Enterprise Bancorp 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended June 30, 2008
For the transition period from to
Commission File Number 0-21021
Enterprise Bancorp, Inc.
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
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.
x Yes o No
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition for large accelerated filer, accelerated filer and smaller reporting company 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).
o Yes x No
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date:
July 31, 2008 Common Stock - Par Value $0.01: 7,977,973 shares outstanding
ENTERPRISE BANCORP, INC.
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
See the accompanying notes to the unaudited consolidated financial statements
ENTERPRISE BANCORP, INC.
See accompanying notes to the unaudited consolidated financial statements.
ENTERPRISE BANCORP, INC.
(1) Organization of Holding Company
The consolidated financial statements of Enterprise Bancorp, Inc. (the company) include the accounts of the company and its wholly owned subsidiary Enterprise Bank and Trust Company (the bank). The bank is a Massachusetts trust company organized in 1989. Substantially all of the companys operations are conducted through the bank.
The bank has five wholly owned subsidiaries. The banks subsidiaries include Enterprise Insurance Services, LLC and Enterprise Investment Services, LLC, organized for the purposes of engaging in insurance sales activities and offering non-deposit investment products and services, respectively. In addition, the bank has three subsidiary security corporations (Enterprise Security Corporation, Enterprise Security Corporation II, and Enterprise Security Corporation III), which hold various types of qualifying securities. The security corporations are limited to conducting securities investment activities that the bank itself would be allowed to conduct under applicable laws.
Through the bank and its subsidiaries, the company offers a range of commercial and consumer loan products, deposit and cash management products, investment advisory services, trust and insurance services. The services offered through the bank and subsidiaries are managed as one strategic unit and represent the companys only reportable operating segment.
The companys deposit accounts are insured by the Deposit 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 business and operations of the company are subject to the regulatory oversight of the Board of Governors of the Federal Reserve System (the Federal Reserve Board). The Commissioner also retains supervisory jurisdiction over the company.
(2) Basis of Presentation
The accompanying unaudited consolidated financial statements and these notes should be read in conjunction with the companys December 31, 2007 audited consolidated financial statements and notes thereto contained in the companys 2007 Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 14, 2008. Interim results are not necessarily indicative of results to be expected for the entire year.
The company has not changed its significant accounting and reporting policies from those disclosed in its 2007 Annual Report on Form 10-K.
In the opinion of management, the accompanying consolidated financial statements reflect all necessary adjustments consisting of normal recurring accruals for a fair presentation. All significant intercompany balances and transactions have been eliminated in the accompanying consolidated financial statements.
Certain fiscal 2007 information has been reclassified to conform to the 2008 presentation.
(3) Critical Accounting Estimates
In preparing the consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to exercise judgment in determining many of the methodologies, assumptions and estimates to be utilized. These estimates and assumptions affect the reported amounts of assets and liabilities as of the balance sheet date and revenues and expenses for the period. Actual results could differ should the assumptions and estimates used change over time due to changes in circumstances.
As discussed in the companys 2007 Annual Report on Form 10-K, the two most significant areas in which management applies critical assumptions and estimates that are particularly susceptible to change relate to the determination of the allowance for loan losses and the impairment valuation of goodwill. Refer to note 1 to the companys consolidated financial statements included in the companys 2007 Annual Report on Form 10-K for significant accounting policies.
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements
(4) Accounting for Income Taxes
The company uses the asset and liability method of accounting for income taxes. Under this method deferred tax assets and liabilities are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities will be adjusted accordingly through the provision for income taxes.
The companys policy is to classify interest resulting from underpayment of income taxes as income tax expense in the first period the interest would begin accruing according to the provisions of the relevant tax law. The company classifies penalties resulting from underpayment of income taxes as income tax expense in the period for which the company claims or expects to claim an uncertain tax position or in the period in which the companys judgment changes regarding an uncertain tax position.
The company did not have any unrecognized tax benefits accrued as income tax liabilities or receivables or as deferred tax items at June 30, 2008. The Companys tax years ending December 31, 2004 and later are open to federal and state income tax examinations.
On July 3, 2008 the state of Massachusetts enacted a law that included reducing future tax rates on net income applicable to financial institutions. For tax years beginning on or after January 1, 2010, the tax rate drops from the current rate of 10.5% to 10%, for tax years beginning on or after January 1, 2011 the rate drops to 9.5%, and to 9% for tax years beginning on or after January 1, 2012 and thereafter. Applicable accounting guidance requires that deferred tax assets and liabilities be adjusted in the period of enactment for changes in tax laws or tax rate. Management is currently analyzing the impact of the change in future tax rates on its net deferred tax asset and, in accordance with applicable accounting guidance, during the third quarter of 2008, the company expects to recognize additional tax expense related to the adjustment.
(5) Stock-Based Compensation
The company has not significantly changed the general terms and conditions related to stock compensation from those disclosed in the companys 2007 Annual Report on Form 10-K.
Total stock-based compensation expense, which includes stock option awards and restricted stock awards to officers and other employees, and director stock compensation in lieu of cash fees to directors, was $122 thousand and $136 thousand for the three months ended June 30, 2008 and 2007, respectively and $259 thousand and $320 thousand for the six months ended June 30, 2008 and 2007, respectively.
The company recognized stock-based compensation expense related to stock option awards of $64 thousand and $148 thousand for the three and six months ended June 30, 2008, compared to $75 thousand and $206 for the same period in 2007. Stock-based compensation expense recognized in association with a restricted stock award amounted to $13 and $25 thousand for the three month and six month periods ended June 30, 2008 and 2007. Stock-based compensation expense related to Directors election to receive shares of common stock in lieu of cash fees for attendance at Board and Board Committee meetings amounted to $45 thousand and $86 for the three and six months ended June 30, 2008 compared to $48 thousand and $89 thousand for the same periods in 2007. In January 2008, 10,739 shares of common stock were issued to directors in lieu of cash fees related to 2007 annual directors stock-based compensation expense of $165 thousand.
There were no stock option awards granted during the three months ended June 30, 2008, and there were 132,000 stock option awards granted to employees during the six month period ended June 30, 2008. There were 3,500 and 127,600 stock option awards granted to employees during the three and six month periods ended June 30, 2007, respectively. The options become exercisable at the rate of 25% per year and provide for full vesting upon attainment of age 62 while remaining employed with the bank. Options granted in 2008 and 2007 expire seven years from the date of grant.
The per share weighted average fair value of stock options granted in 2008 was determined to be $2.47. The weighted average fair value of the options was determined to be 19% of the market value of the stock at the date of grant. The assumptions used in the valuation model for determining weighted average fair value of the 2008 stock option grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 2.61%, 25%, 2.82% and 5.5 years, respectively.
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements
The per share weighted average fair value of stock options granted in 2007 was determined to be $3.69. The weighted average fair value of the options was determined to be 22% of the market value of the stock at the date of grant. The assumptions used in the valuation model for determining weighted average fair value of the 2007 stock option grants for the risk-free interest rate, expected volatility, dividend yield and expected life in years were 4.43%, 21%, 2.03% and 5.5 years, respectively.
Refer to note 9 Stock Based Compensation Plans in the companys 2007 Annual Report on Form 10-K for a description of the assumptions used in the valuation model.
(6) Supplemental Retirement Plan and Other Postretirement Benefit Obligation
The following table illustrates the net periodic benefit cost for the supplemental executive retirement plan for the periods indicated:
Benefits paid amounted to $20 thousand for the three and six months ended June 30, 2008. There were no benefits paid in 2007. The company anticipates accruing an additional $163 thousand to the plan during the remainder of 2008.
On January 1, 2008, the company adopted the Financial Accounting Standards Boards Emerging Issues Task Force Issue No. 06-4 (EITF No. 06-4) Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance Arrangements. EITF No. 06-4 requires that an employer recognize a liability for future benefits associated with an endorsement split-dollar life insurance arrangement that provides a benefit to an employee that extends to postretirement periods. Upon adoption of EITF No. 06-4, the company recorded a cumulative-effect adjustment to retained earnings of $1.0 million. The benefit expense of postretirement cost of insurance for split dollar insurance coverage amounted to $21 thousand and $41 thousand for the three months and six months ended June 30, 2008.
(7) Earnings Per Share
Basic earnings per share are calculated by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the effect on weighted average shares outstanding of the number of additional shares outstanding if dilutive stock options were converted into common stock using the treasury stock method.
The table below presents the increase in average shares outstanding, using the treasury stock method, for the diluted earnings per share calculation and the effect of those shares on earnings, for the periods indicated:
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements
At June 30, 2008, there were additional options outstanding to purchase up to 520,149 shares which were excluded from the calculation of diluted earnings per share due to the exercise price of these options exceeding the average market price of the companys common stock. These options, which were not dilutive at that date, may potentially dilute earnings per share in the future.
(8) Fair Value Measurements
On January 1, 2008 the company adopted the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). This Statement provides a single definition of fair value and establishes a framework for measuring fair value in generally accepted accounting principles, with the intention of increasing consistency and comparability in fair value measurements. The application of this Statement expanded disclosure requirements about fair value measurements. However, the adoption of SFAS No. 157 did not require any new fair value measurements, as the Statement applies under other existing accounting pronouncements that require or permit fair value measurements. In accordance with FASB Staff Position No. 157-2, Effective Date of FASB Statement No. 157, the company has deferred the application of SFAS No. 157 to non-financial assets such as goodwill and real property held for sale, and non-financial liabilities until January 1, 2009.
SFAS No. 157 defines the fair value to be the price which a seller would receive in an orderly transaction between market participants (an exit price). This Statement also establishes a fair value hierarchy segregating fair value measurements using three levels of inputs: (Level 1) quoted market prices in active markets for identical assets or liabilities; (Level 2) significant other observable inputs, including quoted prices for similar items in active markets, quoted prices for identical or similar items in market that are not active, inputs such as interest rates and yield curves, volatilities, prepayment speeds, credit risks and default rates which provide a reasonable basis for fair value determination or inputs derived principally from observed market data; (Level 3) significant unobservable inputs for situations in which there is little, if any, market activity for the asset or liability. Unobservable inputs must reflect reasonable assumptions that market participants would use in pricing the asset or liability, which are developed on the basis of the best information available under the circumstances.
The following table summarizes significant assets and liabilities carried at fair value at June 30, 2008 (there were no items measured using level 3 inputs):
(1) Investment securities that are considered available for sale are carried at fair value in accordance with SFAS No. 115 (as amended). The company utilizes third-party pricing vendors to provide valuations on its fixed income securities. These vendors generally determine fair value prices based upon pricing matrices utilizing observable market data inputs for similar or benchmark securities. The companys equity portfolio fair value is measured based on quoted market prices for the shares. Net unrealized appreciation and depreciation on investments available for sale, net of applicable income taxes, are reflected as a component of accumulated other comprehensive income. The bank is required to purchase Federal Home Loan Bank of Boston (FHLB) stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.
(2) Impaired loan balances in the table above represent those collateral dependent impaired loans where management has estimated the credit loss by comparing the loans carrying value against the expected realizable fair value of the collateral, in accordance with SFAS No. 114 (as amended). A specific allowance is assigned to the impaired loan for the amount of estimated credit loss. The increase in specific allowances assigned to collateral dependent impaired loans was $231 thousand for the six months ended June 30, 2008.
ENTERPRISE BANCORP, INC.
Notes to the Unaudited Consolidated Financial Statements
Guarantees and Commitments
Standby letters of credit are conditional commitments issued by the company to guarantee the performance by a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. If the letter of credit is drawn upon the company creates a loan for the customer with the same criteria associated with similar loans. The fair value of these commitments was estimated to be the fees charged to enter into similar agreements, and accordingly these fair values measures are deemed to be SFAS No. 157 Level 2 measurements. In accordance with FASB Interpretation No. 45, the estimated fair values of these commitments are carried on the balance sheet as a liability and amortized to income over the life of the letters of credit, which are typically one year. At June 30, 2008 and December 31, 2007, the estimated fair value of these commitments was immaterial.
Interest rate lock commitments related to the origination of mortgage loans that will be sold are considered derivative instruments. The company estimates the fair value of these derivatives using the difference between the guaranteed interest rate in the commitment and the current market interest rate. To reduce the net interest rate exposure arising from its loan sale activity, the company enters into the commitment to sell these loans at essentially the same time that the interest rate lock commitment on the loan is quoted. The commitments to sell loans are also considered derivative instruments, with estimated fair values based on changes in current market rates. These commitments represent the companys only derivative instruments and are accounted for in accordance with SFAS No. 133 (as amended). The fair values of the companys derivative instruments are deemed to be SFAS No. 157 Level 2 measurements. At June 30, 2008 and December 31, 2007, the estimated fair value of the companys derivative instruments was considered to be immaterial.
Managements discussion and analysis should be read in conjunction with the companys consolidated financial statements and notes thereto contained in this report and the companys 2007Annual Report on Form 10-K.
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 2 Managements Discussion and Analysis of Financial Condition and Results of Operations and Item 3 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 (the FASB) 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.
Results of Operations
Net income for the three months ended June 30, 2008 amounted to $1.8 million compared to $2.3 million for the quarter ended June 30, 2007. Diluted earnings per share were $0.22 for the second quarter compared to $0.29 for the same period in 2007. The quarterly results represented decreases of 23% and 24% in net income and diluted EPS, respectively, compared to the same period in the prior year.
Net income for the six months ended June 30, 2008 amounted to $3.8 million compared to $4.5 million for the same period in 2007. Diluted earnings per share were $0.48 for the six months ended June 30, 2008 compared to $0.58 for the comparable 2007 period. The year-to-date results represented decreases of 16% and 17% in net income and diluted EPS, respectively, compared to the same period in the prior year.
The decrease in net income as compared to the prior year periods was primarily attributed to reduced spreads in the first six months of 2008, which is prevalent nationally at community banks, as well as an increase in the provision for loan losses principally due to strong loan growth in the first six months of 2008 and securities gains realized in 2007.
· Net interest income and margin
The companys earnings are largely dependent on its net interest income, which is the difference between interest earned on loans and investments and the cost of funding (primarily deposits and borrowings). Net interest income expressed as a percentage of average interest earning assets is referred to as net interest margin. As with many banks, the rapid decline in
market rates in late 2007 through April of 2008 created margin compression for the company. Interest spreads declined as rates on many of our assets adjusted downward with the market rates, while rates on deposits declined but at a much slower pace due to tight credit markets and a highly-competitive marketplace.
The re-pricing frequency of these assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as interest rate risk and is reviewed in more detail in Item 3, Quantitative and Qualitative Disclosures About Market Risk, of this Form 10-Q.
Net interest income for the quarter ended June 30, 2008 amounted to $10.2 million, compared to $10.1 million in the June 2007 quarter. Net interest margin was 4.12% for the quarter ended June 30, 2008 compared to 4.10% and 4.46% for the quarters ended March 31, 2008 and June 30, 2007, respectively. The company realized slight improvement in net interest margin during the second quarter as loans continued to grow, deposit balances increased and deposit rates declined, higher-cost brokered CDs matured and short-term rates on FHLB advances provided a cost effective funding alternative.
Net interest income for both six month periods ended June 30, 2008 and 2007 amounted to $20.1 million. Net interest margin was 4.10% for the six months ended June 30, 2008, compared to 4.49% for the same period in 2007 and 4.40% for the year ended December 31, 2007. The decrease in the six month margin resulted from the decline in asset yields outpacing the decline in funding costs over the period. As noted above, the company continued to grow the loan portfolio which alleviated much of the impact of this margin compression and help to deliver net interest income levels comparable to the prior year period.
· Provision for loan losses
The provision for loan losses, which is impacted by loan growth and asset quality, amounted to $550 thousand for the second quarter of 2008, as compared to $52 thousand in the second quarter of 2007. The provision for loan losses for the six months ended June 30, 2008 amounted to $867 thousand, compared to $135 thousand for the same period in 2007. The increases over the prior year periods were primarily due to loan growth and the effect of net charge-offs which occurred primarily in the second quarter. Total loans have increased $51.4 million, or 6%, since December 31, 2007. Year-to-date, the company recorded 2008 net charge-offs of $213 thousand, compared to 2007 year-to-date net recoveries of $42 thousand. Despite the charge-offs, asset quality remained strong with annualized year-to-date net charge-offs amounting to only 0.05% of average total loans, and non-performing assets to total assets of 0.57% at June 30, 2008. The allowance for loan losses to total loans ratio was 1.60% at June 30, 2008 compared to 1.62% at December 31, 2007 and 1.65% at June 30, 2007.
· Non-interest income and expense
Non-interest income for the quarter ended June 30, 2008 amounted to $2.4 million, a decrease of $127 thousand, or 5%, over the same quarter in the prior year. The decrease was due primarily to a decrease in gains on sales of investment securities partially offset by an increase in deposit-service fees. Excluding security gains, non-interest income increased $298 thousand or 14%, over the comparable three-month period in the prior year. Non-interest income for the six months ended June 30, 2008 was $4.8 million, an increase of $192 thousand, or 4%, compared to the same period in 2007. The increase resulted primarily from an increase in deposit-service fees, partially offset by a decrease in gains on sales of investment securities. Excluding security gains, non-interest income increased $623 thousand, or 15%, over the comparable six-month period in the prior year.
Non-interest expense was $9.6 million quarter-to-date, an increase of $640 thousand, or 7%, over the comparable period in 2007. Non-interest expense amounted to $18.6 million for the six months ended June 30, 2008, an increase of $1.2 million, or 7%, compared to the same period in 2007. The increases in non-interest expense were primarily related to the companys strategic growth initiatives resulting in increases in the areas of compensation-related costs, advertising expenses, training expense and business consulting expenses. In addition, in 2008 the companys deposit insurance premiums increased, due to FDIC insurance assessment changes which applied to all banks.
· Effective tax rates
The effective tax rate for the six months ended June 30, 2008 was 29.03% compared to 35.77% in the 2007 period. The effective tax rate is impacted by the level of tax-exempt income to total income. The current period effective tax rate was also impacted by the formation of two new security corporations as bank subsidiaries in the fourth quarter of 2007. The income earned by these security corporations are assessed at a more favorable state income tax rate.
Sources and Uses of Funds
The companys primary sources of funds are deposits, brokered certificates of deposit (brokered CDs), borrowings from the Federal Home Loan Bank of Boston (the FHLB), repurchase agreements, current earnings and proceeds from the sales, maturities and paydowns on loans and investment securities. The company uses these funds to originate loans, purchase investment securities, conduct operations, expand the branch network, and pay dividends to shareholders.
Total assets amounted to $1.116 billion at June 30, 2008, an increase of 5.5% since December 31, 2007. The companys core asset strategy is to grow loans, primarily commercial loans. Total loans increased 6% since December 31, 2007 and amounted to $885.2 million, or 79% of total assets. Commercial loans amounted to $754.4 million, or 85% of total loans.
The investment portfolio is the other key component of the companys earning assets and is primarily used to invest excess funds, provide liquidity and to manage the companys asset-liability position. The fair value of total investments amounted to $142.3 million at June 30, 2008, or 13% of total assets, and has decreased $3.2 million since December 31, 2007.
Managements preferred strategy for funding asset growth is to grow low cost deposits (comprised of demand deposit, interest checking and business checking accounts and traditional savings accounts). Asset growth in excess of low cost deposits is typically funded through higher cost deposits (money market accounts, commercial tiered rate or investment savings accounts and certificates of deposit or CDs), wholesale funding (brokered CDs, repurchase agreements, FHLB borrowings), and investment portfolio cash flow.
Deposits, excluding brokered CDs, amounted to $890.0 million, and increased $92.0 million or 12%, since December 31, 2007. Deposit growth was noted in all categories, with the largest increase in higher-cost deposit account balances as customers, sensitive to the market rate decreases, have sought more competitive higher yielding deposit products. At June 30, 2008, total deposits, which include brokered CDs, amounted to $922.5 million, representing 6% growth over December 31, 2007.
As deposit balances increased during the quarter, the company reduced the balances of brokered CDs and utilized FHLB short-term advances to fill funding gaps. At June 30, 2008, the company had $32.4 million in brokered CDs, a reduction of 54% since December 31, 2007. Borrowed funds (repurchase agreements and FHLB borrowings) amounted to $84.1 million, an increase of 3%, since December 31, 2007.
Opportunities and Risks
The companys primary market is the Merrimack Valley and North Central regions of Massachusetts and the South Central region of New Hampshire. Management recognizes that substantial competition exists in the marketplace and views this as a key business risk. Market competition includes the expanded commercial lending capabilities of credit unions, the shift to commercial lending by traditional savings banks, the presence of large regional and national commercial banks with greater financial resources, and the products offered by non-bank financial services competitors.
Management continually strives to differentiate the company and provide a unique customer experience through highly competitive commercial lending, deposit and cash management products, investment advisory and management services, and insurance products. The company delivers these product through consistent, responsive and personal service based on an understanding of the financial needs of its customers. Advances in, and the increased use of, technology, such as internet banking and electronic transaction processing, are expected to have a significant impact on the future competitive landscape confronting financial institutions. Management continually examines new products and technologies in order to maintain a highly competitive mix of product offerings and to target product lines to customer needs.
While the company has consistently had a growth strategy since its inception, several times in its history management has strategically increased and accelerated investments in growth, including in the early 1990s and the late 1990s/2000 when turbulent times, similar to current economic conditions, opened up market share and growth opportunities for the company. Over the past several months, the company has chosen to make significant investments in various growth initiatives, including the following: hiring of key personnel; opening of new branch locations; consistent marketing; and increased investments in our service culture and employee development. The company opened its fifteenth branch location in June and is in the process of obtaining regulatory approvals to establish new branches in Derry, New Hampshire and Acton, Massachusetts. The company expects to open these offices for business in 2009. Such expansion typically increases the companys operating expenses in the short-term, primarily in salary and benefits, marketing, and occupancy, before the long-term growth benefits are fully realized in those markets.
The recent economic turmoil has had a severe impact on nationwide housing and financial markets and the financial services industry in general. Any extended continuation of these national trends could have long-term adverse consequences in the local housing, construction and banking industries, and further weaken the local economy, negatively impacting the companys financial condition and performance in a variety of ways. However, as noted above challenging economic cycles are not new to the bank or its experienced management and lending team. The company opened for business in 1989 during a severe recession. Management believes that the disciplined and consistent lending and credit review practices, and the prudent investment strategies that were established at that time are ingrained in the companys culture and have served to provide quality asset growth over various economic cycles.
Management believes the companys business model, strong service and technology cultures, experienced banking professionals, in-depth knowledge of our markets and reputation within the community create opportunities for the company to be the leading provider of banking and investment management services in its growing market area. Management believes that the company is well positioned, both financially and strategically, to capitalize on opportunities created by the current challenging banking landscape.
In addition to competition, growth and economic unease, the companys significant challenges continue to be the effective management of interest rate, credit and operational risk.
The re-pricing frequency of interest earning assets and liabilities are not identical, and therefore subject the company to the risk of adverse changes in interest rates. This is often referred to as interest rate risk and is reviewed in more detail under Item 3, Quantitative and Qualitative Disclosures About Market Risk, contained in this Form 10-Q.
The risk of loss due to customers non-payment of loans or lines of credit is called credit risk. Credit risk management is reviewed below in this Item 2 under the heading Credit Risk/Asset Quality and the Allowance for Loan Losses.
Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people or systems, or from external events. Operational risk management is also a key component of the companys risk management process, particularly as it relates to technology administration, information security, vendor management and business continuity.
Management utilizes a combination of third party security assessments, key technologies and ongoing internal evaluations in order to protect non-public customer information and continually monitor and safeguard information on its operating systems and those of third party service providers. The company contracts with outside parties to perform a broad scope of both internal and external security assessments on the companys systems on a regular basis. These third parties test the companys network configuration and security controls, and assess internal practices aimed at protecting the companys operating systems. In addition, the company contracts with an outside service provider to monitor usage patterns and identify unusual activity on bank issued debit/ATM cards. The company also utilizes firewall technology and a combination of software and third-party monitoring to detect intrusion, protect against unauthorized access and continuously scans for computer viruses on the companys information systems.
The company has a Business Continuity Plan that consists of the information and procedures required to enable rapid recovery from an occurrence that 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 critical services will be restored.
Refer to Item 1A, Risk Factors included in the companys 2007 Annual Report on Form 10-K for additional factors that could adversely affect the companys future results of operations and financial condition.
Total assets increased $58.1 million, or 5.5%, over December 31, 2007, to $1.116 billion at June 30, 2008. The increase was primarily attributable to increases in total loans funded, primarily through deposit growth.
As of June 30, 2008, short-term investments amounted to $8.9 million, an increase of $1.1 million compared to December 31, 2007. Short-term investments carried as cash equivalents consist of overnight and term federal funds sold and money market mutual funds. The balance of these investments will fluctuate depending on the short-term deposit inflows and the immediate liquidity needs of the company.
At June 30, 2008, the investment portfolios fair market value was $142.3 million, representing a decline of $3.2 million since December 31, 2007. The fair market value of the investment portfolio represented 13% of total assets at June 30, 2008 and 14% at December 31, 2007. As of the periods indicated below, all investment securities (other than FHLB stock) were classified as available for sale and were carried at fair market value.
The following table summarizes the fair market value of investments at the dates indicated:
(1) Federal agency obligations include securities issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and the FHLB. These securities do not represent obligations of the U.S. government and are not backed by the full faith and credit of the United States Treasury.
(2) The bank is required to purchase FHLB stock in association with outstanding advances from the FHLB; this stock is classified as a restricted investment and carried at cost.
See Note 8, Fair Value Measurements to the companys unaudited consolidated financial statements contained in this Form 10-Q for further information regarding the companys fair value measurements for available for sale securities.
During the six months ended June 30, 2008, the total principal paydowns, calls and maturities amounted to $20.9 million. These portfolio outflows were partially utilized to purchase $19.0 million in securities and to fund loan growth over the period. The net unrealized loss on the portfolio at June 30, 2008 was $955 thousand compared to a net unrealized gain of $382 thousand at December 31, 2007. The net unrealized loss at June 30, 2008 was comprised of net losses of $263 thousand on the fixed income portfolio and net market value decreases in the equity portfolio of $692 thousand. Unrealized gains or losses will be recognized in the statements of income if the securities are sold. However, if an unrealized loss is deemed to be other than temporary, the company marks the investment down to its carrying value through a charge to earnings.
The net unrealized gain or loss in the companys fixed income portfolio fluctuates as market interest yields rise and fall. Due to the fixed rate nature of this portfolio, as market yields fall the value of the portfolio rises, and as market yields rise, the value of the portfolio declines. The unrealized gains or loss on fixed income investments will also decline as the securities approach maturity. Included in the net unrealized loss on the fixed income portfolio noted above were unrealized losses of $411 thousand within the CMO/MBS portfolio and unrealized gains of $148 thousand in the municipal portfolio. Management determined that the declines in market value on the fixed income portfolio at June 30, 2008 were due to market volatility. Management does not believe that any securities in the fixed income portfolio had material declines in credit quality. Therefore, these unrealized losses were not considered other than temporary in nature at June 30, 2008.
The net unrealized gain or loss on equity securities will fluctuate based on changes in the market value of the individual securities and mutual funds in the portfolio. The unrealized losses on the equity portfolio at June 30, 2008, were due to the market volatility during the period. Management regularly reviews the portfolio for securities with unrealized losses that are other than temporarily impaired. Managements assessment includes evaluating if any equity security or mutual fund exhibits fundamental deterioration and whether it is unlikely that the security or fund in question will recover its unrealized loss in the foreseeable future. Upon such review, there were no equity securities or mutual funds that were considered other-than-temporarily impaired at June 30, 2008.
At June 30, 2008, management had the intent and ability to hold the fixed income securities in the portfolio with unrealized losses until the recovery of fair value, which may be the date of maturity.
From time to time the company may pledge investments from the portfolio as collateral for various municipal deposit accounts, repurchase agreements and treasury, tax and loan deposits. The fair value of securities pledged as collateral was $30.1 million and $24.5 million at June 30, 2008 and December 31, 2007 respectively. Securities designated as qualified
collateral for FHLB borrowing capacity amounted to $42.1 million and $54.2 million at June 30, 2008 and December 31, 2007 respectively.
The company specializes in lending to business entities, non-profit organizations, professionals and individuals. The companys primary lending focus is on the development of high quality commercial relationships achieved through active business development efforts, strong community involvement and focused marketing strategies. Loans made by the company to businesses include commercial mortgage loans, construction and land development loans, secured and unsecured commercial loans and lines of credit, and standby letters of credit. The company also originates equipment lease financing for businesses. Loans made to individuals include conventional residential mortgage loans, home equity loans, residential construction loans on primary residences, secured and unsecured personal loans and lines of credit. The company does not have a sub-prime mortgage program.
The company continues to grow its loan portfolio. Total loans amounted to $885.2 million at June 30, 2008, an increase of $51.4 million, or 6%, compared to December 31, 2007, and 11% since June 30, 2007. Total loans represented 79% of total assets at both June 30, 2008 and December 31, 2007. The majority of the growth since December has been focused in the commercial portfolio, as total commercial loans have increased $46.4 million over the period.
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.
Commercial real estate loans increased $26.1 million, or 6%, as of June 30, 2008, compared to December 31, 2007, and 13% compared to June 30, 2007. Commercial real estate loans include secured by both owner-use and non-owner occupied real estate. These loans are typically secured by a variety of property types including apartment buildings, office or mixed-use facilities, strip shopping malls or other commercial property.
Commercial and industrial loans increased by $22.5 million, or 12%, since December 31, 2007, and 20% as compared to June 30, 2007. These loans include seasonal revolving lines of credit, working capital loans, equipment financing (including equipment leases), term loans, and revolving lines of credit. Also included in commercial and industrial loans are loans under various U.S. Small Business Administration programs. These commercial loans include unsecured loans or lines to financially strong borrowers, loans secured in whole or in part by real estate unrelated to the principal purpose of the loan, or those secured by inventories, equipment and/or receivables, and are generally guaranteed by the principals of the borrower.
Commercial construction loans decreased by $2.1 million, or 2%, from December 31, 2007, and 7% compared to June 30, 2008. Commercial construction loans include the development of residential housing and condominium projects, the development of commercial and industrial use property and loans for the purchase and improvement of raw land. The decrease reflects the impact of the current economic environment on the construction industry and the companys origination activity. The company limits the amount of financing provided to any single developer for the construction of properties built on a speculative basis. Funds for construction projects are disbursed as pre-specified stages of construction are completed. 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.
Residential real estate loans, residential construction, home equity mortgages and consumer loans combined remained relatively consistent representing approximately 15% of the total loan portfolio at June 30, 2008 and December 2007.
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 those fixed and adjustable rate residential mortgage loans which are eligible for sale in the secondary market, or hold some or all of this residential loan production for the companys portfolio. The company generally does not pool mortgage loans for sale, but instead sells the loans on an individual basis. The company may retain or sell the servicing when selling the loans. During the six months ended June 30, 2008 the company originated $7.9 million in residential loans designated for sale, compared to $10.3 million for the comparable period in the prior year.
At June 30, 2008, the company had commercial loan balances participated out to various banks amounting to $13.9 million, compared to $6.8 million at December 31, 2007. 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 in the loan portfolio at the companys pro rata share of ownership and amounted to $15.3 million and $13.9 million at June 30, 2008 and December 31, 2007, respectively. The company performs an independent credit analysis of each commitment prior to participation in any loan.
Loans designated as qualified collateral for FHLB borrowing capacity amounted to $244.7 million and $219.3 million at June 30, 2008 and December 31, 2007, respectively.
Credit Risk/Asset Quality and the Allowance for Loan Losses
The company manages its loan portfolio to avoid concentration by industry or loan size to minimize its credit risk exposure. In addition, the company does not have a sub-prime lending program. However, inherent in the lending process is the risk of loss. The companys commercial lending focus may entail significant additional risks compared to long term financing on existing owner occupied residential real estate. Commercial loan size is typically larger and the underlying commercial real estate values, the actual cost necessary to complete a construction project and customer cash flow and payment expectations on such loans can be more easily influenced by conditions in the related industries, the real estate market or in the local economy. As such, an extended downturn in the national or local economy or real estate markets, among other factors, could have a material adverse impact on the borrowers ability to repay outstanding loans and on the value of the collateral securing these loans. While the company endeavors to minimize this risk through the risk management function, 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 companys credit risk management function focuses 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 and the continuity of borrowers management teams. Early detection of credit issues is critical to minimize credit losses. Accordingly, management regularly monitors these factors, among others, through ongoing credit reviews by the Credit Department, an external loan review service, reviews by members of senior management and the Loan Committee of the Board of Directors.
The allowance for loan losses is an estimate of credit risk inherent in the loan portfolio as of the balance sheet dates. The companys allowance is accounted for in accordance with SFAS No. 114, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures, and SFAS No. 5, Accounting for Contingencies. The allowance for loan losses is established through a provision for loan losses, a direct charge to earnings. 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. 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 individual assessment of larger and high risk credits, delinquency trends and the level of non-performing loans, net charge-offs, the growth and composition of the loan portfolio, expansion in geographic market area, the strength of the local and national economy, and comparison to industry peers, among other factors.
On a quarterly basis, management prepares an estimate of the reserves necessary to cover estimated credit losses. Except for loans specifically identified as impaired, the estimate is a two-tiered approach that allocates loan loss reserves to adversely classified loans by credit rating and to non-classified loans by credit type. The general loss allocations take into account the historic loss experience as well as the quantitative and qualitative factors identified above.
There were no significant changes in credit quality, the companys underwriting, or the allowance assessment methodology used to estimate loan loss exposure as reported in the companys Annual Report on Form 10-K for the year ended December 31, 2007.
The allowance for loan losses to total loans ratio was 1.60% at June 30, 2008 and was consistent with the December 31, 2007 ratio of 1.62%. Based on the foregoing, as well as managements judgment as to the risks inherent in the loan portfolio, the companys allowance for loan losses was deemed adequate to absorb reasonably anticipated losses from specifically known and other credit risks associated with the portfolio as of June 30, 2008.
The following table sets forth information regarding non-performing assets and past due loans at the dates indicated:
Management closely monitors the credit quality of individual delinquent and non-performing relationships, industry concentrations, the local and regional real estate market and current economic conditions. The level of delinquent and non-performing assets is largely a function of economic conditions and the overall banking environment. Despite prudent loan underwriting, adverse changes within the companys market area or further deterioration in the local, regional or national economic conditions could negatively impact the companys level of non-performing assets in the future.
In general, non-performing statistics have trended upward as would be expected during the current economic decline. However, management does not consider the increase since 2007 to be indicative of deterioration in the credit quality of the general loan portfolio. Overall asset quality remained favorable during the period as indicated by the following factors: the reasonable level of non-performing loans, given the size and mix of the companys loan portfolio; the absence of any foreclosures resulting in OREO during the current period; the low levels of loans 60-89 days delinquent; and managements assessment that the majority of non-performing loans are adequately collateralized at June 30, 2008.
At June 30, 2008, the company had adversely classified loans (loans carrying substandard or doubtful classifications) amounting to $9.7 million, compared to $6.3 million at December 31, 2007. Loans classified as substandard include those characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. Loans classified as doubtful have all the weaknesses inherent in a substandard rated loan with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. While a portion of adversely classified loans are non-performing, the remaining balances of adversely classified loans were performing but possessed potential weaknesses and, as a result, could ultimately become non-performing loans.
Included in these classified balances were $6.0 million and $3.6 million of non-performing loans at June 30, 2008 and December 31, 2007, respectively. The $349 thousand and $400 thousand of non-performing loans which were not adversely classified at June 30, 2008 and December 31, 2007, represented the guaranteed portions of non-performing Small Business Administration (SBA) loan balances. The $2.4 million net increase in non-performing loans, and the resulting increase in the ratio of non-performing loans as a percentage of total loans outstanding, since December 31, 2007, was due primarily to commercial real estate and commercial and industrial loans added to non-accrual status during the period, partially offset by principal paydowns, charge-offs and upgrades.
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. The majority of impaired loans are included within the non-accrual balances; however, not every loan in non-accrual status has been designated as impaired. Impaired loans exclude large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment, loans that are measured at fair value and leases as defined in SFAS No. 114. Impaired loans included in non-accrual balances were $6.4 million and $3.9 million as of June 30, 2008 and December 31, 2007. The increase since December 2007 was mainly due to the net additions to commercial non-performing loans, as noted above. Accruing impaired loans amounted to $1.0 million and $75 thousand at June 30, 2008 and December 31, 2007, respectively. Based on managements assessment, at June 30, 2008, impaired loans totaling $1.5 million required specific reserves of $333 thousand and impaired loans of $5.9 million required no specific reserves. At December 31, 2007, impaired loans totaling $200 thousand required specific reserves of $195 thousand and impaired loans of $3.8 million required no specific reserves.
One loan was transferred into OREO in 2007 as the result of foreclosure proceedings. The OREO property was subsequently sold in February 2008 and the company recovered the December 31, 2007 carrying value. There was no additional OREO added during the period ended June 30, 2008.
The following tables summarize the activity in the allowance for loan losses for the periods indicated:
The allowance reflects managements estimate of loan loss reserves necessary to support the level of credit risk inherent in the portfolio during the period. The provision for loan losses is impacted by asset quality and loan growth. The increased provision compared to the prior period is primarily due to the level of loan growth and the effect of net charge-offs which
occurred primarily in the second quarter. The largest component of the second quarter charge-offs was a charge of $390 thousand for a single commercial relationship based on managements assessment of the weakness associated with this borrower. Also in the second quarter, the company realized a $300 thousand recovery on a commercial relationship which was charged-off in December 2007.
Refer to Credit Risk/Asset Quality and Allowance for Loan Losses contained in Item 7, Management Discussion and Analysis, included in the companys 2007 Annual Report on Form 10-K for additional information regarding the companys credit risk management process and allowance for loan losses.
Total deposits amounted to $922.5 million at June 30, 2008, an increase of $53.7 million, or 6%, compared to December 31, 2007, and a decrease of 2% since June 30, 2007.
The following table sets forth the deposit balances by certain categories at the dates indicated and the percentage of each category to total deposits.
Excluding brokered CDs, deposit balances increased $92.0 million, or 12%, since December 31, 2007, and 9% compared to June 30, 2007. Increases in balances were noted in all categories as of June 30, 2008, with the largest increase in certificates of deposit. Certificates of deposit have increased $40.1 million, or 20%, since December 31, 2007 and 23% since June 30, 2007. Saving and money market accounts increased $20.9 million, or 8%, since December 31, 2007 and 4% since June 30, 2007. The increases are attributed to customers seeking higher-yielding secure products as alternatives for their investable funds due to recent volatility in financial markets. Additionally, checking account balances increased $30.9 million, or 9%, since December 31, 2007 and 4% since June 30, 2007, respectively. Checking account balances fluctuate based on customers cash needs for operations.
As community generated deposit balances increased and borrowing rates for short-term FHLB advances declined, the company reduced the balance of brokered CDs. At June 30, 2008, brokered CDs decreased by $38.3 million, or 54%, since December 31, 2007, and $87.7 million, or 73%, since June 30, 2007.
Borrowed funds, consisting of securities sold under agreements to repurchase (repurchase agreements) and FHLB borrowings, amounted to $84.1 million at June 30, 2008, an increase of $2.6 million, or 3%, since December 31, 2007 and $78.7 million compared to the low June 30, 2007 level.
The following table sets forth the borrowed funds by categories at the dates indicated and the percentage of each category to total borrowed funds.