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Harleysville National 10-K 2006

 

GRAPHIC

2005 ANNUAL REPORT

ON FORM 10-K




 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


Form 10-K

(Mark One)

x                               Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2005.

OR

o                                  Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from                to                .

Commission file number 0-15237

Harleysville National Corporation

(Exact name of registrant as specified in its charter)

Pennsylvania

 

23-2210237

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

483 Main Street,
Harleysville, Pennsylvania

 

19438

(Address of principal executive offices)

 

(Zip Code)

(215) 256-8851

Registrant’s telephone number, including area code:

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $1.00 par value

Title of Class

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s 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 a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer o

Accelerated filer x

Non-accelerated filer o

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o  No x

The aggregate market value of the Registrant’s Common Stock held by non-affiliates is $546,390,728 based on the June 30, 2005 closing price of the Registrant’s Common Stock of $22.06 per share (restated for stock dividend paid on September 15, 2005).

As of March 8, 2006, there were 27,515,862 outstanding shares of the Registrant’s Common Stock.

DOCUMENTS INCORPORATED BY REFERENCE:

1.                  Portions of the Registrant’s Definitive Proxy Statement relating to the Annual Meeting of Shareholders to be held April 25, 2006 are incorporated by reference into Part II, Item 5 and Part III, Items 10-14 of this report.

 




HARLEYSVILLE NATIONAL CORPORATION
FORM 10-K
INDEX

 

Page

 

Part I

 

4

 

Item 1.

Business

 

4

 

Item 1A.

Risk Factors

 

11

 

Item 1B.

Unresolved Staff Comments

 

13

 

Item 2.

Properties

 

14

 

Item 3.

Legal Proceedings

 

15

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

15

 

Part II

 

16

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

16

 

Item 6.

Selected Financial Data

 

18

 

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

19

 

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

 

41

 

Item 8.

Financial Statements and Supplementary Data

 

42

 

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

 

83

 

Item 9A.

Controls and Procedures

 

83

 

Item 9B.

Other Information

 

85

 

Part III

 

86

 

Item 10.

Directors and Executive Officers of the Registrant

 

86

 

Item 11.

Executive Compensation

 

86

 

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

 

86

 

Item 13.

Certain Relationships and Related Transactions

 

86

 

Item 14.

Principal Accounting Fees and Services

 

86

 

Part IV

 

87

 

Item 15.

Exhibits, Financial Statement Schedules

 

87

 

Signatures

 

91

 

 

2




Forward-Looking Statements

In addition to historical information, this report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. We have made forward-looking statements in this report, and in documents that we incorporate by reference, that are subject to risks and uncertainties. Forward-looking statements include the information concerning possible or assumed future results of operations of Harleysville National Corporation and its subsidiaries. When we use words such as “believes,” “expects,” “anticipates,” “may,” “estimates,” or “intends” or similar expressions, we are making forward-looking statements. Forward-looking statements are representative only as of the date they are made, and the Corporation undertakes no obligation to update any forward-looking statement.

Shareholders should note that many factors, some of which are discussed elsewhere in this report and in the documents that we incorporate by reference, could affect the future financial results of the Corporation and its subsidiaries and could cause those results to differ materially from those expressed or implied in our forward-looking statements contained or incorporated by reference in this document. These factors include but are not limited to those described in Item 1A, “Risk Factors.”

The SEC has not approved or disapproved this Report or passed upon its accuracy or adequacy.

3




PART I

Item 1.        Business

Harleysville National Corporation (the Corporation), a Pennsylvania corporation, was incorporated in June, 1982. On January 1, 1983, the Corporation became the parent bank holding company of Harleysville National Bank and Trust Company (the Bank or Harleysville National Bank), established in 1909, a wholly owned subsidiary of the Corporation. The Corporation is registered as a bank holding company under the Bank Holding Company Act of 1956.

Since commencing operations, the Corporation’s business has consisted primarily of providing financial services through its subsidiaries and has acquired seven financial institutions since 1991 and also recently completed the acquisition of the Cornerstone Companies (registered investment advisors) in January 2006. The Corporation is also the parent holding company of HNC Financial Company and HNC Reinsurance Company. HNC Financial Company was incorporated on March 17, 1997 as a Delaware Corporation and its principal business function is to expand the investment opportunities of the Corporation. HNC Reinsurance Company was incorporated on March 30, 2001 as an Arizona Corporation and reinsures consumer loan credit life and accident and health insurance.

The Bank is a national banking association under the supervision of the Office of the Comptroller of the Currency (the OCC). The Corporation’s and the Bank’s legal headquarters are located at 483 Main Street, Harleysville, Pennsylvania 19438. HNC Financial Company’s legal headquarters is located at 2751 Centerville Road, Suite 3164, Wilmington, Delaware 19808. HNC Reinsurance Company’s legal headquarters is located at 101 North First Avenue, Suite 2460, Phoenix, AZ 85003.

The Bank provides a full range of banking services including loans and deposits, investment management and trust and investment advisory services to individual and corporate customers located in eastern Pennsylvania. The Bank engages in the full-service commercial banking and trust business, including accepting time and demand deposits, making secured and unsecured commercial and consumer loans, financing commercial transactions, making construction and mortgage loans and performing corporate pension and personal investment and trust services. Deposits are insured by the Federal Deposit Insurance Corporation (FDIC) to the extent provided by law. The Bank has 45 branch offices located in Montgomery, Bucks, Chester, Berks, Carbon, Wayne, Monroe, Lehigh and Northampton counties, Pennsylvania.

The Bank enjoys a stable base of core deposits and is a leading community bank in its service areas. The Bank believes it has gained its position as a result of a customer-oriented philosophy and a strong commitment to service. Senior management has made the development of a sales orientation throughout the Bank one of their highest priorities and emphasizes this objective with extensive training and sales incentive programs. The Bank maintains close contact with the local business community to monitor commercial lending needs and believes it responds to customer requests quickly and with flexibility. Management believes these competitive strengths are reflected in the Corporation’s results of operations.

The Bank opened a new location in Dorneyville, Lehigh County during the fourth quarter of this year. The location houses a retail branch as well as a Millennium Wealth Management office. The Bank also plans to open a new retail branch in Warminster, Bucks County during 2006. The Bank continues to evaluate potential new branch sites that are contiguous to our current service area and will expand the Bank’s market area and market share of loans and deposits.

At the close of business on January 13, 2006, the Corporation completed its acquisition of the Cornerstone Companies, registered investment advisors for high net worth, privately held business owners, wealthy families and institutional clients. Located in the Lehigh Valley, Pennsylvania, the firm specializes in providing sophisticated open architecture asset management platforms, business succession and estate planning services, life insurance sales and compensation and benefits consulting. With assets under

4




management of approximately $1.5 billion, the Cornerstone Companies serve clients within the Harleysville footprint, throughout Pennsylvania and other mid-Atlantic states.

The acquisition was consummated pursuant to the Purchase Agreement dated November 15, 2005, by and among the Bank and Cornerstone Financial Consultants, Ltd., a Pennsylvania corporation (CFC), Cornerstone Institutional Investors, Inc., a Pennsylvania corporation (CII), Cornerstone Advisors Asset Management, Inc., a Pennsylvania corporation ((CAAM), and together with CFC and CII collectively, the Cornerstone Companies), Cornerstone Management Resources, Inc., (CMR), John R. Yaissle, Malcolm L. Cowen, II and Thomas J. Scalici. Under the Purchase Agreement, the Bank acquired (i) all of the outstanding capital stock of CFC and CII, (ii) substantially all of the assets of CAAM, and (iii) certain limited assets of CMR. The purchase price consisted of $15.0 million in cash paid at closing and a contingent payment of up to $7.0 million to be paid post-closing. The contingent payment is based upon the Cornerstone Companies meeting certain minimum operating results during a five-year earn-out period, with a maximum payout of $7.0 million over this period. Management expects the transaction to be immediately accretive to earnings per share.

The acquisition has been accounted for using the purchase method of accounting, which requires that the financial statements include activity of the Cornerstone Companies effective January 1, 2006. Accordingly, the Corporation’s consolidated financial statements and the information herein at and for the year ended December 31, 2005 does not include the Cornerstone Companies. The Cornerstone Companies have become part of the Millennium Wealth Management division of the Bank. The acquisition is expected to provide significant strategic advantages to the Corporation, broadening wealth management products and services, growing our business client base and positioning the Millennium Wealth Management division as a leader in our market.

On June 30, 2005, the Bank sold its former subsidiary, Cumberland Advisors, Inc. Cumberland Advisors, based in Vineland, New Jersey, is a SEC registered investment advisor specializing in fixed income money management and equities. It was acquired by the Corporation on April 30, 2004 as part of its Millennium Bank acquisition.

On April 30, 2004, the Corporation completed its acquisition of Millennium Bank, which was merged with and into the Bank. Millennium Bank was based in Malvern, Pennsylvania with four banking offices, specializing in commercial lending and client relationship banking along with Cumberland Advisors, Inc.

As of December 31, 2005, the Corporation had total assets of $3.12 billion, total shareholders’ equity of $273.2 million and total deposits of $2.37 billion.

As of December 31, 2005, the Corporation and the Bank employed approximately 665 full-time equivalent employees. The Corporation provides a variety of employment benefits and considers its relationships with its employees to be satisfactory.

Competition

The Bank competes actively with other eastern Pennsylvania financial institutions, many larger than the Bank, as well as with financial and non-financial institutions headquartered elsewhere. Commercial banks, savings banks, savings and loan associations, credit unions, and money market funds actively compete for deposits and loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors with respect to one or more services they render. The Bank is generally competitive with all competing institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts, interest rates charged on loans and fees for trust and investment advisory services. At December 31, 2005, the Bank’s legal lending limit to a single customer was $39.0 million. Many of the institutions with which the Bank competes are able to lend significantly more than this amount to a single customer.

5




Supervision and Regulation—The Registrant

The Gramm-Leach-Bliley Financial Modernization Act of 1999 (Modernization Act) allows bank holding companies meeting management, capital, and Community Reinvestment Act standards to engage in a substantially broader range of non-banking activities than permissible before enactment, including underwriting insurance and making merchant banking investments in commercial and financial companies. It allows insurers and other financial services companies to acquire banks, removes various restrictions that currently apply to bank holding company ownership of securities firms and mutual fund advisory companies, and establishes the overall regulatory structure applicable to bank holding companies that also engage in insurance and securities operations.

The Modernization Act also modified law related to financial privacy and community reinvestment. The privacy provisions generally prohibit financial institutions, including the Corporation, from disclosing nonpublic financial information to nonaffiliated third parties unless customers have the opportunity to “opt out” of the disclosure.

Pending Legislation

Management is not aware of any other current specific recommendations by regulatory authorities or proposed legislation which, if they were implemented, would have a material adverse effect upon the liquidity, capital resources, or results of operations, although the general cost of compliance with numerous federal and state laws and regulations does have, and in the future may have, a negative impact on the Corporation’s results of operations.

Effects of Inflation

Inflation has some impact on the Corporation’s and the Bank’s operating costs. Unlike many industrial companies, however, substantially all of the Bank’s assets and liabilities are monetary in nature. As a result, interest rates have a more significant impact on the Corporation’s and the Bank’s performance than the general level of inflation. Over short periods of time, interest rates may not necessarily move in the same direction or in the same magnitude as prices of goods and services.

Effect of Government Monetary Policies

The earnings of the Corporation are and will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. An important function of the Federal Reserve is to regulate the money supply and interest rates. Among the instruments used to implement those objectives are open market operations in United States government securities and changes in reserve requirements to member bank deposits. These instruments are used in varying combinations to influence overall growth and distribution of bank loans, investments and deposits, and their use may also affect rates charged on loans or paid for deposits.

The Bank is a member of the Federal Reserve and, therefore, the policies and regulations of the Federal Reserve have a significant effect on its deposits, loans and investment growth, as well as the rate of interest earned and paid, and are expected to affect the Bank’s operations in the future. The effect of such policies and regulations upon the future business and earnings of the Corporation and the Bank cannot be predicted.

Environmental Regulations

There are several federal and state statutes which regulate the obligations and liabilities of financial institutions pertaining to environmental issues. In addition to the potential for attachment of liability resulting from its own actions, a bank may be held liable under certain circumstances for the actions of its

6




borrowers, or third parties, when such actions result in environmental problems on properties that collateralize loans held by the bank. Further, the liability has the potential to far exceed the original amount of a loan issued by the bank. Currently, neither the Corporation nor the Bank are a party to any pending legal proceeding pursuant to any environmental statute, nor are the Corporation and the Bank aware of any circumstances that may give rise to liability under any such statute.

Supervision and Regulation—Bank

The operations of the Bank are subject to federal and state statutes applicable to banks chartered under the banking laws of the United States, to members of the Federal Reserve and to banks whose deposits are insured by the FDIC. The Bank’s operations are also subject to regulations of the OCC, the Federal Reserve and the FDIC. The primary supervisory authority of the Bank is the OCC, who regularly examines the Bank. The OCC has authority to prevent a national bank from engaging in unsafe or unsound practices in conducting its business.

Federal and state banking laws and regulations govern, among other things, the scope of a bank’s business, the investments a bank may make, the reserves against deposits a bank must maintain, loans a bank makes and collateral it takes, the activities of a bank with respect to mergers and consolidations and the establishment of branches.

The Corporation and the Bank are subject to regulations of certain state and federal agencies and, accordingly, these regulatory authorities periodically examine the Corporation and the Bank. As a consequence of the extensive regulation of commercial banking activities, the Corporation’s and the Bank’s business is susceptible to being affected by state and federal legislation and regulations.

As a subsidiary bank of a bank holding company, the Bank is subject to certain restrictions imposed by the Federal Reserve Act on any extensions of credit to the bank holding company or its subsidiaries, or investments in the stock or other securities as collateral for loans. The Federal Reserve Act and Federal Reserve regulations also place certain limitations and reporting requirements on extensions of credit by a bank to principal shareholders of its parent holding company, among others, and to related interests of such principal shareholders. In addition, such legislation and regulations may affect the terms upon which any person becoming a principal shareholder of a holding company may obtain credit from banks with which the subsidiary bank maintains a correspondent relationship.

Under the Federal Deposit Insurance Act, the OCC possesses the power to prohibit institutions regulated by it (such as the Bank) from engaging in any activity that would be an unsafe and unsound banking practice or would otherwise be in violation of the law.

Community Reinvestment Act

Under the Community Reinvestment Act, the OCC is required to assess the record of all financial institutions regulated by it to determine if these institutions are meeting the credit needs of the community, including low and moderate income neighborhoods which they serve and to take this record into account in its evaluation of any application made by any of such institutions for, among other things, approval of a branch or other deposit facility, office relocation, a merger or an acquisition of bank shares. The Financial Institutions Reform, Recovery and Enforcement Act amended the CRA to require, among other things, that the OCC make publicly available the evaluation of a bank’s record of meeting the credit needs of its entire community, including low and moderate income neighborhoods. This evaluation will include a descriptive rating like “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance” and a statement describing the basis for the rating. These ratings are publicly disclosed.

7




Bank Secrecy Act

Under the Bank Secrecy Act, banks and other financial institutions are required to report to the Internal Revenue Service currency transactions of more than $10,000 or multiple transactions of which a bank is aware in any one day that aggregate in excess of $10,000. Civil and criminal penalties are provided under the Bank Secrecy Act for failure to file a required report, for failure to supply information required by the Bank Secrecy Act or for filing a false or fraudulent report.

Capital Requirements / FDICIA

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) requires that institutions be classified, based on their risk-based capital ratios into one of five defined categories, as illustrated below: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. Under these guidelines, the Bank was considered well capitalized as of December 31, 2005.

 

 

Total
Risk
Based
Ratio

 

Tier 1
Risk
Based
Ratio

 

Tier 1
Leverage
Ratio

 

Under a
Capital
Order
or
Directive

 

Capital category

 

 

 

 

 

 

 

 

 

 

 

 

 

Well capitalized

 

³10.0%

 

³6.0%

 

 

³5.0

%

 

 

NO

 

 

Adequately capitalized

 

³8.0%

 

³4.0%

 

 

³4.0

%(1)

 

 

 

 

 

Undercapitalized

 

<8.0%

 

<4.0%

 

 

<4.0

%(1)

 

 

 

 

 

Significantly undercapitalized

 

<6.0%

 

<3.0%

 

 

<3.0

%

 

 

 

 

 

Critically undercapitalized

 

 

 

 

 

 

<2.0

%

 

 

 

 

 


(1)          3.0 for those banks having the highest available regulatory rating.

In the event an institution’s capital deteriorates to the undercapitalized category or below, FDICIA prescribes an increasing amount of regulatory intervention, including: the institution of a capital restoration plan and a guarantee of the plan by a parent institution; and the placement of a hold on increases in assets, number of branches or lines of business. If capital has reached the significantly or critically undercapitalized levels, further material restrictions can be imposed, including restrictions on interest payable on accounts, dismissal of management and, in critically undercapitalized situations, appointment of a receiver. For well capitalized institutions, FDICIA provides authority for regulatory intervention where the institution is deemed to be engaging in unsafe or unsound practices or receives a less than satisfactory examination report rating for asset quality, management, earnings or liquidity. All but well capitalized institutions are prohibited from accepting brokered deposits without prior regulatory approval.

Under FDICIA, financial institutions are subject to increased regulatory scrutiny and must comply with certain operational, managerial and compensation standards to be developed by Federal Reserve Board regulations. FDICIA also requires the regulators to issue new rules establishing certain minimum standards to which an institution must adhere including standards requiring a minimum ratio of classified assets to capital, minimum earnings necessary to absorb losses and minimum ratio of market value to book value for publicly held institutions. In addition, FDICIA requires regulators to develop standards relating to internal controls, loan documentation, credit underwriting, interest rate exposure, asset growth and excessive compensation, fees and benefits.

Annual full-scope, on site regulatory examinations are required for all the FDIC-insured institutions except institutions with assets under $100 million which are well capitalized, well-managed and not subject to a recent change in control, in which case, the examination period is every 18 months. Banks with total

8




assets of $500 million or more are required to submit to their supervising federal and state banking agencies a publicly available annual audit report. The independent accountants of banks with total assets of $1 billion or more are required to attest to the accuracy of management’s report regarding the internal controls of the bank. In addition, such banks also are required to have an independent audit committee composed of outside directors who are independent of management, to review with management and the independent accountants, the reports that must be submitted to the bank regulatory agencies. If the independent accountants resign or are dismissed, written notification must be given to the bank’s supervising government banking agencies.

FDICIA also requires that banking agencies reintroduce loan-to-value ratio regulations which were previously repealed by the 1982 Act. Loan-to-values limit the amount of money a financial institution may lend to a borrower, when the loan is secured by real estate, to no more than a percentage, set by regulation, of the value of the real estate.

A separate subtitle within FDICIA, called the “Bank Enterprise Act of 1991,” requires “truth-in-savings” on consumer deposit accounts so that consumers can make meaningful comparisons between the competing claims of banks with regard to deposit accounts and products. Under this provision, a bank is required to provide information to depositors concerning the terms of their deposit accounts, and in particular, to disclose the annual percentage yield.

Capital Distributions

The Corporation is a legal entity separate and distinct from its banking and other subsidiaries. The majority of the Corporation’s revenue is from dividends paid to the Corporation by the Bank. The Bank is subject to various regulatory policies and requirements relating to the amount and frequency of dividend declarations. Future dividend payments to the Corporation by the Bank will be dependent on a number of factors, including the earnings and financial condition of the Bank, and are subject to limitations and other statutory powers of bank regulatory agencies.

The National Banking Laws require the approval of the OCC if the total of all dividends declared by a national bank in any calendar year exceed the net profits of the bank for that year combined with its retained net profits for the preceding two calendar years. An insured depository institution is prohibited from making any capital distributions to its owner, including any dividend, if, after making such distribution, the depository institution fails to meet the required minimum level for any relevant capital measure, including the risk-based capital adequacy and leverage standards previously discussed in the capital requirements section.

Deposit Insurance and Premiums

The Bank’s deposits are insured by the Bank Insurance Fund (BIF), which is administered by the FDIC. The basic insurance limit is $100,000 per depositor, per insured institution and such insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the insurance fund. The FDIC also has the authority to terminate an institution’s deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition. The deposit insurance premiums are assessed based both on the balance of insured deposits held as well as the degree of risk the institution poses to the insurance fund. Each insured institution is placed in one of nine risk categories based upon the institution’s capital classifications and supervisory evaluation. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.

9




The FDIC is authorized to increase assessment rates, on a semi-annual basis, to maintain the reserve ratio at the designated minimum ratio of 1.25% of estimated insured deposits or such higher reserve ratio as established by the FDIC. The current premium schedule for BIF insured institutions ranges from 0 to 27 basis points per $100 of deposits depending on the assessment category into which the insured institution is placed. Banks classified as strongest by the FDIC were subject in 2005 to a 0.00% assessment. The Bank was placed in this category and, therefore, had a 0.00% assessment rate in 2005.

In addition, all insured institutions are required to pay a Financing Corporation (FICO) assessment. FICO is a government agency-sponsored entity that was formed to borrow money necessary to carry out the closing and disposition of failed thrift institutions in the 1980’s. The annual FICO rate for all insured institutions as of December 31, 2005 was 1.32 basis points. These assessments are revised quarterly and will continue until the bonds mature in the year 2019. The Bank paid FICO premiums of $306,000 in 2005.

Any significant increases in assessment rates or additional special assessments by the FDIC could have an adverse impact on the results of operations and capital of the Bank and the Corporation.

Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 implemented a broad range of corporate governance, accounting and reporting measures for companies that have securities registered under the Exchange Act, including publicly-held bank holding companies. The more significant reforms of the Sarbanes-Oxley Act of 2002 include: (1) new requirements for audit committees, including independence, expertise, and responsibilities; (2) certification of financial statements by the Chief Executive Officer and Chief Financial Officer of the reporting company; (3) new standards for auditors and regulation of audits, including independence provisions that restrict non-audit services that accountants may provide to their audit clients; (4) increased disclosure and reporting obligations for the reporting company and their directors and executive officers, including accelerated reporting of stock transactions and a prohibition on trading during pension blackout periods; (5) a range of new and increased civil and criminal penalties for fraud and other violations of the securities laws.

USA Patriot Act

The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA Patriot Act) imposes additional obligations on financial institutions, including banks and broker-dealer subsidiaries, to implement policies, procedures and controls which are reasonably designed to detect and report instances of money laundering and the financing of terrorism. In addition, provisions of the USA Patriot Act require the federal financial institution regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.

Regulatory Impact of the Cornerstone Companies Acquisition

CII is subject to regulation by a number of federal regulatory agencies that are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interests of customers participating in those markets. The SEC is the federal agency that is primarily responsible for the regulation of broker-dealers and investment advisers doing business in the United States. The Federal Reserve Board promulgates regulations applicable to securities credit transactions involving broker-dealers and certain other institutions. Much of the regulation of broker-dealers, however, has been delegated to self-regulatory organizations (SROs), principally the NASD (and its subsidiaries NASD Regulation, Inc. and the Nasdaq Stock Market), and the national securities exchanges. These SROs, which are subject to oversight by the SEC, adopt rules (which are subject to approval by the SEC) that govern the industry, monitor daily activity and conduct periodic examinations of member broker-dealers.

10




CII, CFC and CAAM are registered as investment advisers with the SEC and are subject to the requirements of the Investment Advisers Act of 1940 and the SEC’s regulations, as well as certain state securities laws and regulations. These requirements relate to limitations on the ability of an investment adviser to charge performance-based or non-refundable fees to clients, record-keeping and reporting requirements, disclosure requirements, limitations on principal transactions between an adviser or its affiliates and advisory clients, as well as general anti-fraud prohibitions. CII, as a broker-dealer registered with the SEC and as a member firm of the NASD, is subject to capital requirements of the SEC and the NASD. These capital requirements specify minimum levels of capital that CII is required to maintain and also limit the amount of leverage that it is able to obtain in its respective business.

In the event of non-compliance with an applicable regulation, governmental regulators and the NASD may institute administrative or judicial proceedings that may result in censure, fine, civil penalties, the issuance of cease-and-desist orders or the deregistration or suspension of the non-compliant broker-dealer or investment adviser or other adverse consequences. The imposition of any such penalties or orders on CII could have a material adverse effect on CII’S (and therefore the Corporation’s) operating results and financial condition.

CII is a member of the Securities Investor Protection Corporation (SIPC), which is a non-profit corporation that was created by the United States Congress under the Securities Protection Act of 1970. SIPC protects customers of member broker-dealers against losses caused by the financial failure of the broker-dealer but not against a change in the market value of securities in customers’ accounts at the broker-dealer. In the event of the inability of a member broker-dealer to satisfy the claims of its customers in the event of its failure, the SIPC’s funds are available to satisfy the remaining claims up to maximum of $500,000 per customer, including up to $100,000 on claims for cash. In addition, CII’s clearing firm carries private insurance that provides unlimited account protection in excess of SIPC’s protection.

Changes in Regulations

From time to time, various types of federal and state legislation have been proposed that could result in additional regulation of, and restriction on, the business of the Corporation and the Bank. It cannot be predicted whether any such legislation will be adopted or, if adopted, how such legislation would affect the business of the Corporation or the Bank. As a consequence of the extensive regulation of commercial banking activities in the United States, the Corporation and the Bank are particularly susceptible to being affected by federal legislation and regulations that may increase the costs of doing business.

Additional Information

The Corporation’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge on the Corporation’s website (www.hncbank.com under “Investor Information”) as soon as reasonably practicable after the Corporation electronically files such material with, or furnishes it to the Securities and Exchange Commission. These filings are also accessible on the Securities and Exchange Commission’s website (www.sec.gov). In addition, the Corporation makes available on www.hncbank.com under “Investor Information—Corporate Governance” the following: 1) Audit Committee Charter, 2) Code of Ethics, which applies to all directors and all employees, 3) Whistleblower Policy, 4) Nominating and Corporate Governance Committee Charter and 5) Compensation Committee Charter.

Item 1A.                Risk Factors

The business of the Corporation and the Bank involve significant risks as described below. Additional risks may arise in the future or risks that are currently not considered significant may also impact the operations of the Corporation and the Bank. The Corporation may amend or supplement the risk factors

11




described below from time to time by reports filed with the SEC in the future. Management’s ability to analyze and manage these and other risks could affect the future financial results of the Corporation. If any of the events or circumstances described in the following risks occur, the financial condition or results of operations of the Corporation could suffer and the trading price of the Corporation’s common stock could decline.

Interest rate movements impact the earnings of the Corporation.

The Corporation is exposed to interest rate risk, through the operations of its banking subsidiary, since substantially all of the Bank’s assets and liabilities are monetary in nature. Interest rate risk arises from market driven fluctuations in interest rates that affect cash flows, income, expense and value of financial instruments. The Bank’s earnings, like that of most financial institutions, largely depends on net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and investments, and the interest expense paid on interest-bearing liabilities, such as deposits and borrowings. In an increasing interest rate environment, the cost of funds is expected to increase more rapidly than the interest earned on the loans and securities because the primary source of funds are deposits with generally shorter maturities than the maturities on loans and investment securities. This causes the net interest rate spread to compress and negatively impacts the Bank’s profitability. The Corporation actively manages its interest rate sensitivity positions. The objectives of interest rate risk management are to control exposure of net interest income to risks associated with interest rate movements and to achieve consistent growth in net interest income.

The Corporation is exposed to risks in connection with loans the Bank makes and if the allowance for loan losses is not sufficient to cover actual loan losses, the Corporation’s earnings could decrease.

A significant source of risk for the Corporation arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The Corporation has underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for loan losses, that are believed to be adequate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying loan portfolios. Such policies and procedures, however, may not prevent unexpected losses that could adversely affect the Corporation’s results of operations.

The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporation’s results of operations in the future.

Strong competition within the Corporation’s market area may limit its growth and profitability.

Competition in the banking and financial services industry is intense. The Bank competes actively with other eastern Pennsylvania financial institutions, many larger than the Bank, as well as with financial and non-financial institutions headquartered elsewhere. Commercial banks, savings banks, savings and loan associations, credit unions, and money market funds actively compete for deposits and loans. Such institutions, as well as consumer finance and insurance companies, may be considered competitors with

12




respect to one or more services they render. The Bank is generally competitive with all competing institutions in its service areas with respect to interest rates paid on time and savings deposits, service charges on deposit accounts, interest rates charged on loans and fees for trust and investment advisory services. Many of the institutions with which the Bank competes have substantially greater resources and lending limits and may offer certain services that the Bank does not or cannot provide. The Corporation’s profitability depends upon the Bank’s ability to successfully compete in its market area.

An economic downturn in eastern Pennsylvania or a general decline in economic conditions could adversely affect the Corporation’s financial results.

The Bank’s operations are concentrated in eastern Pennsylvania. As a result of this geographic concentration, the Corporation’s financial results may correlate to the economic conditions in this area. Deterioration in economic conditions in this market area, particularly in the industries on which this geographic areas depend, or a general decline in economic conditions may adversely affect the quality of the loan portfolio (including the level of non-performing assets, charge offs and provision expense) and the demand for products and services, and accordingly, the Corporation’s results of operations. Inflation has some impact on the Corporation’s and the Bank’s operating costs.

The Corporation operates in a highly regulated environment and may be adversely affected by changes in laws and regulations.

The Corporation and the Bank are subject to extensive regulation, supervision and examination by certain state and federal agencies including the Pennsylvania State Department of Banking, the Federal Deposit Insurance Corporation, as insurer of the Bank’s deposits, the Board of Governors of the Federal Reserve System, as regulator of the holding company and the Office of the Comptroller of Currency. Such regulation and supervision governs the activities in which an institution and its holding company may engage, and are intended primarily to ensure the safety and soundness of financial institutions. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on operations, the classification of assets and determination of the level of the allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on the Bank’s and the Corporation’s operations.

Item 1B.               Unresolved Staff Comments

None.

13




Item 2.                        Properties

The principal executive offices of the Corporation and of the Bank are located in Harleysville, Pennsylvania in a two-story office building owned by the Bank, built in 1929. The Bank also owns the buildings in which twenty-two of its branches are located and leases space for the other twenty-five branches from unaffiliated third parties under leases expiring at various times through 2036. The Bank leases office space for commercial business development in Lansdale, Pennsylvania. HNC Investment Company leases an office in Wilmington, Delaware. HNC Reinsurance Company leases an office in Phoenix, Arizona. HNB Auto Sales re-markets off lease vehicles at a Bank owned property in Harleysville, Pennsylvania.

Office

 

 

 

Office Location

 

Owned/Leased

Harleysville

 

483 Main Street, Harleysville, PA

 

Owned

Harleysville

 

278 Main Street, Harleysville, PA

 

Leased

Skippack

 

3893 Skippack Pike, Skippack, PA

 

Owned

Limerick

 

260 West Ridge Pike, Limerick, PA

 

Owned

North Wales

 

1498 North Wales Road, North Wales, PA

 

Owned

Gilbertsville

 

1050 East Philadelphia Avenue, Gilbertsville, PA

 

Leased

Hatfield

 

1632 Cowpath Road, Hatfield, PA

 

Leased

North Broad

 

1804 North Broad Street, Lansdale, PA

 

Owned

Marketplace

 

1551 Valley Forge Road, Lansdale, PA

 

Leased

Normandy Farms

 

Morris Road & Route 202, Blue Bell, PA

 

Leased

Horsham

 

955 Horsham Road, Horsham, PA

 

Leased

Meadowood

 

3205 Skippack Pike, Worcester, PA

 

Leased

Collegeville

 

364 Main Street, Collegeville, PA

 

Owned

Sellersville

 

209 North Main Street, Sellersville, PA

 

Owned

Trainers Corner

 

120 North West End Boulevard, Quakertown, PA

 

Leased

Quakertown Main

 

224 West Broad Street, Quakertown, PA

 

Owned

Spring House

 

1017 North Bethlehem Pike, Spring House, PA

 

Owned

Red Hill

 

400 Main Street, Red Hill, PA

 

Owned

Doylestown

 

500 East Farm Lane, Doylestown, PA

 

Leased

Audubon

 

2624 Egypt Road, Norristown, PA

 

Owned(1)

Chalfont

 

251 West Butler Avenue, Chalfont, PA

 

Leased

Royersford

 

440 W. Linfield-Trappe Road, Royersford, PA

 

Owned(1)

Souderton

 

702 Route 113, Souderton, PA

 

Leased

Foulkeways

 

1120 Meetinghouse Road, Gwynedd, PA

 

Leased

Malvern(2)

 

30 Valley Stream Parkway, Malvern, PA

 

Leased

Malvern

 

83 Lancaster Avenue, Malvern, PA

 

Leased

Blue Bell(2)

 

721 Skippack Pike, Blue Bell, PA

 

Leased

Wyomissing(2)

 

2800 State Hill Road, Wyomissing, PA

 

Owned

Lansford

 

13-15 West Ridge Street, Lansford, PA

 

Owned

Summit Hill

 

2 East Ludlow Street, Summit Hill, PA

 

Owned

Lehighton

 

904 Blakeslee Blvd, Lehighton, PA

 

Owned

Honesdale

 

1001 Main Street, Honesdale, PA

 

Owned

Slatington

 

502 Main Street, Slatington, PA

 

Owned

Slatington Handi-Bank

 

701-705 Main Street, Slatington, PA

 

Owned

Lehigh Township

 

4421 Lehigh Drive, Walnutport, PA

 

Owned

Palmerton

 

372 Delaware Avenue, Palmerton, PA

 

Owned

Kresgeville

 

Route 209, Kresgeville, PA

 

Leased

Allentown(2)

 

1602 Allen Street, Allenton, PA

 

Leased

Pottstown

 

One Security Plaza, Pottstown, PA

 

Leased

14




 

Pottstown

 

1450 East High Street, Pottstown, PA

 

Leased

Pottstown

 

930 North Charlotte Street, Pottstown, PA

 

Leased

Pottstown

 

Rt. 100 and Shoemaker Road, Pottstown, PA

 

Owned(1)

Pottstown

 

2 Glocker Way, Pottstown, PA

 

Leased

Boyertown

 

Rt. 100 and Baus Road, Boyertown, PA

 

Leased

Douglassville

 

1191 Ben Franklin Parkway, Douglassville, PA

 

Leased

Dorneyville

 

3570 Hamilton Boulevard, Allentown, PA

 

Leased

Warminster(3)

 

190 Veterans Way, Warminster, PA

 

Leased


(1)          Branch buildings are owned by the Bank and the land is leased.

(2)          Locations include Millennium Wealth Management and Private Banking offices.

(3)          This branch is expected to open for business in 2006.

In management’s opinion, all of the above properties are in good condition and are adequate for the Corporation’s and the Bank’s purposes.

Item 3.                        Legal Proceedings

Management, based on consultation with the Corporation’s legal counsel, is not aware of any litigation that would have a material adverse effect on the consolidated financial position of the Corporation. There are no proceedings pending other than the ordinary routine litigation incident to the business of the Corporation and its subsidiaries—the Bank, HNC Financial Company and HNC Reinsurance Company. In addition, no material proceedings are pending or are known to be threatened or contemplated against the Corporation and the Bank by government authorities.

Item 4.                        Submission of Matters to a Vote of Security Holders

No matter was submitted during the fourth quarter of 2005 to a vote of holders of the Corporation’s Common Stock.

15




PART II

Item 5.                        Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The following table sets forth high and low closing sales prices for the Corporation’s common stock and quarterly cash dividends paid per share for 2005 and 2004. The Corporation’s stock is traded under the symbol “HNBC” on the NASDAQ National Market Systems. All share information has been restated to reflect stock dividends and splits. For certain limitations on the Bank’s ability to pay dividends to the Corporation, see Item 1, “Supervision and Regulation—Bank” and Item 8, Note 18, “Notes to Consolidated Financial Statements—Regulatory Capital.”

Price of Common Stock and Cash Dividends

2005

 

 

 

High Price

 

Low Price

 

Cash dividends
per share

 

First Quarter(1)

 

 

$

24.96

 

 

 

$

19.80

 

 

 

$

0.17

 

 

Second Quarter(1)

 

 

23.48

 

 

 

18.72

 

 

 

0.17

 

 

Third Quarter

 

 

24.26

 

 

 

21.00

 

 

 

0.18

 

 

Fourth Quarter

 

 

22.75

 

 

 

19.02

 

 

 

0.23

 

 

 

2004

 

 

 

High Price

 

Low Price

 

Cash dividends
per share

 

First Quarter(2)

 

 

$

28.27

 

 

 

$

23.62

 

 

 

$

0.15

 

 

Second Quarter(2)

 

 

26.54

 

 

 

21.42

 

 

 

0.16

 

 

Third Quarter(1)

 

 

24.51

 

 

 

20.23

 

 

 

0.16

 

 

Fourth Quarter(1)

 

 

27.10

 

 

 

22.72

 

 

 

0.21

 

 


(1)          Adjusted for a five percent stock dividend effective 9/15/05.

(2)          Adjusted for a five percent stock dividend effective 9/15/05 and 9/15/04.

At December 31, 2005, there were 3,637 shareholders of record, not including the number of persons or entities whose stock is held in nominee or “street” name through various brokerage firms and banks.

Information on the Corporation’s equity compensation plans included under Item 8, Note 1, “Notes to Consolidated Financial Statements—Stock Based Compensation, Note 13, “Stock Options,” and the 2005 Proxy Statement under the caption, “Equity Compensation Plan Information, is incorporated herein by reference.

The Corporation has a stock repurchase program that permits the repurchase of up to five percent of its outstanding common stock. The repurchased shares will be used for general corporate purposes.

16




The following table provides information about purchases made by the Corporation of its common stock during the quarter ended December 31, 2005:

Issuer Purchases of Common Stock

 

 

Total Number of
Common Shares
Purchased

 

Weighted
Average
Price Paid
Per Share

 

Total Number
of Shares
Purchased as
Part of Publicly
Announced
Plans

 

Maximum
Number of
Shares that may
yet be
Purchased
under the
Plans(1)

 

October 1-31, 2005

 

 

34,500

 

 

 

$

19.58

 

 

 

34,500

 

 

 

1,161,117

 

 

November 1-30, 2005

 

 

55,678

 

 

 

21.26

 

 

 

55,678

 

 

 

1,105,439

 

 

December 1-31, 2005

 

 

17,400

 

 

 

21.26

 

 

 

17,400

 

 

 

1,088,039

 

 

Total

 

 

107,578

 

 

 

$

20.72

 

 

 

107,578

 

 

 

 

 

 


(1)          On December 14, 2000, the Board of Directors authorized a program to purchase up to 1,311,450 shares (restated for stock dividends and splits), or 5%, of its outstanding common stock. This repurchase plan was completed during the second quarter of 2005. On May 12, 2005, the Board of Directors authorized a plan to purchase up to 1,349,250 shares (restated for five percent stock dividend paid on September 15, 2005) or 4.9%, of its outstanding common stock.

17




Item 6.                        Selected Financial Data

 

 

Year Ended December 31,

 

 

 

2005

 

2004(2)

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands, except per share information)

 

Income and expense

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

$

151,739

 

$

127,729

 

$

119,200

 

$

132,630

 

$

138,679

 

Interest expense

 

64,618

 

42,638

 

40,079

 

52,610

 

64,937

 

Net interest income

 

87,121

 

85,091

 

79,121

 

80,020

 

73,742

 

Provision for loan losses

 

3,401

 

2,555

 

3,200

 

4,370

 

3,930

 

Net interest income after provision for loan losses

 

83,720

 

82,536

 

75,921

 

75,650

 

69,812

 

Noninterest income

 

29,990

 

28,158

 

27,638

 

22,523

 

22,225

 

Noninterest expense

 

62,479

 

59,561

 

59,529

 

56,297

 

55,043

 

Income before income tax expense

 

51,231

 

51,133

 

44,030

 

41,876

 

36,994

 

Income tax expense

 

12,403

 

12,566

 

8,697

 

8,949

 

8,174

 

Net income

 

$

38,828

 

$

38,567

 

$

35,333

 

$

32,927

 

$

28,820

 

Per share information(1)

 

 

 

 

 

 

 

 

 

 

 

Basic earnings

 

$

1.41

 

$

1.42

 

$

1.35

 

$

1.25

 

$

1.09

 

Diluted earnings

 

1.38

 

1.37

 

1.30

 

1.21

 

1.06

 

Cash dividends paid

 

0.75

 

0.68

 

0.59

 

0.51

 

0.45

 

Basic average common shares outstanding

 

27,515,630

 

27,147,992

 

26,244,807

 

26,352,201

 

26,489,291

 

Diluted average common shares outstanding

 

28,085,920

 

28,062,489

 

27,148,029

 

27,149,733

 

27,147,635

 

Average balance sheet

 

 

 

 

 

 

 

 

 

 

 

Loans

 

$

1,900,023

 

$

1,625,419

 

$

1,354,127

 

$

1,333,300

 

$

1,264,750

 

Investments

 

903,063

 

941,910

 

950,225

 

823,004

 

660,983

 

Other interest-earning assets

 

51,740

 

41,064

 

28,782

 

25,411

 

19,228

 

Total assets

 

3,039,186

 

2,773,405

 

2,466,070

 

2,309,422

 

2,058,738

 

Deposits

 

2,259,831

 

2,094,998

 

1,927,899

 

1,808,390

 

1,599,515

 

Borrowed funds

 

456,599

 

372,141

 

270,325

 

247,221

 

226,247

 

Shareholders’ equity

 

272,974

 

251,963

 

216,846

 

198,373

 

182,178

 

Balance sheet at year-end

 

 

 

 

 

 

 

 

 

 

 

Loans

 

$

1,985,493

 

$

1,845,802

 

$

1,408,391

 

$

1,333,292

 

$

1,316,609

 

Investments

 

901,208

 

943,563

 

924,874

 

971,467

 

732,470

 

Other interest-earning assets

 

37,455

 

56,291

 

38,551

 

41,910

 

19,650

 

Total assets

 

3,117,359

 

3,024,515

 

2,510,939

 

2,490,864

 

2,208,971

 

Deposits

 

2,365,457

 

2,212,563

 

1,979,081

 

1,979,822

 

1,746,862

 

Borrowed funds

 

439,168

 

488,182

 

255,056

 

253,906

 

215,820

 

Shareholders’ equity

 

273,232

 

270,532

 

227,053

 

206,206

 

189,349

 

Performance ratios

 

 

 

 

 

 

 

 

 

 

 

Return on average assets

 

1.28

%

1.39

%

1.43

%

1.43

%

1.40

%

Return on average equity

 

14.22

 

15.31

 

16.29

 

16.60

 

15.82

 

Average equity to average
assets

 

8.98

 

9.08

 

8.79

 

8.59

 

8.85

 

Dividend payout ratio

 

53.41

 

48.16

 

44.06

 

40.94

 

41.27

 


(1)          Adjusted for a five percent stock dividend effective 9/15/05, 9/15/04 and 9/16/02, a five-for-four stock split effective 9/15/03 and a one hundred percent stock dividend effective 8/10/01

(2)          The results of operations include the acquisition of Millennium Bank effective April 30, 2004

18




Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is management’s discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in its accompanying consolidated financial statements for Harleysville National Corporation (the Corporation), and its wholly owned subsidiaries—Harleysville National Bank (the Bank), HNC Financial Company and HNC Reinsurance Company. The Corporation’s consolidated financial condition and results of operations consist almost entirely of the Bank’s financial condition and results of operations. Current performance does not guarantee, and may not be indicative of, similar performance in the future. The information in Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Corporation’s consolidated financial statements and the accompanying footnotes under Item 8 of this report on Form 10-K.

Critical Accounting Estimates

The accounting and reporting policies of the Corporation and its subsidiaries conform to accounting principles generally accepted in the United States and general practices with the financial services industry. The Corporation’s significant accounting policies are described in Note 1 of the consolidated financial statements and are essential in understanding Management’s Discussion and Analysis of Results of Operations and Financial Condition. In applying accounting policies and preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amount of assets and liabilities as of the dates of the balance sheets and revenues and expenditures for the periods presented. Therefore, actual results could differ significantly from those estimates. Judgments and assumptions required by management, which have, or could have a material impact on the Corporation’s financial condition or results of operations are considered critical accounting estimates. The following is a summary of the policies the Corporation recognizes as involving critical accounting estimates: Allowance for Loan Loss, Goodwill and Other Intangible Asset Impairment, Stock-Based Compensation, Unrealized Gains and Losses on Debt Securities Available for Sale, and Deferred Taxes.

Allowance for Loan Losses:   The Corporation maintains an allowance for loan losses at a level management believes is sufficient to absorb estimated probable credit losses. Management’s determination of the adequacy of the allowance is based on periodic evaluations of the loan portfolio and other relevant factors. However, this evaluation is inherently subjective as it requires significant estimates by management. Consideration is given to a variety of factors in establishing these estimates including current and anticipated economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, borrowers’ perceived financial and management strengths, the adequacy of underlying collateral, the dependence on collateral, or the strength of the present value of future cash flows and other relevant factors. These factors may be susceptible to significant change. To the extent actual outcomes differ from management estimates, additional provisions for loan losses may be required which may adversely affect the Corporation’s results of operations in the future.

Goodwill and Other Intangible Asset Impairment:   Goodwill and other intangible assets are reviewed for potential impairment on an annual basis, or more often if events or circumstances indicate that there may be impairment, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” Goodwill is tested for impairment at the reporting unit level and an impairment loss is recorded to the extent that the carrying amount of goodwill exceeds its implied fair value. The Corporation employs general industry practices in evaluating the fair value of its goodwill and other intangible assets. The Corporation calculates the fair value using a combination of the following valuations: deposit premiums based on market deals, current stock pricing tracking as a multiple of book value, discounted cash flow of earnings with a terminal value and market multiple of earnings. Management performed its annual review of goodwill at June 30, 2005 in accordance with SFAS No. 142 and determined there was no impairment of

19




goodwill and identifiable intangible assets. No assurance can be given that future impairment tests will not result in a charge to earnings.

Stock-based Compensation:   Under SFAS No. 123 “Accounting for Stock-Based Compensation” (FAS 123), companies have a choice whether to adopt the fair value based method of accounting for stock-based compensation or remain with the intrinsic value based method prescribed under APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) but provide pro-forma disclosure as if the fair value based method was applied. The Corporation chose the intrinsic value based method under APB 25 and provides pro-forma disclosure required under FAS 123. In preparing the pro-forma disclosure, the Corporation estimates the fair value of employee stock options using a pricing model which takes into consideration the exercise price and expected life of the options, the current price of the underlying stock and its expected volatility, the expected dividends on the stock and the current risk-free interest rate for the expected life of the option. The Corporation’s estimate of the fair value of a stock option is based on expectations derived from historical experience and may not necessarily equate to its market value when fully vested. In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (FAS 123(R)). Under FAS 123(R), all forms of share-based payments to employees, including employee stock options, will be treated the same as other forms of compensation by recognizing the related cost in the income statement. Registrants are required to implement FAS 123(R) at the beginning of their next fiscal year that begins after June 15, 2005, per the Securities and Exchange Commission’s rule issued in April 2005 amending the FAS 123(R) compliance date.

The Corporation has adopted SFAS 123(R) on January 1, 2006. The Corporation will use the modified prospective application method of transition. Effective January 1, 2006, the Corporation will recognize compensation expense for the portion of outstanding awards at January 1, 2006 for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under SFAS 123 for pro forma disclosures. For new grants awarded on or after January 1, 2006, the Corporation has chosen to continue the use of the Black-Scholes option-pricing model to estimate the fair value of each option on the date of grant. In accordance with SFAS 123(R), the Corporation will estimate the number of options for which the requisite service is expected to be rendered as compared to accounting for forfeitures as they occur under SFAS 123. The Corporation has chosen to recognize compensation expense for new grants using the straight-line method which spreads compensation expense for shares vesting evenly over the period of vesting. Proforma disclosures under SFAS 123 have been based upon the accrual method which treats each vesting tranche as a separate award and amortizes expense evenly (prorated) from grant date to vest date for each tranche. The Corporation estimates that share-based compensation expense, net of tax, to be recognized during the year of 2006 will be approximately $284,000. The number and timing of options granted during 2006 and vesting criteria may alter this projected number.

Unrealized Gains and Losses on Debt Securities Available for Sale:   The Corporation receives estimated fair values of debt securities from independent valuation services and brokers. In developing these fair values, the valuation services and brokers use estimates of cash flows based on historical performance of similar instruments in similar rate environments. Debt securities available for sale are mostly comprised of mortgage-backed securities.

Deferred Taxes:   The Corporation recognizes deferred tax assets and liabilities for the future effects of temporary differences, net operating loss carryforwards, and tax credits. Deferred tax assets are subject to management’s judgment based upon available evidence that future realizations are likely. If management determines that the Corporation may not be able to realize some or all of the net deferred tax asset in the future, a charge to income tax expense may be required to reduce the value of the net deferred tax asset to the expected realizable value.

20




The Corporation has not substantively changed its application of the foregoing policies, and there have been no material changes in assumptions or estimation techniques used as compared to prior periods.

Financial Overview

The Corporation achieved its 30th consecutive year of earnings growth and the 31th consecutive year of dividend increases to shareholders during 2005. Net income in 2005 was $38.8 million compared to $38.6 million in 2004. The earnings for 2005 reflected an increase in loan interest income partially offset by increases in interest expense on deposits and borrowings. Growth in average earning assets for 2005 was 9.4%.

For the year ended December 31, 2005, diluted earnings per share were $1.38 compared to $1.37 for 2004 and basic earnings per share were $1.41 for 2005 compared to $1.42 in 2004. The financial results for 2005 include the issuance of 1,310,000 shares of the Corporation’s common stock for a 5% stock dividend payable September 15, 2005. All share and per share information has been restated to reflect this stock dividend.

The Corporation’s consolidated total assets were $3.12 billion at December 31, 2005, an increase of 3.1% or $92.8 million over $3.02 billion in total assets reported at December 31, 2004. Of this increase, 4.6% or $140.0 million was due to loan growth, partially offset by a net decrease in cash and investments of 1.8% or $54.1 million. The return on average shareholders’ equity was 14.22% in 2005 compared to 15.31% in 2004. The return on average assets was 1.28% in 2005 compared to 1.39% in 2004. The decrease in the annualized return on average shareholders’ equity during 2005 was primarily due to the retention of earnings.

Net interest income on a tax-equivalent basis increased $962,000, or 1.0%, for the year ending December 31, 2005, over the prior year. The increase in net interest income for the year was mainly attributed to higher loan volume from commercial mortgage and home equity loans partially offset by higher deposit rates. The net interest margin for 2005 was 3.27% compared to 3.55% for 2004. The decline in the net interest margin from 2004 was primarily due to higher funding costs, particularly in money market deposit accounts and short-term borrowings. As a result of market conditions, deposit rates have increased more quickly than the loan rates have increased. During 2005, noninterest income increased $1.8 million, or 6.5% primarily attributed to an increase in gain on sales of investment securities of $1.1 million and the gain on the sale of the Bank’s McAdoo branch of $690,000. Noninterest expense increased $2.9 million mainly due to increased expenses for occupancy and professional fees (Sarbanes-Oxley related) as well as lower loan origination expense deferrals related to decreased loan origination volume.

The quality of the loan portfolio is a key focus of the Corporation. Nonperforming assets (including nonaccrual loans, net assets in foreclosure and loans 90 days or more past due) were .27% of total assets at December 31, 2005, compared to .20% at December 31, 2004. The increase in nonperforming assets at December 31, 2005, in relation to December 31, 2004 was mainly due to commercial mortgage loans for one borrower totaling $1.5 million and commercial business loans for four borrowers totaling $1.1 million which have been placed on nonaccrual of interest. The increase in the provision for 2005, compared to 2004, was primarily due to inherent risk related to loan growth and the increase in nonperforming loans.

Core deposits increased 2.1% or $33.6 million, to $1.61 billion at December 31, 2005, up from $1.58 billion at December 31, 2004. Total deposits increased $152.9 million, or 6.9% for the same period, which was primarily attributable to the growth in core deposit checking products and public funds time deposits of $100,000 or greater.

On June 30, 2005, the Bank sold its former subsidiary, Cumberland Advisors, Inc., to David R. Kotok and Associates, Inc. in a stock sale. The sale price was $2.0 million cash. Cumberland Advisors, based in Vineland, New Jersey, is a SEC registered investment advisor specializing in fixed income money management and equities. It was acquired by the Corporation on April 30, 2004 as part of its

21




Millennium Bank acquisition. Based upon management’s analysis of Cumberland Advisors’ results of operations and assets in comparison to the Corporation’s, management determined the impact of the sale of Cumberland Advisors is immaterial, and therefore the transaction is not presented as discontinued operations.

On April 30, 2004, the Corporation completed the acquisition of Millennium Bank, Malvern, PA. Millennium Bank was merged into the Bank. This transaction was accounted for in accordance with SFAS No. 141 “Business Combinations.” Millennium Bank’s shareholders received 946,000 shares (1,043,000 restated*) of the Corporation’s common stock and $16.1 million in exchange for all outstanding common shares. Millennium Bank option holders received $2.3 million and options to acquire 284,000 shares (313,000 restated*) of the Corporation’s common stock in exchange for all outstanding options.

For a five-year summary of financial information, see Item 6, “Selected Financial Data,” which is incorporated herein by reference.

For quarterly information for 2005 and 2004, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Fourth Quarter 2005 Results,” and Table 17, “Selected Quarterly Financial Data,” which are incorporated herein by reference.

Investment Securities

SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” requires that debt and equity securities classified as available for sale be reported at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The net effect of unrealized gains or losses, caused by marking an available for sale portfolio to market, causes fluctuations in the level of shareholders’ equity and equity-related financial ratios as market interest rates cause the fair value of fixed-rate securities to fluctuate.

Investment securities decreased 4.5% to $901.2 million at December 31, 2005 from $943.6 million at December 31, 2004. The investment securities available for sale decreased $33.1 million and the investment securities held to maturity decreased $9.3 million. During 2005, $273.9 million of securities available for sale were sold which generated a pretax gain of $4.8 million. The securities sold consisted primarily of tax-exempt bonds, trust preferred bonds and equity securities. In comparison, $1.35 billion of securities available for sale were sold in 2004 which generated a pretax gain of $3.7 million. During the fourth quarter of 2004, the Corporation transferred $50.0 million of obligations of states and political subdivisions from available for sale to held to maturity. The Bank intends to hold these securities to maturity as these securities are an effective tool to lower the Corporation’s effective tax rate. The Corporation sells investment securities available for sale to fund the purchase of other securities in an effort to enhance the overall return of the portfolio and to reduce the interest rate risk within different interest rate environments.


*—Restated for five percent stock dividends paid on September 15, 2005 and September 15, 2004.

22




The following table shows the carrying value of the Corporation’s investment securities available for sale and held to maturity:

Table 1—Investment Portfolio

 

 

December 31,

 

 

 

2005

 

2004

 

2003

 

 

 

(Dollars in thousands)

 

Investment securities available for sale:

 

 

 

 

 

 

 

Obligations of other U.S. government agencies and corporations

 

$

157,396

 

$

153,103

 

$

32,495

 

Obligations of states and political subdivisions

 

173,845

 

198,499

 

240,149

 

Mortgage-backed securities

 

467,568

 

454,730

 

575,788

 

Other securities

 

42,844

 

68,400

 

56,438

 

Total investment securities available for sale

 

$

841,653

 

$

874,732

 

$

904,870

 

Investment securities held to maturity:

 

 

 

 

 

 

 

Obligations of other U.S. government agencies and corporations

 

$

3,843

 

$

3,830

 

$

 

Obligations of states and political subdivisions

 

55,712

 

64,662

 

19,568

 

Mortgage-backed securities

 

 

339

 

436

 

Total investment securities held to maturity

 

$

59,555

 

$

68,831

 

$

20,004

 

 

The maturity analysis of investment securities including the weighted average yield for each category as of December 31, 2005 is as follows. Actual maturities may differ from contractual maturities because issuers and borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

23




Table 2—Maturity and Tax-Equivalent Yield Analysis of Investment Securities

 

 

December 31, 2005

 

 

 

Due in 1 year
or less

 

Due after
1 year through
5 years

 

Due after
5 years through
10 years

 

Due after
10 years

 

Total

 

 

 

(Dollars in thousands)

 

Investment securities available for sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Obligations of other U.S. government agencies and corporations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

2,959

 

 

 

$

88,663

 

 

 

$

55,149

 

 

$

10,625

 

$

157,396

 

Weighted average yield

 

 

3.31

%

 

 

3.93

%

 

 

4.81

%

 

5.23

%

4.31

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

5.1 years

 

Obligations of states and political subdivisions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

 

 

 

29,594

 

 

 

65,371

 

 

78,880

 

173,845

 

Weighted average yield(1)

 

 

%

 

 

6.48

%

 

 

6.26

%

 

6.26

%

6.29

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7.9 years

 

Mortgage-backed securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

47,210

 

 

 

393,358

 

 

 

13,909

 

 

13,091

 

467,568

 

Weighted average yield

 

 

3.83

%

 

 

3.94

%

 

 

3.98

%

 

4.35

%

3.94

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.2 years

 

Other debt securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

 

 

 

10,942

 

 

 

 

 

 

10,942

 

Weighted average yield

 

 

%

 

 

4.68

%

 

 

%

 

%

4.68

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3.6 years

 

Equity securities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

 

 

 

 

 

 

 

 

 

31,902

 

Weighted average yield

 

 

%

 

 

%

 

 

%

 

%

3.53

%

Total investment securities available for sale

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair value

 

 

$

50,169

 

 

 

$

522,557

 

 

 

$

134,429

 

 

$

102,596

 

$

841,653

 

Weighted average yield

 

 

3.80

%

 

 

4.10

%

 

 

5.43

%

 

5.91

%

4.49

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.6 years

 

Investment securities held to maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Obligations of other U.S. government agencies and corporations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortized cost

 

 

$

 

 

 

$

 

 

 

$

 

 

$

3,843

 

$

3,843

 

Weighted average yield

 

 

%

 

 

%

 

 

%

 

5.45

%

5.45

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12.5 years

 

Obligations of states and political subdivisions:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortized Cost

 

 

1,104

 

 

 

35,444

 

 

 

 

 

19,164

 

55,712

 

Weighted average yield(1)

 

 

9.02

%

 

 

6.84

%

 

 

%

 

6.28

%

6.69

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6.8 years

 

Total investment securities held to maturity:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortized Cost

 

 

$

1,104

 

 

 

$

35,444

 

 

 

$

 

 

$

23,007

 

$

59,555

 

Weighted average yield

 

 

9.02

%

 

 

6.84

%

 

 

%

 

6.15

%

6.61

%

Weighted average maturity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7.1 years

 


(1)          Weighted average yield on nontaxable investment securities is shown on a tax equivalent basis (tax rate of 35%).

24




Loans

Loans increased $140.0 million, or 7.6% in 2005, primarily attributed to growth in commercial real estate loans and home equity loans. The growth in real estate loans was due to the Bank’s strategy of growing real estate loans in its primary market. One of the Bank’s strategic objectives is to increase its loan to deposit ratio by growing its loan portfolio at a faster pace than its deposits. The planned reduction in lease financing was due to run-off and sales. Loans increased $437.4 million, or 31.1% in 2004, primarily due to growth in real estate loans and home equity loans and lines of credit along with $157.1 million in loans acquired in the acquisition of Millennium Bank.

The following table shows the composition of the Bank’s loans:

Table 3—Composition of Loan Portfolio

 

 

December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

Amount

 

Percent
of Loans

 

Amount

 

Percent
of Loans

 

Amount

 

Percent
of Loans

 

Amount

 

Percent
of Loans

 

Amount

 

Percent
of Loans

 

 

 

(Dollars in thousands)

 

Real estate

 

$

791,358

 

 

40

%

 

$

693,468

 

 

37

%

 

$

498,135

 

 

35

%

 

$

422,692

 

 

33

%

 

$

418,742

 

 

32

%

 

Commercial and industrial

 

479,238

 

 

24

%

 

473,514

 

 

26

%

 

385,554

 

 

27

%

 

376,406

 

 

27

%

 

349,849

 

 

26

%

 

Consumer

 

697,373

 

 

35

%

 

645,718

 

 

35

%

 

463,492

 

 

34

%

 

446,953

 

 

33

%

 

440,182

 

 

34

%

 

Lease financing

 

17,524

 

 

1

%

 

33,102

 

 

2

%

 

61,210

 

 

4

%

 

87,241

 

 

7

%

 

107,836

 

 

8

%

 

Total

 

$

1,985,493

 

 

100

%

 

$

1,845,802

 

 

100

%

 

$

1,408,391

 

 

100

%

 

$

1,333,292

 

 

100

%

 

$

1,316,609

 

 

100

%

 

 

The following table details outstanding loans by type as of December 31, 2005, in terms of contractual maturity date:

Table 4—Selected Loan Maturity Data

 

 

December 31, 2005

 

 

 

Due in
1 year or less

 

Due after
1 year
through 5 years

 

Due after
5 years

 

Total

 

 

 

(Dollars in thousands)

 

Real estate

 

 

$

100,625

 

 

 

$

319,756

 

 

$

370,977

 

$

791,358

 

Commercial and industrial

 

 

110,209

 

 

 

164,137

 

 

204,892

 

479,238

 

Consumer

 

 

291,924

 

 

 

170,589

 

 

234,860

 

697,373

 

Lease financing

 

 

17,524

 

 

 

 

 

 

17,524

 

Total

 

 

$

520,282

 

 

 

$

654,482

 

 

$

810,729

 

$

1,985,493

 

Loans with variable or floating interest
rates

 

 

$

361,463

 

 

 

$

135,948

 

 

$

293,791

 

$

791,202

 

Loans with fixed predetermined interest rates

 

 

158,819

 

 

 

518,534

 

 

516,938

 

1,194,291

 

Total

 

 

$

520,282

 

 

 

$

654,482

 

 

$

810,729

 

$

1,985,493

 

 

25




The following table details those loans that were placed on nonaccrual status, or were delinquent by 90 days or more and still accruing interest:

Table 5—Nonaccrual Loans and Loans 90 Days or more Past Due Accruing Interest

 

 

December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

Nonaccrual loans

 

$

7,493

 

$

4,705

 

$

3,343

 

$

5,109

 

$

6,354

 

Loans 90 days or more past due accruing interest

 

846

 

981

 

1,164

 

1,193

 

1,926

 

Total

 

$

8,339

 

$

5,686

 

$

4,507

 

$

6,302

 

$

8,280

 

 

The Bank had no concentration of loans to individual borrowers which exceeded 10% of total loans at December 31, 2005 and 2004. The Bank actively monitors the risk of this loan concentration. The Bank had no foreign loans, and the impact of nonaccrual and delinquent loans on total interest income was not material.

A loan is generally classified as nonaccrual when principal or interest has consistently been in default for a period of 90 days or more, when there has been deterioration in the financial condition of the borrower, or payment in full of principal or interest is not expected. Delinquent loans past due 90 days or more and still accruing interest are loans that are generally well-secured and expected to be restored to a current status in the near future.

Nonperforming assets (including nonaccrual loans, net assets in foreclosure and loans 90 days or more past due) was .27% of total assets at December 31, 2005, compared to 0.20% at December 31, 2004 and 0.22% at December 31, 2003. The ratio of nonperforming loans to total net loans was 0.42% at December 31, 2005, compared to 0.31% at December 31, 2004 and 0.32% at December 31, 2003.

Nonaccruing loans increased $2.8 million to $7.5 million at December 31, 2005, as compared to December 31, 2004. The increase was primarily due to commercial mortgage loans for one borrower totaling $1.5 million and commercial business loans for four borrowers totaling $1.1 million which were placed on nonaccrual of interest. Nonaccruing loans increased $1.3 million to $4.7 million at December 31, 2004, in comparison to December 31, 2003. The increase in nonaccruing loans was primarily the result of increases in nonaccruing commercial real estate loans of $1.4 million and commercial and industrial loans of $514,000 partially offset by decreases in nonaccruing residential real estate loans of $443,000. The increase in nonaccruing commercial real estate consists primarily of two loans to one borrower in the amount of $1.3 million. The Bank’s policy for interest income recognition on nonaccrual loans is to recognize income under the cash basis when the loans are both current and the collateral on the loan is sufficient to cover the outstanding obligation to the Bank. The Bank will not recognize income if these factors do not exist. During 2005, interest accrued on nonaccruing loans and not recognized as interest income was $310,000 and interest paid on nonaccruing loans of $250,000 was recognized as interest income. During 2004, interest accrued on nonaccruing loans and not recognized as interest income was $238,000 and interest paid on nonaccruing loans of $47,000 was recognized as interest income.

Net assets in foreclosure were $29,000 at December 31, 2005, a decrease of $341,000 from December 31, 2004. During 2005, transfers from loans to assets in foreclosure were $288,000, disposals on foreclosed properties were $466,000, and charge offs of $123,000 were recorded. The December 31, 2004 net assets in foreclosure balance of $370,000, decreased $565,000 from December 31, 2003. During 2004, transfers from loans to assets in foreclosure were $586,000, disposals on foreclosed properties were $1.1 million, and charge offs of $66,000 were recorded. Efforts to liquidate assets acquired in foreclosure proceed as quickly as potential buyers can be located and legal constraints permit. Foreclosed assets are

26




carried at the lower of cost (lesser of carrying value of the asset or fair value at date of acquisition) or estimated fair value.

Loans past due 90 days or more and still accruing interest are loans that are generally well secured and are in the process of collection. As of December 31, 2005, loans past due 90 days or more and still accruing interest were $846,000, compared to $981,000 at December 31, 2004 and $1.2 million at December 31, 2003.

The Bank uses the reserve method of accounting for loan losses. The balance in the allowance for loan losses is determined based on management’s review and evaluation of the loan portfolio in relation to past loss experience, the size and composition of the portfolio, current economic events and conditions, and other pertinent factors, including management’s assumptions as to future delinquencies, recoveries and losses. Increases to the allowance for loan losses are made by charges to the provision for loan losses. The allowance for loan losses increased $1.4 million, or 7.6%, to $19.9 million at December 31, 2005 as compared to December 31, 2004. The increase in the allowance was primarily due to loan growth and the increase in nonperforming loans of $2.7 million. The allowance for loan losses increased $1.7 million, or 10.2%, to $18.5 million at December 31, 2004 as compared to December 31, 2003. The increase in the allowance was primarily due to loan growth and the increase in nonperforming loans of $1.2 million.

Table 6—Nonperforming Assets

 

 

December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

Nonaccrual loans

 

$

7,493

 

$

4,705

 

$

3,343

 

$

5,109

 

$

6,354

 

Loans 90 days or more past due

 

846

 

981

 

1,164

 

1,193

 

1,926

 

Total nonperforming loans

 

8,339

 

5,686

 

4,507

 

6,302

 

8,280

 

Net assets in foreclosure

 

29

 

370

 

935

 

390

 

609

 

Total nonperforming assets

 

$

8,368

 

$

6,056

 

$

5,442

 

$

6,692

 

$

8,889

 

Allowance for loan losses to nonperforming
loans

 

238.2

%

324.6

%

371.7

%

272.8

%

187.9

%

Nonperforming loans to total loans

 

0.42

%

0.31

%

0.32

%

0.47

%

0.63

%

Allowance for loan losses to total loans

 

1.00

%

1.00

%

1.19

%

1.29

%

1.18

%

Nonperforming assets to total assets

 

0.27

%

0.20

%

0.22

%

0.27

%

0.40

%

 

27




Allowance for Loan Losses

A summary of the activity in the allowance for loan losses is as follows:

Table 7—Allowance for Loan Losses

 

 

December 31,

 

 

 

2005

 

2004

 

2003

 

2002

 

2001

 

 

 

(Dollars in thousands)

 

Average loans

 

$

1,900,023

 

$

1,625,419

 

$

1,354,127

 

$

1,333,300

 

$

1,264,750

 

Allowance, beginning of
period

 

18,455

 

16,753

 

17,190

 

15,558

 

15,210

 

Loans charged off:

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

353

 

522

 

515

 

108

 

494

 

Consumer

 

2,123

 

1,921

 

2,173

 

2,589

 

2,594

 

Real estate

 

383

 

208

 

1,311

 

352

 

498

 

Lease financing

 

188

 

883

 

556

 

828

 

1,075

 

Total loans charged off

 

3,047

 

3,534

 

4,555

 

3,877

 

4,661

 

Recoveries:

 

 

 

 

 

 

 

 

 

 

 

Commercial and industrial

 

66

 

58

 

33

 

105

 

38

 

Consumer

 

586

 

496

 

685

 

786

 

607

 

Real estate

 

326

 

307

 

80

 

163

 

328

 

Lease financing

 

78

 

143

 

120

 

85

 

106

 

Total recoveries

 

1,056

 

1,004

 

918

 

1,139

 

1,079

 

Net loans charged off

 

1,991

 

2,530

 

3,637

 

2,738

 

3,582

 

Reserve from Millennium Bank acquisition

 

 

1,677

 

 

 

 

Provision for loan losses

 

3,401

 

2,555

 

3,200

 

4,370

 

3,930

 

Allowance, end of period

 

$

19,865

 

$

18,455

 

$

16,753

 

$

17,190

 

$

15,558

 

Ratio of net charge offs to average loans outstanding