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Lake Shore Bancorp 10-K 2006
Form 10-K
Table of Contents

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

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No.: 000-51821

Lake Shore Bancorp, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

United States   Pending

(State or Other Jurisdiction

of Incorporation or Organization)

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

125 East Fourth Street, Dunkirk, NY 14048

(Address of Principal Executive Offices, including zip code)

(716) 366-4070

(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, $.01 par value per share

Indicate by check mark if the registrant is a well-know seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes  ¨    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  ¨    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  ¨    No  x

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. x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨                    Accelerated filer  ¨                    Non-accelerated filer  x

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

No shares of the registrant’s common stock, $.01 par value per share were outstanding at March 31, 2006.

DOCUMENTS INCORPORATED BY REFERENCE: None

 



Table of Contents

LAKE SHORE BANCORP, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED

DECEMBER 31, 2005

TABLE OF CONTENTS

 

ITEM         PAGE
   PART I   

1

   BUSINESS    1

1A

   RISK FACTORS    39

1B

   UNRESOLVED STAFF COMMENTS    42

2

   PROPERTIES    42

3

   LEGAL PROCEEDINGS    43

4

   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS    43
   PART II   

5

   MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES    44

6

   SELECTED FINANCIAL DATA    45

7

   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    47

7A

   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    58

8

   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA    59

9

   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE    60

9A

   CONTROLS AND PROCEDURES    60

9B

   OTHER INFORMATION    60
   PART III   

10

   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT    61

11

   EXECUTIVE COMPENSATION    64

12

   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS    67

13

   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS    67

14

   PRINCIPAL ACCOUNTING FEES AND SERVICES    67
   PART IV   

15

   EXHIBITS, FINANCIAL STATEMENT SCHEDULES    69
   SIGNATURES    71


Table of Contents

PART I

 

Item 1. Business

General

Lake Shore Savings and Loan Association is currently in the process of reorganizing from a New York State-chartered mutual savings and loan association into the federal mutual holding company form of organization. In connection with the reorganization, Lake Shore Savings and Loan Association will change its name to Lake Shore Savings Bank. When used herein, the name “Lake Shore Savings” refers to either Lake Shore Savings and Loan Association or Lake Shore Savings Bank, as context requires.

Lake Shore Bancorp, Inc. has not engaged in any business to date. Upon completion of the reorganization, Lake Shore Bancorp will be a federally-chartered corporation and will be registered as a savings and loan holding company with the Office of Thrift Supervision (“OTS”). Lake Shore Savings will become a wholly-owned subsidiary of Lake Shore Bancorp. In connection with the reorganization, Lake Shore Bancorp offered 2,975,625 shares of its common stock to the public, representing 45% of its to-be outstanding shares, at $10.00 per share. The remaining 3,636,875 shares, or 55% of the outstanding shares of Lake Shore Bancorp, will be issued to Lake Shore, MHC. Lake Shore, MHC, will be a federal mutual holding company registered as a savings and loan holding company with the OTS. Lake Shore, MHC will not engage in any business activity other than its investment in a majority of the common stock of Lake Shore Bancorp. Federal law and regulations require that as long as Lake Shore, MHC is in existence, it must own at least a majority of Lake Shore Bancorp’s common stock.

Lake Shore Bancorp will contribute 50% of the net proceeds to Lake Shore Savings. Lake Shore Bancorp’s common stock will be quoted on the National Market System of the Nasdaq Stock Market under the symbol “LSBK.” We expect the reorganization and offering to be completed in early April 2006.

At December 31, 2005, Lake Shore Savings had total assets of $333.7 million, of which $206.2 million was comprised of loans receivable and $94.1 million was comprised of available for sale securities. At December 31, 2005, total deposits were $250.9 million and total equity was $28.0 million.

Our principal business consists of attracting retail deposits from the general public in the areas surrounding our corporate headquarters in Dunkirk, New York and eight branch offices in Chautauqua and Erie Counties, New York and investing those deposits, together with funds generated from operations, primarily in one- to four-family residential mortgage loans, home equity loans and lines of credit and commercial real estate loans and, to a lesser extent, commercial business loans, consumer loans, and investment securities. Our revenues are derived principally from interest on loans and securities. We also generate revenues from fees and service charges and other income. Our primary sources of funds are deposits, borrowings and principal and interest payments on loans and securities.

For 115 years we have served the local community of Dunkirk, New York. Lake Shore Savings was chartered as a New York savings and loan association in 1891. In 1987, we opened our second office in Fredonia, New York. Since 1993, we have tripled our asset-size and expanded to eight branch offices. In addition, we have added three administrative office buildings which comprise our corporate headquarters in Dunkirk, New York.

We are a community and customer oriented savings bank that offers residential real estate mortgage loans, including home equity loans, consumer loans, commercial real estate loans, and commercial loans as well as traditional deposit products. We purchase securities issued by the U.S.

 

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Government and government agencies, municipal securities, mortgage-backed and asset-backed securities and other investments permitted by applicable laws and regulations. Our revenues are derived principally from interest generated from our loans and interest earned and dividends paid on our investment securities. Our primary sources of funds for lending and investments are deposits, payments of loan principal, payments on mortgage-backed and asset-backed securities, maturities and calls of investment securities and income resulting from operations in prior periods.

Available Information

Lake Shore Bancorp’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, will be made available free of charge on our website, www.lakeshoresavings.com, as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission. Such reports will also be available on the Securities and Exchange Commission’s website at www.sec.gov. Information on our website shall not be considered a part of this Form 10-K.

 

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Market Area

Our operations are conducted out of our corporate headquarters in Dunkirk, New York and eight branch offices. Our branches are located in Dunkirk, Fredonia, Jamestown, Lakewood and Westfield in Chautauqua County, New York. In Erie County, New York our branch offices are located in Orchard Park, East Amherst and Hamburg, which opened in April and August of 2003 and December of 2005, respectively. We also have four stand-alone ATMs. The opening of the Orchard Park, East Amherst and Hamburg offices demonstrates the implementation of our growth strategy which is focused on expansion within Erie County while preserving our market share in Chautauqua County. We believe we are among the top residential mortgage lenders in Chautauqua County.

Our geographic market area for loans and deposits is principally Chautauqua and Erie Counties, New York. Additionally, Cattaraugus County, New York is part of our designated lending area, although we have no branches in the market area. Northern Chautauqua County is located on Lake Erie in the western portion of New York and is approximately 45 miles from Buffalo, New York. There are multiple prime industrial and building sites in this county and a skilled and productive labor force. Northern Chautauqua County is served by three accredited hospitals and offers higher education opportunities. We have lending and deposit relationships with such institutions. Southern Chautauqua County is more of a tourist attraction, featuring Chautauqua Lake, but it also hosts a broad diversity of industry, commercial establishments and financial institutions as well as a skilled and productive workforce. Jamestown, New York, where we opened the first of two branch offices in 1996, is the most populous city in Chautauqua County. It is also the ninth largest metropolitan region in the State of New York.

Erie County is a metropolitan center located on the western border of New York covering 1,058 square miles. Located within Erie County is the city of Buffalo, the second largest city in the State of New York. As the city of Buffalo has redeveloped, so too have its suburbs throughout Erie County, which also host the Buffalo Niagara International Airport in Cheektowaga, New York and professional sports franchises. One of the main commercial thorough-fares in Erie County is Transit Road, which has experienced robust development in recent years and is the location of our East Amherst branch office. Our newest branch office, which opened in December 2005, is in Hamburg, New York, also located in Erie County.

The demographic characteristics of our market area are less attractive than national and state measures. Both Chautauqua and Erie Counties exhibit slower rates of population growth when compared to the United States and New York State averages. In addition, both Chautauqua and Erie Counties have lower per capita income and slower growth in per capita income when compared to the United States and the New York State averages. Since Chautauqua County has historically exhibited less attractive demographic characteristics, Lake Shore Savings may have limited growth opportunities in Chautauqua County. However, Erie County displays a stronger housing market and Erie County’s population base is five times larger than Chautauqua County, which may offer Lake Shore a new source of customers in the form of deposit and lending opportunities. Notwithstanding these demographic characteristics, our primary market area has historically been stable, with a diversified base of employers and employment sectors. The local economies that we serve are not dependent on one key employer. Transportation equipment is the largest manufacturing industry in the Buffalo area, as well as production of component parts. The principal employment sectors are service-related (excluding financial), wholesale and retail trade, and durable-goods manufacturing. Similar to national trends, most of the job growth currently realized in Chautauqua and Erie Counties has been in service-related industries, and service jobs now account for the largest portion of the workforce.

 

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The following table compares the historical population and per capita income levels and growth rates for Chautauqua and Erie Counties, New York State and the United States.

 

     Year    Growth Rate  
     2000    2005    2000-2005  

Population (in thousands)

        

United States

     281,422      298,728    1.2 %

New York State

     18,976      19,412    0.5 %

Chautauqua County

     140      139    -0.1 %

Erie County

     950      948    0.0 %

Per Capita Income

        

United States

   $ 21,586    $ 26,228    4.0 %

New York State

     23,389      28,677    4.2 %

Chautauqua County

     16,840      20,058    3.6 %

Erie County

     20,357      24,506    3.8 %

Sources: SNL Financial, L.C. and ESRI Business Information Solutions

Our future growth will be influenced by opportunities and stability in our regional economy, other demographic trends and the competitive environment. We believe that we have developed lending products and marketing strategies to address the credit-related needs of the residents in our local market area.

Competition

We face intense competition both in making loans and attracting deposits. New York has a high concentration of financial institutions, many of which are branches of large money centers and regional banks which have resulted from the consolidation of the banking industry in New York and surrounding states. Some of these competitors have greater resources than we do and may offer services that we do not provide. For example, we do not offer trust or investment services. Customers who seek “one stop shopping” may be drawn to our competitors who offer such services.

Our competition for loans comes principally from commercial banks, savings institutions, mortgage banking firms, credit unions, finance companies, insurance companies, and brokerage and investment banking firms. The most direct competition for deposits has historically come from credit unions, commercial banks, savings banks and savings and loan associations. Specifically, we compete with regional financial institutions such as Greater Buffalo Savings Bank, Jamestown Savings Bank and Evans National Bank; state-wide financial institutions such as Manufacturers and Traders’ Trust Company (M&T Bank) and Key Bank; and nation-wide financial institutions such as HSBC Bank USA and Bank of America. We are significantly smaller than institutions like Bank of America, HSBC Bank USA and Key Bank. We face additional competition for deposits from short-term money market funds, corporate and government securities funds, and from brokerage firms, mutual funds and insurance companies.

To remain competitive, we provide superior customer service and are active participants in our local community. The following are examples of our commitment to customer service:

 

    We have built additional branch offices to both grow our customer base and to provide greater convenience to our existing customers.

 

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    In 1999, we began offering a Direct Access Secure Hotline (“DASH”) with 24 hour 7 days a week access to all customer accounts via telephone access.

 

    In 2001, we added a Secure Account Management (“SAM”) on-line banking website allowing customers instant access via the internet. We have continued to upgrade our on-line banking as technology evolves and now offer check imaging through our website.

 

    Customers with a Smart Account, which is a checking account, Free & Easy Checking or Money Market Checking, may have a “Navigator Card,” our no-annual fee ATM/Debit card which may be used at ATM machines throughout Chautauqua and Erie Counties for deposits and withdrawals and as a debit card anywhere MasterCard is accepted.

 

    In 2003, we entered into alliances with Key Bank, NA and Evans National Bank to provide customers free access to their accounts with us through the ATMs of these institutions as well as our own.

 

    We have continued to upgrade our corporate headquarters and established branches, our ATMs and drive-through facilities to ensure that we are providing a high level of customer satisfaction.

 

    Recently, we have added six new mortgage loan products: 5/1, 7/1 and 7/23 adjustable rate mortgages, an 80/10/10 loan, which is a combined mortgage and home equity product, a construction end loan and an FHA 203(b) loan product.

 

    In our last three Community Reinvestment Act evaluations by the Office of Thrift Supervision, most recently concluding on November 17, 2004, we consistently received an “Outstanding” rating.

 

    During 2005, online bill pay was added as a new service for our customers.

Lending Activities

General. We have a long-standing commitment to the origination of residential mortgage loans, including home equity loans, and we also originate commercial real estate, commercial and consumer loans. We currently retain substantially all of the loans that we originate; however, we have sold and may in the future sell residential mortgage and student loans into the secondary market, retaining servicing rights for the residential mortgage loans. At December 31, 2005, we had total loans of $206.2 million, of which $148.2 million, or 71.8%, were one-to-four family residential mortgages. Of residential mortgage loans outstanding at that date, 6.0% were adjustable-rate mortgage loans and 94.0%were fixed rate loans. At December 31, 2005, 13.9% of the loan portfolio was comprised of home equity loans, of which 80.0% were adjustable rate mortgage loans and 20.0% were fixed rate loans. The remainder of our loans at December 31, 2005, amounting to $29.4 million, or 14.3% of total loans, consisted of 8.2% commercial real estate loans, 0.8% construction loans, 4.0% commercial loans and 1.3% consumer loans, which includes personal loans, home improvement loans, overdraft lines of credit, automobile loans and guaranteed student loans.

 

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Our loans are subject to federal and state laws and regulations. The Office of Thrift Supervision has been and will continue to be our primary federal regulator. We have also been subject to regulation by the New York State Banking Department, which will cease once we have completed the reorganization to a federal savings bank charter. The interest rates we offer for loans are affected principally by the demand for loans, the supply of money available for lending purposes and the interest rates offered by our competitors. These factors are, in turn, affected by general and local economic conditions, monetary policies of the federal government, including the Federal Reserve Board and legislative tax policies.

 

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Loan Portfolio. The following table sets forth the composition of our loan portfolio, by type of loan, in dollar amounts and in percentages at the dates indicated.

 

     At December 31,  
     2005     2004     2003     2002     2001  
     Amount     Percent
of Total
    Amount     Percent
of Total
    Amount     Percent
of Total
    Amount     Percent
of Total
    Amount     Percent
of Total
 
     (Dollars in thousands)  

Mortgage loans:

                    

One-to-four family

   $ 148,172     71.85 %   $ 142,222     71.14 %   $ 135,293     72.12 %   $ 107,115     68.01 %   $ 99,542     68.51 %

Commercial real estate

     16,827     8.16       15,310     7.66       14,628     7.80       13,628     8.65       10,866     7.48  

Construction loans

     1,635     0.79       2,463     1.23       2,531     1.35       3,300     2.10       2,739     1.88  

Home equity loans and lines of credit

     28,624     13.88       28,442     14.23       25,876     13.79       23,742     15.07       21,085     14.51  
                                                                      
     195,258     94.68       188,437     94.26       178,328     95.06       147,785     93.83       134,232     92.38  
                                                                      

Other loans:

                    

Commercial loans

     8,264     4.00       8,615     4.30       5,957     3.18       6,229     3.96       7,338     5.05  

Consumer loans

     2,712     1.32       2,870     1.44       3,310     1.76       3,482     2.21       3,734     2.57  
                                                                      
     10,976     5.32       11,485     5.74       9,267     4.94       9,711     6.17       11,072     7.62  
                                                                      

Total loans

     206,234     100.00 %     199,922     100.00 %     187,595     100.00 %     157,496     100.00 %     145,304     100.00 %
                                        

Less:

                    

Deferred loan costs

     1,166         891         836         461         220    

Allowance for loan losses

     (1,240 )       (1,288 )       (1,293 )       (1,217 )       (924 )  
                                                  

Loans, net

   $ 206,160       $ 199,525       $ 187,138       $ 156,740       $ 144,600    
                                                  

 

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Loan Maturity. The following table presents the contractual maturity of our loans at December 31, 2005. The table does not include the effect of prepayments or scheduled principal amortization. Loans having no stated repayment schedule or maturity and overdraft loans are reported as being due in one year or less.

 

    

Real Estate

One-to-Four

Family

  

Real
Estate

Commercial

   Home
Equity
   Construction    Commercial    Consumer    Total
     (Dollars in thousands)

Amounts due in:

                    

One year or less

   $ 67    $ 3    $ 115    $ 90    $ 62    $ 1,130    $ 1,467

After one year

through five years

     1,749      704      1,988           2,602      694      7,737

Beyond five years

     146,356      16,120      26,521      1,545      5,600      888      197,030
                                                

Total

   $ 148,172    $ 16,827    $ 28,624    $ 1,635    $ 8,264    $ 2,712    $ 206,234
                                                

Interest rate terms on amounts due after one year:

                    

Fixed rate

   $ 139,302    $ 7,343    $ 5,757    $ 692    $ 6,028    $ 1,322      160,444

Adjustable rate

     8,803      9,481      22,752      853      2,174      260      44,323
                                                

Total

   $ 148,105    $ 16,824    $ 28,509    $ 1,545    $ 8,202    $ 1,582    $ 204,767
                                                

 

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The following table presents our loan originations, purchases, sales, and principal payments for the periods indicated.

 

     For the Year Ended
December 31,
     2005    2004    2003    2002    2001
     (Dollars in thousands)

Total loans:

              

Balance outstanding at beginning of period

   $ 199,922    $ 187,595    $ 157,496    $ 145,304    $ 129,788
                                  

Originations:

              

Mortgage loans

     36,504      40,737      85,146      52,320      43,921

Commercial and consumer loans

     7,067      8,819      6,595      4,049      7,717
                                  

Total originations

     43,571      49,556      91,741      56,369      51,638
                                  

Deduct:

              

Principal repayments:

              

Mortgage loans

     30,498      31,235      47,877      39,850      29,755

Commercial and

consumer loans

     6,141      4,724      8,080      3,541      5,447
                                  

Total principal payments

     36,639      35,959      55,957      43,391      35,202
                                  

Transfers to foreclosed

real estate

     118      374      761      302      373

Loan sales – Sonyma(1) and Freddie Mac Freddie Mac

     —        —        4,046      —        —  

Loan sales – guaranteed student loans

     419      592      603      405      354

Loans charged off

     83      304      275      79      193
                                  

Total deductions

     37,259      37,229      61,642      44,177      36,122
                                  

Balance outstanding at end of period

   $ 206,234    $ 199,922    $ 187,595    $ 157,496    $ 145,304
                                  

(1) State of New York Mortgage Agency.

Residential Mortgage Lending. We emphasize the origination of residential mortgage loans secured by one-to-four family properties. At December 31, 2005, loans on one-to-four family residential properties accounted for $148.2 million, or 71.8%, of our total loan portfolio. Of residential mortgage loans outstanding on that date and at December 31, 2004, 6.0% and 5.7%, respectively of our loans were adjustable rate mortgage loans and 94.0% and 94.3%, respectively, were fixed rate loans. At December 31, 2005, approximately 83% of our residential mortgage portfolio was secured by property located in Chautauqua County, 15% by property located in Erie County and 2% by property located elsewhere. Approximately 7.5% of all residential loan originations during fiscal 2005 were refinancings of loans already in our portfolio.

Our loan originations are from customers, residents of our local communities or referrals from local real estate agents, attorneys and builders. Management believes that the Erie County branch offices could be a significant source of new loan generation. Following the reorganization, we may seek to expand residential lending activities with the proceeds received in the offering primarily through the origination of residential mortgage and commercial real estate loans. Management believes that expanding our residential mortgage lending will continue to enhance our reputation as a service-oriented institution particularly in Erie County, where we are actively developing and expanding our market presence.

 

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Residential mortgage loan originations are generally for terms of 15, 20 or 30 years, amortized on a monthly basis with interest and principal due either bi-weekly or monthly. Residential real estate loans may remain outstanding for significantly shorter periods than their contractual terms as borrowers may refinance or prepay loans at their option without penalty. Conventional residential mortgage loans originated by us customarily contain “due-on-sale” clauses that permit us to accelerate the indebtedness of the loan upon transfer of ownership of the mortgaged property. We do not offer 40-year mortgage loans, “interest only” mortgage loans or “negative amortization” mortgage loans.

Our residential lending policies and procedures ensure that our residential mortgage loans generally conform to secondary market guidelines. We originate residential mortgage loans with a loan to value ratio up to 97%. Mortgages originated with a loan-to-value ratio exceeding 80% normally require private mortgage insurance. Private mortgage insurance is not required on loans with an 80% or less loan to value ratio.

We offer adjustable rate mortgage loans with a maximum term of 30 years. Our adjustable rate mortgage loans include loans that provide for an interest rate based on the interest paid on U.S. treasury securities of varying maturities plus varying margins. We currently offer adjustable rate mortgage loans with initial rates below those which would prevail under the foregoing computation, based upon a determination of market factors and competitive rates for adjustable-rate loans in our market area. For adjustable rate mortgage loans, borrowers are qualified at the initial fully indexed rate.

Our adjustable rate mortgage loans include limits on increases or decreases in the interest rate of the loan. The interest rate may increase or decrease by a maximum of 2% or 5% per adjustment period with a ceiling rate of 6% over the life of the loan. The retention of adjustable rate mortgage loans in our loan portfolio helps reduce exposure to changes in interest rates. However, there are unquantifiable credit risks resulting from potential increased costs to the borrower as a result of the pricing of adjustable rate mortgage loans. During periods of rising interest rates, the risk of default on adjustable rate mortgage loans may increase due to the increase of interest cost to the borrower.

We regularly provide a loan product to our customers that is underwritten using the same criteria required by the State of New York Mortgage Agency for its own loan products. After a loan is originated and funded, we may sell the loan to the State of New York Mortgage Agency. We have also sold loans to the Federal Home Loan Mortgage Corporation in the past and may do so again, from time to time. We retain all servicing rights for residential mortgage loans that we sell.

Home Equity Loans and Lines of Credit. We provide home equity loans and home equity lines of credit to our customers. We offer a home equity loan or line of credit with a minimum balance of $5,000 up to a maximum of 90% of the total loan to value ratio. Home equity lines of credit products, which have interest rates tied to prime, generally have a 15 year draw period and a 15 year payback period. Fixed rate home equity loans range from terms of 5 to 15 years. These loans, as a group, totaled $28.6 million and $28.4 million at December 31, 2005 and 2004, respectively. Approximately 80.0% of such loans have adjustable rates and 20.0% have fixed rates. At December 31, 2005 and 2004, such loans constituted 13.9% and 14.2% of our total loan portfolio.

Commercial Real Estate Loans. We originate commercial real estate loans to finance the purchase of real property, which generally consists of developed real estate. In underwriting commercial real estate loans, consideration is given to the property’s historic cash flow, current and projected occupancy, location, and physical condition. At December 31, 2005 and 2004, our commercial real estate loan portfolio consisted of loans totaling $16.8 million and $15.3 million respectively, or 8.2% and 7.7%, respectively, of total loans. Of the commercial real estate portfolio at December 31, 2005, approximately 87% consisted of loans that are collateralized by properties in Chautauqua County and 13% by properties in Erie County. Our commercial real estate loan portfolio is diverse and does not have any significant loan concentration by type of industry or borrower. We lend up to a maximum loan-to-value ratio of 80%

 

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on commercial properties and require a minimum debt coverage ratio of 1.2 to 1. Commercial real estate lending involves additional risks compared with one-to-four family residential lending. Because payments on loans secured by commercial real estate properties are often dependent on the successful operation or management of the properties, and/or the collateral value of the commercial real estate securing the loan, repayment of such loans may be subject, to a greater extent, to adverse conditions in the real estate market or economic conditions. Also, commercial real estate loans typically involve large loan balances to single borrowers or groups of related borrowers. Our loan policies limit the amount of loans to a single borrower or group of borrowers to reduce this risk and are designed to set such limits within those prescribed by applicable federal and state statutes and regulations.

Construction Loans. We originate loans to finance the construction of both one-to-four family homes and commercial real estate. These loans typically have a one-year construction period, whereby draws are taken and interest only payments are made. As part of the draw process, inspection and lien checks are required prior to the disbursement of the proceeds. At the end of the construction period, the loan automatically converts to either a conventional or commercial mortgage, as applicable. At December 31, 2005 and 2004, our construction loan portfolio consisted of loans totaling $1.6 million and $2.5 million, respectively, or 0.8% and 1.2%, respectively, of total loans.

Commercial Loans. In addition to commercial real estate loans, we also engage in small business commercial lending, including business installment loans, lines of credit, and other commercial loans. We have fewer than 10 loans with balances in excess of $1.0 million and the average commercial loan is for a principal amount ranging from $100,000 to $300,000. At December 31, 2005 and 2004, our commercial loan portfolio consisted of loans totaling $8.3 million and $8.6 million, respectively, or 4.0% and 4.3%, respectively, of total loans. Many commercial loans have variable interest rates tied to the prime rate, and are for terms generally not in excess of 15 years. Whenever possible, we collateralize these loans with a lien on business assets and equipment and the personal guarantees from principals of the borrower. Interest rates on commercial loans generally have higher yields than residential mortgages. We offer commercial loan services designed to give business owners borrowing opportunities for modernization, inventory, equipment, construction, consolidation, real estate, working capital, vehicle purchases, and the refinancing of existing corporate debt.

Commercial loans are generally considered to involve a higher degree of risk than residential mortgage loans because the collateral underlying the loans may be in the form of intangible assets and/or inventory subject to market obsolescence. Commercial loans may also involve relatively large loan balances to single borrowers or groups of related borrowers, with the repayment of such loans typically dependent on the successful operation and income stream of the borrower. Such risks can be significantly affected by economic conditions. In addition, commercial business lending generally requires substantially greater oversight efforts compared to residential real estate lending. We conduct on-site reviews of the commercial loan portfolio to ensure adherence to our underwriting standards and policy requirements.

Consumer Loans. We offer a variety of consumer loans. At December 31, 2005 and 2004, our consumer loan portfolio totaled $2.7 million and $2.9 million, respectively, or 1.3% and 1.4%, respectively, of total loans. The largest component of our consumer loan portfolio are personal consumer loans and overdraft lines of credit, which are available for amounts up to $5,000 for unsecured loans and greater amounts for secured loans depending on the type of loan and value of the collateral. Consumer loans, excluding overdraft lines of protection, generally are offered for terms of up to 10 years, depending on the collateral, at fixed interest rates. Our consumer loan portfolio also consists of:

 

    new and used automobile loans;

 

    recreational vehicle loans;

 

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    motorcycle loans;

 

    guaranteed student loans;

 

    other unsecured consumer loans up to $3,500;

 

    secured and unsecured property improvement loans; and

 

    other secured loans.

Generally, the volume of consumer lending has declined as borrowers have opted for home equity lines, where a mortgage-interest federal tax deduction is available, as compared to unsecured loans or loans secured by property other than residential real estate. We continue to make automobile loans directly to the borrowers and primarily on used vehicles. We also maintain a portfolio of guaranteed student loans. Our student loans are typically resold to the Student Loan Marketing Association, Sallie Mae, when the loans go into repayment. We make other consumer loans, which may or may not be secured. The terms of such loans vary depending on the collateral.

Consumer loans are generally originated at higher interest rates than residential mortgage loans but also tend to have a higher credit risk due to the loans being either unsecured or secured by rapidly depreciable assets. Despite these risks, our level of consumer loan delinquencies generally has been low. No assurance can be given, however, that our delinquency rate or losses will continue to remain low in the future.

Loan Approval Procedures and Authority. Our lending policies are established by our Board of Directors. Currently, our President and Chief Executive Officer and Executive Vice President, Chief Operating and Commercial Officer have authority to approve loans for principal amounts of up to $100,000. Loans in excess of $100,000 in principal amount, but less than $500,000 must be approved by the Executive Committee of our Board of Directors, which meets once a month. Loans with principal amounts in excess of $500,000 must be reviewed and approved by a vote of our Board of Directors, which meets once a month. Additionally, branch managers are granted authority to approve loans, mainly consumer loans, in smaller amounts deemed appropriate by our Board of Directors.

Current Lending Procedures. Upon receipt of a completed loan application from a prospective borrower, we order a credit report and verify certain other information. If necessary, we obtain additional financial or credit related information. We require an appraisal for all mortgage loans, including loans made to refinance existing mortgage loans. Appraisals are performed by licensed third-party appraisal firms that have been approved by our Board of Directors. We require title insurance on all secondary market mortgage loans and certain other loans. We also require borrowers to obtain hazard insurance, and if applicable, we may require borrowers to obtain flood insurance prior to closing. Based on loan to value ratios and lending guidelines, escrow accounts may be required for such items as real estate taxes, hazard insurance, flood insurance, and private mortgage insurance premiums.

Asset Quality

One of our key operating objectives has been, and continues to be, maintaining a high level of asset quality. Our high proportion of one-to-four family mortgage loans, the maintenance of sound credit standards for new loan originations and loan administration procedures have resulted in historically low delinquency ratios. These factors have contributed to our strong financial condition.

 

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Collection Procedures. We have adopted a loan collection policy to maintain adequate control on the status of delinquent loans and to ensure compliance with the Fair Debt Collection Practices Act. When a borrower fails to make required payments on a residential or commercial loan, we take a number of steps to induce the borrower to cure the delinquency and restore the loan to a current status. Our collections department documents every time a borrower is contacted either by phone or in writing and maintains records of all collection efforts. Once an account becomes delinquent for 15 days, a late notice is mailed to the borrower and any guarantors on a loan. A second notice is mailed following the 30th day of delinquency. At this time, we also directly contact the borrower. Such contact may be repeated if a loan is delinquent between 60-89 days.

Once a residential loan has been delinquent for 90 days or more, the loan is deemed a “classified asset” and is reported to our board of directors. A final letter is sent to the borrower demanding payment in full by a certain date. Failure to pay after 90 days of the original due date generally results in legal action, notwithstanding ongoing collection. In the case of a secured loan, the collateral is reviewed to determine whether its possession would be cost-effective for us. In cases where the collateral fails to fully secure the loan, we may also sue on the note and not just repossess any collateral.

If a commercial loan has been delinquent for 30 days or more, the loan file is reviewed for classification, and the borrower is contacted. If a commercial loan is 90 days or more past due, the loan is considered non-performing. If the delinquency continues, the borrower is advised of the date that the delinquency must be cured, or the loan is considered to be in default. Foreclosure procedures will begin on loans secured by real estate, and all other legal remedies are pursued.

The collection procedures for consumer loans include the sending of periodic late notices and letters to a borrower once a loan is past due. On a monthly basis, a review is made of all consumer loans which are 30 days or more past due. Consumer loans that are 180 days delinquent, where the borrowers have failed to demonstrate repayment ability, are classified as loss and charged-off. Once a charge-off decision has been made, the collections manager or management pursues legal action such as small claims court, judgments, salary garnishment, repossessions and attempt to collect the deficiency from the borrower.

Loans Past Due and Non-performing Assets. We define non-performing loans as loans that are either non-accruing or accruing whose payments are 90 days or more past due. Non-performing assets, including non-performing loans and foreclosed real estate, totaled $1.5 million at December 31, 2005 and $934,000 at December 31, 2004.

 

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The following table presents information regarding our non-accrual loans, accruing loans delinquent 90 days or more, and foreclosed real estate as of the dates indicated.

 

     At
December 31,
 
     2005     2004     2003     2002     2001  
     (Dollars in thousands)  

Loans past due 90 days or more but still accruing:

          

Mortgage loans on real estate:

          

One-to-four family

   $ 548     $ 419     $ 368     $ 417     $ 733  

Construction

     —         —         —         —         —    

Commercial real estate

     239       101       55       —         —    

Home equity loans and lines of credit

     54       106       31       81       151  

Other loans:

          

Commercial loans

     76       —         —         7       —    

Consumer loans

     12       24       14       —         5  
                                        

Total

   $ 929     $ 650     $ 468     $ 505     $ 889  
                                        

Loans accounted for on a nonaccrual basis:

          

Mortgage loans on real estate:

          

One-to-four family

   $ 368     $ 127     $ 230     $ 674     $ 237  

Construction

     —         —         194       —         90  

Commercial real estate

     —         —         —         —         —    

Home equity loans and lines of credit

     5       6       8       118       —    

Other loans:

          

Commercial loans

     43       —         126       94       161  

Consumer loans

     17       9       26       17       25  
                                        

Total non-accrual loans

     433       142       584       903       513  
                                        

Total nonperforming loans

     1,362       792       1,052       1,408       1,402  
                                        

Foreclosed real estate

     86       140       454       112       79  

Restructured loans

     —         —         —         —         —    
                                        

Total nonperforming assets

   $ 1,448     $ 932     $ 1,506     $ 1,520     $ 1,481  
                                        

Ratios:

          

Nonperforming loans as a percent of gross loans:

     0.66 %     0.40 %     0.56 %     0.89 %     0.97 %

Nonperforming assets as a percent of total assets:

     0.43 %     0.28 %     0.50 %     0.64 %     0.69 %

Loans are placed on non-accrual status either when reasonable doubt exists as to the full timely collection of interest and principal, or when a loan becomes 90 days past due, unless an evaluation by the Asset Classification Committee indicates that the loan is well-secured or in the process of collection. Our Asset Classification Committee designates loans on which we stop accruing interest income as non-accrual loans and we reverse outstanding interest income that was previously credited. We may again recognize income in the period that we collect such income, when the ultimate collectibility of principal is no longer in doubt. We return a non-accrual loan to accrual status when factors indicating doubtful collection no longer exist.

Our recorded investment in non-accrual loans totaled $433,000 and $142,000 at December 31, 2005 and 2004, respectively. If all non-accrual loans had been current in accordance with their terms during the years ended December 31, 2005, 2004 and 2003, interest income on such loans would have amounted to $49,000, $19,000 and $51,000, respectively. At December 31, 2005, we did not have any loans not included above which are “troubled debt restructurings” as defined in SFAS No. 15.

Real estate acquired as a result of foreclosure is classified as other real estate owned until such time as it is sold. We carry foreclosed real estate at its fair market value less estimated selling costs. If a foreclosure action is commenced and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, we either sell the real property securing the loan at a foreclosure sale or sell the property as soon thereafter as practical.

 

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Classification of Assets. Federal regulations require us to regularly review and classify our assets. In addition, our regulators have the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful assets” have all the weaknesses inherent in substandard assets with the additional characteristic that the weaknesses present make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose us to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving our close attention.

When we classify assets as either substandard or doubtful, we allocate a portion of the related general loss allowances to such assets as we deem prudent. The allowance for loan losses represents amounts that have been established to recognize losses inherent in the loan portfolio that are both probable and reasonably estimable at the date of the financial statements. When we classify problem assets as loss, we charge-off such amount. Our determination as to the classification of our assets and the amount of our loss allowances are subject to review by our regulatory agencies, which can require that we establish additional loss allowances. We regularly review our asset portfolio to determine whether any assets require classification in accordance with applicable regulations. On the basis of our review of our assets at December 31, 2005, classified assets consisted of special mention assets of $1.5 million, substandard assets of $2.9 million, doubtful assets of $17,000 and loans classified as loss assets of $48,000. The classified assets total includes $1.4 million of nonperforming loans.

The following table shows the aggregate amounts of our classified assets at the dates indicated.

 

     At December 31,
     2005    2004    2003
     (Dollars in thousands)

Special mention assets

   $ 1,494    $ 680    $ 1,089

Substandard assets

     2,923      1,522      1,618

Doubtful assets

     17      13      337

Loss assets

     48      —        —  
                    

Total classified assets

   $ 4,482    $ 2,215    $ 3,044
                    

 

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Delinquencies. The following table provides information about delinquencies in our loan portfolios at the dates indicated.

 

     At December 31,
     2005    2004    2003
     60-89
Days Past
Due
   90 + Days
Past Due
   60-89
Days Past
Due
   90 + Days
Past Due
   60-89
Days Past
Due
   90 + Days
Past Due
     (Dollars in thousands)

Residential real estate(1)

   $ 755    $ 974    $ 524    $ 658    $ 230    $ 637

Commercial real estate

     218      239      111      101      —        249

Commercial business

     11      76      39      —        39      126

Consumer loans

     6      25      18      33      26      40
                                         

Total

   $ 990    $ 1,314    $ 692    $ 792    $ 295    $ 1,052
                                         

(1) Includes home equity loans and lines of credit and construction loans.

Allowance for Loan Losses. The allowance for loan losses is a valuation account that reflects our evaluation of the losses inherent in our loan portfolio. We maintain the allowance through provisions for loan losses that we charge to income. We charge losses on loans against the allowance for loan losses when we believe the collection of the loan is unlikely.

Our evaluation of risk in maintaining the allowance for loan losses includes the review of all loans on which the collectibility of principal may not be reasonably assured. We consider the following factors as part of this evaluation: historical loan loss experience; payment status; the estimated value of the underlying collateral; loans originated in areas outside of the historic market area for loan activity; trends in loan volume; and national and local economic conditions. There may be other factors that may warrant consideration in maintaining an allowance at a level sufficient to provide for probable loan losses. Although our management believes that it has established and maintained the allowance for loan losses to reflect losses inherent in our loan portfolio, based on its evaluation of the factors noted above, future additions may be necessary if economic and other conditions differ substantially from the current operating environment.

In addition, various regulatory agencies, as an integral part of their examination process, periodically review our allowance for loan losses. These agencies, including the Office of Thrift Supervision, may require us to increase the allowance for loan losses or the valuation allowance for foreclosed real estate based on their evaluation of the information available to them at the time of their examination, thereby adversely affecting our results of operations.

The allowance consists of allocated, general and unallocated components. The allocated component relates to loans that are classified as either doubtful, substandard, or special mention. See “Asset Quality – Classification of Assets.” For such loans that are also classified as impaired, an allowance is established when the discounted cash flows, collateral value or observable market price of the impaired loan is lower than the carrying value of the loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. Qualitative factors include past loss experience, loans originated in areas outside of the historic market area for loan activity, trends in loan volume, type and volume of loans, changes in lending policies and procedures, underwriting standards, collections, chargeoffs and recoveries, national and local economic conditions, concentrations of credit and the effect of external factors on the level of estimated credit losses in the

 

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current portfolio. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses, such as downturns in the local economy. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating allocated and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that we will not be able to collect the scheduled payments of principal and interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payment when due. Impairment is measured on a loan-by-loan basis for commercial loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate or the fair value of the collateral if the loan is collateral dependent. Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, we do not separately identify individual consumer and residential loans for impairment disclosures. At December 31, 2005, we had two loans classified as impaired loans, for $103,000. Refer to Note 4 in the Notes to the Financial Statements for more information on our impaired loans.

For the year ended December 31, 2005, a significant increase to our allowance for loan losses through a provision for loan losses was not deemed necessary based on our evaluation of the items discussed above. During 2005, our analysis of the allowance for loan losses allowed us to more accurately identify risks inherent within the loan portfolio by loan categories. As a result, the amount needed in the unallocated portion of the allowance for loan losses was reduced from 22.4% of the total allowance as of December 31, 2004 to 6.9% as of December 31, 2005. We believe that the allowance for loan losses accurately reflects the level of risk inherent in the loan portfolio and the risk of lending in our community.

 

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The following table sets forth activity in our allowance for loan losses and other ratios at or for the dates indicated.

 

     At or for the Year Ended
December 31,
 
     2005     2004     2003     2002     2001  
     (Dollars in thousands)  

Balance at beginning of period:

   $ 1,288     $ 1,293     $ 1,217     $ 924     $ 797  

Provision for loan losses

     20       267       345       360       325  
                                        

Charge-offs:

          

Mortgage loans on real estate:

          

One-to-four family

     16       24       200       43       34  

Construction

     —         —         —         —         —    

Commercial real estate

     —         117       —         —         —    

Home equity loans and lines of credit

     29       —         —         8       —    

Other loans:

          

Commercial loans

     12       126       17       5       141  

Consumer loans

     26       37       58       23       43  
                                        

Total charge-offs:

     83       304       275       79       218  
                                        

Recoveries:

          

Mortgage loans on real estate:

          

One-to-four family

     —         23       4       4       6  

Construction

     —         —         —         —         —    

Commercial real estate

     —         —         —         —         —    

Home equity loans and lines of credit

     —         —         —         1       4  

Other loans:

          

Commercial loans

     14       —         —         —         1  

Consumer loans

     1       9       2       7       9  
                                        

Total Recoveries

     15       32       6       12       20  
                                        

Net charge-offs

     68       272       269       67       198  
                                        

Balance at end of period

   $ 1,240     $ 1,288     $ 1,293     $ 1,217     $ 924  
                                        

Average loans outstanding

   $ 200,652     $ 193,428     $ 162,810     $ 149,260     $ 145,524  

Ratio of net charge-offs to average loans outstanding

     0.03 %     0.14 %     0.17 %     0.04 %     0.14 %

 

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The following table presents our allocation of the allowance for loan losses by loan category and the percentage of loans in each category to total loans at the periods indicated. The allowance for loan losses allocated to each category is not necessarily indicative of inherent losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.

 

     At December 31,  
     2005     2004     2003     2002     2001  
     Amount    % of
Allowance
to Total
Allowance
    % of
Loans in
Category
to Total
Loans
    Amount    % of
Allowance
to Total
Allowance
    % of
Loans in
Category
to Total
Loans
    Amount    % of
Allowance
to Total
Allowance
    % of
Loans in
Category
to Total
Loans
    Amount    % of
Allowance
to Total
Allowance
    % of
Loans in
Category
to Total
Loans
    Amount    % of
Allowance
to Total
Allowance
    % of Loans
in Category
to Total
Loans
 
     (Dollars in thousands)  

Mortgage loans:

                                   

One-to-four

family

   $ 648    52.2 %   71.8 %   $ 527    40.9 %   71.2 %   $ 379    29.3 %   72.1 %   $ 503    41.3 %   68.0 %   $ 353    38.2 %   68.5 %

Home equity

loans and lines

of credit

     94    7.6 %   13.9 %     110    8.5 %   14.2 %     61    4.7 %   13.8 %     107    8.8 %   15.0 %     86    9.3 %   14.5 %

Commercial

real estate

     238    19.2 %   8.2 %     197    15.3 %   7.7 %     430    33.3 %   7.8 %     189    15.5 %   8.7 %     143    15.5 %   7.5 %

Construction

     —      —       0.7 %     —      —       1.2 %     —      —       1.3 %     —      —       2.1 %     —      —       1.8 %
                                                                                               
     980    79.0 %   94.7 %     834    64.7 %   94.3 %     870    67.3 %   95.0 %     799    65.6 %   93.8 %     582    63.0 %   92.3 %
                                                                                               

Other loans:

                                   

Commercial

loans

     141    11.4 %   4.0 %     139    10.8 %   4.3 %     156    12.1 %   3.2 %     145    11.9 %   4.0 %     119    12.9 %   5.1 %

Consumer

loans

     33    2.7 %   1.3 %     27    2.1 %   1.4 %     35    2.7 %   1.8 %     25    2.1 %   2.2 %     43    4.6 %   2.6 %
                                                                                               
     174    14.1 %   5.3 %     166    12.9 %   5.7 %     191    14.8 %   5.0 %     170    14.0 %   6.2 %     162    17.5 %   7.7 %
                                                                                               

Total allocated

   $ 1,154    93.1 %   100.0 %   $ 1,000    77.6 %   100.0 %   $ 1,061    82.1 %   100.0 %   $ 969    79.6 %   100.0 %   $ 744    80.5 %   100.0 %
                                                                                               

Total unallocated

   $ 86    6.9 %     $ 288    22.4 %     $ 232    17.9 %     $ 248    20.4 %     $ 180    19.5 %  
                                                                           

Balance at end of

period

   $ 1,240    100.0 %     $ 1,288    100.0 %     $ 1,293    100.0 %     $ 1,217    100.0 %     $ 924    100.0 %  
                                                                           

The allowance for loan losses allocated to the commercial real estate portfolio increased significantly in 2003, due to loans classified as a loss at the end of 2003.

 

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We will consider various qualitative factors when establishing our allowance for loan losses. Some of the factors cannot be assigned to a specific loan category, such as commercial real estate loans or consumer loans. An example of this type of factor is national and local economic conditions. Changes in economic conditions could affect the financial strength of our borrowers or the value of collateral securing our loans. The majority of our loans are made to borrowers located in Chautauqua County, New York or are secured by properties located in Chautauqua County. In recent years, economic conditions in Chautauqua County have been stagnant, with limited opportunities for business expansion, minimal growth in real estate values and limited job growth. In the event that these economic conditions decline in the future, some of our borrowers may be unable to make the required contractual payments on their loans. As a result, Lake Shore Savings may be unable to realize the full carrying value of such loans through foreclosure.

 

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Investment Activities

General. Our Board of Directors reviews and approves our investment policy on an annual basis. This policy dictates that investment decisions be made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, and consistency with our interest rate risk management strategy. The Board of Directors has delegated primary responsibility for ensuring that the guidelines in the investment policy are followed by the President and the Chief Financial Officer. Our Chief Executive Officer and Chief Financial Officer are responsible for making securities portfolio decisions in accordance with established policies and have the authority to purchase and sell securities within the specific guidelines established by the investment policy. In addition, all transactions are reviewed by the Asset/Liability Committee which meets every other month.

Our investment policy is designed primarily to manage the interest rate sensitivity of our assets and liabilities, to generate a favorable return without incurring undue interest rate or credit risk, to complement our lending activities and to provide and maintain liquidity within established guidelines. In establishing our investment strategies, we consider our interest rate sensitivity, the types of securities to be held, liquidity and other factors. We have also engaged an independent financial advisor to recommend investment securities according to a plan which has been approved by the Asset/Liability Committee and the Board of Directors. Federal savings banks have authority to invest in various types of assets, including U.S. Government obligations, securities of various federal agencies, obligations of states and municipalities, mortgage-backed and asset-backed securities, collateralized-mortgage obligations, certain time deposits of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements, loans of federal funds, and, subject to certain limits, corporate debt and commercial paper.

Nearly our entire portfolio is classified as “available for sale” and is reported at fair value. Our portfolio consists of collateralized mortgage obligations, U.S. Government agency backed securities, asset-backed securities, U.S. Government obligations and municipal bonds. Nearly all our mortgage backed securities are directly or indirectly insured or guaranteed by the Federal Home Loan Mortgage Corporation, the Government National Mortgage Association or the Federal Home Loan Mortgage Association.

Beginning in 2005, we also invested in privately insured state and municipal obligations with maturities of twenty years or less. We invest in these securities because of their favorable after tax yields in comparison to U.S. Government and U.S. Government Agency securities of comparable maturity. These securities are classified as available for sale. Finally, we have investments in Federal Home Loan Bank of New York stock, which must be held as a condition of membership in the Federal Home Loan Bank system.

 

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The following table presents the composition of our securities portfolio (excluding Federal Home Loan Mortgage Corporation common stock) in dollar amount of each investment type at the dates indicated.

 

     At December 31,
     2005    2004    2003
     Amortized
Cost
   Fair
Value
   Amortized
Cost
   Fair Value    Amortized
Cost
   Fair
Value
     (Dollars in thousands)

Securities available for sale:

                 

U.S. Government agencies

   $ —      $ —      $ —      $ —      $ 1,000    $ 1,063

U.S. Government obligations

     3,099      3,226      2,118      2,162      2,123      2,084

State and municipal obligations

     2,662      2,634      —        —        —        —  

Mortgage-backed securities:

                 

Collateralized mortgage obligations

     48,803      47,731      47,306      46,933      34,160      33,879

Federal Home Loan Mortgage Association

     7,072      6,886      9,158      9,175      6,322      6,398

Federal Home Loan Mortgage Corporation

     15,877      15,274      19,151      18,923      14,193      14,201

Asset-backed securities:

     17,072      16,869      20,395      20,328      23,828      24,097
                                         

Total available for sale

     94,585      92,620      98,128      97,521      81,626      81,722
                                         

Securities held to maturity:

                 

U.S. Government obligations:

     2,057      2,267      2,067      2,196      —        —  

Mortgage-backed securities:

                 

Government National Mortgage Association

     65      69      80      88      86      95

Federal Home Loan Mortgage Association

     107      107      136      139      176      182

Federal Home Loan Mortgage Corporation

     46      46      76      80      109      112
                                         

Total held to maturity

     2,275      2,489      2,359      2,503      371      389
                                         

Total investment securities

   $ 96,860    $ 95,109    $ 100,487    $ 100,024    $ 81,997    $ 82,111
                                         

 

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At December 31, 2005, non-U.S. Government obligations and Government agency securities that exceeded 10.0% of equity were as follows:

 

Issuer

   Book
Value
   Fair
Value
     (In thousands)

Asset backed securities

     

Countrywide Asset Backed Certificates

   $ 4,500    $ 4,455

Chase Funding Mortgage Asset Backed

   $ 3,204    $ 3,161

Residential Asset Securities Corporation

     4,693      4,634
             

Total

   $ 12,397    $ 12,250
             

Investment Securities Portfolio, Maturities and Yields. The following table sets forth the scheduled maturities, amortized cost and weighted average yields for our investment portfolio, with the exception of equity securities, at December 31, 2005. Due to repayments of the underlying loans, the average life maturities of mortgage-backed and asset-backed securities generally are substantially less than the final maturities.

 

     One year or less     More than One Year
through Five Years
    More than Five Years
through Ten Years
    More than Ten Years     Total  
   Amortized
Cost
   Weighted
Average
Yield
    Amortized
Cost
   Weighted
Average
Yield
    Amortized
Cost
   Weighted
Average
Yield
    Amortized
Cost
   Weighted
Average
Yield
    Amortized
Cost
   Fair
Value
   Weighted
Average
Yield
 
     ( Dollars in thousands)  

Available for Sale Securities:

                            

U.S. Government agencies

   $ —      —       $ 985    4.22 %   $ —      —       $ 2,114    4.98 %   $ 3,099    $ 3,226    4.74 %

State and municipal obligations(1)

     —      —         —      —         2,259    3.62 %     403    3.82 %     2,662      2,634    3.65 %

Mortgage-backed securities

     40    6.07 %     17,157    3.86 %     7,753    3.48 %     46,802    3.93 %     71,752      69,891    3.87 %

Asset-backed securities

     —      —         —      —         —      —         17,072    4.07 %     17,072      16,869    4.07 %

Held to Maturity securities:

                            

U.S. Government securities

     —      —         —      —         —      —         2,057    5.44 %     2,057      2,267    5.44 %

Mortage-backed securities

     —      —         21    8.46 %     22    5.08 %     175    6.59 %     218      222    6.62 %
                                                                        

Total debt securities:

   $ 40    6.07 %   $ 18,163    3.88 %   $ 10,034    3.52 %   $ 68,623    4.05 %   $ 96,860    $ 95,109    3.96 %
                                                                        

(1) Yields are presented on a tax-equivalent basis.

 

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Sources Of Funds

General. Deposits, borrowings, repayments and prepayments of loans and securities principal, proceeds from the sale of securities, proceeds from maturing securities, and cash flows provided by operations are our primary sources of funds for use in lending, investing and for other general purposes. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

Deposits. We offer a variety of deposit accounts having a range of interest rates and terms. We currently offer regular savings deposits (consisting of Christmas Club, passbook and statement savings accounts), money market accounts, interest bearing and non-interest bearing checking accounts, retirement accounts, time deposits and Interest on Lawyer Accounts.

Deposit balances in our NOW account constituted 75% and 78% of our checking account balances at December 31, 2005 and 2004, respectively. These accounts provide interest-earning checking, with a weighted average rate at December 31, 2005 of 0.52%.

Deposit flows are influenced significantly by general and local economic conditions, changes in prevailing interest rates, pricing of deposits, and competition. Our deposits are primarily obtained from communities surrounding our offices and we rely primarily on paying competitive rates, service, and long-standing relationships with customers to attract and retain these deposits. We normally do not use brokers to obtain deposits.

When we determine our deposit rates, we consider local competition, U.S. Treasury securities offerings, and the rates charged on other sources of funds. Core deposits (defined as savings deposits, money market accounts, demand accounts and other interest bearing accounts) represented 44.3% and 45.8% of total deposits on December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, time deposits with remaining terms to maturity of less than one year amounted to $94.8 million and $76.6 million, respectively.

The following table presents our time deposit accounts categorized by interest rates which mature during each of the periods set forth below and the amounts of such time deposits by interest rate at each of December 31, 2005, 2004 and 2003.

 

     Period to maturity from December 31, 2005    At December 31,
   Less than One
Year
  

More than
One Year to

Two Years

   More Than
Two Years to
Three Years
   More than
Three Years
   2005    2004    2003
   (Dollars in thousands)

Interest Rate Range

                    

1.99% and below

   $ 8,241    $ 930    $ 51    $ 5    $ 9,227    $ 36,591    $ 48,497

2.00% to 2.99%

     31,083      3,077      66      135      34,361      66,497      41,299

3.00% to 3.99%

     45,619      18,158      8,433      928      73,138      27,226      19,740

4.00% to 4.99%

     9,747      11,161      1,217      384      22,509      1,141      14,233

5.00% to 5.99%

     103      330      —        150      583      572      773

6.00% and above

     —        —        —        —        —        59      182
                                                

Total

   $ 94,793    $ 33,656    $ 9,767    $ 1,602    $ 139,818    $ 132,086    $ 124,724
                                                

 

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The following table presents the distribution of our deposit accounts at the dates indicated by dollar amount and percent of portfolio:

 

     At December 31,  
   2005     2004     2003  
   Amount    Percent
of total
deposits
    Amount    Percent
of total
deposits
    Amount    Percent
of total
deposits
 
   (Dollars in thousands)  

Deposit type:

  

Savings

   $ 27,871    11.11 %   $ 30,007    12.32 %   $ 31,483    13.66 %

Money market

     27,949    11.14 %     30,765    12.63 %     26,219    11.38 %

Interest bearing demand

     41,443    16.52 %     39,488    16.21 %     37,076    16.09 %

Noninterest bearing demand

     13,809    5.50 %     11,208    4.60 %     10,993    4.77 %
                                       

Total core deposits

     111,072    44.27 %     111,468    45.76 %     105,771    45.90 %
                                       

Time deposits with original maturities of:

               

Three months or less

     1,749    0.70 %     1,861    0.76 %     2,763    1.20 %

Over three months to twelve months

     28,544    11.38 %     31,069    12.77 %     35,889    15.57 %

Over twelve months to twenty-four months

     62,636    24.97 %     57,634    23.66 %     70,934    30.77 %

Over twenty-four months to thirty-six months

     40,253    16.04 %     35,692    14.66 %     12,283    5.33 %

Over thirty-six months to forty-eight months

     5,176    2.06 %     4,416    1.81 %     1,568    0.68 %

Over forty-eight months to sixty months

     941    0.37 %     1,100    0.45 %     1,258    0.54 %

Over sixty months

     519    0.21 %     314    0.13 %     29    0.01 %
                                       

Total time deposits

     139,818    55.73 %     132,086    54.24 %     124,724    54.10 %
                                       

Total deposits

   $ 250,890    100.00 %   $ 243,554    100.00 %   $ 230,495    100.00 %
                                       

At December 31, 2005, we had $30.6 million in time deposits with balances of $100,000 or more maturing as follows:

 

Maturity Period

   Amount
     (In thousands)

Three months or less

   $ 3,656

Over three months through six months

     6,355

Over six months through twelve months

     11,580

Over twelve months

     9,034
      

Total

   $ 30,625
      

 

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Borrowings. Our borrowings consist of short-term Federal Home Loan Bank advances. The following table sets forth information concerning balances and interest rates on our borrowings at the dates and for the periods indicated. We also have an available line of credit of $23.4 million at December 31, 2005 and a one month overnight repricing line of credit of $23.4 million. We did not have any outstanding borrowings on the lines of credit as of December 31, 2005.

 

     At December 31,  
     2005     2004     2003  
     (Dollars in thousands)  

At December 31

      

Amount outstanding

   $ 11,205     $ 11,725     $ 11,800  

Weighted average interest rate

     4.41 %     2.30 %     1.35 %

For the period ended December 31

      

Highest amount at a month-end

   $ 12,305     $ 13,700     $ 12,100  

Daily average amount outstanding

     10,420       12,501       4,073  

Weighted average interest rate

     3.30 %     2.24 %     2.90 %

Subsidiary Activities

Upon completion of the reorganization, Lake Shore Savings will be the only subsidiary of Lake Shore Bancorp. Lake Shore Savings has no subsidiaries.

Personnel

As of December 31, 2005, we had 100 full-time employees and 10 part-time employees. The employees are not represented by a collective bargaining unit and we consider our relationship with our employees to be good.

Regulation

General

Lake Shore Savings is currently a New York-chartered savings and loan association. It is currently subject to regulation, examination, and supervision by the New York State Banking Department and pursuant to the Federal Deposit Insurance Act. As a state-chartered savings association, Lake Shore Savings is also currently subject to the regulation, examination and supervision of the Office of Thrift Supervision and the Federal Deposit Insurance Corporation as its deposit insurer. As a result of the reorganization, Lake Shore Savings will convert to a federal stock savings bank and will thereby become subject solely to the regulation, examination and supervision of the Office of Thrift Supervision with the Federal Deposit Insurance Incorporation as its deposit insurer.

Lake Shore Savings is a member of the Savings Association Insurance Fund, and its deposit accounts are insured up to applicable limits by the Federal Deposit Insurance Incorporation. All of the deposit premiums paid by Lake Shore Savings to the Federal Deposit Insurance Incorporation for deposit insurance are currently paid to the Savings Association Insurance Fund. Lake Shore Savings is also a member of the Federal Home Loan Bank of New York, which is one of the 12 regional Federal Home Loan Banks. Lake Shore Savings must file reports with the Office of Thrift Supervision concerning its activities and financial condition, and it must obtain regulatory approvals prior to entering into certain transactions, such as mergers with, or acquisitions of, other depository institutions. The Office of Thrift Supervision conducts periodic examinations to assess Lake Shore Savings’ compliance with various

 

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regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which a savings association can engage and is intended primarily for the protection of the insurance fund and depositors. As a savings and loan holding company, Lake Shore Bancorp will be required to file certain reports with, and otherwise comply with, the rules and regulations of the Office of Thrift Supervision and of the Securities and Exchange Commission under the federal securities laws.

The Office of Thrift Supervision and the Federal Deposit Insurance Incorporation have significant discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such policies, whether by the Office of Thrift Supervision, the Federal Deposit Insurance Incorporation, the Securities and Exchange Commission or the United States Congress, could have a material adverse impact on us, Lake Shore Savings, and our operations and stockholders.

The following discussion is intended to be a summary of the material statutes and regulations applicable to savings associations and their savings and loan holding companies, and it does not purport to be a comprehensive description of all such statutes and regulations.

Regulation of Federal Savings Associations

Business Activities. Lake Shore Savings derives its lending and investment powers from the Home Owners’ Loan Act, as amended, and Office of Thrift Supervision regulations. Under these laws and regulations, Lake Shore Savings may invest in mortgage loans secured by residential and commercial real estate, commercial and consumer loans, certain types of debt securities, and certain other assets. Lake Shore Savings may also establish service corporations that may engage in activities not otherwise permissible for Lake Shore Savings, including certain real estate equity investments and securities and insurance brokerage. Lake Shore Savings’ authority to invest in certain types of loans or other investments is limited by federal law.

Liquidity. A federal savings bank is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation.

Loans to One Borrower. Lake Shore Savings is generally subject to the same limits on loans to one borrower as is a national bank. With specified exceptions, Lake Shore Savings’ total loans or extensions of credit to a single borrower cannot exceed 15% of Lake Shore Savings’ unimpaired capital and surplus, which does not include accumulated other comprehensive income. Lake Shore Savings may lend additional amounts up to 10% of its unimpaired capital and surplus which does not include accumulated other comprehensive income, if the loans or extensions of credit are fully-secured by readily-marketable collateral. Lake Shore Savings currently complies with applicable loans-to-one borrower limitations.

Qualified Thrift Lender Test. The Home Owners’ Loan Act requires that Lake Shore Savings, as a savings association, comply with the qualified thrift lender test. Under the qualified thrift lender test, Lake Shore Savings is required to maintain at least 65% of its portfolio assets in certain “qualified thrift investments” for at least nine months of the most recent twelve-month period. “Portfolio assets” means, in general, Lake Shore Savings’ total assets less the sum of:

 

    specified liquid assets up to 20% of total assets;

 

    goodwill and other intangible assets; and

 

    the value of property used to conduct Lake Shore Savings’ business.

 

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Lake Shore Savings may also satisfy the qualified thrift lender test by qualifying as a domestic building and loan association as defined in the Internal Revenue Code of 1986, as amended. Lake Shore Savings met the qualified thrift lender test at December 31, 2005 and in each of the prior 12 months, and, therefore, qualified as a thrift lender. If Lake Shore Savings fails the qualified thrift lender test, it must either operate under certain restrictions on its activities or convert to a national bank charter.

Capital Requirements. The Office of Thrift Supervision regulations require savings associations to meet three minimum capital standards: (i) a tangible capital ratio requirement of 1.5% of total assets as adjusted under the Office of Thrift Supervision regulations; (ii) a leverage ratio requirement of 3.0% of core capital to such adjusted total assets, if a savings association has been assigned the highest composite rating of 1 under the Uniform Financial Institutions Rating System; and (iii) a risk-based capital ratio requirement of 8.0% of core and supplementary capital to total risk-based assets. The minimum leverage capital ratio for any other depository institution that does not have a composite rating of 1 will be 4%, unless a higher leverage capital ratio is warranted by the particular circumstances or risk profile of the depository institution. In determining the amount of risk-weighted assets for purposes of the risk-based capital requirement, a savings association must compute its risk-based assets by multiplying its assets and certain off-balance sheet items by risk-weights, which range from 0% for cash and obligations issued by the United States Government or its agencies to 100% for consumer and commercial loans, as assigned by the Office of Thrift Supervision capital regulation based on the risks found by the Office of Thrift Supervision to be inherent in the type of asset.

Tangible capital is defined, generally, as common stockholders’ equity (including retained earnings), certain non-cumulative perpetual preferred stock and related earnings, minority interests in equity accounts of fully consolidated subsidiaries, less intangibles (other than certain mortgage servicing rights), and investments in and loans to subsidiaries engaged in activities not permissible for a national bank. Core capital is defined similarly to tangible capital, but core capital also includes certain qualifying supervisory goodwill and certain purchased credit card relationships. Supplementary capital currently includes cumulative and other preferred stock, mandatory convertible debt securities, subordinated debt and intermediate preferred stock and the allowance for loan and lease losses. In addition, up to 45% of unrealized gains on available-for-sale equity securities with a readily determinable fair value may be included in tier 2 capital. The allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets, and the amount of supplementary capital that may be included as total capital cannot exceed the amount of core capital.

At December 31, 2005, Lake Shore Savings met each of its capital requirements, in each case on a fully phased-in basis.

Capital Distributions. The Office of Thrift Supervision imposes various restrictions or requirements on Lake Shore Savings’ ability to make capital distributions, including cash dividends. A savings institution that is the subsidiary of a savings and loan holding company must file a notice with the Office of Thrift Supervision at least 30 days before making a capital distribution. Lake Shore Savings must file an application for prior approval if the total amount of its capital distributions, including the proposed distribution, for the applicable calendar year would exceed an amount equal to Lake Shore Savings’ net income for that year plus Lake Shore Savings’ retained net income for the previous two years.

The Office of Thrift Supervision may disapprove of a notice of application if:

 

    Lake Shore Savings would be undercapitalized following the distribution;

 

    the proposed capital distribution raises safety and soundness concerns;

 

    the capital distribution would violate a prohibition contained in any statute, regulation, or agreement; or

 

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Lake Shore Bancorp’s ability to pay dividends, service its debt obligations, and repurchase its common stock will be dependent upon receipt of dividend payments from Lake Shore Savings.

Branching. Subject to certain limitations, Home Owners’ Loan Act and Office of Thrift Supervision regulations permit federally-chartered savings associations to establish branches in any State of the United States. The authority to establish such a branch is available: (i) in States that expressly authorize branches of savings associations located in another State; and (ii) to an association that qualifies as a “domestic building and loan association” under the Internal Revenue Code, which imposes qualification requirements similar to those for a qualified thrift lender under the Home Owners’ Loan Act. See “—Qualified Thrift Lender Test.” The authority for a federal savings association to establish an interstate branch network would facilitate a geographic diversification of the association’s activities. This authority under the Home Owners’ Loan Act and Office of Thrift Supervision regulations preempts any State law purporting to regulate branching by federal savings associations.

Community Reinvestment and Fair Lending Laws. Under the Community Reinvestment Act, as implemented by Office of Thrift Supervision regulations, a savings association has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The Community Reinvestment Act does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the Community Reinvestment Act. The Community Reinvestment Act requires the Office of Thrift Supervision, in connection with its examination of a savings association, to assess the association’s record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such association. The Community Reinvestment Act also requires all institutions to publicly disclose their Community Reinvestment Act ratings.

The Community Reinvestment Act regulations establish an assessment system that bases an association’s rating on its actual performance in meeting community needs. In particular, the assessment system focuses on three tests: (i) a lending test, to evaluate the institution’s record of making loans in its assessment areas; (ii) an investment test, to evaluate the institution’s record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution’s delivery of services through its branches, ATMs, and other offices.

Lake Shore Savings has an on-going commitment to work with the Chautauqua Home Rehabilitation and Improvement Corporation in obtaining Federal Home Loan Bank grants to assist with community improvement efforts. There are many homes in Chautauqua County that are in need of repairs to enable such homes to be in compliance with applicable housing codes. Lake Shore Savings works with the Chautauqua Home Rehabilitation and Improvement Corporation to locate blighted properties and apply for grant assistance for repairs. Lake Shore Savings also participates in the Chautauqua Home Rehabilitation and Improvement Corporation Family Loan program which is a consumer lending program. Through this program, it makes secured and insured consumer loans at below market rates to lower and moderate income borrowers who have been qualified by this agency and who are trying to improve their credit score. The agency guarantees these loans and will make the final $1,000 payment on a loan if the borrower is current and in good standing with us. These commitments are ways Lake Shore Savings strives to improve its community and which has contributed to its receiving an “Outstanding” Community Reinvestment Act rating on its last three evaluations the most recent being as of November 17, 2004.

 

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Transactions with Related Parties. Lake Shore Savings’ authority to engage in transactions with its affiliates is limited by the Office of Thrift Supervision regulations and by Sections 23A and 23B of the Federal Reserve Act. In general, these transactions must be on terms which are as favorable to Lake Shore Savings as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of Lake Shore Savings capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from Lake Shore Savings. In addition, the Office of Thrift Supervision regulations prohibit a savings association from lending to any of its affiliates that engage in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary.

Effective April 1, 2003, the Federal Reserve Board rescinded its interpretations of Sections 23A and 23B of the Federal Reserve Act and replaced these interpretations with Regulation W. In addition, Regulation W makes various changes to existing law regarding Sections 23A and 23B, including expanding the definition of what constitutes an affiliate subject to Sections 23A and 23B and exempting certain subsidiaries of state-chartered banks from the restrictions of Sections 23A and 23B. Under Regulation W, all transactions entered into on or before December 12, 2002, which either became subject to Sections 23A and 23B solely because of Regulation W, and all transactions covered by Sections 23A and 23B, the treatment of which will change solely because of Regulation W, became subject to Regulation W on July 1, 2003. All other covered affiliate transactions become subject to Regulation W on April 1, 2003. The Federal Reserve Board expects each depository institution that is subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W.

Lake Shore Savings’ authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders: (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features; and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of Lake Shore Savings’ capital. The regulations allow small discounts on fees on residential mortgages for directors, officers and employees. In addition, extensions for credit in excess of certain limits must be approved by Lake Shore Savings’ Board of Directors.

Section 402 of the Sarbanes-Oxley Act of 2002 prohibits the extension of personal loans to directors and executive officers of issuers (as defined in Sarbanes-Oxley). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as Lake Shore Savings, that are subject to the insider lending restrictions of Section 22(h) of the Federal Reserve Act.

Enforcement. The Office of Thrift Supervision has primary enforcement responsibility over savings associations, including Lake Shore Savings. This enforcement authority includes, among other things, the ability to assess civil money penalties, to issue cease and desist orders and to remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices.

Standards for Safety and Soundness. Under federal law, the Office of Thrift Supervision has adopted a set of guidelines prescribing safety and soundness standards. These guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings standards, compensation, fees and benefits. In general, the guidelines require appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. In addition, the Office of Thrift Supervision adopted regulations that authorize, but do not require, the Office of Thrift Supervision to

 

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order an institution that has been given notice that it is not satisfying these safety and soundness standards to submit a compliance plan. If, after being notified, an institution fails to submit an acceptable plan of compliance or fails in any material respect to implement an accepted plan, the Office of Thrift Supervision must issue an order directing action to correct the deficiency and may issue an order directing other actions of the types to which an undercapitalized association is subject under the “prompt corrective action” provisions of federal law. If an institution fails to comply with such an order, the Office of Thrift Supervision may seek to enforce such order in judicial proceedings and to impose civil money penalties.

Real Estate Lending Standards. The Office of Thrift Supervision and the other federal banking agencies adopted regulations to prescribe standards for extensions of credit that: (i) are secured by real estate; or (ii) are made for the purpose of financing the construction of improvements on real estate. The Office of Thrift Supervision regulations require each savings association to establish and maintain written internal real estate lending standards that are consistent with safe and sound banking practices and appropriate to the size of the association and the nature and scope of its real estate lending activities. The standards also must be consistent with accompanying Office of Thrift Supervision guidelines, which include loan-to-value ratios for the different types of real estate loans. Associations are also permitted to make a limited amount of loans that do not conform to the proposed loan-to-value limitations so long as such exceptions are reviewed and justified appropriately. The guidelines also list a number of lending situations in which exceptions to the loan-to-value standards are justified.

Prompt Corrective Regulatory Action. Under the Office of Thrift Supervision prompt corrective action regulations, the Office of Thrift Supervision is required to take certain, and is authorized to take other, supervisory actions against undercapitalized savings associations. For this purpose, a savings association would be placed in one of the following four categories based on the association’s capital:

 

    well-capitalized;

 

    adequately capitalized;

 

    undercapitalized; or

 

    critically undercapitalized.

At December 31, 2005, Lake Shore Savings met the criteria for being considered “well-capitalized.” When appropriate, the Office of Thrift Supervision can require corrective action by a savings association holding company under the “prompt corrective action” provision of federal law.

Insurance of Deposit Accounts. Lake Shore Savings is a member of the Savings Association Insurance Fund. Under federal law, the Federal Deposit Insurance Incorporation established a risk based assessment system for determining the deposit insurance assessments to be paid by insured depository institutions. Under the assessment system, the Federal Deposit Insurance Incorporation assigns an institution to one of three capital categories based on the institution’s financial information as of the quarter ending three months before the beginning of the assessment period. An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Under the regulation, there are nine risk assessment classifications (i.e., combinations of capital groups and supervisory subgroups) to which different assessment rates are applied. Assessment rates currently range from 0.0% of deposits for an institution in the highest category (i.e., well-capitalized and financially sound, with no more than a few minor weaknesses) to 0.27% of deposits for an institution in the lowest category (i.e., undercapitalized and substantial supervisory concern). The Federal Deposit Insurance Incorporation is authorized to raise the assessment rates as necessary to maintain the required reserve ratio of 1.25%.

 

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In addition, all Federal Deposit Insurance Incorporation-insured institutions are required to pay assessments to the Federal Deposit Insurance Incorporation at an annual rate of approximately 0.0168% of insured deposits to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments will continue until the Financing Corporation bonds mature in 2017.

Federal Home Loan Bank System. Lake Shore Savings is a member of the Federal Home Loan Bank of New York, which is one of the regional Federal Home Loan Banks composing the Federal Home Loan Bank System. Each Federal Home Loan Bank provides a central credit facility primarily for its member institutions: (i) the greater of $1,000 or 0.20% of the member’s mortgage-related assets; and (ii) 4.50% of the dollar amount of any outstanding advances under such member’s advances, collateral pledge and security agreement with the Federal Home Loan Bank of New York. Lake Shore Savings, as a member of the Federal Home Loan Bank of New York, is required to acquire and hold shares of capital stock in the Federal Home Loan Bank of New York in an amount at least equal to 0.20% of the total assets of Lake Shore Savings. Lake Shore Savings is also required to own activity based stock, which is based on 4.50% of Lake Shore Savings’ outstanding advances. These percentages are subject to change by the Federal Home Loan Bank. Lake Shore Savings was in compliance with this requirement with an investment in Federal Home Loan Bank of New York stock at December 31, 2005 of $2.7 million. Any advances from a Federal Home Loan Bank must be secured by specified types of collateral, and all long-term advances may be obtained only for the purpose of providing funds for residential housing finance.

The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts and to contribute funds for affordable housing programs. These requirements could reduce the amount of earnings that the Federal Home Loan Banks can pay as dividends to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, Lake Shore Savings’ net interest income would be affected.

Under the Gramm-Leach-Bliley Act, membership in the Federal Home Loan Bank is now voluntary for all federally-chartered savings associations, such as Lake Shore Savings. The Gramm-Leach-Bliley Act also replaces the existing redeemable stock structure of the Federal Home Loan Bank System with a capital structure that requires each Federal Home Loan Bank to meet a leverage limit and a risk-based permanent capital requirement. Two classes of stock are authorized: Class A (redeemable on six-months notice) and Class B (redeemable on five-years notice).

Privacy Regulations. Pursuant to the Gramm-Leach-Bliley Act, the Office of Thrift Supervision has published final regulations implementing the privacy protection provisions of the Gramm-Leach-Bliley Act. The new regulations generally require that Lake Shore Savings disclose its privacy policy, including identifying with whom it shares a customer’s “non-public personal information,” to customers at the time of establishing the customer relationship and annually thereafter. In addition, Lake Shore Savings is required to provide its customers with the ability to “opt-out” of having their personal information shared with unaffiliated third parties and not to disclose account numbers or access codes to non-affiliated third parties for marketing purposes. Lake Shore Savings currently has a privacy protection policy in place and believes that such policy is in compliance with the regulations.

Prohibitions Against Tying Arrangements. Federal savings banks are subject to the prohibitions of 12 U.S.C. § 1972 on certain tying arrangements. A depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.

 

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Federal Reserve System

Lake Shore Savings is subject to provisions of the Federal Reserve Act and the Federal Reserve Board’s regulations pursuant to which depository institutions may be required to maintain non-interest-earning reserves against their deposit accounts and certain other liabilities. Currently, reserves must be maintained against transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve Board regulations generally require that reserves be maintained in the amount of 3.0% of the aggregate of transaction accounts up to $42.1 million. The amount of aggregate transaction accounts in excess of $42.1 million are currently subject to a reserve ratio of 10.0%. The Federal Reserve Board regulations currently exempt $6.0 million of otherwise reservable balances from the reserve requirements, which exemption is adjusted by the Federal Reserve Board at the end of each year. Lake Shore Savings is in compliance with the foregoing reserve requirements. Because required reserves must be maintained in the form of either vault cash, a non interest-bearing account at a Federal Reserve Bank, or a pass-through account as defined by the Federal Reserve Board, the effect of this reserve requirement is to reduce Lake Shore Savings’ interest-earning assets. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements imposed by the Office of Thrift Supervision. Federal Home Loan Bank System members are also authorized to borrow from the Federal Reserve discount window, but Federal Reserve Board regulations require such institutions to exhaust all Federal Home Loan Bank sources before borrowing from a Federal Reserve Bank.

The USA PATRIOT Act

Lake Shore Savings is subject to the USA PATRIOT Act, which gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents, and parties registered under the Commodity Exchange Act.

Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:

 

    Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls; (ii) specific designation of an anti-money laundering compliance officer; (iii) ongoing employee training programs; and (iv) an independent audit function to test the anti-money laundering program.

 

    Pursuant to Section 326, on May 9, 2003, the Secretary of the Department of Treasury, in conjunction with other bank regulators, issued Joint Final Rules that provide for minimum standards with respect to customer identification and verification. These rules became effective on October 1, 2003.

 

    Section 312 requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.

 

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    Effective December 25, 2001, financial institutions are prohibited from establishing, maintaining, administering, or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and will be subject to certain record keeping obligations with respect to correspondent accounts of foreign banks.

 

    Bank regulators are directed to consider a holding company’s effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.

Holding Company Regulation

Lake Shore Bancorp and Lake Shore, MHC will be savings and loan holding companies regulated by the Office of Thrift Supervision. As such, Lake Shore Bancorp and Lake Shore, MHC will be registered with and subject to Office of Thrift Supervision examination and supervision, as well as certain reporting requirements. In addition, the Office of Thrift Supervision will have enforcement authority over Lake Shore Bancorp and Lake Shore, MHC and any of their non-savings institution subsidiaries. Among other things, this authority permits the Office of Thrift Supervision to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings institution. Unlike bank holding companies, federal savings and loan holding companies are not subject to any regulatory capital requirements or to supervision by the Federal Reserve System.

Restrictions Applicable to Lake Shore Bancorp. Because Lake Shore Savings will have been acquired after May 4, 1999, under the Gramm-Leach-Bliley Act, its holding companies will be prohibited from engaging in non-financial activities. Lake Shore Bancorp’s activities will be restricted to:

 

    furnishing or performing management services for a savings institution subsidiary of such holding company;

 

    conducting an insurance agency or escrow business;

 

    holding, managing, or liquidating assets owned or acquired from a savings institution subsidiary of such company;

 

    holding or managing properties used or occupied by a savings institution subsidiary of such company;

 

    acting as trustee under a deed of trust;

 

    any other activity (i) that the Federal Reserve Board, by regulation, has determined to be permissible for bank holding companies under Section 4(c) of the Bank Holding Company Act of 1956, unless the Director of the Office of Thrift Supervision, by regulation, prohibits or limits any such activity for savings and loan holding companies, or (ii) in which multiple savings and loan holding companies were authorized by regulation to directly engage in on March 5, 1987;

 

    purchasing, holding, or disposing of stock acquired in connection with a qualified stock issuance if the purchase of such stock by such holding company is approved by the Director of the Office of Thrift Supervision; and

 

    any activity permissible for financial holding companies under section 4(k) of the Bank Holding Company Act.

 

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Permissible activities which are deemed to be financial in nature or incidental thereto under section 4(k) of the Bank Holding Company Act include:

 

    lending, exchanging, transferring, investing for others, or safeguarding money or securities;

 

    insurance activities or providing and issuing annuities, and acting as principal, agent, or broker;

 

    financial, investment, or economic advisory services;

 

    issuing or selling instruments representing interests in pools of assets that a bank is permitted to hold directly;

 

    underwriting, dealing in, or making a market in securities;

 

    activities previously determined by the Federal Reserve Board to be closely related to banking;

 

    activities that bank holding companies are permitted to engage in outside of the U.S.; and

 

    portfolio investments made by an insurance company.

In addition, Lake Shore Bancorp will not be permitted to be acquired unless the acquirer is engaged solely in financial activities or to acquire a company unless the company is engaged solely in financial activities.

Restrictions Applicable to Activities of Mutual Holding Companies. Under federal law, a mutual holding company may engage only in the following activities:

 

    investing in the stock of a savings institution;

 

    acquiring a mutual association through the merger of such association into a savings institution subsidiary of such holding company or an interim savings institution subsidiary of such holding company;

 

    merging with or acquiring another holding company, one of whose subsidiaries is a savings institution;

 

    investing in a corporation the capital stock of which is available for purchase by a savings institution under federal law or under the law of any state where the subsidiary savings institution or association is located; and

 

    the permissible activities described above for non-grandfathered savings and loan holding companies.

If a mutual holding company acquires or merges with another holding company, the holding company acquired or the holding company resulting from such merger or acquisition may only invest in assets and engage in the activities listed above, and it has a period of two years to cease any non-conforming activities and divest any non-conforming investments.

 

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Restrictions Applicable to All Savings and Loan Holding Companies. Federal law prohibits a savings and loan holding company, which will include Lake Shore Bancorp and Lake Shore, MHC, directly or indirectly, from acquiring:

 

    control (as defined under the Home Owners’ Loan Act) of another savings institution (or a holding company parent) without prior Office of Thrift Supervision approval;

 

    through merger, consolidation, or purchase of assets, another savings institution or a holding company thereof, or acquiring all or substantially all of the assets of such institution (or a holding company) without prior Office of Thrift Supervision approval; or

 

    control of any depository institution not insured by the Federal Deposit Insurance Incorporation (except through a merger with and into the holding company’s savings institution subsidiary that is approved by the Office of Thrift Supervision).

A savings and loan holding company may not acquire as a separate subsidiary an insured institution that has a principal office outside of the state where the principal office of its subsidiary institution is located, except:

 

    in the case of certain emergency acquisitions approved by the Federal Deposit Insurance Incorporation;

 

    if such holding company controls a savings institution subsidiary that operated a home or branch office in such additional state as of March 5, 1987; or

 

    if the laws of the state in which the savings institution to be acquired is located specifically authorize a savings institution chartered by that state to be acquired by a savings institution chartered by the state where the acquiring savings institution or savings and loan holding company is located or by a holding company that controls such a state-chartered association.

If the savings institution subsidiary of a federal mutual holding company fails to meet the qualified thrift lender test set forth in Section 10(m) of the Home Owners’ Loan Act and regulations of the Office of Thrift Supervision, the holding company must register with the Federal Reserve Board as a bank holding company under the BHC Act within one year of the savings institution’s failure to so qualify.

Waivers of Dividends by Lake Shore, MHC. Office of Thrift Supervision regulations will require Lake Shore, MHC to notify the Office of Thrift Supervision of any proposed waiver of its receipt of dividends from Lake Shore Bancorp. The Office of Thrift Supervision reviews dividend waiver notices on a case-by-case basis, and, in general, does not object to any such waiver if:

 

    the waiver would not be detrimental to the safe and sound operation of the subsidiary savings association; and

 

    the mutual holding company’s board of directors determines that such waiver is consistent with such directors’ fiduciary duties to the mutual holding company’s members.

In the event Lake Shore, MHC waives dividends, under Office of Thrift Supervision regulations, our public stockholders would not be diluted because of any dividends waived by Lake Shore, MHC (and

 

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waived dividends would not be considered in determining an appropriate exchange ratio) in the event Lake Shore, MHC converts to stock form.

Conversion of Lake Shore, MHC to Stock Form. Office of Thrift Supervision regulations will permit Lake Shore, MHC to convert from the mutual form of organization to the capital stock form of organization (a “Conversion Transaction”). There can be no assurance when, if ever, a Conversion Transaction will occur, and the board of directors has no current intention or plan to undertake a Conversion Transaction. In a Conversion Transaction a new stock holding company would be formed as the successor to Lake Shore Bancorp (the “New Holding Company”), Lake Shore, MHC’s corporate existence would end, and certain depositors and borrowers of Lake Shore Savings would receive the right to subscribe for additional shares of the New Holding Company. In a Conversion Transaction, each share of common stock held by stockholders other than Lake Shore, MHC (“Minority Stockholders”) would be automatically converted into a number of shares of common stock of the New Holding Company determined pursuant to an exchange ratio that ensures that Minority Stockholders own the same percentage of common stock in the New Holding Company as they owned in Lake Shore Bancorp immediately prior to the Conversion Transaction. Under Office of Thrift Supervision regulations, Minority Stockholders would not be diluted because of any dividends waived by Lake Shore, MHC (and waived dividends would not be considered in determining an appropriate exchange ratio), in the event Lake Shore, MHC converts to stock form. The total number of shares held by Minority Stockholders after a Conversion Transaction also would be increased by any purchases by Minority Stockholders in the offering conducted as part of the Conversion Transaction.

Any Conversion Transaction would require the approval of a majority of the outstanding shares of common stock of Lake Shore Bancorp held by Minority Stockholders and by two thirds of the total outstanding shares of common stock of Lake Shore Bancorp. Any second-step conversion transaction also would require the approval of a majority of the eligible votes of members of Lake Shore, MHC.

Federal Securities Laws

Our common stock will be registered with the Securities and Exchange Commission under Section 12(g) of the Securities Exchange Act of 1934, as amended. We will be subject to information, proxy solicitation, insider trading restrictions, and other requirements under the Securities Exchange Act of 1934.

The Sarbanes-Oxley Act

As a public company, we will be subject to the Sarbanes-Oxley Act, which implements a broad range of corporate governance and accounting measures for public companies designed to promote honesty and transparency in corporate America and better protect investors from corporate wrongdoing. The Sarbanes-Oxley Act’s principal legislation and the derivative regulation and rule making promulgated by the Securities and Exchange Commission includes:

 

    the creation of an independent accounting oversight board;

 

    auditor independence provisions that restrict non-audit services that accountants may provide to their audit clients;

 

    additional corporate governance and responsibility measures, including the requirement that the chief executive officer and chief financial officer certify financial statements;

 

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    a requirement that companies establish and maintain a system of internal control over financial reporting and that a company’s management provide an annual report regarding its assessment of the effectiveness of such internal control over financial reporting to the company’s independent accountants and that such accountants provide an attestation report with respect to management’s assessment of the effectiveness of the company’s internal control over financial reporting;

 

    the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer’s securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;

 

    an increase in the oversight of, and enhancement of certain requirements relating to audit committees of public companies and how they interact with the company’s independent auditors;

 

    the requirement that audit committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the issuer;

 

    the requirement that companies disclose whether at least one member of the committee is a “financial expert” (as such term is defined by the Securities and Exchange Commission) and if not, why not;

 

    expanded disclosure requirements for corporate insiders, including accelerated reporting of stock transactions by insiders and a prohibition on insider trading during pension blackout periods;

 

    a prohibition on personal loans to directors and officers, except certain loans made by insured financial institutions;

 

    disclosure of a code of ethics and the requirement of filing of a Form 8-K for a change or waiver of such code;

 

    mandatory disclosure by analysts of potential conflicts of interest; and

 

    a range of enhanced penalties for fraud and other violations.

Although we anticipate that we will incur additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.

Quotation on Nasdaq

Our common stock will be quoted on The Nasdaq Stock Market. In order to maintain such quotation, we are subject to certain corporate governance requirements, including:

 

    a majority of our board must be composed of independent directors;

 

    we are required to have an audit committee composed of at least three directors, each of whom is an independent director, as such term is defined by both the rules of the National Association of Securities Dealers and by Securities Exchange Act of 1934 regulations;

 

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    our nominating committee and compensation committee must also be composed entirely of independent directors; and

 

    our audit committee and our nominating committee must have publicly available written charters.

 

Item 1A. Risk Factors.

Risks Related To Our Business

We Have Recently Opened New Branches And Expect To Open Additional New Branches In The Near Future. Opening New Branches Reduces Our Short-Term Profitability Due To One-time Fixed Expenses Coupled With Low Levels Of Income Earned By The Branches Until Their Customer Bases Are Built. We opened two new branches in Orchard Park and East Amherst, New York in 2003 and one more in Hamburg, New York in December 2005. We intend to continue to expand through de novo branching. The expense associated with building and staffing new branches will significantly increase our noninterest expense, with compensation and occupancy costs constituting the largest amount of increased costs. Losses are expected from the proposed new branch for some time as the expenses associated with it are largely fixed and is typically greater than the income earned as a branch builds up its customer base. Our management has projected that it will take approximately 36 to 48 months for the Hamburg branch to become profitable. The branch we opened in East Amherst in 2003 is not yet profitable. We expect it to be profitable by the end of 2006. All of our other full-service branches are individually profitable. There can be no assurance that our branch expansion strategy will result in increased earnings, or that it will result in increased earnings within a reasonable period of time. We expect that the success of our branching strategy will depend largely on the ability of our staff to market the deposit and loan products offered by us. Depending upon locating acceptable sites, we anticipate opening one or two branches in each of the next several years.

Our Loan Portfolio Includes Loans With A Higher Risk Of Loss. We originate commercial mortgage loans, commercial loans, consumer loans, and residential mortgage loans primarily within our market area. Commercial mortgage, commercial, and consumer loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. In addition, commercial real estate and commercial business loans may also involve relatively large loan balances to individual borrowers or groups of borrowers. These loans also have greater credit risk than residential real estate for the following reasons:

 

    Commercial Mortgage Loans. Repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service.

 

    Commercial Loans. Repayment is generally dependent upon the successful operation of the borrower’s business.

 

    Consumer Loans. Consumer loans (such as personal lines of credit) may or may not be collateralized with assets that provide an adequate source of payment of the loan due to depreciation, damage, or loss.

Any downturn in the real estate market or our local economy could adversely affect the value of the properties securing the loans or revenues from the borrower’s business thereby increasing the risk of non-performing loans. At this time, however, there is no downturn in the local economy or real estate market and we are not aware of any adverse effects in property values or business declines as a result of the local economy.

 

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If Our Allowance For Loan Losses Is Not Sufficient To Cover Actual Loan Losses, Our Earnings Could Decrease. Our loan customers may not repay their loans according to their terms and the collateral securing the payment of these loans may be insufficient to pay any remaining loan balance. We therefore may experience significant loan losses, which could have a material adverse effect on our operating results.

Material additions to our allowance for loan losses also would materially decrease our net income, and the charge-off of loans may cause us to increase the allowance. We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. We rely on our loan quality reviews, our experience and our evaluation of economic conditions, among other factors, in determining the amount of the allowance for loan losses. If our assumptions prove to be incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, resulting in additions to our allowance.

The high percentage of traditional real estate loans in our loan portfolio has been one of the more significant factors we have taken into account in evaluating our allowance for loan losses and provision for loan losses. If we were to further increase the amount of loans in our portfolio other than traditional real estate loans, we may decide to make increased provisions for loan losses. In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs, which may have a material adverse effect on our financial condition and results of operations. We believe that the current amount of allowance for loan losses is sufficient to absorb inherent losses in our loan portfolio.

Low Demand For Real Estate Loans May Lower Our Profitability. Making loans secured by real estate, including one-to-four family and commercial real estate, is our primary business and primary source of revenue. If customer demand for real estate loans decreases, our profits may decrease because our alternative investments, primarily securities, generally earn less income than real estate loans. Customer demand for loans secured by real estate could be reduced due to weaker economic conditions, an increase in unemployment, a decrease in real estate values or an increase in interest rates. For example, customer demand for loans secured by real estate has decreased in our market area as a result of interest rate increases during 2004 and 2005.

We Depend On Our Executive Officers And Key Personnel To Implement Our Business Strategy And Could Be Harmed By The Loss Of Their Services. We believe that our growth and future success will depend in large part upon the skills of our management team. The competition for qualified personnel in the financial services industry is intense, and the loss of our key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business. We cannot assure you that we will be able to retain our existing key personnel or attract additional qualified personnel. Although we have an employment agreement with our President and Chief Executive Officer that contains a non-compete provision, the loss of the services of one or more of our executive officers and key personnel could impair our ability to continue to develop our business strategy.

The Implementation Of Stock-Based Benefits Will Increase Our Future Compensation Expense And Reduce Our Earnings, And May Dilute Your Ownership Interest In Lake Shore Bancorp. We intend to adopt a stock option plan that will provide for grants to eligible officers, directors and employees of options to purchase common stock of up to 4.90% of the shares of common stock outstanding after the offering. We also intend to adopt a management recognition plan that will provide for awards of common stock to eligible officers, directors and employees of up to 1.96% of the shares of common stock outstanding after the offering. We will fund these plans through either open market purchases, if permitted, or from the issuance of authorized but unissued shares. These plans will increase our future costs of compensating our officers and directors, thereby reducing our earnings. In addition,

 

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stockholders will experience a 1.9% reduction or dilution in ownership interest in the event newly-issued shares are used to fund restricted stock awards and a 4.7% reduction or dilution in ownership interest in the event newly-issued shares are used to fund the stock options.

After Our Initial Public Offering, Our Return On Equity Will Be Low Compared To Other Companies. This Could Hurt The Price Of Your Common Stock. We will not be able to immediately deploy all of the new capital generated from our initial public offering into high-yielding earning assets, and due to the difficult economic environment in our market area, deployment of the new capital may take a significant amount of time. For example, due to intense competition and market rates, our borrower demand may be limited. Our ability to leverage our new capital profitably will be significantly affected by industry competition for loans and deposits. Initially, we intend to invest the net proceeds in short-term investments and mortgage-backed securities, which generally have lower yields than loans. This will reduce our return on average equity to a level that will be lower than our historical ratios.

Our Ability To Grow May Be Limited If We Cannot Make Acquisitions. In an effort to fully deploy the capital we raise in the offering, we intend to seek to expand our banking franchise, internally and by acquiring other financial institutions or branches and other financial services providers. However, we have no specific plans for expansion or acquisitions at this time. Our ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring and integrating those institutions or branches. We cannot assure you that we will be able to generate internal growth or identify attractive acquisition candidates, make acquisitions on favorable terms or successfully integrate any acquired institutions or branches.

Risks Related To The Banking Industry

Competition In Our Primary Market Area May Reduce Our Ability To Attract And Retain Deposits And Originate Loans. We operate in a competitive market for both attracting deposits, which is our primary source of funds, and originating loans. Historically, our most direct competition for savings deposits has come from credit unions, community banks, large commercial banks and thrift institutions in our primary market area. Particularly in times of extremely low or extremely high interest rates, we have faced additional significant competition for investors’ funds from brokerage firms and other firms’ short-term money market securities and corporate and government securities. Our competition for loans comes principally from mortgage brokers, commercial banks, other thrift institutions, and insurance companies. Competition for loan originations and deposits may limit our future growth and earnings prospects.

Changes In Interest Rates Could Adversely Affect Our Results Of Operations And Financial Condition. Our results of operations and financial condition are significantly affected by changes in interest rates. Our results of operations depend substantially on our net interest income, which is the difference between the interest income earned on our interest-earning assets and the interest expense paid on our interest-bearing liabilities. Increases in interest rates may decrease loan demand and make it more difficult for borrowers to repay adjustable rate loans.

We also are subject to reinvestment risk associated with changes in interest rates. Changes in interest rates may affect the average life of loans and mortgage-related securities. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are unable to reinvest the cash received from such prepayments at rates that are comparable to the rates on existing loans and securities.

Our earnings may be adversely impacted by an increase in interest rates because the majority of our interest-earning assets are long-term, fixed rate mortgage-related assets that will not reprice as long-term interest rates increase while a majority of our interest-bearing liabilities are expected to reprice as

 

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interest rates increase. Therefore, in an increasing interest rate environment, our cost of funds is expected to increase more rapidly than the yields earned on our loan portfolio and securities portfolio. An increasing rate environment is expected to cause a narrowing of our net interest rate spread and a decrease in our net interest income.

 

Item 1B. Unresolved Staff Comments.

None.

 

Item 2. Properties.

We conduct our business through our corporate headquarters, administrative offices, and eight branch offices. At December 31, 2005, the net book value of the computer equipment and other furniture, fixtures, and equipment of our offices totaled $1.6 million. For more information, see Note 5 of Notes to our Financial Statements.

 

Location

  

Leased

or

Owned

 

Original

Date

Acquired

  

Net Book Value

December 31, 2005

(In thousands)

Corporate Headquarters

       

125 East Fourth Street Dunkirk, NY 14048

   Owned   1995    $ 98

Branch Offices:

       

Chautauqua County

       

128 East Fourth Street

Dunkirk, NY 14048

   Owned   1930      964

30 East Main Street Fredonia, NY 14063

   Owned   1996      814

1 Green Avenue

Jamestown, NY 14701

   Owned/Leased(1)   1996      781

115 East Fourth Street

Jamestown, NY 14701

   Owned   1997      347

106 East Main Street

Westfield, NY 14787

   Owned/Leased(2)   1998      327

Erie County

       

5751 Transit Road

East Amherst, NY 14051

   Owned   2003      1,207

3111 Union Road

Orchard Park, NY 14127

   Leased(3)   2003      213

59 Main Street

Hamburg, NY 14075

   Leased(4)   2005      25

Administrative Offices:

       

31 East Fourth Street

Dunkirk, NY 14048

   Owned   2003      312

123 East Fourth Street

Dunkirk, NY 14048

   Owned   1995      103

(1) The building is owned. The land is leased. The lease expires in September 2015.

 

(2) The building is owned. Parking is leased on a monthly basis.

 

(3) The lease expires in January 2017.

 

(4) The lease expires in December 2028.

 

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Item 3. Legal Proceedings.

We are not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. We believe that these routine legal proceedings, in the aggregate, are immaterial to our financial condition and results of operations.

 

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

No matters were submitted to a vote of security holders during the year ended December 31, 2005.

 

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PART II

 

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.

Lake Shore Bancorp, Inc. will be formed in connection with the reorganization of Lake Shore Savings from a New York State-chartered savings and loan association to a federally-chartered mutual holding company form of organization. In connection with the reorganization, on or about February 13, 2006, the Lake Shore Bancorp commenced a public offering of shares of its common stock in a subscription offering for a purchase price of $10.00 per share pursuant to a Registration Statement on Form S-1 (No. 333-129439) which was declared effective by the Securities and Exchange Commission on February 13, 2006. In accordance with Lake Shore Savings’ Plan of Reorganization and Minority Stock Issuance, and pursuant to the registration statement, first priority rights to subscribe for shares of Lake Shore Bancorp common stock were offered to eligible depositors of Lake Shore Savings. Ryan Beck & Co., Inc. (“Ryan Beck”) was engaged to assist in the marketing of the common stock. For their services, Ryan Beck will received an advisory and administrative fee of $50,000 and a marketing fee equal to 1% of the dollar amount of common stock sold in the offering other than shares purchased by officers, directors and employees or their immediate families, for which no fee will be paid. In addition, Ryan Beck & Co. will be reimbursed an amount not to exceed $100,000, without consent, for expenses, including attorney fees.

We expect that the stock offering, which expired on March 16, 2006, will result in the sale of 2,975,625 shares of Lake Shore Bancorp common stock for gross proceeds of approximately $29.8 million. As a result of completion of the offering, we expect that 6,612,500 shares will be outstanding, representing 2,975,625 shares sold at $10.00 per share and 3,363,875 shares contributed to Lake Shore, MHC for payment of the $.01 par value per share.

50% of the net proceeds of the offering will be retained by Lake Shore Bancorp, and 50% will be contributed to Lake Shore Savings in exchange for all of the outstanding common stock of Lake Shore Savings. Of the proceeds it retained, Lake Shore Bancorp will loan to The Employee Stock Ownership Plan of Lake Shore Bancorp, Inc. (“ESOP”) such amount necessary to allow the ESOP to purchase up to 238,050 shares of Lake Shore Bancorp common stock in the open market. Initially, both Lake Shore Bancorp and Lake Shore Savings intend to invest the net proceeds from the stock offering in short-term investments and mortgage-backed and asset-backed securities until these proceeds can be deployed for other purposes.

Lake Shore Bancorp’s common stock will be quoted on the Nasdaq National Market under the symbol “LSBK.”

We expect the reorganization and offering to be completed in early April 2006.

 

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Item 6. Selected Financial Data.

The summary information presented below at December 31, 2005 and 2004 and for the years ended December 31, 2005, 2004 and 2003 is derived in part from and should be read in conjunction with the financial statements of Lake Shore Savings and the notes thereto presented elsewhere in this Form 10-K. The information at December 31, 2003, 2002, and 2001 and for the years ended December 31, 2002 and 2001 is derived from the audited financial statements of Lake Shore Savings which are not included herewith.

 

     As of December 31,
     2005    2004    2003    2002    2001
     (Dollars in thousands)

Selected financial condition data:

              

Total assets

   $ 333,724    $ 329,841    $ 303,511    $ 238,056    $ 214,086

Loans, net

     206,160      199,525      187,138      156,740      144,600

Securities available for sale

     94,082      99,170      83,027      52,225      41,934

Securities held to maturity

     2,275      2,359      371      765      1,118

Federal Home Loan Bank stock

     2,716      2,709      2,167      1,420      1,162

Total cash and cash equivalents

     12,053      11,577      16,753      16,238      14,269

Total deposits

     250,890      243,554      230,495      195,092      182,066

Short-term borrowings

     11,205      11,725      11,800      4,005      1,115

Long-term debt

     37,480      42,260      31,535      11,535      5,540

Total equity

     27,995      26,915      24,947      23,942      21,705

Allowance for loan losses

     1,240      1,288      1,293      1,217      924

Non-performing loans

     1,362      792      1,052      1,408      1,402

Non-performing assets

     1,448      932      1,506      1,520      1,481
    

For the year

ended December 31,

     2005    2004    2003    2002    2001
     (Dollars in thousands)

Selected operating data:

              

Interest income

   $ 15,956    $ 14,744    $ 12,780    $ 13,182    $ 14,215

Interest expense

     6,426      5,332      4,694      4,946      7,053

Net interest income

     9,530      9,412      8,086      8,236      7,162

Provision for loan losses

     20      267      345      360      325

Net interest income after provision for loan losses

     9,510      9,145      7,741      7,876      6,837

Total non-interest income

     1,847      1,875      1,728      1,646      1,820

Total non-interest expense

     8,350      7,939      7,218      6,201      5,576

Income before income taxes

     3,007      3,081      2,251      3,321      3,081

Income taxes

     953      902      744      1,085      1,018

Net income

   $ 2,054    $ 2,179    $ 1,507    $ 2,236    $ 2,063
                                  

 

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For the year

ended December 31,

 
     2005     2004     2003     2002     2001  

Selected financial ratios and other data

          

Performance ratios:

          

Return on average assets

   0.62 %   0.68 %   0.58 %   1.00 %   0.99 %

Return on average equity

   7.47 %   8.45 %   6.24 %   9.97 %   10.37 %

Interest rate spread(1)

   2.93 %   3.03 %   3.18 %   3.68 %   3.25 %

Net interest margin(2)

   3.09 %   3.15 %   3.32 %   3.95 %   3.70 %

Efficiency ratio(3)

   73.39 %   70.34 %   73.55 %   62.75 %   62.08 %

Non interest expense to average total assets

   2.53 %   2.48 %   2.76 %   2.77 %   2.67 %

Average interest-earning assets to average interest-bearing liabilities

   107.51 %   106.35 %   107.49 %   111.21 %   112.40 %

Capital ratios:

          

Total risk-based capital to risk weighted assets

   17.06 %   16.34 %   16.37 %   18.47 %   17.84 %

Tier 1 risk-based capital to risk weighted assets

   16.00 %   15.18 %   15.19 %   17.10 %   16.75 %

Tangible capital to tangible Assets

   8.47 %   7.99 %   7.97 %   9.56 %   9.53 %

Tier 1 leverage (core) capital to adjustable tangible assets

   8.47 %   7.99 %   7.97 %   9.56 %   9.53 %

Equity to total assets

   8.39 %   8.16 %   8.22 %   10.06 %   10.14 %

Asset quality ratios:

          

Non-performing loans as a percent of total net loans

   0.66 %   0.40 %   0.56 %   0.90 %   0.97 %

Non-performing assets as a percent of total assets

   0.43 %   0.28 %   0.50 %   0.64 %   0.69 %

Allowance for loan losses as a Percent of total net loans

   0.60 %   0.65 %   0.69 %   0.78 %   0.64 %

Allowance for loan losses as a percent of non-performing loans

   91.04 %   162.63 %   122.91 %   86.43 %   65.91 %

Other data:

          

Number of full service offices

   8     7     7     5     5  

(1) Represents the difference between the weighted-average yield on interest-earning assets and the weighted-average cost of interest-bearing liabilities for the period.

 

(2) The net interest margin represents the net interest income as a percent of average interest-earning assets for the period.

 

(3) The efficiency ratio represents non-interest expense divided by the sum of net interest income and non-interest income.

 

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

This discussion and analysis reflects Lake Shore Savings’ financial statements and other relevant statistical data and is intended to enhance your understanding of Lake Shore Savings’ financial condition and results of operations. You should read the information in this section in conjunction with Lake Shore Savings financial statements and accompanying notes to financial statements beginning on page F-1 of this Form 10-K, and the other statistical data provided in this Form 10-K. Upon completion of the reorganization, Lake Shore Savings will become the wholly-owned subsidiary of Lake Shore Bancorp. At that time, the financial information presented herein will be part of the consolidated financial information for Lake Shore Bancorp. Prior to completion of the reorganization, Lake Shore Bancorp will not exist.

General

Our results of operations depend primarily on our net interest income, which is the difference between the interest income we earn on loans and investments and the interest we pay on deposits and other interest-bearing liabilities. Net interest income is affected by the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on these balances. For the years ended December 31, 2005 and 2004, our net income was $2.1 million and $2.2 million, respectively.

Our operations are also affected by non-interest income, such as service fees and gains and losses on the sales of securities and loans, our provision for loan losses and non-interest expenses which include salaries and employee benefits, occupancy costs, and other general and administrative expenses.

Financial institutions like us, in general, are significantly affected by economic conditions, competition, and the monetary and fiscal policies of the federal government. Lending activities are influenced by the demand for and supply of housing, competition among lenders, interest rate conditions, and funds availability. Our operations and lending are principally concentrated in the Western New York area, and our operations and earnings are influenced by local economic conditions. Deposit balances and cost of funds are influenced by prevailing market rates on competing investments, customer preferences, and levels of personal income and savings in our primary market area. Since 1993, following the appointment of our current chief executive officer, and despite the fact that the Western New York market area has been economically stagnant, we have tripled in asset size and gone from being a two office institution to having eight branches. Since 1998 our asset size has more than doubled and we have opened three new branches.

Management Strategy

Our Reputation. Our primary management strategy has been to retain our perceived image as one of the most respected and recognized community banks in Western New York with 115 years of service to our community. Our management strives to accomplish this goal by continuing to emphasize our high quality customer service and financial strength. We are one of the largest lenders in market share of residential mortgages in Chautauqua County.

Branching. In 2003, we opened new branch offices in Orchard Park and East Amherst, New York. These new offices have generated deposits of $29.9 million and $18.8 million as of December 31, 2005, respectively. We opened an additional new branch office in Hamburg, New York in December 2005. Our offices are located in Dunkirk, Fredonia, Jamestown, Lakewood and Westfield, in Chautauqua County, New York and in East Amherst, Hamburg and Orchard Park in Erie County, New York. Saturation of the market in Chautauqua County led to our expansion plan in Erie County which is a critical component of our future profitability and growth.

 

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Our People. A large part of our success is related to customer service and customer satisfaction. Having employees who understand and value our clientele and their business is a key component to our success. We believe that our present staff is one of our competitive strengths and thus the retention of such persons and our ability to continue to attract high quality personnel are high priorities

Residential Mortgage and Other Lending. Historically, our lending portfolio has been composed predominantly of residential mortgage loans. At December 31, 2005 and 2004, we held $148.2 million and $142.2 million of residential mortgage loans, respectively, which constituted 71.8% and 71.1% of our total loan portfolio, at such respective dates. Due to the historically low interest rates in recent past years, we experienced an increase of mortgage lending and refinancing in 2003 and 2002. Mortgage lending and refinancing has slowed in the past two years as interest rates have risen and the competition for residential mortgage loans, which had previously increased to meet the higher number of loans being generated and refinanced, remained strong. We originate commercial real estate loans to finance the purchase of real property, which generally consists of developed real estate. At December 31, 2005 and December 31, 2004, our commercial real estate loan portfolio consisted of loans totaling $16.8 million and $15.3 million respectively, or 8.2% and 7.7%, respectively, of total loans. In addition to commercial real estate loans, we also engage in small business commercial lending, including business installment loans, lines of credit, and other commercial loans. Other loan products offered to our customers include home equity loans, construction loans and consumer loans, including auto loans, overdraft lines of credit and share loans. At December 31, 2005 and December 31, 2004, our commercial loan portfolio consisted of loans totaling $8.3 million and $8.6 million, respectively, or 4.0% and 4.3%, respectively, of total loans. We will sell loans when appropriate and will retain servicing rights to those loans. We will invest excess funds in permissible investments such as mortgage-backed securities and asset-backed securities, when such investment opportunities are prudent. Residential mortgage loans will continue to be the dominant type of loan in our lending portfolio.

Investment Strategy. Our investment policy is designed primarily to manage the interest rate sensitivity of our assets and liabilities, to generate a favorable return without incurring undue interest rate and credit risk, to complement our lending activities and to provide and maintain liquidity within established guidelines. At December 31, 2005, our investment securities totaled $99.1 million. Investment securities available for sale, which constituted approximately 95% of investment securities, totaled $94.1 million at December 31, 2005.

Flattening Yield Curve. As with all community banks, we face a challenge in monitoring our interest rate risk with a “flattening yield curve.” Banks generate revenue on the difference between the interest earned on loans, which are generally for longer terms, and the interest paid on deposits, which are generally for shorter terms. Banks try to match interest-earning assets and interest-paying liabilities against one another. As the Federal Reserve Board has increased the federal funds rate, short-term interest rates have risen; however, long-term rates, which are generally responsive to the bond market, have not been increasing, and have even decreased. Thus, the margin between interest earning assets and interest bearing liabilities is shrinking, resulting in reduced net interest income. Our strategy of maintaining and increasing our interest income in a flattening yield curve environment is two-fold. First, we seek protection by locking in lower long-term rates with advances from the Federal Home Loan Bank of New York. At December 31, 2005, we had total Federal Home Loan Bank borrowings of $48.7 million with an average interest rate of 3.85%. Second, we have engaged a third party financial advisor to assist us in investing such borrowed funds in attractive permissible investment securities. At December 31, 2005, we had $94.1 million in investment in securities available for sale, the majority of which are mortgage-backed or asset backed securities.

 

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Expected Increases In Non-interest Expenses. As a result of our reorganization and offering, our non-interest expenses will increase.

 

    To have publicly-traded common stock, Lake Shore Bancorp was required to register as a public company with the Securities and Exchange Commission and under the Securities and Exchange Act of 1934, as amended, and became subject to periodic reporting requirements and associated disclosure controls and procedures and internal control over financial reporting standards. It is expected that in complying with these requirements, we will incur additional costs in preparing the necessary filings. Lake Shore Bancorp’s common stock will be quoted on the Nasdaq National Market. To maintain such listing we must pay fees. Additionally, in anticipation of our publicly-held stock corporation structure, we retained a stock transfer agent and will incur miscellaneous operating expenses such as stockholder communications expenses, all of which are new and recurring costs.

 

    As part of the reorganization, we will convert Lake Shore Savings from a New York-chartered mutual savings and loan association to a federal stock savings bank. Lake Shore Bancorp and Lake Shore, MHC will also have federal charters. As a result, the Office of Thrift Supervision will be the primary federal regulator for all three entities. As a state-chartered savings and loan association, Lake Shore Savings had been subject to the regulation of and assessments by each of the New York State Banking Department, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision. We expect cost savings by having the Office of Thrift Supervision as our primary regulator; however, these cost savings may be diminished by having three regulated entities rather than just a mutual savings bank.

 

    As part of the reorganization and offering, we will make a loan to an employee stock ownership plan to purchase up to 8% of the shares sold in the offering. In addition, no earlier than six months after the closing of the offering, subject to stockholder approval, we plan to reserve for issuance up to 1.96% and 4.90% of the shares outstanding after the offering for a management recognition plan and a stock option plan, respectively. The funding of each of these intentions, will cause Lake Shore Bancorp to recognize additional expenses on a consolidated basis.

We expect to continue to grow our base of interest-earning assets by expanding our loan portfolio and by using borrowings, where appropriate, to supplement deposits as a funding source. We also intend to grow by adding new branch offices. We may also use proceeds from the offering to establish or acquire branch offices, to fund the building of new offices and to make other acquisitions, although no acquisitions or new branches are being specifically considered at this time.

Critical Accounting Policies

It is management’s opinion that accounting estimates covering certain aspects of our business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity required in making such estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance for loan losses required for probable credit losses and the material effect that such judgments can have on the results of operations. Management’s quarterly evaluation of the adequacy of the allowance considers our historical loan loss experience, review of specific loans, current economic conditions, and such other factors considered appropriate to estimate loan losses. Management uses presently available information to estimate probable losses on loans; however, future additions to the allowance may be necessary based on changes in estimates, assumptions, or economic conditions. Significant factors that could give rise to changes in these estimates include, but are not limited to, changes in economic conditions in the local area, concentrations of risk and decline in local property values.

 

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Management also considers the accounting policy relating to the impairment of investments to be a critical accounting policy due to the subjectivity and judgment involved and the material effect an impairment loss could have on the results of operations. A decline in the fair value of investments below cost deemed to be other than temporary is charged to earnings resulting in the establishment of a new cost basis for an asset. Management continually reviews the current value of its investments for evidence of other than temporary impairment.

These critical policies and their application are reviewed periodically by the Audit Committee and the Board of Directors. All accounting policies are important, and as such, we encourage the reader to review each of the policies included in Note 2 to the Notes to the Financial Statements to better understand how our financial performance is reported.

Analysis Of Net Interest Income

Net interest income represents the difference between the interest we earn on our interest-earning assets, such as mortgage loans and investment securities and the expense we pay on interest-bearing liabilities, such as time deposits. Net interest income depends on both the volume of our interest-earning assets and interest-bearing liabilities and the interest rates we earn or pay on them.

 

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Average Balances, Interest and Average Yields. The following table sets forth certain information relating to our average balance sheets and reflects the average yield on interest-earnings assets and average cost of interest-bearing liabilities, interest earned and interest paid for the periods indicated. Such yields and costs are derived by dividing income or expense by the average balance of interest-earning assets or interest-bearing liabilities, respectively, for the periods presented. Average balances are derived from daily balances over the periods indicated. The average balances for loans are net of allowance for loan losses, but include non-accrual loans. Interest income on securities include a tax equivalent adjustment for bank qualified municipals.

 

     At December 31, 2005    

For the Year ended

December 31, 2005

   

For the Year ended

December 31, 2004

   

For the Year ended

December 31, 2003

 
    

Actual

Balance

  

Yield/

Rate

   

Average

Balance

  

Interest
Income/

Expense

  

Yield/

Rate

   

Average

Balance

  

Interest
Income/

Expense

  

Yield/

Rate

   

Average

Balance

  

Interest
Income/

Expense

  

Yield/

Rate

 
     (Dollars in thousands)  

Interest-earning assets:

                             

Federal funds sold and other interest-bearing deposits

     1,167    3.75 %     6,560      142    2.16 %     9,393      101    1.08 %     12,360      122    0.99 %

Securities

     99,073    4.06 %     101,532      4,021    3.96 %     96,075      3,541    3.69 %     68,026      2,586    3.80 %

Loans

     206,160    5.72 %     200,652      11,793    5.88 %     193,435      11,102    5.74 %     162,886      10,072    6.18 %
                                                                         

Total interest-earning Assets

     306,400    5.21 %     308,744      15,956    5.17 %     298,903      14,744    4.93 %     243,272      12,780    5.25 %

Other assets

     27,324        21,373           20,681           17,965      
                                             

Total assets

   $ 333,724      $ 330,117         $ 319,584         $ 261,237      
                                             

Interest-bearing liabilities:

                             

Demand and NOW accounts

   $ 41,443    0.37 %   $ 38,163      152    0.40 %   $ 38,344      110    0.29 %   $ 36,099      176    0.49 %

Money market accounts

     27,949    0.96 %     29,413      268    0.91 %     30,922      275    0.89 %     24,404      276    1.13 %

Savings accounts

     27,871    0.54 %     29,833      151    0.51 %     31,391      159    0.51 %     30,951      287    0.93 %

Time deposits

     139,818    2.82 %     136,141      3,945    2.90 %     127,658      3,130    2.45 %     111,908      3,148    2.81 %

Borrowed funds

     48,685    3.75 %     51,357      1,824    3.55 %     50,760      1,593    3.14 %     21,447      747    3.48 %

Advances from borrowers on taxes and insurance

     2,432    1.85 %     1,890      45    2.38 %     1,610      40    2.48 %     1,342      35    2.61 %

Other interest-bearing liabilities

     1,424    2.88 %     368      41    11.14 %     379      25    6.60 %     164      25    15.24 %
                                                                     

Total interest bearing liabilities

     289,622    2.22 %     287,165      6,426    2.24 %     281,064      5,332    1.90 %     226,315      4,694    2.07 %
                                         

Other non-interest bearing liabilities

     16,107        15,345           12,737           10,764      

Equity

     27,995        27,607           25,783           24,158      
                                         

Total liabilities and equity

   $ 333,724      $ 330,117         $ 319,584         $ 261,237      
                                             

Net interest income

           $ 9,530         $ 9,412         $ 8,086   
                                         

Interest rate spread

              2.93 %         3.03 %         3.18 %

Net interest margin

              3.09 %         3.15 %         3.32 %

 

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Rate Volume Analysis. The following table analyzes the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It shows the amount of the change in interest income or expense caused by either changes in outstanding balances (volume) or changes in interest rates. The effect of a change in volume is measured by applying the average rate during the first period to the volume change between the two periods. The effect of changes in rate is measured by applying the change in rate between the two periods to the average volume during the first period. Changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the absolute value of the change due to volume and the change due to rate.

 

    

Year Ended December 31, 2005

Compared to Year Ended December 31, 2004

    Year Ended December 31, 2004
Compared to Year Ended December 31, 2003
 
     Rate     Volume     Net Change     Rate     Volume     Net Change  
     (Dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other interest-bearing deposits

   $ 79     $ (38 )   $ 41     $ 10     $ (31 )   $ (21 )

Securities

     272       208       480       (81 )     1,036       955  

Loans

     271       420       691       (761 )     1,791       1,030  
                                                

Total interest-earning assets

     622       590       1,212       (832 )     2,796       1,964  
                                                

Interest-bearing liabilities:

            

Demand and NOW accounts

     43       (1 )     42       (76 )     10       (66 )

Money market accounts

     7       (14 )     (7 )     (66 )     65       (1 )

Savings accounts

     —         (8 )     (8 )     (132 )     4       (128 )

Time deposits

     597       218       815       (431 )     413       (18 )
                                                

Total deposits

     647       195       842       (705 )     492       (213 )

Other interest-bearing liabilities:

            

Borrowed funds

     212       19       231       (81 )     927       846  

Advances from borrowers on taxes and insurance and other interest-bearing liabilities

     15       6       21       (22 )     27       5  
                                                

Total interest-bearing liabilities

     874       220       1,094       (808 )     1,446       638  
                                                

Net change in interest income

   $ (252 )   $ 370     $ 118     $ (24 )   $ 1,350     $ 1,326  
                                                

 

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Comparison Of Financial Condition at December 31, 2005 and December 31, 2004

Total assets at December 31, 2005 were $333.7 million, an increase of $3.9 million from $329.8 million at December 31, 2004. The increase in total assets is predominantly the result of an increase in loans receivable and premises and equipment, offset by a decrease in investment securities.

Our cash and cash equivalents increased by $476,000 to $12.1 million at December 31, 2005, from $11.6 million at December 31, 2004. This is due to an increase of $3.7 million in cash and due from banks from $7.2 million at December 31, 2004 to $10.9 million at December 31, 2005, offset by a decrease in our Federal funds sold of $2.0 million and a decrease in interest bearing deposits of $1.2 million. All of our cash and cash equivalent balances reflect our liquid funds until they are deployed into lending or investment securities.

Investment securities decreased by $5.2 million to $99.0 million at December 31, 2005 from $104.2 million at December 31, 2004. More specifically, investment securities available for sale decreased by $5.1 million to $94.1 million at December 31, 2005 as compared to $99.2 million at December 31, 2004. The decrease is attributable to the proceeds from investment payoffs being used to paydown our borrowings at the Federal Home Loan Bank of New York, instead of being reinvested.

Loans receivable, net increased by $6.6 million to a total of $206.2 million at December 31, 2005 from $199.5 million at December 31, 2004. Residential mortgage loans increased $6.0 million to a total of $148.2 million at December 31, 2005 in comparison to $142.2 million at December 31, 2004. Commercial real estate loans increased by $1.5 million from December 31, 2004 to December 31, 2005 while home equity loans increased by $182,000. Mortgage loans and commercial real estate loans represented 71.9% and 8.2%, respectively, of the loan portfolio at December 31, 2005. Deferred loan fees increased by $275,000 from $891,000 at December 31, 2004 to $1.2 million at December 31, 2005 due to an increase in our loan volume. The allowance for loan losses decreased slightly by $48,000 during the period from December 31, 2004 to December 31, 2005. During 2005, our analysis of the allowance for loan losses allowed us to more accurately identify risks inherent within the loan portfolio by loan categories. As a result, the amount needed in the unallocated portion of the allowance for loan loss was reduced from 22.4% of the total allowance for loan loss as of December 31, 2004 to 6.9% as of December 31, 2005. The remainder of the loan portfolio consists of commercial, consumer and construction loans.

Deposits grew by $7.3 million, or 3.0%, to $250.9 million at December 31, 2005, as compared to $243.6 million at December 31, 2004, primarily due to increased time deposit levels.

Our borrowings, consisting of advances from the Federal Home Loan Bank of New York, decreased by $5.3 million from $54.0 million at December 31, 2004 to $48.7 million at December 31, 2005. We have used these funds as a source of liquidity for loans and investment securities.

Total equity increased by $1.1 million from $26.9 million at December 31, 2004 to $28.0 million at December 31, 2005. The increase in total equity was primarily due to net income of $2.1 million for the year ended December 31, 2005 offset by changes in the mark-to-market value of our available for sale investment securities for the year ended December 31, 2005.

Comparison of Results of Operations for the Years Ended December 31, 2005 and 2004

General. Net income was $2.1 million for the year ended December 31, 2005, a decrease of $125,000 or 5.7%, compared with net income of $2.2 million for the year ended December 31, 2004.

 

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Net Interest Income. Net interest income increased by $118,000, or 1.3%, to $9.5 million for the year ended December 31, 2005 as compared to $9.4 million for the year ended December 31, 2004. This increase reflects increased interest income of $1.2 million for the year ended December 31, 2005, partially offset by an increase in interest expense of $1.1 million.

Interest Income. Interest income increased $1.2 million, or 8.2%, from $14.7 million for the year ended December 31, 2004 to $15.9 million for the year ended December 31, 2005. Approximately $691,000 of this increase was attributable to an increase in interest on loans, the average balance of which increased by $7.2 million over the year and had an average yield of 5.88% in 2005 as compared to an average yield of 5.74% in the prior year. $480,000 of the increase was attributable to an increase from interest on investment securities, the average balance of which increased by $5.5 million over the year and had an average yield of 3.96% in 2005 as compared to an average yield of 3.69% in the prior year.

Interest Expense. Interest expense increased by $1.1 million, or 20.5%, from $5.3 million for the year ended December 31, 2004 to $6.4 million for the year ended December 31, 2005. The interest paid on deposits increased by $842,000 from $3.7 million for the year ended December 31, 2004 to $4.5 million for the year ended December 31, 2005. This was due to an increase in the average yield paid on interest-bearing deposits over the year of 0.58% and an increase in the average balance of interest-bearing deposits of $5.2 million over the year. The interest expense related to advances from the Federal Home Loan Bank of New York increased by $231,000 from $1.6 million for the year ended December 31, 2004 to $1.8 million for the year ended December 31, 2005 due to increased borrowings at the beginning of 2005.

Provision for Loan Losses. For the year ended December 31, 2005, the provision for loan losses was $20,000, a decrease as compared to the provision for loan losses for the prior year which was $267,000. Despite growth in our loan portfolio and an increase in the percent of nonperforming loans to total net loans, we were able to decrease the provision for loan losses based on the quality of our loan portfolio and the adequacy of reserves already in place.

We establish provisions for loan losses, which are charged to operations, in order to maintain the allowance for loan losses at a level management considers necessary to absorb probable incurred credit losses in the loan portfolio. The amount of the allowance is based on estimates and the ultimate losses may vary from such estimates as more information becomes available or later events occur. Management assesses the allowance for loan losses on a quarterly basis and makes provisions for loan losses in order to maintain the adequacy of the allowance.

Non-interest Income. For the year ended December 31, 2005, non-interest income, which is a total of service charges and fees, net gains or losses on sales of available-for-sale securities and loans, as well as other income, not including interest and dividends, totaled $1.8 million, which was a decrease of $28,000 in comparison to the corresponding period in the prior year.

Non-interest Expense. Non-interest expense increased $411,000 from $7.9 million for the year ended December 31, 2004 to $8.3 million for the year ended December 31, 2005. Non-interest expense includes the expense of salaries and employee benefits, occupancy and equipment costs, data processing, and other items not related to expenses on deposits or borrowings. The increase in non-interest expense was attributable in large part to a loss expense recorded as a result of a check kiting matter involving one of our customers. The total loss recorded was $188,000. This situation is an isolated incident. Our advertising expenditures increased $107,000, or 55.4%, and our professional service expenditures increased $95,000, or 23.2%. Advertising expense increased due to continuing efforts to obtain name recognition in the Erie County, New York market area, where we have opened three branches in the last two years. Professional service expenditures increased as a result of outsourcing our back-office check processing operations to a third-party processor during 2005. These increases were offset by a decrease

 

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in salaries and employee benefits expense of $96,000, or 2.1%. The decrease in salaries and employee benefits was due to a new health care plan that was introduced to our employees during 2005.

Income Tax Expense. Income tax expense increased by $51,000 from $902,000 for the year ended December 31, 2004 to $953,000 for the year ended December 31, 2005. The increase is largely attributed to a decrease in our New York State tax credits in 2005, as compared to 2004.

Comparison of Results of Operations for the Years Ended December 31, 2004 and 2003

General. Net income was $2.2 million for the year ended December 31, 2004, an increase of $672,000, or 44.6%, compared with net income of $1.5 million for the year ended December 31, 2003. The increase in net income is attributable to two new branch offices that we opened in 2003. Operating expenses associated with the new branches were recorded during 2003.

Net Interest Income. Net interest income increased by $1.3 million, or 16.4%, to $9.4 million for the year ended December 31, 2004 as compared to $8.1 million for the year ended December 31, 2003. This increase reflects increased interest income of $1.9 million for the year ended December 31, 2004 as compared to the prior year, partially offset by an increase in interest expense of $638,000 over the same period.

Interest Income. Interest income increased $1.9 million, or 15.4%, from $12.8 million for the year ended December 31, 2003 to $14.7 million for the year ended December 31, 2004. Approximately $1.0 million of this increase was attributable to an increase in interest on loans, the average balance of which increased by $30.6 million over the year and had an average yield of 5.74% as compared to an average yield of 6.18% in the prior year. The remaining $1.0 million of the increase was attributable to an increase from interest on investment securities, the average balance of which increased by $28.0 million over the year and had an average yield of 3.69% as compared to an average yield of 3.80% in the prior year.

Interest Expense. Interest expense increased by $638,000, or 13.6%, from $4.7 million for the year ended December 31, 2003 to $5.3 million for the year ended December 31, 2004. The interest paid on deposits decreased by $213,000 from $3.9 million for the year ended December 31, 2003 to $3.7 million for the year ended December 31, 2004. This was due to an decrease in the average yield paid on deposits over the year of 1.22% offset by an increase in the average balance of deposits of $25.0 million over the year. The interest expense related to advances from the Federal Home Loan Bank of New York increased from $747,000 for the year ended December 31, 2003 to $1.6 million for the year ended December 31, 2004 as our borrowings increased.

Provision for Loan Losses. For the year ended December 31, 2004, the provision for loan losses was $267,000, a decrease as compared to the provision for loan losses for the prior year which was $345,000. Despite increasing our loan portfolio, we were able to decrease the provision for loan losses based on the quality of the loan portfolio and the amount of allowance for loan losses already in place. Management has determined this based on a detailed review of our existing loan portfolio, historical charge-off rates and non-performing loans.

Non-interest Income. Non-interest income increased by $147,000 between the years ended December 31, 2004 and 2003. For the year ended December 31, 2004, non-interest income totaled $1.9 million, whereas for the prior year it totaled $1.7 million. The increase is attributable to increased overdraft service charges and increased gains on sales of available for sale securities, offset in part by decreased net gains on sales of loans and decreased other income.

Non-interest Expense. Non-interest expense increased $721,000 from $7.2 million for the year ended December 31, 2003 to $7.9 million for the year ended December 31, 2004. The majority of the

 

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increase in non-interest expense was attributable to salaries and employee benefits which increased $614,000, or 15.9%, from $3.9 million for the year ended December 31, 2003 to $4.5 million for the year ended December 31, 2004. The increase in salaries and employee benefits was primarily due to annual salary increases and hiring additional personnel to staff new branch offices opened during 2003 in Erie County.

Income Tax Expense. Income tax expense increased by $158,000 from $744,000 for the year ended December 31, 2003 to $902,000 for the year ended December 31, 2004. The increase reflects an increase in our pretax income from $2.3 million in 2003 to $3.1 million in 2004.

Liquidity and Capital Resources

Liquidity describes our ability to meet the financial obligations that arise during the ordinary course of business. Liquidity is primarily needed to meet the lending and deposit withdrawal requirements of our customers and to fund current and planned expenditures. Our primary sources of funds consist of deposits, scheduled amortization and prepayments of loans and mortgage-backed and asset-backed securities, maturities and sales of other investments, interest bearing deposits at other financial institutions and funds provided from operations. We have written agreements with the Federal Home Loan Bank of New York, which as of December 31, 2005, allowed us to borrow up to $23.4 million on an overnight line of credit and $23.4 million on a one-month overnight repricing line of credit We have no borrowings through either of these agreements. We also have a third agreement to obtain advances from the Federal Home Loan Bank collateralized by a pledge of our mortgage loans. At December 31, 2005, we had outstanding advances totaling $48.7 million.

Loan repayments and maturing investment securities are a relatively predictable source of funds. However, deposit flows, calls of investment securities, and prepayments of loans and mortgage-backed securities are strongly influenced by interest rates, general and local economic conditions, and competition in the marketplace. These factors reduce the predictability of the timing of these sources of funds.

Our primary investing activities include the origination of loans and, to a lesser extent, the purchase of investment securities. For the year ended December 31, 2005, we originated loans of approximately $43.6 million in comparison to approximately $49.6 million of loans originated during the year ended December 31, 2004. Purchases of investment securities totaled $21.4 million in the year ended December 31, 2005 and $44.1 million in the year ended December 31, 2004.

At December 31, 2005, we had loan commitments to borrowers of approximately $6.0 million and overdraft lines of protection and unused home equity lines of credit of approximately $20.1 million.

Total deposits were $250.8 million at December 31, 2005, as compared to $243.6 million at December 31, 2004. Time deposit accounts scheduled to mature within one year were $94.8 million at December 31, 2005. Based on our deposit retention experience, current pricing strategy, and competitive pricing policies, we anticipate that a significant portion of these time deposits will remain with us.

We are committed to maintaining a strong liquidity position, therefore, we monitor our liquidity position on a daily basis. We anticipate that we will have sufficient funds to meet our current funding commitments. The marginal cost of new funding, however, whether from deposits or borrowings from the Federal Home Loan Bank, will be carefully considered as we monitor our liquidity needs. Therefore, in order to minimize our cost of funds, we may consider additional borrowings from the Federal Home Loan Bank in the future.

 

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We do not anticipate any material capital expenditures in 2006. We do not have any balloon or other payments due on any long-term obligations or any off-balance sheet items other than debt as described in Note 8 to the Financial Statements and the commitments and unused lines and letters of credit noted above.

We are contractually obligated to make payments as of December 31, 2005 as follows:

 

          Payments due by Period:
     Total    1 year    1-3 years    3-5
years
   After 5
years
     (Dollars in thousands)

Long term debt

   $ 37,480    $ 8,230    $ 17,990    $ 9,350    $ 1,910

Capital Leases

     3,272      141      286      304      2,541

Operating Leases

     848      87      166      161      434

Data processing contract

     841      265      553      23      —  
                                  

Total contractual obligations

   $ 42,441    $ 8,723    $ 18,995    $ 9,838    $ 4,885
                                  

The net proceeds raised in the offering will significantly increase our liquidity and capital resources. Over time, the initial level of liquidity will be reduced as net proceeds from the offering are used for general corporate purposes, including the funding of lending activities. In addition, the large increase in equity resulting from the capital raised in the offering will, initially, have an adverse impact on our return on equity. See “Risk Factors - After The Offering, Our Return On Equity Will Be Low Compared To Other Companies. This Could Hurt The Price Of Your Common Stock.”

Off-Balance Sheet Arrangements

Other than loan commitments, Lake Shore Savings does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Refer to Note 14 of the Financial Statements beginning at page F-1 for a summary of loan commitments outstanding as of December 31, 2005.

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123 (revised 2004), “Share-Based Payment.” Statement No. 123(R) addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Statement No. 123(R) requires an entity to recognize the grant-date fair-value of stock options and other equity-based compensation issued to employees in the income statement. The revised Statement generally requires that an entity account for those transactions using the fair-value-based method, and eliminates the intrinsic value method of accounting in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” which was permitted under Statement 123, as originally issued. The revised Statement also requires entities to disclose information about the nature of the share-based payment transactions and the effects of those transactions on the financial statements. At present, the Association has not issued any stock options or other equity-based compensation.

In March 2004, the EITF reached a consensus on Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-1 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS 115 and non-marketable equity securities accounted for under the cost method. The EITF

 

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developed a basic three-step model to evaluate whether an investment is other-than-temporarily impaired. In November 2005, the FASB approved the issuance of FASB Staff Position FAS No. 11501 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The FSP addresses when an investment is considered impaired, whether the impairment is other-than-temporary and the measurement of an impairment loss. The FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary. The FSP is effective for reporting period beginning after December 15, 2005 with earlier application permitted. For Lake Shore Savings and Loan Association, the effective date will be the first quarter of fiscal 2006. The adoption of this accounting principle is not expected to have a significant impact on our financial position or results of operations.

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Management Of Market Risk

The majority of our assets and liabilities are monetary in nature. Consequently, interest rate risk is our most significant market risk. Other types of market risk, such as movements in foreign currency exchange rates and commodity prices, do not arise in the normal course of our business operations. Interest rate risk can be defined as an exposure to a movement in interest rates that could have an adverse effect on our net interest income. Interest rate risk arises naturally from the imbalance in the repricing, maturity, and/or cash flow characteristics of assets and liabilities. In periods of falling interest rates, prepayments of loans typically increase, which would lead to reduced net interest income if such proceeds could not be reinvested at a comparable spread. Also in a falling interest rate environment, certain categories of deposits may reach a point where market forces prevent further reduction in the interest rate paid on those instruments. Generally, during extended periods when short-term and long-term interest rates are relatively close, a flat yield curve may lead to smaller net interest margins thereby reducing net interest income. The net effect of these circumstances is reduced net interest income, offset only by a nominal decrease in interest expense, thereby narrowing the net interest margin.

Managing interest rate risk is of primary importance to us. The responsibility for interest rate risk management is the function of our Asset/Liability Committee, which includes our Chief Executive Officer and President, Chief Financial Officer and certain members of our Board of Directors. Our Asset/Liability Committee meets every other month to review our asset/liability policies and identify and measure potential risks to earnings due to changes in interest rates. The primary goal of our interest rate risk management is to minimize the potential loss in net interest income that could arise from changes in interest rates given our business strategy, operating environment, capital, liquidity and performance objectives. Our Chief Financial Officer also receives recommendations from a third party financial advisor regarding permissible investment securities, the use of which are part of our management of interest rate risk.

Net Interest Income At Risk

In past years, many savings banks have measured interest rate sensitivity by computing the “gap” between the assets and liabilities which are expected to mature or reprice within certain time periods, based on assumptions regarding loan prepayment and deposit decay rates formerly provided by the Office of Thrift Supervision. However, the Office of Thrift Supervision now requires the computation of amounts by which the net present value of an institution’s cash flow from assets, liabilities and off balance sheet items (the institution’s net portfolio value) would change in the event of a range of assumed changes in market interest rates. The Office of Thrift Supervision provides all institutions that file a Consolidated Maturity/Rate Schedule as part of their quarterly Thrift Financial Report with an interest rate sensitivity report of net portfolio value. The Office of Thrift Supervision’s simulation model uses discounted cash flow analysis and an option-based pricing approach to measure the interest rate

 

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sensitivity of net portfolio value. Historically, the Office of Thrift Supervision model estimated the economic value of each type of asset, liability and off-balance sheet contract under the assumption that the United States Treasury yield curve increases or decreases instantaneously by 100 to 300 basis points in 100 basis point increments. However, given the current low level of market interest rates, we did not prepare a net portfolio value calculation for an interest rate decrease of greater than 100 basis points. A basis point equals one-hundredth of one percent, and 100 basis points equals one percent. An increase in interest rates from 3% to 4% would mean, for example, a 100 basis point increase in the “Change in Interest Rates” column below.

The table below sets forth as of December 31, 2005 and December 31, 2004, the estimated changes in our net portfolio value that would result from designated instantaneous changes in the United States Treasury yield curve. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual results.

 

     As of December 31, 2005     As of December 31, 2004  

Change in

Interest Rates

(basis points) (1)

   Amount    Dollar
Change
from Base
    Percentage
Change
from Base
    Amount   

Dollar

Change

From Base

    Percentage
Change
from Base
 
     (Dollars in thousands)  

+300

   $ 20,909    $ (18,806 )   (47 %)   $ 21,985    $ (17,304 )   (44 %)

+200

     27,341      (12,374 )   (31 %)     28,435      (10,854 )   (28 %)

+100

     33,713      (6,002 )   (15 %)     34,441      (4,848 )   (12 %)

0

     39,715      —       —         39,289      —       —    

-100

     43,357      3,642     9 %     40,957      1,668     4 %

(1) Assumes an instantaneous uniform change in interest rates. A basis point equals 0.01%.

Our earnings may be adversely impacted by an increase in interest rates because the majority of our interest-earning assets are long-term, fixed rate mortgage-related assets that will not reprice as long-term interest rates increase, while a majority of our interest-bearing liabilities are expected to reprice. At December 31, 2005, 78.4% of our loans with contractual maturities of greater than one year had fixed rates of interest, and 95.5% of our total loans had contractual maturities of five or more years. Overall, at December 31, 2005 , 90.0% of our total interest-earning assets had contractual maturities of more than five years. Conversely, our interest-bearing liabilities generally have much shorter contractual maturities. A significant portion of our deposits have no contractual maturities and are likely to reprice quickly as short-term interest rates increase. In addition, 67.8% of our certificates of deposit will mature within one year, and 39.9% of our borrowed funds contractually mature within one year. Therefore, in an increasing rate environment, our cost of funds is expected to increase more rapidly than the yields earned on our loan portfolio and securities portfolio. An increasing rate environment is expected to cause a narrowing of our net interest rate spread and a decrease in our earnings.

We anticipate short-term market interest rates will continue to increase in 2006, and long-term market interest rates will begin to increase, but not as fast as short-term interest rates. This potential market interest rate scenario would cause the spread between long-term interest rates and short-term interest rates to decrease. If this occurs, the resulting interest rate environment is expected to have a negative impact on our results of operations as our interest-bearing liabilities, both deposits and borrowed funds, generally price off short-term interest rates, while our interest-earning assets, both mortgage loans and securities, generally price off long-term interest rates.

 

Item 8. Financial Statements and Supplementary Data.

See pages F-1 through F-30 following the signature page of this Annual Report on Form 10-K.

 

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

On January 28, 2004, the Audit Committee of the Board of Directors of Lake Shore Savings and Loan Association dismissed PricewaterhouseCoopers LLP (“PwC”), and retained Fagliarone Group CPAs, as our independent registered public accounting firm. We had no disagreements with PwC on accounting and financial disclosure matters.

Effective August 24, 2005, the Audit Committee of the Board of Directors of Lake Shore Savings and Loan Association dismissed Fagliarone Group CPAs , and retained Beard Miller Company LLP, as our independent registered public accounting firm. We had no disagreements with Fagliarone Group CPAs on accounting and financial disclosure matters.

 

Item 9A. Controls and Procedures.

Our management, including our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d—15(e)) as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective, as of December 31, 2005, to ensure that information relating to us, which is required to be disclosed in the reports we file with the Securities and Exchange Commission under the Exchange Act, is (i) recorded, processed, summarized and reported as and when required and (ii) accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosures.

There has been no change in our internal control over financial reporting identified in connection with the evaluation that occurred during our last fiscal quarter that has materially affected, or that is reasonably likely to materially affect, our internal control over financial reporting.

 

Item 9B. Other Information.

None.

 

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PART III

 

Item 10. Directors and Executive Officers of the Registrant.

Our Directors

Upon consummation of the reorganization, Lake Shore Bancorp will have eight directors. Our Charter will provide that the Board of Directors shall be divided into three classes, as nearly equal in number as possible. At each Lake Shore Bancorp annual meeting of stockholders, directors will be elected to fill the seats of those directors whose terms are expiring in that year and any vacant seats. It is expected that Lake Shore, MHC, as the majority stockholder of Lake Shore Bancorp, will be able to control the outcome of director elections. Lake Shore Bancorp, as the sole stockholder of Lake Shore Savings, will elect Lake Shore Savings’ directors.

Lake Shore Savings currently has eight directors. Upon the consummation of the reorganization, the directors of Lake Shore Savings will be divided into three classes with staggered three-year terms of office, similar to Lake Shore Bancorp’s Board of Directors and will be eligible to serve until age 75. We expect that Lake Shore Bancorp and Lake Shore Savings will continue to have common directors and common executive officers until there is a business reason to establish separate management structures.

Upon consummation of the reorganization, the current directors of Lake Shore Savings will become the directors of Lake Shore Bancorp. The following table states such directors’ names, their ages as of December 31, 2005, their positions, the years they began serving as directors of Lake Shore Savings and the years their terms as directors of Lake Shore Bancorp will expire:

 

Name

   Age   

Positions

  

Bank

Director

Since

  

Bancorp

Term Will

Expire

Sharon E. Brautigam

   49    Director    2004    2008

Michael E. Brunecz

   68    Chairman of the Board    1984    2008

James P. Foley DDS

   68    Director    1983    2009

David C. Mancuso

   60   

Director, President and Chief

Executive Officer

   1998    2007

Thomas E. Reed

   63    Director    1988    2009

Daniel P. Reininga

   47    Vice Chairman of the Board    1994    2009

Gary W. Winger

   61    Director    1997    2007

Nancy L. Yocum

   59    Director    1995    2007

Business Experience of Directors

The principal occupation and business experience for the last five years of each director is set forth below. All directors have held their current positions for five years unless otherwise stated.

Sharon E. Brautigam is a partner in the law firm of Brautigam & Brautigam, LLP in Fredonia, New York where her practice is concentrated in real estate transactions, estates, trusts and elder law.

Michael E. Brunecz is the Chairman of the Board of Directors of Lake Shore Bancorp and Lake Shore Savings. Mr. Brunecz is the President of Office Concepts, Inc. in Dunkirk, New York, a company involved in the retailing and wholesaling of office furniture.

 

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James P. Foley DDS is a dentist in private practice in Dunkirk, New York. He is a retired commander of the U.S. Naval Reserve. Dr. Foley’s daughter, Rachel A. Foley is the Chief Financial Officer of Lake Shore Bancorp and Lake Shore Savings.

David C. Mancuso is the President and Chief Executive Officer of Lake Shore Bancorp and Lake Shore Savings. Mr. Mancuso has been employed in various positions by Lake Shore Savings since 1965. He became President and Chief Executive Officer of Lake Shore Savings in 1993. Mr. Mancuso has been a member of the New York State Banking Board since 2001.

Thomas E. Reed is the Chairman of the Board of ECR International, Inc., a manufacturer of heating and cooling products headquartered in Utica, New York.

Daniel P. Reininga is Vice Chairman of the Board of Directors of Lake Shore Bancorp and Lake Shore Savings. Mr. Reininga is the President of G.H. Graf Realty Corporation, Inc., a real estate investment company located in Dunkirk, New York.

Gary W. Winger has been a principal of Compass Consulting, Inc. in Auburn and Jamestown, New York and Venice, Florida, a firm that provides consulting services in the area of higher education, since July 2002. From 1975 until June 2002, Mr. Winger was the Dean of Administration and Development and Chief Financial and Development Officer of Jamestown Community College in Jamestown, New York.

Nancy L. Yocum is a practicing certified public accountant. She is a partner in the firm of Brumfield & Associates in Fredonia, New York where her practice is concentrated in estates and trusts.

Our Executive Officers

Our initial senior executive officers will be the same as those who currently serve as executive officers of Lake Shore Savings. In addition to Mr. Mancuso, we have the following executive officers:

Reginald S. Corsi, 63, is the Executive Vice President of Lake Shore Bancorp. He has also been the Executive Vice President of Lake Shore Savings since 1994. Prior to joining Lake Shore Savings, Mr. Corsi was Vice President of M&T Bank.

Rachel A. Foley, 37, is the Chief Financial Officer of Lake Shore Bancorp. She was appointed Chief Financial Officer of Lake Shore Savings in March 2006 after serving as the Controller since March 1999. Prior to joining Lake Shore Savings, Ms. Foley was a Financial Audit Supervisor in the Internal Audit department of M&T Bank. Ms. Foley’s father, Dr. James P. Foley, is a director of Lake Shore Bancorp and Lake Shore Savings.

Beverley J. Mulkin, 63, is the Secretary/Treasurer of Lake Shore Bancorp. She has also been the Secretary of Lake Shore Savings since 1984 and its Treasurer since 2002.

The Boards of Directors will annually elect the executive officers of Lake Shore Bancorp and Lake Shore Savings. The elected officers will hold office until their respective successors have been elected and qualified, or until death, resignation or removal by the Board of Directors.

Meetings of the Boards of Directors.

Regular meetings of the board of directors of Lake Shore Savings are held monthly. Following the completion of the stock offering, regular meetings of the board of directors of Lake Shore Bancorp will also be held monthly. Special meetings of these boards are and will be held as needed.

 

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Committees of the Board of Directors.

Upon consummation of the reorganization, the Board of Directors of Lake Shore Bancorp will establish the following committees.

Executive Committee. The Executive Committee of the Board of Directors of Lake Shore Bancorp will exercise the powers of the Board of Directors in between Board meetings.

Compensation Committee. The Compensation Committee will assess the structure of the management team and the overall performance of Lake Shore Bancorp. It will oversee executive compensation by approving salary increases and review general personnel matters such as staff performance evaluations.

Audit Committee. The Audit Committee of Lake Shore Bancorp will be comprised of the following three directors: Mr. Brunecz, Mr. Reed and Ms. Yocum. Ms. Yocum will serve as Chairperson of the Committee. It will oversee and monitor our financial reporting process and internal control system, review and evaluate the audit performed by our independent auditors, and report any substantive issues found during the audit to the Board. The Audit Committee will be directly responsible for the appointment, compensation, and oversight of the work of our independent auditors. The Audit Committee will also review and approve all transactions with affiliated parties. The Board of Directors will adopt a written charter for the Audit Committee. The Board of Directors has determined that Nancy L. Yocum qualifies as an “audit committee financial expert” as defined in Item 401(h) of Regulation S-K. The Board of Directors has determined that Ms. Yocum is an “independent director” as defined in Nasdaq listing standards.

Nominating and Corporate Governance Committee. The Nominating and Corporate Governance Committee will meet to recommend the nomination of Directors to the full Board of Directors to fill the terms for the upcoming year or to fill vacancies during a term. The Nominating and Corporate Governance Committee will consider recommendations from stockholders if submitted in a timely manner in accordance with the procedures established in the Bylaws and will apply the same criteria to all persons being considered.

Each of the Audit, Compensation and Nominating and Corporate Governance Committees will be composed entirely of directors who are independent as such term is defined by Rule 4200(a)(15) of the National Association of Securities Dealers’ Manual and Rule 10A-3 of the Securities Exchange Act of 1934, as amended.

Director Compensation

Meeting Fees. Lake Shore Savings pays a fee to each of the non-employee directors for attendance at each board meeting and each meeting of a committee of which they are members. Members receive $975 for each Board meeting attended in person and half of that amount for each Board meeting attended telephonically. Board members also receive fees for membership on the Board’s committees. The Chairman of the Executive Committee receives an annual fee of $23,000 and its Vice Chairman receives an annual fee of $7,500. All other non-employee members of the Executive Committee receive annual fees of $5,000. The Chairpersons of the other committees receive annual fees of $4,000 and their other members receive annual fees of $2,500. Members of the Board of Directors who are also employees do not receive directors’ fees.

Lake Shore Savings and Loan Association paid fees totaling $129,233 to its non-employee directors for the year ended December 31, 2005.

 

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Directors’ Deferred Compensation Plan. Lake Shore Savings previously maintained a deferred compensation plan for non-employee directors under which each non-employee director could defer receipt of his or her directors fees and have such amounts credited with a market-rate investment return. This plan was terminated in October 2005 with all vested amounts paid to the plan participants pursuant to the requirements of the American Jobs Creation Act of 2004.

Supplemental Benefit Plan for Non-Employee Directors. Lake Shore Savings has entered into separate supplemental benefit plans in 1999 and 2001 with each of its current non-employee directors except for Ms. Brautigam. Under the 1999 plan, each participant is guaranteed monthly payments over a period of fifteen years commencing at age 70 equal to $18,105 per year based upon twenty-one years of service as a director to Lake Shore Savings (or an earlier retirement age if twenty-one years of service is attained prior to age 70) with the annual benefit payable reduced proportionately for each year of service as a director less than twenty-one years attained at age 70. Under the 2001 plan, each participant is guaranteed monthly payments over a period of fifteen years commencing at age 72 equal to $12,000 per year based upon twenty-one years of service to Lake Shore Savings with the annual benefit payable reduced proportionately for each year of service less than twenty-one years attained at age 72.

 

Item 11. Executive Officer Compensation

The following table provides information about the compensation paid for 2005 to our Chief Executive Officer, our Executive Vice President, and our Chief Financial Officer. No other officer’s total annual salary and bonus for 2005 was in excess of $100,000.