalents at December 31, 2005. The increase in personnel is attributable to the acquisition of support personnel required due to our growth and for the opening of two new branch offices during November, 2004 and September, 2005.
Occupancy and equipment expenses increased $213,000, or 15.6%, to $1.6 million for the year ended December 31, 2005. The increase was attributable to the opening of two new branch offices during November 2004 and September 2005, which resulted in increased lease expense and increased maintenance costs.
All other operating expenses increased $298,000, or 16.3%, to $2.1 million for the year ended December 31, 2005 from $1.8 million for the year ended December 31, 2004.
We anticipate that the expense of our expanding branch system, combined with increased expenses associated with our expanding lending activities, as well as increased costs associated with our ongoing efforts to penetrate our target markets, will continue to increase non-interest expense in subsequent years.
Income Tax Expenses
For the year ended December 31, 2005, we recorded $1.2 million in income tax expense compared to $793,000 for the year ended December 31, 2004. The effective tax rate for the year ended December 31, 2005 was 36.9% compared to 37.4% for the year ended December 31, 2004.
December 31, 2006 Compared to December 31, 2005
At December 31, 2006, our total assets were $520.5 million, an increase of $252.2 million, or 94.0%, over total 2005 year-end assets of $268.3 million. At December 31, 2006, our total loans were $416.9 million, an increase of $200.6 million, or 92.7%, from the $216.3 million reported at December 31, 2005. Investment securities increased to $52.4 million at December 31, 2006, from $40.0 million at December 31, 2005, an increase of $12.4 million, or 31.0%. At December 31, 2006, we had $6.1 million of federal funds sold compared to no federal funds sold at December 31, 2005. Our fixed assets increased by $2.8 million, or 116.7%, to $5.2 million at December 31, 2006 from $2.4 million at December 31, 2005. At December 31, 2006, we recorded goodwill amounting to $24.7 million and core deposit intangibles amounting to $2.1 million as a result of our acquisition of Town Bank. At March 31, 2006, the total assets of Town Bank amounted to $208.0 million.
We had total deposits of $441.9 million at December 31, 2006, an increase of $205.5 million, or 86.9%, over total deposits of $236.4 million at December 31, 2005. Deposits are our primary source of funds. The deposit growth during 2006 was primarily due to the acquisition of Town Bank, which had $160.7 million of deposits at March 31, 2006, and to the expansion and maturation of our existing branch system, which had organic deposit growth of $44.8 million for the year ended December 31, 2006. We also generated a significant increase in our deposit products through promotional activities at our branches, which were targeted to gain market penetration as we expanded our branch office network. During 2006, our primary promotional products were interest-bearing deposits. At December 31, 2006, our non-interest bearing deposits represented 16.3% of our total deposits, down from 21.3% at year-end 2005. As long as our quality loan demand remains strong, we intend to raise the most cost effective funding available within our market area.
We maintain an investment portfolio to fund increased loans or decreased deposits and other liquidity needs and to provide an additional source of interest income. The portfolio is composed of obligations of the U.S. government and agencies, government-sponsored entities, municipal securities and a limited amount of corporate debt securities.
The Company accounts for its investment securities in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. This standard requires, among other things, that debt and equity securities be classified as available-for-sale or held-to-maturity. Management determines the appropriate classification at the time of purchase. Based on an evaluation of the probability of the occurrence of future events, we determine if we have the ability and intent to hold the investment securities to maturity, in which case we classify them as held-to-maturity. All other investments are classified as available-for-sale.
Securities classified as available-for-sale must be reported at fair value, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders equity, net of taxes. Gains or losses on the sales of securities available-for-sale are recognized upon realization utilizing the specific identification method. The net effect of unrealized gains or losses, caused by marking an available-for-sale portfolio to market, could cause fluctuations in the level of undivided profits and equity-related financial ratios as market interest rates cause the fair value of fixed-rate securities to fluctuate.
Securities classified as held-to-maturity are carried at cost, adjusted for amortization of premium and accretion of discount over the terms of the maturity in a manner that approximates the interest method.
Investments totaled $52.4 million at December 31, 2006 compared to $40.0 million at December 31, 2005, an increase of $12.4 million, or 31.0%. The increase in investment securities was from the acquisition of Town Bank, which had $13.9 million of investment securities at March 31, 2006. For the years ended December 31, 2006 and 2005, we had no sales of securities.
The following table sets forth the carrying value of the securities portfolio as of December 31, 2006, 2005 and 2004 (in thousands).
The contractual maturity distribution and weighted average yields, calculated on the basis of the stated yields to maturity, taking into account applicable premiums or discounts, of the securities portfolio at December 31, 2006 is as follows. Securities available-for-sale are carried at amortized cost in the table for purposes of calculating the weighted average yield. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. There have been no tax equivalent adjustments made to the yields on tax-exempt securities.
The following table summarizes total loans outstanding by loan category and amount on the dates indicated.
Net loans increased by $198.4 million, or 92.8%, from $213.9 million recorded at December 31, 2005 compared to $412.3 million at December 31, 2006. The growth was recorded in all loan categories except for residential real estate, which is not a core loan product of ours. Within the loan portfolio, commercial real estate loans remained the largest component, constituting 38.0% of our total loans outstanding. These loans increased by $60.6 million, or 61.9%, to $158.5 million at December 31, 2006, compared to $97.9 million at December 31, 2005. Real estate construction loans increased by $69.4 million, or 162.5%, to $112.1 million at December 31, 2006, and comprised 26.8% of our total loans outstanding. Commercial and industrial loans increased $44.5 million to $100.0 million at year-end 2006 compared to $55.5 million at year-end 2005, an increase of 80.2% and comprised 24.0% of our portfolio. Consumer loans increased by $26.6 million, or 151.1%, to $44.2 million at December 31, 2006 compared to $17.6 million at December 31, 2005, and comprised 10.6% of our 2006 loan portfolio.
The increases in the loan portfolio categories are largely the result of the acquisition of Town Bank, which had $137.3 million of loans outstanding at March 31, 2006, the date of acquisition.
The following table sets forth the aggregate maturities of loans net of unearned discounts and deferred loan fees, in specified categories and the amount of such loans which have fixed and variable rates as of December 31, 2006.
Loans are considered to be non-performing if they are on a non-accrual basis, past due 90 days or more, or have been renegotiated to provide a reduction of or deferral of interest or principal because of a weakening in the financial condition of the borrowers. Loans are placed on non-accrual when a loan is specifically determined to be impaired or when principal or interest is delinquent for 90 days or more. Any unpaid interest previously accrued on those loans is reversed from income. Interest income generally is not recognized on specific impaired loans unless the likelihood of further loss is remote. Interest income on other non-accrual loans is recognized only to the extent of interest payments received. At December 31, 2006 and 2005, the Company had no non-accrual loans. At December 31, 2004 and 2003, we had a $94,000 non-accrual loan and no non-accrual loans at December 31, 2002. The Company had no loans past due 90 days or more and still accruing, no restructured loans and no other real estate owned at December 31, 2006, 2005, 2004, 2003 and 2002.
The Company maintains a list of loans where management has identified problems which potentially could cause such loans to be placed on non-accrual status in future periods. Loans on this watch list are subject to heightened scrutiny and more frequent review by management. The balance of watch list loans at December 31, 2006 totaled approximately $17.4 million.
The following table summarizes our allowance for loan losses for each of the five years ended December 31, 2006.
The allowance for loan losses is a valuation reserve available for losses incurred or expected on extensions of credit. Credit losses primarily arise from the Companys loan portfolio, but may also be derived from other credit related sources including commitments to extend credit. Additions are made to the allowance through periodic provisions which are charged to expense. All losses of principal are charged to the allowance when incurred or when a determination is made that a loss is expected. Subsequent recoveries, if any, are credited to the allowance.
We attempt to maintain an allowance for loan losses at a sufficient level to provide for probable losses in the loan portfolio. Loan losses are charged directly to the allowance when they occur and any recovery is credited to the allowance. Risks within the loan portfolio are analyzed on a continuous basis by our officers, by outside independent loan review auditors, by our Directors Loan Committee, and by the board of directors. A risk system, consisting of multiple grading categories, is utilized as an analytical tool to assess risk and set appropriate reserves. Along with the risk system, management further evaluates risk characteristics of the loan portfolio under current economic conditions and considers such factors as the financial condition of the borrower, past and expected loss experience, and other factors management feels deserve recognition in establishing an appropriate reserve. Additions to the allowance are made by provisions charged to expense and the allowance is reduced by net charge-offs (i.e., loans judged to be un-collectible and charged against the reserve, less any recoveries on such loans). Although management attempts to maintain the allowance at a level deemed adequate, future additions to the allowance may be necessary based upon changes in market conditions, either generally or specific to our area, or changes in the circumstances of particular borrowers. In addition, various regulatory agencies periodically review the Companys allowance for loan losses. These agencies may require us to take additional provisions based on their judgments about information available to them at the time of their examination.
Allocation of the Allowance for Loan Losses
The following table sets forth the allocation of the allowance for loan losses by category of loans and the percentage of loans in each category to total loans at December 31, 2006, 2005, 2004, 2003 and 2002 (dollars in thousands).
Bank-Owned Life Insurance
During 2004, we invested in $3.5 million of bank-owned life insurance as a source of funding for employee benefit expenses, primarily for the Companys Salary Continuation Plan for certain directors and executive officers implemented in 2004 that provides for payments upon retirement, death or disability. Expenses related to the plan were approximately $143,000, $143,000, and $23,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Bank-owned life insurance involves our purchase of life insurance on a chosen group of officers. We are the owner and beneficiary of the policies. Increases in the cash surrender values of this investment are recorded in other income in the statements of income.
Premises and Equipment
Premises and equipment totaled $5.2 million and $2.4 million at December 31, 2006 and 2005, respectively. The $2.8 million, or 116.7% increase in our investment in premises and equipment in 2006 over 2005 was due primarily to the acquisition of Town Bank, which had $2.5 million of recorded investment in premises and equipment at March 31, 2006.
Deposits are the primary source of funds used by us in lending and for general corporate purposes. The level of deposit liabilities may vary significantly and are dependent upon prevailing interest rates, money market conditions, general economic conditions and competition. Our deposits consist of checking, savings and money market accounts along with certificates of deposit and individual retirement accounts. Deposits are obtained from individuals, partnerships, corporations, unincorporated businesses and non-profit organizations throughout our market area. We attempt to control the flow of deposits primarily by pricing our deposit offerings to be competitive with other financial institutions in our market area but not necessarily offering the highest rate. The deposit growth experienced since our inception was primarily due to the expansion and maturation of our branch system. We also generated significant increases in our deposit and customer base through promotional activities at our branches, which were targeted to gain market penetration as we expanded our branch office network. During 2006, we acquired Town Bank, which had $160.8 million of deposits at March 31, 2006.
One of our primary strategies is the accumulation and retention of core deposits. Core deposits consist of all deposits, except certificates of deposits in excess of $100,000. Total deposits increased $205.5 million, or 86.9% from December 31, 2005, to the December 31, 2006 of $441.9 million. Excluding Town Bank deposits acquired, deposits increased $44.7 million in 2006.
Core deposits at December 31, 2006 accounted for 73.7% of total deposits compared to 86.7% at December 31, 2005. During 2006, we marketed a certificate of deposit program in our local market area for the purpose of increasing deposits to fund the loan portfolio. This program accounted for the decline in the core deposit ratio.
The following table reflects the average balances and average rates paid on deposits for the years ended December 31, 2006, 2005 and 2004.