Enterprise Bancorp 10-K 2005
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
ý ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 0-21021
Enterprise Bancorp, Inc.
(Exact name of registrant as specified in its charter)
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 ý 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 the registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý No o
State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid price and asked price of such common equity, as of the last business day of the registrants most recently completed second fiscal quarter.
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:
March 1, 2005, Common Stock - Par Value $0.01: 3,691,210 shares outstanding
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the issuers proxy statement for its annual meeting of stockholders to be held on May 3, 2005 are incorporated by reference in Part III of this Form 10-K. Such information incorporated by reference shall not be deemed to specifically incorporate by reference the information referred to in Item 402(a)(8) of Regulation S-K.
ENTERPRISE BANCORP, INC.
TABLE OF CONTENTS
Item 1. Business
Enterprise Bancorp, Inc. (the company) is a Massachusetts corporation, which was organized on February 29, 1996, at the direction of Enterprise Bank and Trust Company (the bank) for the purpose of becoming the holding company for the bank. On July 26, 1996, the bank became the wholly owned subsidiary of the company and the former shareholders of the bank became shareholders of the company. The business and operations of the company are subject to the regulatory oversight of the Board of Governors of the Federal Reserve System.
Substantially all of the companys operations are conducted through the bank. The bank is a Massachusetts trust company with two wholly owned subsidiaries, Enterprise Investment Services, LLC and Enterprise Insurance Services, LLC. The banks deposit accounts are insured by the Bank Insurance Fund of the Federal Deposit Insurance Corporation (the FDIC), up to the maximum amount provided by law. The FDIC and the Massachusetts Commissioner of Banks (the Commissioner) have regulatory authority over the bank.
The companys headquarters and the banks main office are located at 222 Merrimack Street in Lowell, Massachusetts. The companys primary market area is northeastern Massachusetts and southern New Hampshire. The company has twelve additional full service branch banking offices located in the Massachusetts cities and towns of Andover, Billerica, Chelmsford, Dracut, Fitchburg, Leominster, Lowell, Tewksbury, and Westford; and in Salem, New Hampshire which serve those cities and towns as well as the surrounding communities. The company anticipates opening a second Tewksbury location in mid-2005.
The company is principally engaged in the business of attracting deposits from the general public and investing in commercial loans and investment securities. Through the bank and its subsidiaries, the company offers a range of commercial and consumer loan and deposit products, and investment management, trust and insurance services. Management seeks to hire, develop and retain highly motivated top professionals who understand the communities in which the bank operates as well as the local banking environment. The company endeavors to expand market share in existing markets and to pursue strategic growth through expansion into neighboring markets. The company places an emphasis on providing highly responsive, knowledgeable, personal service to its customers and on developing innovative products to serve the financial requirements of growing businesses, professionals, non-profit organizations, and individuals.
The company specializes in lending to growing businesses, corporations, partnerships, non-profits, professionals and individuals. Loans made by the company to businesses include commercial mortgage loans, construction loans, secured and unsecured commercial loans and lines, and standby letters of credit. The company also originates equipment lease financing for businesses. Loans made to individuals include residential mortgage loans, home equity loans, residential construction loans, secured and unsecured personal loans and lines of credit and mortgage loans on investment and vacation properties.
The company has an internal loan review function that assesses the compliance of loan originations with the companys internal policies and underwriting guidelines and monitors the ongoing quality of the loan portfolio. The company also contracts with an external loan review company to review loans in the loan portfolio on a pre-determined schedule, based on the type, size, rating, and overall risk of the loan.
In addition, a management loan review committee, consisting of senior lending officers and loan review personnel, meets monthly to discuss loan policy and procedures, as well as loans on the companys internal watch asset list and classified loan report. A loan committee, consisting of nine outside members of the board of directors, and two senior managers who are also members of the board of directors, also meets six times per year to review current portfolio statistics, new credits, construction loan reviews, loan delinquencies, allowance for loan losses and watched assets, as well as current market conditions and issues relating to the construction and real estate development industry.
The company has also established an internal credit review committee, consisting of senior lending officers and loan review personnel. The committee meets on an as needed basis to review loan requests related to borrowing relationships of certain levels, as well as other borrower relationships recommended for discussion by committee members. The companys executive committee of the board of directors also approves loan relationships exceeding certain prescribed limits.
At December 31, 2004, the banks statutory lending limit, based on 20% of capital, to any individual borrower was approximately $12.9 million, subject to certain exceptions provided under applicable law. At December 31, 2004, the bank had no outstanding lending relationships or commitments in excess of the legal lending limit. Total loans amounted to $570.5 million and represented 67% of total assets at December 31, 2004.
Commercial Real Estate, Commercial and Construction Loans
The companys primary lending focus is on the development of high quality commercial real estate, construction and commercial industrial lending relationships achieved through active business development efforts, strong community involvement and focused marketing strategies. The company employs a seasoned commercial lending staff, with commercial lenders supporting each branch location.
Commercial real estate loans include loans secured by commercial and industrial properties, apartment buildings, office and mixed use facilities, strip shopping malls, or other commercial property. Commercial real estate loans generally have repayment periods of approximately fifteen to twenty years. Variable rate loans comprise approximately 90% of the commercial real estate portfolio. Variable interest rate loans are generally fixed for the first one to five years before periodic rate adjustment begins. Adjustable rates are generally set at a margin above the Federal Home Loan Bank of Bostons Regular Classic Advance rate or a monthly average of the prime lending rate as published in The Wall Street Journal (Prime), with a variety of periodic adjustment terms. At December 31, 2004, commercial real estate loans totaled $257.7 million, an increase of 15% over the prior year, and represented 45% of gross loans outstanding at December 31, 2004.
Commercial and industrial loans include seasonal revolving lines of credit, working capital loans, equipment financing and leases, loans partially guaranteed by the Small Business Administration (SBA), and loans under various programs issued in conjunction with the Massachusetts Development and Finance Agency and other agencies, as well as unsecured loans and lines to financially strong borrowers. Commercial loans may be secured in whole or in part by real estate unrelated to the principal purpose of the loan or secured by inventories, equipment, or receivables, and are generally guaranteed by the principals of the borrower. Approximately 80% of loans in this portfolio have interest rates that are periodically adjusted, generally with fixed initial periods of one to three years. The interest rates on adjustable commercial loans vary at a margin above a key index, generally the Prime rate, however other indices are also utilized from time to time. Commercial and industrial loans have average repayment periods of one to seven years. At December 31, 2004, commercial and industrial loans totaled $142.9 million, an increase of 8% over the prior year, and represented 25% of gross loans. Unadvanced portions of commercial and industrial loans and lines amounted to $80.2 million at December 31, 2004.
Construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property, loans for the purchase and improvement of raw land and loans for the construction of owner-occupied single-family residences. The companys seasoned construction lenders work to cultivate long term relationships with experienced developers. The company limits the amount of financing provided for the construction of properties built on a speculation basis. Funds for construction projects are disbursed as pre-specified stages of construction are completed and regular site inspections are performed, either by experienced construction lenders on staff or by independent outside inspection companies, at each construction phase, prior to advancing additional funds. Construction loans generally have terms of one to three years. Adjustable rate construction loans generally have interest rates set at a margin above Prime and subject to periodic adjustments. Approximately 90% of the construction portfolio is composed of adjustable rate loans. Construction loans amounted to $83.4 million, or 15% of gross loans outstanding, at December 31, 2004. At that date, amounts committed but unadvanced in connection with such loans amounted to $62.5 million. Construction loans outstanding increased by 54% over the prior year due to the companys market expansion and the results of managements strategic planning to grow this segment of the portfolio.
From time to time the company participates in the financing of certain large commercial real estate or construction projects with other banks. In some cases the company may act
as the lead lender, originating and servicing the loans, but participating out a portion of the funding to other local community banks. In other cases the company may participate in loans originated by other institutions. In each case the participating bank funds a percentage of the loan commitment and takes on the related risk.
Commercial real estate lending may entail significant additional risks compared to residential mortgage lending. Loan size is typically larger and payment expectations on such loans can be more easily influenced by adverse conditions in the real estate market or in the economy in general. Construction financing involves a higher degree of risk than long term financing on existing occupied real estate. Property values at completion of construction or development can be influenced by underestimation of the actual costs expended to complete the project. Thus, the company may be required to advance funds beyond the original commitment in order to finish the development. If projected cash flows to be derived from the loan collateral or the values of the collateral prove to be inaccurate, for example because of unprojected additional costs or slow unit sales, the collateral may have a value that is insufficient to ensure full repayment.
The company makes conventional mortgage loans on single family residential properties with original loan-to-value ratios generally up to 97% (with private mortgage insurance) of the appraised value of the property securing the loan. These residential properties serve as the primary homes of the borrowers. The company also originates loans on second homes, vacation properties and two-to-four family owner occupied dwellings with original loan-to-value ratios generally up to 80% of the propertys appraised value. At December 31, 2004, residential loans totaled $40.7 million, or 7% of gross loans outstanding, and represented 3% growth over the prior year.
Residential mortgage loans made by the company have traditionally been long-term loans made for periods of up to 30 years at either fixed or adjustable rates of interest. Depending on the current interest rate environment, management projections of future interest rates and the overall asset-liability management program of the company, management may elect to sell or hold residential loan production for the companys portfolio. Long-term fixed rate residential mortgage loans are generally originated using underwriting standards and standard documentation allowing their sale in the secondary market. The company generally sells fixed rate residential mortgage loans and puts variable rate loans into the companys portfolio. The company may retain or sell the servicing when selling the loans. All loans sold are currently sold without recourse.
Home Equity Lines of Credit
Home equity lines are originated for the companys portfolio for single family residential properties with maximum original loan-to-value ratios generally up to 80% of the appraised value of the property securing the loan. Home equity lines generally have interest rates that adjust monthly based on changes in the Prime rate. The payment schedule for home equity lines for the first 10 years of the loans are interest only payments. At the end of ten years the line is frozen to future advances and principal and interest payments are collected over a fifteen-year amortization schedule. Home equity lines amounted to $42.8 million at December 31, 2004, representing 8% of gross loans outstanding, and 22% growth over the prior year. Amounts committed but unadvanced related to home equity lines amounted to $41.7 million at December 31, 2004.
Consumer loans primarily consist of secured or unsecured personal loans and overdraft protection lines on checking accounts extended to individual customers. Consumer loans amounted to $4.1 million, or 0.7% of gross loans outstanding at December 31, 2004, which constituted a 9% decrease since December 31, 2003.
Non-performing assets consist of non-performing loans and other real estate owned (OREO). Non-performing loans include non-accrual loans, impaired loans, and loans past due 90 days or more but still accruing. Loans on which the accrual of interest has been discontinued are designated as non-accrual loans. Accrual of interest on loans is discontinued when a loan becomes contractually past due, with respect to interest or principal, by 90 days for real estate loans and generally 60 days for all other loans, or when reasonable doubt exists as to the full and timely collection of interest or principal. In certain instances, loans that have become 90 days past due may remain on
accrual status if the value of the collateral securing the loan is sufficient to cover principal and interest and the loan is in the process of collection or if the principal and interest is guaranteed by the federal government or an agency thereof.
Loans for which management considers it probable that not all contractual principal and interest will be collected in accordance with the original loan terms are designated as impaired loans. Loans where interest rates and/or principal payments have been deferred or reduced as a result of financial difficulties of the borrower are also classified as restructured. Not all loans on non-accrual status are designated as impaired. OREO consists of real estate acquired through foreclosure proceedings and real estate acquired through acceptance of a deed in lieu of foreclosure.
The classification of a loan or other asset as non-performing does not necessarily indicate that loan principal and interest will be ultimately uncollectable. However, management recognizes the greater risk characteristics of these assets and therefore considers the potential risk of loss on assets included in this category in evaluating the adequacy of the allowance for loan losses.
Non-performing assets amounted to $2.1 million, or 0.38% of total loans at December 31, 2004.
Additional information regarding these risk elements is contained in Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, under the heading Asset Quality, contained in this report.
Allowance for Loan Losses
Inherent in the lending process is the risk of loss. While the company endeavors to minimize this risk, management recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio. The credit risk of the portfolio depends on a wide variety of factors.
The allowance for loan losses is an estimate of credit losses inherent in the loan portfolio. The allowance for loan losses is established through a provision for loan losses charged to operations. Loan losses are charged against the allowance when management believes that the collectability of the loan principal is unlikely. Recoveries on loans previously charged off are credited to the allowance. The company maintains the allowance at a level that it deems adequate to absorb all reasonably anticipated losses from specifically known and other credit risks associated with the portfolio.
The allowance for loan losses was $10.9 million, or 1.91% of total loans, at December 31, 2004. The company provided $1.7 million to the allowance for loan losses, and net charge-offs amounted to $0.7 million during 2004.
Additional information regarding the allowance for loan losses is contained in Item 7 of this report, Managements Discussion and Analysis of Financial Condition and Results of Operations, under the heading Allowance for Loan Losses, which is contained in both the Critical Accounting Estimates section and the Financial Condition section of Item 7.
The companys investment activity is an integral part of the overall asset-liability management program of the company. The investment function provides readily available funds to support loan growth as well as to meet withdrawals and maturities of deposits and attempts to provide maximum return consistent with liquidity constraints and general prudence, including diversification and safety of investments. The securities in which the company may invest are subject to regulation. In addition, the company has an internal investment policy which restricts investments to the following categories: U.S. treasury securities, federal agency obligations (obligations issued by government sponsored enterprises that are not backed by the full faith and credit of the United State government), mortgage-backed securities (MBSs), including collateralized mortgage obligations (CMOs), and state, county and municipal securities (Municipals), all of which must be considered investment grade by a recognized rating service. The company also invests in Federal Home Loan Bank of Boston (FHLB) stock, certificates of deposit, and on a limited basis in equity securities. The short-term investments classified as cash equivalents may be comprised of short-term U.S. Agency Discount Notes, money market mutual funds and overnight and short-term federal funds sold. Other short-term investments may consist of auction rate preferred securities, which typically have redemption (auction) dates of up to 49 days, but cannot readily be converted to cash at
par value until the next successful auction. The investment policy also limits the categories within the investment portfolio to particular percentages of the total portfolio and to certain percentages of total assets and/or capital. The effect of changes in interest rates, principal payments and market values are considered when purchasing securities.
Investment transactions, portfolio allocations and projected cash flows are prepared monthly and presented to the companys Asset-Liability Committee of the Board of Directors (ALCO) on a periodic basis. ALCO is comprised of six outside directors and three senior managers of the company who are also directors, with various management liaisons. ALCO also meets at least quarterly to perform an in-depth review of the companys asset-liability strategy. The credit rating of each security or obligation in the portfolio is closely monitored by management and presented, at least annually, to the ALCO, along with a detailed evaluation of the companys municipal securities portfolio.
The fair market value of the investment portfolio was $187.6 million at December 31, 2004, and total short-term investments amounted to $40.3 million at that date.
At December 31, 2004, 2003, and 2002, all investment securities were classified as available for sale and were carried at fair market value.
Source of Funds
Deposits have traditionally been the principal source of the companys funds. The company offers a broad selection of deposit products to the general public, including personal interest checking accounts (PIC), savings accounts, money market accounts, individual retirement accounts (IRA) and certificates of deposit. The company also offers commercial checking, business and municipal savings accounts, money markets and business sweep accounts, escrow management accounts, as well as checking and Simplified Employee Pension (SEP) accounts to employees of our business customers. Terms on certificates of deposit range from overnight to thirty months. The company does not currently use brokered deposits. The company has offered premium rates on specially designated products from time to time in order to promote new branches and to attract customers.
Management determines the interest rates offered on deposit accounts based on current and expected economic conditions, competition, liquidity needs, the volatility of the existing deposits, the asset-liability position of the company and the overall objectives of the company regarding the growth and retention of relationships.
The company utilizes money market mutual funds managed by Federated Investors, Inc. (Federated) for the investment portion of the companys commercial sweep accounts. Management believes that commercial customers benefit from enhanced interest rate options on sweep accounts, while retaining a conservative investment option of the highest quality and safety. The balances transferred to Federated do not represent obligations of the company.
Total deposits were $768.6 million at December 31, 2004, representing 91% of total assets.
The bank is a member of the FHLB. This membership enables the bank to borrow funds from the FHLB. The company utilizes borrowings from the FHLB to fund short term liquidity needs. This facility is an integral component of the companys asset-liability management program. At December 31, 2004, the company had outstanding FHLB advances of $1.9 million.
The company also borrows funds from customers (generally commercial and municipal customers) by entering into agreements to sell and repurchase investment securities from the companys portfolio with terms typically ranging from overnight to six months. These repurchase agreements represent a cost competitive funding source for the company. Interest rates paid by the company on the repurchase agreements are based on market conditions and the companys need for additional funds at the time of the transaction. Repurchase agreements amounted to $1.7 million at December 31, 2004.
Junior Subordinated Debentures
In March 2000 the company organized Enterprise (MA) Capital Trust I (the Trust), a statutory business trust created under the laws of Delaware, in order to issue $10.5 million of 10.875% trust preferred securities that mature in 2030 and are callable beginning in 2010. The proceeds from the sale of the trust preferred securities were used
by the Trust, along with the companys $0.3 million capital contribution, to acquire $10.8 million in aggregate principal amount of the companys 10.875% Junior Subordinated Debt Securities that mature in 2030 and are callable beginning in 2010.
Pursuant to Financial Interpretation No. 46R, issued by the Financial Accounting Standards Board in December 2003, the company has excluded the Trust from current period financial statements beginning in 2003, and has elected to voluntarily restate prior period financial statements for comparability purposes. This deconsolidation has caused the company to carry its $10.8 million of Junior Subordinated Debt Securities, which were issued by the company to the Trust, on the companys financial statements as borrowings, with related interest expense, and to exclude the $10.5 million of trust preferred securities issued by the Trust, and the related non-interest expense, from its financial statements. This deconsolidation did not have a material impact on the companys financial statements.
Investment Management and Trust Division
The company provides a range of investment management services to individuals, family groups, businesses, trusts, foundations and retirement plans. These services include: securities brokerage services through Enterprise Investment Services LLC, which provides these services through a third party service arrangement with Commonwealth Financial Network, a licensed securities brokerage firm; management of equity, fixed income, balanced and strategic cash management portfolios through the companys investment management and trust division; and commercial sweep accounts through Federated for the companys commercial deposit customers. Portfolios are managed based on the individual investment objectives of each client.
The companys investment management and trust division utilizes an open-architecture, manager of managers approach to client investment management. Our philosophy is to identify and hire highly competitive outside investment management firms on behalf of our clients. The company performs in house searches and related due diligence in identifying and hiring outside investment managers, as well as all of the ongoing oversight and monitoring of each outside investment manager retained by the company.
Enterprise Insurance Services
Enterprise Insurance Services LLC engages in insurance sales activities through a third party arrangement with HUB International New England, LLC (HUB), formerly known as C.J. McCarthy Insurance Agency, Inc., a full service insurance agency, with nine offices in Massachusetts and New Hampshire. Enterprise Insurance Services provides, through HUB, a full array of insurance products including property and casualty, employee benefits and risk-management solutions tailored to serve the specific insurance needs of businesses in a range of industries operating in the companys market area.
The company uses an in-house turn-key solution from its core banking system vendor for internet banking services for retail and commercial customers. Major internet banking capabilities include the following: balance inquiry; internal transfers; loan payments; ACH origination; federal tax payments; placement of stop payments; and initiation of request for wire transfers. In addition to the services described above the in-house solutions also give customers access to images of checks paid as well as previous account statements.
The company currently uses an outside vendor to design, support and host its website. The site provides information on the company and its services, as well as providing the access point to various specified banking services and to various financial management tools. In addition, the site includes the following major capabilities: career opportunities; loan and deposit rates; calculators; an ATM/Branch Locator/Map; and shareholder and investor information, which includes a corporate governance page containing board of directors committees, charters, corporate governance guidelines and the companys code of business conduct and ethics, among other items, and a link to the companys SEC filings. The company makes available free of charge through a link to its SEC filings, its annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments to these reports. Access to these reports is essentially simultaneous with the SECs posting of these reports on its EDGAR system through the SEC website (www.SEC.gov). The underlying structure of the site provides for dynamic
maintenance of the information by company personnel. The companys internet web address is: www.ebtc.com.
The company faces strong competition to attract deposits and to generate loans. National and larger regional commercial banks have a local presence in the Merrimack Valley and in the Leominster/Fitchburg, Massachusetts area. Numerous local savings banks, cooperative banks, credit unions and savings and loan associations have one or more offices in the companys market area. Larger banks have certain competitive advantages over the company, including the ability to make larger loans to a single borrower than is possible for the company. The greater financial resources of larger banks also allow them to offer a broad range of automated banking services, to maintain numerous branch offices and to mount extensive advertising and promotional campaigns. Competition for loans and deposits also comes from other businesses that provide financial services, including consumer finance companies, mortgage brokers, insurance companies, securities brokerage firms, institutional mutual funds and private lenders. Advances in, and the increased use of, technology, such as Internet banking and electronic item processing, are expected to have a significant impact on the future competitive landscape confronting financial institutions.
Management believes that the companys market position has been enhanced by the acquisition of peer independent banks by the larger regional and national banking organizations, and the resultant consolidation of competitors banking operations and services within the companys market area. This consolidation is expected to continue as national banks seek entrance into the New England market area and local regional banks continue their growth by acquisition strategy. Management actively seeks to strengthen its position by capitalizing on the market disruption of these activities by pursuing growth opportunities in neighboring markets, as evidenced by the companys 2004 expansion into the Andover, Massachusetts and Salem, New Hampshire markets. The company also continues to examine new products and technologies in order to maintain a competitive mix of offerings and services that can be delivered through multiple distribution channels at competitive prices.
Notwithstanding the substantial competition with which the company is faced, management believes that the company has established a solid reputation in the Merrimack Valley and the Leominster/Fitchburg area. The company believes that it has differentiated itself from competitors by providing customers, composed principally of growing and privately held businesses, professionals, and consumers, with highly responsive and personal service based on managements familiarity and understanding of such customers banking needs. The companys officers and directors have substantial business and personal ties in the cities and towns in which the company operates. The companys past and continuing emphasis is to target product lines to customer needs, and to seek out and hire top professionals who understand the community and local banking environment.
To the extent that changes in the regulation of financial services may further increase competition, these changes could result in the company paying increased interest rates to obtain deposits while receiving lower interest rates on its loans. Under such circumstances, the companys net interest margin would decline.
See also Supervision and Regulation below, for further discussion on how new laws and regulations may effect the companys competitive position.
Supervision and Regulation
Bank holding companies and banks are subject to extensive government regulation through federal and state statutes and related regulations, which are subject to changes that can significantly affect the way in which financial service organizations conduct business.
As a general matter, regulation of the banking and financial services industries continues to undergo significant changes, some of which are intended to ease legal and regulatory restrictions while others have increased regulatory requirements. For example, the Gramm-Leach-Bliley Act of 1999 (the GLB Act) eased regulatory restrictions by removing the legal barriers that formerly served to separate the banking, insurance and securities industries. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, which reduced geographic restrictions on banking organizations by enhancing their ability to operate on a nationwide basis, is another example of federal legislation that has reduced the legal and regulatory burdens on banks and their holding companies.
Changes in law and regulation that have increased banks and financial organizations regulatory requirements include the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the USA Patriot Act). The USA Patriot Act added new provisions to the Bank Secrecy Act that are intended to facilitate the prevention, detection and prosecution of international money laundering and the financing of terrorism. Among other requirements under the USA Patriot Act, in 2003 the company implemented a comprehensive risk-based customer identification program that is applied to all new account openings.
The passage of the Sarbanes-Oxley Act of 2002 (SOX) has also added new financial reporting and corporate governance requirements to the companys ongoing regulatory compliance obligations. Pursuant to SOX requirements, the company took several steps in 2003 and 2004 to formalize the corporate governance policies, procedures and guidelines that are followed by the management and directors of the company. These included: developing an independent Corporate Governance/Nominating Committee, determining the independence of each of the companys directors, restructuring board committees, identifying an audit committee financial expert, providing internal control and disclosure certifications, enhancing our code of ethics and developing board committee charters. In 2004, the company became an accelerated filer, as defined by the SEC, and as such, fell under the SECs rules implementing Section 404 of SOX. As required by Section 404, management undertook a complete evaluation and documentation of the company-wide systems of internal controls and procedures over financial reporting and fraud. Management must present a report on its assessment of the effectiveness of the companys internal control over financial reporting, which must be attested to, and reported on, by the companys independent registered public accounting firm and included in the companys annual report on Form 10-K. See Managements Report on Internal Control Over Financial Reporting in Item 9A, Controls and Procedures and also the Report of Independent Registered Public Accounting Firm on Internal Controls Over Financial Reporting on page 79.
The Check Clearing for the 21st Century Act (Check 21) became effective on October 28, 2004. Check 21 is designed to facilitate the automation of the nations check-processing system away from physical transportation of paper checks via couriers over land and through air. The law allows banks to process check information electronically, and to deliver digital images of the check to banks that choose to continue to receive paper checks. The digital image is converted to a substitute check, which replaces and becomes the legal equivalent of the original check.
On December 4, 2003, the President signed into law the Fair and Accurate Credit Transaction Act (FACT Act), which amends the Fair Credit Reporting Act. The FACT Act establishes uniform national standards in key areas of regulation regarding consumer credit report information. In general, the FACT Act enhances the ability of consumers to combat identity theft, increases the accuracy of consumer reports, allows consumers to exercise greater control regarding the type and amount of marketing solicitations they receive, restricts the use and disclosure of sensitive medical information, and establishes a commission to improve federal financial education programs and financial literacy among consumers.
Any future increase in the extent of regulation imposed upon the banking or financial services industries generally could result in the company incurring additional operating and compliance costs, which in turn could impede profitability.
To the extent that the information in this report under the heading Supervision and Regulation describes statutory or regulatory provisions, it is qualified in its entirety by reference to the particular statutory or regulatory provision so described. Any changes in applicable laws or regulations may have a material effect on the business and prospects of the company.
Regulation of the Holding Company
The company is a registered bank holding company under the federal Bank Holding Company Act of 1956, as amended (the Bank Holding Company Act). It is subject to the supervision and examination of the Board of Governors of the Federal Reserve System (the Federal Reserve Board) and files reports with the Federal Reserve Board as required under the Bank Holding Company Act. Under applicable Massachusettss law, the company is also subject to the supervisory jurisdiction of the Commissioner.
The Bank Holding Company Act requires prior approval by the Federal Reserve Board of the acquisition by the company of substantially all the assets or more than five percent of the voting stock of any bank. The Bank Holding Company Act also authorizes the Federal
Reserve Board to determine (by order or by regulation) what activities are so closely related to banking as to be a proper incident of banking, and thus, whether the company, either directly or indirectly through non-bank subsidiaries, can engage in such activities. The Bank Holding Company Act prohibits the company and the bank from engaging in certain tie-in arrangements in connection with any extension of credit, sale of property or furnishing of services. There are also restrictions on extensions of credit and other transactions between the bank, on the one hand, and the company, or other affiliates of the bank, on the other hand.
The GLB Act enhanced the authority of banks and their holding companies to engage in non-banking activities. By electing to become a financial holding company, a qualified parent company of a banking institution may engage, directly or through its non-bank subsidiaries, in any activity that is financial in nature or incidental to such financial activity or in any other activity that is complimentary to a financial activity and does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally.
A bank holding company will be able to successfully elect to be regulated as a financial holding company if all of its depository institution subsidiaries meet certain prescribed standards pertaining to management, capital adequacy and compliance with the federal Community Reinvestment Act. Financial holding companies remain subject to regulation and oversight by the Federal Reserve Board. The company believes that the bank, which is the companys sole depository institution subsidiary, presently satisfies all of the requirements that must be met to enable the company to successfully elect to become a financial holding company. However, the company has no current intention of seeking to become a financial holding company. Such a course of action may become necessary or appropriate at some time in the future depending upon the companys strategic plan.
Regulation of the Bank
As a trust company organized under Chapter 172 of the Massachusetts General Laws, the deposits of which are insured by the FDIC, the bank is subject to regulation, supervision and examination by the Commissioner and the FDIC. The bank is also subject to certain requirements of the Federal Reserve Board.
The regulations of these agencies govern many aspects of the banks business, including permitted investments, the opening and closing of branches, the amount of loans which can be made to a single borrower, mergers, appointment and conduct of officers and directors, capital levels and terms of deposits. The Federal Reserve Board also requires the bank to maintain minimum reserves on its deposits. Federal and state regulators can impose sanctions on the bank and its management if the bank engages in unsafe or unsound practices or otherwise fails to comply with regulatory standards. Various other federal and state laws and regulations, such as truth-in-lending and truth-in-savings statutes, the Equal Credit Opportunity Act, the Bank Secrecy Act, the Real Estate Settlement Procedures Act, the Community Reinvestment Act, Check 21 and the FACT Act, also govern the banks activities and operations.
Pursuant to the GLB Act, the bank may also form, subject to the approvals of the Commissioner and the FDIC, financial subsidiaries to engage in any activity that is financial in nature or incidental to a financial activity. In order to qualify for the authority to form a financial subsidiary, the bank would be required to satisfy certain conditions, some of which are substantially similar to those that the company would be required to satisfy in order to elect to become a financial holding company. The company believes that the bank would be able to satisfy all of the conditions that would be required to form a financial subsidiary, although the company has no current intention of doing so. Such a course of action may become necessary or appropriate at some time in the future depending upon the companys strategic plan.
Under Massachusetts law, the companys board of directors is generally empowered to pay dividends on the companys capital stock out of its net profits to the extent that the board of directors considers such payment advisable. Massachusetts banking law also imposes substantially similar standards upon the payment of dividends by the bank to the company. The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) also prohibits a bank from paying any dividends on its capital stock in the event that the bank is in default on the payment of any assessment to the FDIC or if the payment of any such dividend would otherwise cause the bank to become undercapitalized.
Capital planning by the company and the bank considers current needs and anticipated future growth. The primary sources of capital have been the sale of common stock in 1988 and 1989, the issuance of $10.5 million of trust preferred securities in 2000 by the Trust, and retention of earnings less dividends paid since the bank commenced operations.
The Federal Reserve Board has adopted capital adequacy guidelines that generally require bank holding companies to maintain total capital equal to 8% of total risk-weighted assets, with at least one-half of that amount (or 4% of total risk-weighted asset) consisting of core or Tier 1 capital. Total capital for the company consists of Tier 1 capital and supplementary or Tier 2 capital. Tier 1 capital for the company begins with common stockholders equity and is reduced by certain intangible assets. In addition, trust preferred securities may compose up to 25% of the companys Tier 1 capital (with any excess allocable to Tier 2 capital). Supplementary capital for the company is comprised solely of a portion of the allowance for loan losses. Assets are adjusted under the risk-based capital guidelines to take into account different levels of credit risk, for example, cash and government securities are placed in a 0% risk category (requiring no additional capital), most home mortgage loans are placed in a 50% risk category, and the bulk of assets that, by their nature in the ordinary course of business, pose a direct credit risk to a bank holding company, including commercial real estate loans, commercial business loans and consumer loans are placed in a 100% risk category.
In addition to the risk-based capital requirements, the Federal Reserve Board requires bank holding companies to maintain a minimum leverage ratio of Tier 1 capital to quarterly average total assets of 3%, with most bank holding companies required to maintain at least a 4% ratio.
The bank is subject to separate capital adequacy requirements of the FDIC, which are substantially similar to the requirements of the Federal Reserve Board applicable to the company. However, trust preferred proceeds contributed to the bank from the company are included in Tier 1 capital of the bank without limitation. The company contributed $10.3 million of proceeds from the sale of these securities to the bank. Under the FDIC requirements, the minimum total capital requirement is 8% of total assets and certain off-balance sheet items, weighted by risk. At least 4% of the total 8% ratio must consist of Tier 1 capital (primarily common equity including retained earnings) and the remainder may consist of subordinated debt, cumulative preferred stock and a limited amount of loan loss reserves. At the bank level, as at the company level on a consolidated basis, certain intangible assets are deducted from Tier 1 capital in calculating regulatory capital ratios.
Under the applicable FDIC capital requirements, the bank is also required to maintain a minimum leverage ratio. The ratio is determined by dividing Tier 1 capital by quarterly average total assets, less intangible assets and other adjustments. FDIC rules require a minimum of 3% for the highest rated banks. Banks experiencing high growth rates are expected to maintain capital positions well above minimum levels.
Depository institutions, such as the bank, are also subject to the prompt corrective action framework for capital adequacy established by FDICIA. Under FDICIA, the federal banking regulators are required to take prompt supervisory and regulatory actions against undercapitalized depository institutions. FDICIA establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically capitalized. A well capitalized institution has a total capital to total risk-weighted assets ratio of at least 10%, a Tier 1 capital to total risk-weighted assets ratio of at least 6%, a leverage ratio of at least 5% and is not subject to any written order, agreement or directive; an adequately capitalized institution has a total capital to total risk-weighted assets ratio of at least 8%, a Tier 1 capital to total risk-weighted assets ratio of at least 4%, and a leverage ratio of at least 5% (3% percent if given the highest regulatory rating and not experiencing significant growth), but does not qualify as well capitalized. An undercapitalized institution fails to meet one of the three minimum capital requirements. A significantly undercapitalized institution has a total capital to total risk-weighted assets ratio of less than 6%, a Tier 1 capital to total risk-weighted assets ratio of less than 3%, and a leverage ratio of less than 3%. A critically capitalized institution has a ratio of tangible equity to assets of 2%, or less. Under certain circumstances, a well
capitalized, adequately capitalized or undercapitalized institution may be required to comply with supervisory actions as if the institution were in the next lowest category.
Failure to meet applicable minimum capital requirements, including a depository institution being classified as less than adequately capitalized within FDICIAs prompt corrective action framework, may subject a bank holding company or its subsidiary depository institution(s) to various enforcement actions, including substantial restrictions on operations and activities, dividend limitations, issuance of a directive to increase capital and, for a depository institution, termination of deposit insurance and the appointment of a conservator or receiver.
Patents, Trademarks, etc.
The company holds no patents, registered trademarks, licenses (other than licenses required to be obtained from appropriate banking regulatory agencies), franchises or concessions which are material to its business.
At December 31, 2004, the company employed 249 full-time equivalent employees, including 90 officers. None of the companys employees are presently represented by a union or covered by a collective bargaining agreement. Management believes its employee relations to be excellent.
Item 2. Properties
The company conducts its business from its main office located at 222 Merrimack Street, and operational support and lending offices at 21-27 Palmer Street and 170 Merrimack Street, Lowell, Massachusetts. The company currently has twelve additional full service branch banking offices in Massachusetts and New Hampshire, and anticipates opening its thirteenth branch office in mid-2005, in Tewksbury Massachusetts. The company is currently renovating a facility in Andover and anticipates relocating its current temporary Andover branch (63 Park Street) into this expanded location in late 2005. The company is obligated under various non-cancelable operating leases, some of which provide for periodic adjustments. The company believes that all its facilities are well maintained and suitable for the purpose for which they are used.
The following table sets forth general information related to facilities owned or used by the company.
(1) Relocation of the Park St. office expected to open in late 2005
(2) The company has the option to purchase this facility on the last day of the basic term or at any time during any extended term at the price of $550,000 as adjusted for increases in the producers price index.
(3) Anticipated to open in mid-2005
See note 4, Premises and Equipment, to the consolidated financial statements in Item 8 for further information regarding the companys lease obligations.
Item 3. Legal Proceedings
The company is involved in various legal proceedings incidental to its business. Management does not believe resolution of any present litigation will have a material adverse effect on the financial condition of the company.
See Massachusetts Department of Revenue Tax Dispute contained in Item 7, and also in note 14 to the consolidated financial statements contained in Item 8, for further details regarding 2003 tax legislation and the companys dispute and settlement of prior year assessments, and a description of the adverse effect that this new legislation will have on the companys earnings in future periods.
Item 4. Submission of Matters to a Vote of Security Holders
There were no matters submitted to a vote of security holders during the quarter ended December 31, 2004.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market for Common Stock
On February 14, 2005 the companys common stock began trading on the NASDAQ® Stock Market, under the symbol EBTC. Prior to this date there had been no established public trading market for the companys common stock. Although periodically there have been private trades of the companys common stock, prior to its trading on the NASDAQ Stock Market, the company cannot state with certainty the sales price at which such transactions occurred. The following table sets forth sales volume and price information, to the best of managements knowledge, for the common stock of the company for the periods indicated.
The number of shares outstanding of the companys common stock and number of shareholders of record as of March 1, 2005, were 3,691,210 and 770 respectively.
The company declared and paid annual cash dividends of $0.43 per share and $0.38 per share in 2004 and 2003, respectively. Although the company expects to continue to pay an annual dividend, the amount and timing of any declaration and payment of dividends by the board of directors will depend on a number of factors, including capital requirements, the tax effect on individual stockholders, regulatory limitations, the companys operating results and financial condition, anticipated growth of the company and general economic conditions. As the principal asset of the company, the bank currently provides the only source of cash for the payment of dividends by the company. Under Massachusetts law, trust companies such as the bank may pay dividends only out of net profits and only to the extent that such payments will not impair the banks capital stock. Any dividend payment that would exceed the total of the banks net profits for the current year plus its retained net profits of the preceding two years would require the Commissioners approval. FDICIA also prohibits a bank from paying any dividends on its capital stock if the bank is in default on the payment of any assessment to the FDIC or if the payment of dividends would otherwise cause the bank to become undercapitalized. These restrictions on the ability of the bank to pay dividends to the company may restrict the ability of the company to pay dividends to the holders of its common stock.
The statutory term net profits essentially equates with the accounting term net income and is defined under the Massachusetts banking statutes to mean the remainder of all earnings from current operations plus actual recoveries on loans and investments and other assets after deducting from such total all current operating expenses, actual losses, accrued dividends on any preferred stock and all federal and state taxes.
Sales of Unregistered Securities and Repurchases of Shares
The company has not sold any equity securities that were not registered under the Securities Exchange Act of 1934 during the year ended December 31, 2004. Neither the company nor any affiliated purchaser (as defined in the SECs Rule 10b-18(a)(3)) has repurchased any of the companys outstanding shares, nor caused any such shares to be repurchased on its behalf, during the fiscal quarter ended December 31, 2004.
Item 6. Selected Consolidated Financial Data
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
Managements discussion and analysis should be read in conjunction with the companys consolidated financial statements and notes thereto contained in Item 8, the information contained in the description of the companys business in Item 1 and other financial and statistical information contained in this annual report.
Special Note Regarding Forward-Looking Statements
This report contains certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements concerning plans, objectives, future events or performance and assumptions and other statements that are other than statements of historical fact. Forward-looking statements may be identified by reference to a future period or periods or by use of forward-looking terminology such as anticipates, believes, expects, intends, may, plans, pursue, views and similar terms or expressions. Various statements contained in Item 1 Business, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 7A Quantitative and Qualitative Disclosures About Market Risk, including, but not limited to, statements related to managements views on the banking environment and the economy, competition and market expansion opportunities, the interest rate environment, credit risk and the level of future non-performing assets and charge-offs, potential asset and deposit growth, future non-interest expenditures and non-interest income growth, and borrowing capacity are forward-looking statements. The company wishes to caution readers that such forward-looking statements reflect numerous assumptions and involve a number of risks and uncertainties that may adversely affect the companys future results. The following important factors, among others, could cause the companys results for subsequent periods to differ materially from those expressed in any forward-looking statement made herein: (i) changes in interest rates could negatively impact net interest income; (ii) changes in the business cycle and downturns in the local, regional or national economies, including deterioration in the local real estate market, could negatively impact credit and/or asset quality and result in credit losses and increases in the companys reserve for loan losses; (iii) changes in consumer spending could negatively impact the companys credit quality and financial results; (iv) increasing competition from larger regional and out-of-state banking organizations as well as non-bank providers of various financial services could adversely affect the companys competitive position within its market area and reduce demand for the companys products and services; (v) deterioration of securities markets could adversely affect the value or credit quality of the companys assets and the availability of funding sources necessary to meet the companys liquidity needs; (vi) changes in technology could adversely impact the companys operations and increase technology-related expenditures; (vii) increases in employee compensation and benefit expenses could adversely affect the companys financial results; (viii) changes in laws and regulations that apply to the companys business and operations could increase the companys regulatory compliance costs and adversely affect the companys business environment, operations and financial results; and (ix) changes in accounting standards, policies and practices, as may be adopted or established by the regulatory agencies, the Financial Accounting Standards Board or the Public Company Accounting Oversight Board could negatively impact the companys financial results. Therefore, the company cautions readers not to place undue reliance on any such forward-looking information and statements.
Critical Accounting Estimates
The companys significant accounting policies are described in note 1, Summary of Significant Accounting Policies, to the consolidated financial statements contained in Item 8. In applying these accounting policies, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. Certain of the critical accounting estimates are more dependent on such judgment and in some cases may contribute to volatility in the companys reported financial performance should the assumptions and estimates used change over time due to changes in circumstances. The two most significant areas in which management applies critical assumptions and estimates include the areas described further below.
Allowance for Loan Losses
The credit risk of the portfolio depends on a wide variety of factors, including, among others, current and expected economic conditions, the real estate market, the financial condition of borrowers, the ability of borrowers to adapt to changing conditions or
circumstances affecting their business, the continuity of borrowers management teams and the credit management process. The company regularly monitors these factors, among others, in order to determine the adequacy of its allowance for loan losses through ongoing credit reviews by the credit department, an external loan review service, members of senior management and the loan and executive committees of the board of directors.
The company uses a methodology to systematically measure the amount of estimated loan loss exposure inherent in the portfolio for purposes of establishing a sufficient allowance for loan losses. The methodology includes three elements: identification of specific loan losses, general loss allocations for certain loan types based on credit grade and loss experience factors, and general loss allocations for other economic or market factors. The methodology includes analysis of individual loans deemed to be impaired in accordance with the terms of SFAS 114. Other individual commercial and commercial mortgage loans are evaluated using an internal rating system and the application of loss allocation factors. The loan rating system and the related loss allocation factors take into consideration the borrowers financial condition, the borrowers performance with respect to loan terms and the adequacy of collateral. Portfolios of more homogenous populations of loans, including residential mortgages and consumer loans, are analyzed as groups taking into account delinquency ratios and other indicators, the companys historical loss experience and comparison to industry standards of loss allocation factors for each type of credit product. Finally, management considers qualitative and quantitative assessments of other factors, including industry concentrations, results of regulatory examinations, historical charge-off and recovery experience, composition and size of the loan portfolio, trends in loan volume, delinquencies and non-performing loans, the strength of the local and national economy, interest rates and other changes in the portfolio. The allowance for loan losses is managements estimate of the probable loan losses incurred as of the balance sheet date.
Impairment Review of Goodwill and Other Intangible Assets
Goodwill and core deposit intangibles carried on the companys consolidated financial statements were $5.7 million and $0.7 million, respectively, at December 31, 2004. Both of these assets are related to the companys acquisition of two branch offices in July 2000.
In accordance with generally accepted accounting standards, the company does not amortize goodwill and instead, at least annually, evaluates whether the carrying value of goodwill has become impaired. Impairment of the goodwill occurs when the estimated fair value of the company is less than its recorded value. A determination that goodwill has become impaired results in immediate write-down of goodwill to its determined value with a resulting charge to operations.
The annual impairment test is a two-step process used to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized, if any. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of the reporting unit with its carrying amount, or the book value of the reporting unit, including goodwill. If the fair value of the reporting unit equals or exceeds its book value, goodwill is considered not impaired, and the second step of the impairment test is unnecessary. The second step, if necessary, measures the amount of goodwill impairment loss to be recognized. The reporting unit must determine fair values for all assets and liabilities, excluding goodwill. The net of the assigned fair value of assets and liabilities is then compared to the book value of the reporting unit, and any excess book value becomes the implied fair value of goodwill. If the carrying amount of the goodwill exceeds the newly calculated implied fair value of that goodwill, an impairment loss is recognized in the amount required to write down the goodwill to the implied fair value.
The companys consolidated financial statements also include intangible assets (core deposit intangibles), which are amortized to expense over their estimated useful life of ten years and reviewed for impairment on an ongoing basis or whenever events or changes in business circumstances warrant a review of the carrying value. If impairment is determined to exist, the related write-down of the intangible assets carrying value is charged to operations.
Based on these impairment reviews the company determined that goodwill and core deposit intangible assets were not impaired at December 31, 2004.
Composition of Earnings
The company had net income in 2004 of $7.5 million compared to $6.9 million for 2003, an increase of 8%.
The companys earnings are largely dependent on its net interest margin or spread, which is the difference between the yield on interest earning assets (loans, investment securities and total short-term investments) and the cost of interest bearing liabilities (deposits and borrowings). The companys earnings are, therefore, subject to the risks associated with changes in the interest rate environment. The management of interest rate risk is a significant component of the companys risk management process and is discussed in more detail below under the heading Opportunities and Risks.
Net interest income, which is the margin or spread in dollar terms (i.e., interest income less interest expense) amounted to $32.1 million or 82% of the companys revenue (net interest income plus non-interest income) in 2004 compared to $28.4 million or 76% of revenue in 2003. Net interest income increased $3.8 million or 13% in 2004 compared to 2003. The increase in net interest income was primarily attributed to an increase in interest earning balances and an increase in net interest margin.
The companys net interest margin increased by 12 basis points to 4.50% for the year ended December 31, 2004, compared to 4.38% for the year ended December 31, 2003. This compares to margin compression of 37 basis points in the period from December 31, 2002 through December 31, 2003. The increase in margin in 2004 was primarily due to the decline in total cost of funds of 15 basis points, compared to the 3 basis point reduction in yield on interest earning assets. The slight reduction in yield on interest earning assets reflects the lower market rates during the period partially offset by the increase in higher yielding average loan balances in conjunction with the decline of comparatively lower yielding investment balances.
The significant declines in yields on both assets and liabilities seen in prior years slowed in 2004, primarily due to the majority of term balances having already repriced downward during the low rate environment of prior years. Also minimizing declines were the recent increases to short-term market indices, including the prime lending rate and federal funds rates, in the second half of 2004. The increase in short-term rates triggered a modest repricing on earning assets, particularly loans tied to such indices, while deposit rates remained relatively stable.
The provision for loan losses was $1.7 million in 2004 compared to $1.1 million in 2003. The primary reason for the increase was a provision of $0.8 million taken in the first quarter of 2004 primarily resulting from approximately $0.5 million in net charge-offs during that quarter. The provision reflects managements estimate of the level of loan loss reserves necessary to support the level of credit risk inherent in the portfolio.
The management of credit risk is a significant component of the companys risk management process and is discussed in more detail below under the heading Opportunities and Risks.
The companys earnings are also directly impacted by non-interest income, consisting of traditional banking fee income such as deposit and loan fees, gains on the sales of investment securities and loans, and non-deposit revenue streams such as investment management, trust and insurance services. Non-interest income was $7.0 million and $8.7 million for 2004 and 2003, respectively. The decrease in 2004 was primarily due to reductions in gains on sales of investment securities and loans.
The effective management of operating expenses and the level of income taxes are also key components of the companys financial results. Non-interest expense amounted to $25.7 million and $23.3 million in 2004 and 2003, respectively. The 10% increase in 2004 was primarily related to the infrastructure necessary to support the companys growth and expansion into new markets.
The effective tax rate for 2004 and 2003 was 36.2% and 45.2%, respectively. The effective rate for 2004 reflects normal activity with the decrease from statutory rates of 40.93% primarily due to interest income earned on tax exempt municipal securities. The 2003 effective rate was impacted by retroactive legislation related to state tax assessments.
See Massachusetts Department of Revenue Tax Dispute in this Item 7 below for further details.
Sources and Uses of Funds
The companys primary sources of funds are deposits, borrowings from the FHLB, securities sold under agreements to repurchase, current earnings and proceeds from the sales, maturities and paydowns on loans and investment securities. The company uses funds to originate loans and purchase investment securities, conduct operations, expand the branch network, and pay dividends to shareholders.
Opportunities and Risks
Notwithstanding the substantial competition the company faces to attract deposits and to generate loans within its market area, management believes that the company has established a market niche in the Merrimack Valley and North Central regions of Massachusetts.
Management believes that it continually differentiates the company from competitors by providing innovative commercial and consumer banking, investment, and insurance products to our customers, composed principally of growing and privately held businesses, professionals, and consumers, delivered through prompt and personal service based on managements familiarity and understanding of such customers banking needs.
Management believes that the companys market position has been enhanced by the ongoing consolidation within the banking industry, and in particular in Massachusetts. Additionally, management actively seeks to improve its market position by pursuing opportunities in neighboring markets. During 2004, the company opened two new branches, located in Andover, Massachusetts and in Salem, New Hampshire. The company will open its fourteenth office, to be located in Tewksbury, Massachusetts, in mid-2005.
The company has added four branches over the last three years and the continued branch expansion is expected to increase the companys operating expenses, primarily in salaries, marketing, and occupancy expenses, before the growth benefits are fully achieved. Through business development and focused marketing efforts, management expects to continue penetration into existing markets, and to position itself to increase market share as the industry consolidation by larger regional banking companies continues.
The companys interest rate risk management process involves evaluating various interest rate scenarios, competitive dynamics and market opportunities. Currently, management considers the companys primary interest rate risk exposure to be from margin compression due to declining interest rates or a flattening yield curve.
Generally, under the declining rate scenario, longer term asset yields re-price lower, while shorter term liability yields, including non-interest bearing deposits, have minimal ability to decline. Such a scenario has been prevalent in the banking industry over the past couple of years. Significant margin contraction occurred as average interest rates approached historic lows, earning assets continued to re-price downward and interest bearing liabilities had little room to move significantly lower. In addition, as market rates declined prepayments of loans and mortgage backed investment securities accelerated, forcing the company to reinvest those proceeds at the lower market rates. However, in 2004 the downward trend in net interest margin appeared to have stabilized and short-term market rates began to move upward.
Under a flattening yield curve scenario, short-term rates would move near or to the levels of longer term rates, also resulting in margin compression. Under such a scenario, shorter-term liability costs would increase, either from market movements or competitive pressures, while longer term asset yields would remain relatively stable. The risk of a flattening yield curve is somewhat mitigated by the companys product mix. Approximately 35% of loans are indexed to the prime lending rate, a short term rate, and approximately 45% of the companys deposits consist of low cost checking accounts, which are considered unlikely to incur significant interest rate increases.
The management of interest rate risk is a significant component of the companys risk management process and is discussed in more detail in Item 7A, Quantitative and Qualitative Disclosures About Market Risk.
The credit risk inherent in the loan portfolio is quantified through the allowance for loan losses, which is primarily increased through the provision for loan losses, which is a direct charge to earnings and is discussed above under the heading Composition of Earnings. Management determined that the allowance for loan losses of $10.9 million, or 1.91% of total loans at December 31, 2004, was adequate to absorb reasonably anticipated losses due to the credit risk associated with the loan portfolio at that date. In order to determine the adequacy of its allowance for loan losses management regularly monitors the level of credit risk through ongoing credit reviews by the credit department, an external loan review service, members of senior management and the loan and executive committees of the board of directors. The company discusses the methodology used to estimate the loan loss exposure under the heading Allowance for Loan Losses in Critical Accounting Estimates above, and further discusses managements assessment of the allowance at December 31, 2004 under the heading Allowance for Loan Losses in the Financial Condition section of this Item 7 below.
In addition to the critical nature of effectively managing the companys credit and interest rate risk, management also recognizes, as a key component of the risk management process, the importance of effectively mitigating operational risk, particularly as it relates to technology administration, information security, and business continuity.
Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to continually monitor and safeguard information on its operating systems and that of third party service providers. The company contracts with an outside party to perform a broad scope of both internal and external security assessments on a regular basis. The third party tests the companys security controls and network configuration, and assesses internal policies, practices and other key items. The company also utilizes firewall technology to protect against unauthorized access and commercial software that continuously scans for computer viruses on the companys information systems. The company maintains an Information Security and Technology Practices policy applicable to all employees. The policy outlines the employees responsibilities and key components of the companys Information Security and Technology Practices Program, which include the following: identification and assessment of risk; institution of policies and procedures to manage and control the risk; risk assessment of outsourced service providers; development of strategic security contingency plans; training of all officers and employees; and reporting to the board of directors. Significant technology issues, related changes in risk and results of third party security assessments are reported to the Boards Technology Steering and Audit Committees. The Board, through these committees, reviews the status of the Information Security and Technology Practices Program and makes adjustments to the policy as deemed necessary.
The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence which would disable the company for an extended period. The plan establishes responsibility for assessing a disruption of business, contains alternative strategies for the continuance of critical business functions, assigns responsibility for restoring services, and sets priorities by which impacted services will be restored.
Management views the current banking landscape as an opportunistic period. Management believes that the combination of its focused business strategy, industry consolidation, branch expansion and continued market penetration have positioned the company well to achieve success in the coming years. The effective management of credit, interest rate and operational risk along with excelling in a very competitive landscape are the significant challenges for the company.
Total assets increased $96.6 million, or 13%, over the prior year, to $848.2 million at December 31, 2004. The increase was primarily attributable to an increase in total loans, of $81.6 million, or 17%. The primary components of the growth were construction and commercial real estate lending.
Asset growth was primarily funded through deposit growth of $107.8 million or 16%, offset by a decrease in borrowed funds of $17.8 million. The primary increase in deposits were in low cost checking deposits of $39.5 million or 15%, exclusive of a $32 million deposit received in late December and withdrawn in early January.
The following table presents condensed financial data as of December 31, 2004 and 2003, and related change in the balance of each category.
Total loans were $570.5 million, or 67% of total assets, at December 31, 2004, compared with $488.8 million, or 65% of total assets, at December 31, 2003. The $81.6 million, or 17%, increase in loans outstanding was attributable to expansion into new markets, continued customer-call efforts, marketing and advertising, and increased market penetration. During 2004, commercial real estate loans increased $33.2 million or 15%, commercial and industrial loans increased by $10.6 million or 8%, construction loans increased $29.3 million, or 54%, residential real estate loans and home equity mortgages increased by $8.9 million, or 12%, and consumer loans decreased $0.4 million or 9%.
The following table sets forth the loan balances by certain loan categories at the dates indicated and the percentage of each category to gross loans.
The following table sets forth the scheduled maturities of commercial real estate, commercial and construction loans in the companys portfolio at December 31, 2004. The following table also sets forth the dollar amount of loans which are scheduled to mature after one year which have fixed or adjustable rates.
Scheduled contractual maturities may not reflect the actual maturities of loans. The average maturity of loans may be shorter than their contractual terms principally due to prepayments.
Commercial real estate, commercial and construction loans secured by apartment buildings, office facilities, shopping malls, raw land or other commercial property, were $464.6 million at December 31, 2004, representing an increase of $82.2 million, or 22%, from the previous year. The growth of the commercial loan portfolio in 2004 is a reflection of the companys emphasis on developing commercial relationships, customer-call efforts, service culture and increased market penetration.
Unsecured commercial loans and lines included in commercial loans were $16.6 million and $25.0 million at December 31, 2004 and 2003, respectively, a decrease of $8.4 million. Also included in commercial loans are loans under various Small Business Administration programs amounting to $10.0 million and $8.8 million as of December 31, 2004 and 2003, respectively.
Over the past year construction loans, including both commercial and residential construction, grew by $29.3 million or 54%. The company attributes this growth to an experienced team of lenders focused on this market segment, coupled with the companys expansion into new geographic markets.
Management views commercial construction lending as a market segment with the potential for continued growth. In recent years, management has made the strategic decision to pursue judicious expansion of this portfolio. Commercial construction loans included in total construction loans amounted to $80.6 million and $50.7 million at December 31, 2004 and 2003, respectively, an increase of $29.9 million, or 59%.
Also included in the construction loan balances are residential construction loans outstanding totaling $2.8 million and $3.5 million at December 31, 2004 and 2003, respectively, a decrease of $0.7 million. Balances represent financing for the construction of single unit owner occupied residences, and are typically moved into the residential mortgage portfolio upon completion of construction.
At December 31, 2004 the company had commercial and construction loan balances participated out to various banks amounting to $20.0 million. These balances participated out to other institutions are not carried as assets on the companys financial statements. Loans originated by other banks in which the company is the participating institution are carried on the balance sheet and amounted to $19.1 million at December 31, 2004.
Residential mortgage loans outstanding were $40.7 million at December 31, 2004, representing an increase of $1.2 million, or 3%, from the previous year. Home equity loans and lines outstanding were $42.8 million at December 31, 2004, representing an increase of $7.7 million, or 22%, from the previous year.
The following table sets forth information regarding non-performing assets, restructured loans and delinquent loans 30-89 days past due as to interest or principal, held by the company at the dates indicated:
Non-performing assets were $2.1 million at December 31, 2004, compared to $3.0 million at December 31, 2003, a decrease of $0.8 million or 28%, and the ratio of non-performing loans as a percentage of total loans outstanding decreased to 0.38% from 0.61% at those same periods. The improvement was due to loans returning to performing status or being paid off, which amounting to $1.8 million, principal and interest payments on existing non-accrual loans of $0.3 million and partial charge-offs of $0.6 million, offset by additions to non-accrual loans of $1.8 million as of December 31, 2004.
There were no other real estate owned balances during the years ended December 31, 2004 or 2003.
Restructured loans are those where interest rates and/or principal payments have been restructured to defer or reduce payments as a result of financial difficulties of the borrower. Total restructured loans outstanding as of December 31, 2004 and 2003 were $167 thousand and $3.1 million, respectively. Restructured loans included in non-performing assets amounted to $141 thousand and $700 thousand at December 31, 2004 and 2003, respectively. Accruing restructured loans as of December 31, 2004 and 2003 were $26 thousand and $2.4 million respectively.
The ratio of delinquent loans 30-89 days past due as a percentage of total loans increased from 0.51% at December 31, 2003 to 0.76% at December 31, 2004, due mainly to three individual commercial real estate loans which were 31 days past due at December 31, 2004 (and which were subsequently brought current in January 2005). Total impaired loans were $2.0 million and $4.3 million at December 31, 2004 and 2003, respectively. Impaired loans included in non-accrual loans were $2.0 million and $1.9 million as of December 31, 2004 and 2003, respectively.
The level of non-performing assets is largely a function of economic conditions and the overall banking environment. Despite prudent loan underwriting, adverse changes within the banks market area, or deterioration in local, regional or national economic conditions, could negatively impact the companys level of non-performing assets in the future.
The company uses an asset classification system, which classifies loans depending on risk of loss characteristics. The most severe classifications are substandard and doubtful. At December 31, 2004, the company classified $8.9 million and $0 as substandard and doubtful loans, respectively. Included in the substandard category is $1.2 million in non-performing loans. The remaining balance of substandard loans is performing but possesses potential weaknesses and, as a result, could become non-performing loans in the future.
The classification of a loan or other asset as non-performing does not necessarily indicate that loan principal and interest will be ultimately uncollectable. However, management recognizes the greater risk characteristics of these assets and therefore considers the potential risk of loss on assets included in this category in evaluating the adequacy of the allowance for loan losses.
Allowance for Loan Losses
Inherent in the lending process is the risk of loss. While the company endeavors to minimize this risk, management recognizes that loan losses will occur and that the amount of these losses will fluctuate depending on the risk characteristics of the loan portfolio.
The following table summarizes the activity in the allowance for loan losses for the periods indicated:
The ratio of the allowance for loan losses to non-performing loans was 510.42% at December 31, 2004 compared to 334.76% and 488.84% at December 31, 2003 and 2002, respectively. The increase in 2004 resulted from an $0.8 million decrease in the balance of non-performing loans, while the balance in the allowance for loan losses increased by $0.9 million over the period. The increase in the allowance was due to provisions of $1.65 million, offset by net charge-offs of $0.7 million. Included in the total charge-offs are $0.7 million related to four commercial borrowing relationships which were charged off primarily in the first half of 2004.
During the period, the companys ratio of the allowance for loan losses to total loans decreased from 2.04% at December 31, 2003 to 1.91% at December 31, 2004.
In making its assessment on the adequacy of the allowance, management considers several quantitative and qualitative factors that could have an effect on the credit quality of the portfolio, including the level of non-performing loans, net charge-offs, loan growth, economic trends and comparison to industry peers.
Following September 11, 2001, the company began providing for loan loss reserves at a higher level due to managements estimate of a prolonged and significant economic downturn, which was expected to result in deterioration of the loan portfolios credit quality. Consequently, the companys loan loss reserve to total loan ratio increased from 1.99% at December 31, 2000 to a range approximating 2.20% to 2.30% through December 31, 2002.
However, in the ensuing periods, neither the economic results nor the portfolios credit quality deteriorated to the extent previously anticipated by management. Consequently, management concluded that reserve levels of 2.04% at December 31, 2003 and 1.91% at December 31, 2004 were reasonable given managements assessment of the credit risk inherent in the portfolio and the economic environment as of those dates.
Management regularly reviews the levels of non-accrual loans, levels of charge-offs and recoveries, peer results, levels and composition of outstanding loans and known and inherent risks in the loan portfolio and will continue to monitor the need to add to the companys allowance for loan losses. Based on the foregoing, as well as managements judgment as to the risks inherent in the loan portfolio, the companys allowance for loan losses is deemed adequate to absorb reasonably anticipated losses from specifically known and other credit risks associated with the portfolio as of December 31, 2004.
The following table represents the allocation of the companys allowance for loan losses amongst the different categories of loans and the percentage of loans in each category to total loans for the periods ending on the respective dates indicated:
The allocation of the allowance for loan losses above reflects managements judgment of the relative risks of the various categories of the companys loan portfolio. This allocation should not be considered an indication of the future amounts or types of possible loan charge-offs.
As of December 31, 2004, total short-term investments amounted to $40.3 million or 5% of total assets compared to $14.0 million, or 2% of total assets, at December 31, 2003. The balance of total short-term investments at December 31, 2004 was partially inflated by the temporary investment of a $32 million demand deposit received in late December and withdrawn in early January. Short-term investments carried as cash equivalents consist of overnight and term federal funds sold, money market mutual funds and discount U.S. agency notes maturing in less than ninety days, and amounted to $32.1 million and $4 million as of December 31, 2004 and 2003, respectively. The remaining balance carried as other short-term investments consists of auction rate preferred securities with redemption options (auction dates) every 49 days, but which cannot readily be converted to cash at par value until the next successful auction. These other short-term investments amounted to $8.2 million and $10 million as of December 31, 2004 and 2003, respectively.
At December 31, 2004 and 2003, all investment securities were classified as available for sale and were carried at fair market value. At December 31, 2004, the investment portfolio represented 22% of total assets.