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Lake Shore Bancorp 10-K 2008
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, 2007

 

¨ 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   20-4729288

(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: Common Stock, $0.01 par value per share

Name of each exchange on which registered: Nasdaq Global Market.

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

 

 

Indicate by check mark if the registrant is a well-known 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  x    No  ¨

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, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer    ¨     Accelerated filer    ¨
Non-accelerated filer    ¨  (Do not check if smaller reporting company)   Smaller reporting company    x

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

The aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2007 was $33,922,129 based on the per share closing price as of June 30, 2007 on the Nasdaq Global Market for the registrant’s common stock, which was $12.00.

There were 6,393,771 shares of the registrant’s common stock, $.01 par value per share outstanding at March 31, 2008.

DOCUMENTS INCORPORATED BY REFERENCE:

 

     Part of 10-K
where incorporated

Portions of the registrant’s Proxy Statement for the 2008 Annual Meeting of Stockholders

   III

 

 

 


Table of Contents

LAKE SHORE BANCORP, INC.

ANNUAL REPORT ON FORM 10-K

FOR THE FISCAL YEAR ENDED

DECEMBER 31, 2007

TABLE OF CONTENTS

 

ITEM

       PAGE
PART I
  1   BUSINESS    1
  1A   RISK FACTORS    37
  1B   UNRESOLVED STAFF COMMENTS    40
  2   PROPERTIES    41
  3   LEGAL PROCEEDINGS    42
  4   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS    42
PART II
  5   MARKET FOR REGISTRANT’S COMMON EQUITY , RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES    42
  6   SELECTED FINANCIAL DATA    44
  7   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS    46
  7A   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK    59
  8   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA    61
  9   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE    61
  9A   CONTROLS AND PROCEDURES    62
  9B   OTHER INFORMATION    62
PART III
10   DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE    63
11   EXECUTIVE COMPENSATION    63
12   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS    63
13   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE    63
14   PRINCIPAL ACCOUNTING FEES AND SERVICES    63
PART IV
15   EXHIBITS, FINANCIAL STATEMENT SCHEDULES    63
  SIGNATURES    66


Table of Contents

PART I

 

Item 1. Business

General

Lake Shore Bancorp, Inc. (“Lake Shore Bancorp,” “us,” or “we”) is a federally-chartered corporation organized in 2006 and is registered as a savings and loan holding company with the Office of Thrift Supervision (“OTS”). Lake Shore Bancorp serves as the holding company for Lake Shore Savings Bank (“Lake Shore Savings”). As of March 31, 2008, Lake Shore, MHC, a federal mutual holding company registered as a savings and loan holding company with the OTS, owned 57% of the outstanding shares of Lake Shore Bancorp’s common stock. Our common stock is quoted on the Nasdaq Global Market under the symbol “LSBK.” Unless the context otherwise requires, all references herein to Lake Shore Bancorp or Lake Shore Savings include Lake Shore Bancorp and Lake Shore Savings on a consolidated basis.

Lake Shore, MHC does 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.

At December 31, 2007, Lake Shore Bancorp had total assets of $357.8 million, of which $218.7 million was comprised of loans receivable and $105.9 million was comprised of available for sale securities. At December 31, 2007, total deposits were $240.8 million and total equity was $53.5 million.

For over 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. Our principal business consists of (1) 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 (2) 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 principally derived 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, are 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 are also 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 in Chautauqua County, New York are located in Dunkirk, Fredonia, Jamestown, Lakewood and Westfield. 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 five 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. 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 area, 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 one of our branch offices. 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, we 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 offers us 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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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 State 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, mortgage brokers, 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 Jamestown Savings Bank and Evans National Bank; state-wide financial institutions such as M&T Bank, Key Bank, and First Niagara Bank; and nation-wide financial institutions such as HSBC Bank USA and Bank of America. We are significantly smaller than many of these state-wide and nation-wide financial institution competitors. 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.

 

   

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 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, are offered a “Navigator Card,” our no-annual fee ATM/Debit card which may be used at ATM machines within our ATM network 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, branch offices, ATMs and drive-through facilities to ensure that we are providing a high level of customer satisfaction.

 

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We offer several new mortgage loan products, including: 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, a “no closing cost” mortgage and home equity product, and a Rural Development Guaranteed Loan Program (GLP) mortgage loan, which provides 100% financing.

 

   

In our last three Community Reinvestment Act evaluations by the Office of Thrift Supervision, most recently concluding on November 28, 2007, we consistently received an “Outstanding” rating.

 

   

During 2005, online bill pay was added as a new service for our customers. In 2006, we expanded our online services to provide e-statements to our customers.

 

   

In 2007, we introduced a Home Equity Line of Credit product which provides an option to convert either a portion, or the entire line of credit balance, to a term loan at a fixed rate of interest. As the customer pays down the balance on the term loan, the funds available on the line of credit increase by a like amount.

 

   

In 2008, we plan to implement Remote Deposit services to our commercial customers, which will allow the customer to deposit checks electronically from their place of business and provide access to detailed reports of their deposit activity. Customers will gain efficiencies from time saved having to go to a branch office to make a deposit.

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, 2007, we had total loans of $218.7 million, of which $157.8 million, or 72.4%, were one-to-four family residential mortgages. Of residential mortgage loans outstanding at that date, 5.4% were adjustable-rate mortgage loans and 94.6% were fixed rate loans. At December 31, 2007, 12.2% of the loan portfolio was comprised of home equity loans, of which 67.5% were adjustable rate loans and 32.5% were fixed rate loans. The remainder of our loans at December 31, 2007, amounting to $33.7 million, or 15.5% of total loans, consisted of 9.3% commercial real estate loans, 1.3% construction loans, 3.8% commercial loans and 1.1% consumer loans, which includes personal loans, home improvement loans, overdraft lines of credit, automobile loans and guaranteed student loans.

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, in turn, are affected by general and local economic conditions and monetary policies of the federal government, including the Federal Reserve Board.

 

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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,  
     2007     2006     2005     2004     2003  
     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

   $ 157,834     72.36 %   $ 149,408     72.72 %   $ 148,172     71.85 %   $ 142,222     71.14 %   $ 135,293     72.12 %

Commercial real estate

     20,394     9.35       17,150     8.34       16,827     8.16       15,310     7.66       14,628     7.80  

Construction loans

     2,775     1.27       1,570     0.76       1,635     0.79       2,463     1.23       2,531     1.35  

Home equity loans and lines of credit

     26,569     12.18       25,896     12.60       28,624     13.88       28,442     14.23       25,876     13.79  
                                                                      
     207,572     95.16       194,024     94.43       195,258     94.68       188,437     94.26       178,328     95.06  
                                                                      

Other loans:

                    

Commercial loans

     8,246     3.78       8,746     4.26       8,264     4.00       8,615     4.30       5,957     3.18  

Consumer loans

     2,306     1.06       2,689     1.31       2,712     1.32       2,870     1.44       3,310     1.76  
                                                                      
     10,552     4.84       11,435     5.57       10,976     5.32       11,485     5.74       9,267     4.94  
                                                                      

Total loans

     218,124     100.00 %     205,459     100.00 %     206,234     100.00 %     199,922     100.00 %     187,595     100.00 %
                                        

Deferred loan costs

     1,813         1,475         1,166         891         836    

Allowance for loan losses

     (1,226 )       (1,257 )       (1,240 )       (1,288 )       (1,293 )  
                                                  

Loans, net

   $ 218,711       $ 205,677       $ 206,160       $ 199,525       $ 187,138    
                                                  

 

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Loan Maturity. The following table presents the contractual maturity of our loans at December 31, 2007. 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

   $ 108    $ 32    $ 193    $ —      $ 131    $ 1,216    $ 1,680

After one year through five years

     1,791      630      4,194      —        2,486      676      9,777

Beyond five years

     155,935      19,732      22,182      2,775      5,629      414      206,667
                                                

Total

   $ 157,834    $ 20,394    $ 26,569    $ 2,775    $ 8,246    $ 2,306    $ 218,124
                                                

Interest rate terms on amounts due after one year:

                    

Fixed rate

   $ 149,293    $ 11,435    $ 8,603    $ 1,829    $ 5,999    $ 913    $ 178,072

Adjustable rate

     8,433      8,927      17,773      946      2,116      177      38,372
                                                

Total

   $ 157,726    $ 20,362    $ 26,376    $ 2,775    $ 8,115    $ 1,090    $ 216,444
                                                

 

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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,
     2007    2006    2005    2004    2003
     (Dollars in thousands)

Total loans:

              

Balance outstanding at beginning of period

   $ 205,459    $ 206,234    $ 199,922    $ 187,595    $ 157,496
                                  

Originations:

              

Mortgage loans

     44,046      30,806      36,504      40,737      85,146

Commercial and consumer loans

     5,371      7,047      7,067      8,819      6,595
                                  

Total originations

     49,417      37,853      43,571      49,556      91,741
                                  

Deduct:

              

Principal repayments:

              

Mortgage loans

     29,641      31,303      30,498      31,235      47,877

Commercial and consumer loans

     6,076      5,990      6,141      4,724      8,080
                                  

Total principal payments

     35,717      37,293      36,639      35,959      55,957
                                  

Transfers to foreclosed real estate

     81      357      118      374      761

Loan sales – Sonyma(1) and Freddie Mac

     482      406      —        —        4,046

Loan sales – guaranteed student loans

     333      402      419      592      603

Loans charged off

     139      170      83      304      275
                                  

Total deductions

     36,752      38,628      37,259      37,229      61,642
                                  

Balance outstanding at end of period

   $ 218,124    $ 205,459    $ 206,234    $ 199,922    $ 187,595
                                  

 

(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, 2007, loans on one-to-four family residential properties accounted for $157.8 million, or 72.4%, of our total loan portfolio. Of residential mortgage loans outstanding on that date, 5.4% of our loans were adjustable rate mortgage loans and 94.6% were fixed rate loans. At December 31, 2007, approximately 76% of our residential mortgage portfolio was secured by property located in Chautauqua County, 21% by property located in Erie County and 3% by property located elsewhere. Approximately 2.5% of all residential loan originations during fiscal 2007 were re-financings of loans already in our portfolio.

Our loan originations are obtained 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 will be a significant source of new loan generation. 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.

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

 

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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 “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 underwrite all conforming rate loans using the same criteria required by the Federal Home Loan Mortgage Corporation. We originate residential mortgage loans with a loan to value ratio up to 97%, and up to 102% with our Rural Development Guaranteed Loan Program (GLP) mortgage loan product. 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 do not originate any sub-prime mortgage loans and we do not have any sub-prime mortgage loans in our residential loan portfolio.

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. A customer has the option to convert either a portion, or the entire line of credit balance, to a term loan at a fixed rate of interest. As the customer pays down the balance on the term loan, the funds available on the line of credit increase by a like amount. Fixed rate home equity loans range from terms of 5 to 15 years. These loans, as a group, totaled $26.6 million and $25.9 million at December 31, 2007 and 2006, respectively. Approximately 67.5% of such loans have adjustable rates and 32.5% have fixed rates. At December 31, 2007 and 2006, such loans constituted 12.2% and 12.6% 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, 2007 and 2006, our commercial real estate loan portfolio consisted of loans totaling $20.4 million and $17.2 million respectively, or 9.4% and 8.3%, respectively, of total loans. Of the commercial real estate portfolio at December 31, 2007, approximately 60% consisted of loans that are collateralized by properties in Chautauqua County and 39% by properties

 

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in Erie County. We lend up to a maximum loan-to-value ratio of 80% 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, and repayment of such loans may be subject to adverse conditions in the real estate market or economic conditions to a greater extent than residential mortgage loans. 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 both December 31, 2007 and 2006, our construction loan portfolio consisted of loans totaling $2.8 million and $1.6 million, or 1.3% and 0.8%, 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. The average commercial loan is for a principal amount of approximately $50,000 . At December 31, 2007 and 2006, our commercial loan portfolio consisted of loans totaling $8.2 million and $8.7 million, respectively, or 3.8% 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, 2007 and 2006, our consumer loan portfolio totaled $2.3 and $2.7 million, or 1.1% and 1.3%, 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 $5,000;

 

   

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 Operations 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. Loans with principal amounts in excess of $500,000 must be reviewed and approved by a vote of our Board of Directors. Our Board of Directors as well as the Executive Committee meet monthly. 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, commercial, or consumer 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 more than 90 days, 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, in addition to repossessing the collateral, we may also sue on the note underlying the loan.

If a commercial loan has been delinquent for more than 30 days, 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. At that time, foreclosure procedures are initiated 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 $1.7 million and $1.5 million at December 31, 2007 and 2006, respectively.

 

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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,
 
     2007     2006     2005     2004     2003  
     (Dollars in thousands)  

Loans past due 90 days or more but still accruing:

          

Mortgage loans on real estate:

          

One-to-four family

   $ 209     $ 503     $ 548     $ 419     $ 368  

Construction

     —         —         —         —         —    

Commercial real estate

     208       133       239       101       55  

Home equity loans and lines of credit

     65       83       54       106       31  

Other loans:

          

Commercial loans

     85       —         76       —         —    

Consumer loans

     —         —         12       24       14  
                                        

Total

   $ 567     $ 719     $ 929     $ 650     $ 468  
                                        

Loans accounted for on a non-accrual basis:

          

Mortgage loans on real estate:

          

One-to-four family

   $ 918     $ 579     $ 368     $ 127     $ 230  

Construction

     —         —         —         —         194  

Commercial real estate

     107       —         —         —         —    

Home equity loans and lines of credit

     42       4       5       6       8  

Other loans:

          

Commercial loans

     —         —         43       —         126  

Consumer loans

     10       7       17       9       26  
                                        

Total non-accrual loans

     1,077       590       433       142       584  
                                        

Total nonperforming loans

     1,644       1,309       1,362       792       1,052  
                                        

Foreclosed real estate

     61       183       86       140       454  

Restructured loans

     —         —         —         —         —    
                                        

Total nonperforming assets

   $ 1,705     $ 1,492     $ 1,448     $ 932     $ 1,506  
                                        

Ratios:

          

Nonperforming loans as a percent of gross loans:

     0.75 %     0.64 %     0.66 %     0.40 %     0.56 %

Nonperforming assets as a percent of total assets:

     0.48 %     0.42 %     0.43 %     0.28 %     0.50 %

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, which consists of seven managers of Lake Shore Savings, 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 $1.1 million and $590,000 at December 31, 2007 and 2006, respectively. If all non-accrual loans had been current in accordance with their terms during the years ended December 31, 2007, 2006 and 2005, interest income on such loans would have amounted to $67,000, $46,000 and $49,000, respectively. At December 31, 2007, we did not have any loans not included above which are “troubled debt restructurings” as defined in Statement of Financial Accounting Standard No. 15.

 

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Real estate acquired as a result of foreclosure is classified as foreclosed real estate until such time as it is sold. We carry foreclosed real estate at lower of outstanding principal balance or 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.

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 as a “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, 2007, classified assets consisted of special mention assets of $2.9 million, substandard assets of $2.9 million, doubtful assets of $510,000 and loans classified as loss assets of $3,000. The classified assets total includes $1.7 million of nonperforming loans and foreclosed real estate.

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

 

     At December 31,
     2007    2006    2005
     (Dollars in thousands)

Special mention assets

   $ 2,900    $ 1,605    $ 1,494

Substandard assets

     2,942      2,968      2,923

Doubtful assets

     510      204      17

Loss assets

     3      —        48
                    

Total classified assets

   $ 6,355    $ 4,777    $ 4,482
                    

 

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

 

     At December 31,
     2007    2006    2005
     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)

   $ 1,091    $ 1,061    $ 307    $ 1,169    $ 755    $ 974

Commercial real estate

     —        314      —        133      218      239

Commercial business

     41      85      192      —        11      76

Consumer loans

     4      10      4      7      6      25
                                         

Total

   $ 1,136    $ 1,470    $ 503    $ 1,309    $ 990    $ 1,314
                                         

 

(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 periodically review our allowance for loan losses as an integral part of their examination process. 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,

 

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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 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, 2007, there was one loan classified as an impaired loan. At December 31, 2006, there were no loans classified as impaired loans. Refer to Note 5 in the Notes to the Consolidated Financial Statements for more information on our impaired loans.

For the year ended December 31, 2007, the provision for loan losses decreased by $53,000 from $158,000 for the year ended December 31, 2006 to $105,000 for the year ended December 31, 2007. Total classified assets increased $1.6 million from $4.8 million as of December 31, 2006 to $6.4 million as of December 31, 2007. Included in the classified assets total as of December 31, 2007, was an increase of $306,000 in the “doubtful” assets category, which indicated a high probability of loss within the loan portfolio. Furthermore, the average balance of our loan portfolio increased from $205.4 million as of December 31, 2006 to $210.6 million as of December 31, 2007 and net charge-offs decreased from $141,000 for the year ended December 31, 2006 to $136,000 for the year ended December 31, 2007. Despite the increase in classified loans and the increase in the average balance of our loan portfolio, we did not deem it necessary to increase our provision for loan losses. The majority of the increase in classified loans was in the “special mention” category. The loans in the special mention category include commercial real estate loans and commercial loans that are under “watch” by the bank for various reasons, such as being a new loan (i.e., less than 6 months old) or being in a riskier business (i.e., a restaurant). These loans possess certain weaknesses which deserve careful monitoring but the risk of loss is minimal. The increase in the average balance of our loan portfolio is attributed to an increase in new residential mortgage loans originated in 2007. These loans are serviced by collateral which limits our risk of loss. 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,  
     2007     2006     2005     2004     2003  
     (Dollars in thousands)  

Balance at beginning of period:

   $ 1,257     $ 1,240     $ 1,288     $ 1,293     $ 1,217  

Provision for loan losses

     105       158       20       267       345  
                                        

Charge-offs:

          

Mortgage loans on real estate:

          

One-to-four family

     25       49       16       24       200  

Construction

     —         —         —         —         —    

Commercial real estate

     —         —         —         117       —    

Home equity loans and lines of credit

     80       —         29       —         —    

Other loans:

          

Commercial loans

     19       86       12       126       17  

Consumer loans

     15       35       26       37       58  
                                        

Total charge-offs:

     139       170       83       304       275  
                                        

Recoveries:

          

Mortgage loans on real estate:

          

One-to-four family

     —         —         —         23       4  

Construction

     —         —         —         —         —    

Commercial real estate

     —         —         —         —         —    

Home equity loans and lines of credit

     —         —         —         —         —    

Other loans:

          

Commercial loans

     —         28       14       —         —    

Consumer loans

     3       1       1       9       2  
                                        

Total Recoveries

     3       29       15       32       6  
                                        

Net charge-offs

     136       141       68       272       269  
                                        

Balance at end of period

   $ 1,226     $ 1,257     $ 1,240     $ 1,288     $ 1,293  
                                        

Average loans outstanding

   $ 210,610     $ 205,419     $ 200,652     $ 193,435     $ 162,810  

Ratio of net charge-offs to average loans outstanding

     0.06 %     0.07 %     0.03 %     0.14 %     0.17 %

 

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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,  
     2007     2006     2005     2004     2003  
     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

   $ 631    51.5 %   72.4 %   $ 733    58.3 %   72.7 %   $ 648    52.2 %   71.8 %   $ 527    40.9 %   71.2 %   $ 379    29.3 %   72.1 %

Home equity loans and lines of credit

     71    5.8 %   12.2 %     93    7.4 %   12.6 %     94    7.6 %   13.9 %     110    8.5 %   14.2 %     61    4.7 %   13.8 %

Commercial real estate

     339    27.6 %   9.3 %     236    18.8 %   8.3 %     238    19.2 %   8.2 %     197    15.3 %   7.7 %     430    33.3 %   7.8 %

Construction

     —      —       1.3 %     —      —       0.8 %     —      —       0.7 %     —      —       1.2 %     —      —       1.3 %
                                                                                               
     1,041    84.9 %   95.2 %     1,062    84.5 %   94.4 %     980    79.0 %   94.7 %     834    64.7 %   94.3 %     870    67.3 %   95.0 %
                                                                                               

Other loans:

                                   

Commercial loans

     130    10.6 %   3.8 %     136    10.8 %   4.3 %     141    11.4 %   4.0 %     139    10.8 %   4.3 %     156    12.1 %   3.2 %

Consumer loans

     34    2.8 %   1.0 %     32    2.5 %   1.3 %     33    2.7 %   1.3 %     27    2.1 %   1.4 %     35    2.7 %   1.8 %
                                                                                               
     164    13.4 %   4.8 %     168    13.4 %   5.6 %     174    14.1 %   5.3 %     166    12.9 %   5.7 %     191    14.8 %   5.0 %
                                                                                               

Total allocated

   $ 1,205    98.3 %   100.00 %   $ 1,230    97.9 %   100.0 %   $ 1,154    93.1 %   100.0 %   $ 1,000    77.6 %   100.0 %   $ 1,061    82.1 %   100.0 %

Total unallocated

   $ 21    1.7 %     $ 27    2.1 %     $ 86    6.9 %     $ 288    22.4 %     $ 232    17.9 %  
                                                                           

Balance at end of period

   $ 1,226    100.0 %     $ 1,257    100.0 %     $ 1,240    100.0 %     $ 1,288    100.0 %     $ 1,293    100.0 %  
                                                                           

 

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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 to the Chief Executive Officer and 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 of the Board of Directors which meets at least quarterly.

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.

As of December 31, 2007, 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,
     2007    2006    2005
     Amortized Cost    Fair Value    Amortized Cost    Fair Value    Amortized Cost    Fair Value
     (Dollars in thousands)

Securities available for sale:

                 

U.S. Government obligations

   $ 5,143    $ 5,546    $ 5,150    $ 5,383    $ 3,099    $ 3,226

State and municipal obligations

     11,572      11,621      7,347      7,359      2,662      2,634

Mortgage-backed securities:

                 

Collateralized mortgage obligations

     53,106      53,113      59,094      58,247      48,803      47,731

Government National Mortgage Association

     28      30      32      34      65      69

Federal Home Loan Mortgage Association

     5,957      5,959      5,988      5,838      7,072      6,886

Federal Home Loan Mortgage Corporation

     15,290      15,203      13,545      13,100      15,877      15,274

Asset-backed securities:

     14,514      13,688      16,651      16,536      17,072      16,869
                                         

Total available for sale

     105,610      105,160      107,807      106,497      94,585      92,620
                                         

Securities held to maturity:

                 

U.S. Government obligations:(1)

     —        —        —        —        2,057      2,267

Mortgage-backed securities:(2)

                 

Government National Mortgage Association

     —        —        —        —        65      69

Federal Home Loan Mortgage Association

     —        —        —        —        107      107

Federal Home Loan Mortgage Corporation

     —        —        —        —        46      46
                                         

Total held to maturity

     —        —        —        —        2,275      2,489
                                         

Total investment securities

   $ 105,610    $ 105,160    $ 107,807    $ 106,497    $ 96,860    $ 95,109
                                         

 

(1) At the end of 2006, U.S. Government obligations in the Held to Maturity portfolio were transferred to the Available for Sale portfolio. The securities were originally purchased to fund a supplemental employee retirement plan (SERP) for our directors and executive officers. In 2006, the Bank purchased bank-owned life insurance to fund the SERP. As such, it was no longer necessary to keep the U.S. Government obligations in the Held to Maturity portfolio, as the original purpose for purchasing the securities was no longer applicable.
(2) At the end of 2006, mortgage-backed securities in the Held to Maturity portfolio were transferred to the Available for Sale portfolio, as the Company had already collected a substantial portion of the principal outstanding on these securities.

 

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At December 31, 2007, 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

   $ 6,142    $ 5,952
             

Total

   $ 6,142    $ 5,952
             

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, 2007. 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

  $ —     —       $ 992   4.21 %   $ —     —       $ 4,151   5.16 %   $ 5,143   $ 5,546   4.98 %

State and municipal obligations(1)

    —     —         —     —         4,725   3.74 %     6,847   3.99 %     11,572     11,621   3.89 %

Mortgage-backed securities

    53   5.03 %     16,668   3.91 %     4,517   4.26 %     53,143   4.48 %     74,381     74,305   4.34 %

Asset-backed securities

    —     —         —     —         —     —         14,514   5.29 %     14,514     13,688   5.29 %
                                                                 

Total debt securities:

  $ 53   5.03 %   $ 17,660   3.93 %   $ 9,242   3.99 %   $ 78,655   4.62 %   $ 105,610   $ 105,160   4.45 %
                                                                 

 

(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 66% and 69% of the total of our checking account balances at December 31, 2007 and 2006, respectively. These accounts provide interest-earning checking, with a weighted average rate at December 31, 2007 of 0.75%.

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, although we have in the past and may do so in the future.

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 43.9% and 42.8% of total deposits on December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006, time deposits with remaining terms to maturity of less than one year amounted to $122.2 million and $125.5 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, 2007, 2006 and 2005.

 

     Period to maturity from December 31, 2007    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
   2007    2006    2005
     (Dollars in thousands)

Interest Rate Range

                    

1.99% and below

   $ 1,018    $ 1,267    $ 1    $ 6    $ 2,292    $ 2,585    $ 9,227

2.00% to 2.99%

     520      65      —        11      596      4,785      34,361

3.00% to 3.99%

     31,489      6,142      1,212      373      39,216      35,802      73,138

4.00% to 4.99%

     68,297      1,900      256      876      71,329      64,731      22,509

5.00% to 5.99%

     20,855      157      446      198      21,656      34,811      583

6.00% and above

     —        —        —        —        —        —        —  
                                                

Total

   $ 122,179    $ 9,531    $ 1,915    $ 1,464    $ 135,089    $ 142,714    $ 139,818
                                                

 

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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,  
     2007     2006     2005  
     Amount    Percent
of total
deposits
    Amount    Percent
of total
deposits
    Amount    Percent
of total
deposits
 
     (Dollars in thousands)  

Deposit type:

               

Savings

   $ 25,282    10.50 %   $ 25,922    10.38 %   $ 27,871    11.11 %

Money market

     23,202    9.63 %     24,551    9.84 %     27,949    11.14 %

Interest bearing demand

     37,934    15.75 %     38,992    15.62 %     41,443    16.52 %

Non-interest bearing demand

     19,321    8.02 %     17,458    6.99 %     13,809    5.50 %
                                       

Total core deposits

     105,739    43.90 %     106,923    42.83 %     111,072    44.27 %
                                       

Time deposits with original maturities of:

               

Three months or less

     1,727    0.72 %     767    0.31 %     1,749    0.70 %

Over three months to twelve months

     95,100    39.50 %     60,316    24.16 %     28,544    11.38 %

Over twelve months to twenty-four months

     23,636    9.81 %     54,184    21.71 %     62,636    24.97 %

Over twenty-four months to thirty-six months

     9,745    4.05 %     22,558    9.04 %     40,253    16.04 %

Over thirty-six months to forty-eight months

     3,202    1.33 %     3,551    1.42 %     5,176    2.06 %

Over forty-eight months to sixty months

     1,212    0.50 %     824    0.33 %     941    0.37 %

Over sixty months

     467    0.19 %     514    0.20 %     519    0.21 %
                                       

Total time deposits

     135,089    56.10 %     142,714    57.17 %     139,818    55.73 %
                                       

Total deposits

   $ 240,828    100.00 %   $ 249,637    100.00 %   $ 250,890    100.00 %
                                       

At December 31, 2007, we had $33.1 million in time deposits with balances of $100,000 or more maturing as follows:

 

Maturity Period

   Amount
     (In thousands)

Three months or less

   $ 8,235

Over three months through six months

     9,977

Over six months through twelve months

     13,000

Over twelve months

     1,860
      

Total

   $ 33,072
      

 

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Short-term Borrowings. Our borrowings consist of short-term Federal Home Loan Bank advances. At December 31, 2007 and 2006, our short-term borrowings from the Federal Home Loan Bank of New York were $18,505,000 and $10,605,000, respectively. The short-term borrowings at December 31, 2007 had fixed rates of interest ranging from 4.52% to 4.85% and mature within one year. The following table sets forth information concerning balances and interest rates on our borrowings at the dates and for the periods indicated. We have an available line of credit of $31.5 million at December 31, 2007 and a one month overnight repricing line of credit of $31.5 million. We had no outstanding borrowings on either of these lines of credit as of December 31, 2007.

 

     At December 31,  
     2007     2006     2005  
     (Dollars in thousands)  

At December 31

      

Amount outstanding

   $ 18,505     $ 10,605     $ 11,205  

Weighted average interest rate

     4.61 %     5.44 %     4.41 %

For the period ended December 31

      

Highest amount at a month-end

   $ 27,502     $ 20,075     $ 12,305  

Daily average amount outstanding

     14,750       11,759       10,420  

Weighted average interest rate

     5.20 %     5.10 %     3.30 %

Subsidiary Activities

Lake Shore Savings is the only subsidiary of Lake Shore Bancorp. Lake Shore Savings has no subsidiaries.

Personnel

As of December 31, 2007, we had 80 full-time employees and 19 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

Regulation of Lake Shore Bancorp and Lake Shore, MHC.

Lake Shore Bancorp and Lake Shore, MHC are savings and loan holding companies regulated by the Office of Thrift Supervision (OTS). As such, Lake Shore Bancorp and Lake Shore, MHC are registered with and subject to OTS examination and supervision, as well as certain reporting requirements. In addition, the OTS has enforcement authority over Lake Shore Bancorp and Lake Shore, MHC and any of their non-savings association subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings association. 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. Activities of unitary savings and loan holding companies formed after May 4, 1999, such as Lake Shore Bancorp, must be financially related activities permissible for bank holding companies, as defined under the Bank Holding Company Act of 1956, as amended (the “BHCA”). Accordingly, Lake Shore Bancorp’s activities are restricted to:

 

   

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

 

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conducting an insurance agency or escrow business;

 

   

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

 

   

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

 

   

acting as trustee under a deed of trust;

 

   

any other activity (i) that the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”), by regulation, has determined to be permissible for bank holding companies under Section 4(c) of the BHCA, unless the Director of the OTS, 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 OTS; and

 

   

any activity permissible for financial holding companies under section 4(k) of the BHCA.

Permissible activities which are deemed to be financial in nature or incidental thereto under section 4(k) of the BHCA 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 is not 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.

OTS recently amended its regulations to expand the permissible activities for savings and loan holding companies to the full extent permitted under the Home Owners’ Loan Act, as amended (the “HOLA”). Specifically, OTS confirmed that savings and loan holding companies and their subsidiaries that are neither savings associations nor services corporations of a savings association can engage in all services and activities permissible for bank holding companies pursuant to regulations promulgated by the

 

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Federal Reserve Board under Section 4(c) of the BHCA. Prior OTS approval to engage in such activities will not be required as long as the holding company received an examination rating of satisfactory or above prior to January 1, 2008 or a composite rating of “1” or “2” thereafter and is not in troubled condition, and the holding company does not propose to commence the activity by an acquisition (in whole or in part) of a going concern.

OTS also recently amended its regulations to prohibit service at a savings and loan holding company by any person convicted of certain criminal offenses or who agreed to enter into a pre-trial diversion. The regulation implements a recently added provision of the Federal Deposit Insurance Act, the purpose of which was to prevent persons who are currently prohibited from serving at an insured institution from serving at a holding company controlling such institution. In general, persons convicted of criminal offenses involving dishonesty, breach of trust or money laundering is prohibited from serving at a bank or its holding company. OTS has the authority to review proposed appointments on a case-by-case basis, and by regulation has exempted categories of employees of certain savings and loan holding companies engaged in activities that the Holding Company is not permitted to not engage in.

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

 

   

investing in the stock of a savings association;

 

   

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

 

   

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

 

   

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

Restrictions Applicable to All Savings and Loan Holding Companies. Federal law prohibits savings and loan holding companies, including Lake Shore Bancorp and Lake Shore, MHC, directly or indirectly, from acquiring:

 

   

control (as defined under the HOLA, Change in Bank Control Act (“CIBCA”) and OTS regulations thereunder) of another savings association (or a holding company parent) without prior OTS approval;

 

   

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

 

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control of any depository institution not insured by the FDIC (except through a merger with and into the holding company’s savings association subsidiary that is approved by the OTS).

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 FDIC;

 

   

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

If the savings association subsidiary of a federal mutual holding company fails to meet the qualified thrift lender test set forth in Section 10(m) of the HOLA and regulations of the OTS, the holding company must register with the Federal Reserve Board as a bank holding company under the BHCA within one year of the savings association’s failure to so qualify.

Change in Control. Federal law requires, with few exceptions, OTS approval (or, in some cases, notice and effective clearance) prior to any acquisition of control of Lake Shore Bancorp. Among other criteria, under the HOLA, CIBCA and OTS regulations thereunder , “control” is conclusively presumed to exist if a person or company acquires, directly or indirectly, more than 25% of any class of voting stock of the savings association or holding company. Under OTS regulations, control is also presumed to exist, subject to rebuttal, if an acquiror acquires more than 10% of any class of voting stock (or more than 25% of any class of stock) and is subject to any of several “control factors,” including, among other matters, the relative ownership position of a person, the existence of control agreements and board composition.

Waivers of Dividends by Lake Shore, MHC. OTS regulations require Lake Shore, MHC to notify the OTS of any proposed waiver of its receipt of dividends from Lake Shore Bancorp. The OTS 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 OTS regulations, our public 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.

Conversion of Lake Shore, MHC to Stock Form. OTS regulations 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

 

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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 OTS 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.

Regulation of Lake Shore Savings

Lake Shore Savings is a federal stock savings bank and is subject to the regulation, examination and supervision of the OTS and the Federal Deposit Insurance Corporation (“FDIC”), as its deposit insurer.

Lake Shore Savings is a member of the Deposit Insurance Fund, and its deposit accounts are insured up to applicable limits by the FDIC. Lake Shore Savings files reports with the OTS 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 OTS and FDIC conduct periodic examinations to assess Lake Shore Savings’ compliance with various 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 is required to file certain reports with, and otherwise comply with, the rules and regulations of the OTS and of the Securities and Exchange Commission under the federal securities laws.

The OTS and the FDIC 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 OTS, the FDIC, 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 HOLA, and OTS regulations thereunder. 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 operating subsidiary to engage in activities permissible for federal savings association and 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.

 

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Capital Requirements. The OTS 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 OTS 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 OTS capital regulation based on the risks found by the OTS 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, 2007, Lake Shore Savings met each of its capital requirements, in each case on a fully phased-in basis.

Prompt Corrective Regulatory Action. Under the OTS prompt corrective action regulations, the OTS 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, 2007, Lake Shore Savings met the criteria for being considered “well-capitalized.” If appropriate, the OTS can require corrective action by a savings association holding company under the “prompt corrective action” provision of federal law.

Capital Distributions. The OTS imposes various restrictions or requirements on Lake Shore Savings’ ability to make capital distributions, including cash dividends. A savings association that is the subsidiary of a savings and loan holding company must file a notice with the OTS at least 30 days before

 

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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 OTS 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

 

   

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

Liquidity. Federal savings associations are required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation.

Deposit Insurance. The FDIC merged the Bank Insurance Fund and the Savings Association Insurance Fund to form the Deposit Insurance Fund on March 31, 2006. Lake Shore Savings is a member of the Deposit Insurance Fund and pays its deposit insurance assessments to the Deposit Insurance Fund.

The FDIC has established a system for setting deposit insurance premiums based upon the risks a particular bank or savings association posed to its deposit insurance fund. Effective January 1, 2007, the FDIC established a risk-based assessment system for determining the deposit insurance assessments to be paid by insured depository institutions. Under the assessment system, the FDIC assigns an institution to one of four risk categories, with the first category having two sub-categories based on the institution’s most recent supervisory and capital evaluations, designed to measure risk. Assessment rates currently range from 0.05% of deposits for an institution in the highest sub-category of the highest category to 0.43% of deposits for an institution in the lowest category. The FDIC is authorized to raise the assessment rates as necessary to maintain the required reserve ratio of 1.25%. The FDIC allows the use of credits for assessments previously paid, and the Bank has been notified that it has credits that will offset certain assessments, which are expected to be fully utilized by the end of the third quarter of 2008. We utilized approximately $65,000 of credits allocated to us in the year ending December 31, 2007. We have approximately $76,000 of credits remaining for use.

In addition, all FDIC-insured institutions are required to pay assessments to the FDIC to fund interest payments on bonds issued by the Financing Corporation, an agency of the federal government established to recapitalize the predecessor to the Savings Association Insurance Fund. These assessments, set by the FDIC quarterly, will continue until the Financing Corporation bonds mature in 2017 through 2019.

Under the Federal Deposit Insurance Act, the FDIC may terminate the insurance of an institution’s deposits upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. Management does not know of any practice, condition or violation that might lead to termination of deposit insurance.

Standards for Safety and Soundness. Under federal law, the OTS has adopted a set of guidelines prescribing safety and soundness standard. These guidelines establish general standards relating to internal controls and information systems, internal audit systems, loan documentation, credit

 

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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 OTS adopted regulations that authorize, but do not require, the OTS to 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 OTS 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 OTS may seek to enforce such order in judicial proceedings and to impose civil money penalties. We believe we are in compliance with the OTS guidelines.

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.

Consumer Protection and Compliance Provisions. Lake Shore Savings is subject to various laws and regulations dealing generally with consumer protection matters. Lake Shore Savings may be subject to potential liability under these laws and regulations for material violations. Lake Shore Savings’ loan operations are also subject to federal laws applicable to credit transactions, such as the:

 

   

Federal Truth-In-Lending Act, governing disclosures of credit terms to consumer borrowers;

 

   

Home Mortgage Disclosure Act of 1975, requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;

 

   

Equal Credit Opportunity Act, prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;

 

   

Fair Credit Reporting Act of 1978, as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, certain identity theft protections and certain credit and other disclosures;

 

   

Fair Debt Collection Act, governing the manner in which consumer debts may be collected by collection agencies;

 

   

Servicemembers Civil Relief Act; and

 

   

Rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

Lake Shore Savings’ deposit operations will also subject to federal laws applicable to deposit transactions, such as the:

 

   

Truth in Savings Act, which imposes disclosure obligations to enable consumers to make informed decisions about accounts at depository institutions;

 

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Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that Act, which govern automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services; and

 

   

Rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.

Subprime Mortgage Lending. To address current issues in the subprime mortgage market, the Federal Reserve Board has proposed amending Regulation Z, which implements the Truth in Lending Act and Home Ownership and Equity Protection Act, to protect consumers in the mortgage market from unfair, abusive or deceptive lending and servicing practices. These amendments would also address advertisements for mortgages loans, and require enhanced and earlier disclosures for consumers of higher-priced mortgage loans secured by the consumer’s principal dwelling. For purposes of the proposed regulation, a higher-priced mortgage would be a loan secured by a consumer’s principal dwelling having an annual percentage rate exceeding comparable Treasury security by three or more percentage points for first-lien loans or five or more percentage points for second mortgage. The proposed regulations would also prohibit a creditor from engaging in a pattern or practice of extending credit without regard to a borrower’s ability to repay from sources other that then collateral itself; require that creditors verify income and assets relied upon in making a loan; prohibit repayment payments, absent certain conditions; and require escrow accounts for taxes and insurance. Lake Shore Savings’ is not involved in any subprime activities, and most mortgage loans originated by Lake Shore Savings will be unaffected by these new regulations. However, until final regulations are promulgated, we cannot predict whether the proposed regulation will be adopted or the extent to which our business may be affected.

Real Estate Lending Standards. The OTS 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 OTS 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 OTS 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.

Qualified Thrift Lender Test. The HOLA 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. “Qualified Thrift Investments” include, but are not limited to loans made to purchase, refinance, construct, improve, or repair domestic residential housing or manufactured housing, home equity loans, mortgage backed securities, Federal Home Loan Bank stock, loans for educational purposes, loans to small businesses, and loans made through credit cards or credit card accounts. “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, 2007 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.

Community Reinvestment Act. Under the Community Reinvestment Act (“CRA”), as implemented by OTS 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 CRA 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 CRA. The CRA requires the OTS, 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 CRA also requires all institutions to publicly disclose their CRA ratings.

The CRA 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 two tests: (i) a lending test, to evaluate the institution’s record of making loans in its assessment areas; and (ii) a community development test, to evaluate the institution’s community development loans, investments, and services in its assessment areas.

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 borrows 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” CRA rating on its last three evaluations by the OTS, the most recent being as of November 28, 2007.

Branching. Subject to certain limitations, HOLA and OTS 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 as long as Lake Shore Savings continues to meet the Qualified Thrift Lender test under the Home Owner’s 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 HOLA and OTS regulations preempts any State law purporting to regulate branching by federal savings associations.

Privacy. The OTS has adopted final regulations applicable to savings associations implementing the privacy protection provisions required by the Gramm-Leach-Bliley Act. The 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

 

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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.

Affiliate Marketing. The federal banking agencies, including the OTS recently finalized a joint rule implementing Section 214 of the FACT Act, which provides consumers with the ability to restrict companies from using certain information obtained from affiliates to make marketing solicitations. In general, a person is prohibited from using information received from an affiliate to make a solicitation for marketing purposes to a consumer, unless the consumer is given notice and had a reasonable opportunity to opt out of such solicitations. The rule permits opt-out notices to be given by any affiliate that has a preexisting business relationship with the consumer and permits a joint notice from two or more affiliates. Moreover, such notice would not be applicable if the Lake Shore Bancorp uses the information if it has pre-existing business relationship with the consumer. Moreover, this notice may be combined with other required disclosures to be provided under other provisions of law, including notices required under the privacy provisions of the Gramm-Leach-Bliley Act.

Identity Theft Prevention. The federal banking agencies, including the OTS also recently finalized, a joint rule implementing Section 315 of the FACT Act, requiring that each financial institution or creditor to develop and implement a written identity theft prevention program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts. The rule became effective January 1, 2008 and mandatory compliance commences on November 1, 2008.

Among the requirements under the new rule, Lake Shore Savings will be required to adopt “reasonable policies and procedures” to:

 

   

Identify relevant red flags for covered accounts and incorporate those red flags into the program;

 

   

Detect red flags that have been incorporated into the identity theft prevention program;

 

   

Respond appropriately to any red flags that are detected to prevent and mitigate identity theft; and

 

   

Ensure the identity theft prevention program is updated periodically, to reflect changes in risks to customers or to the safety and soundness of the financial institution or creditor from identity theft.

Lake Shore Savings will be required to implement its plan no later than November 1, 2008.

Prohibitions Against Tying Arrangements. Federal savings associations are subject to the prohibitions of 12 U.S.C. § 1464(q) and 1467a(x) 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.

Unfair and Deceptive Practices. The OTS is reviewing its current regulations relating to unfair and deceptive acts to determine whether, and, if so, to what extent, additional regulation or guidance is needed to ensure that customers of OTS-regulated entities, including holding companies and non-functionally regulated subsidiaries, are treated fairly. OTS issued an advance notice of proposed rulemaking seeking industry input on how the OTS should implement provisions of the Federal Trade Commission Act, which authorizes OTS to prescribe regulations to prevent unfair or deceptive acts or

 

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practices by savings associations in or affecting commerce, including acts that are unfair or deceptive to consumers and is considering, among other things, listing specific practices that would be prohibited as unfair or deceptive. At this time we cannot predict whether or in what form any proposed regulation or guidance will be adopted or the extent to which our business may be affected.

Transactions with Related Parties. Lake Shore Savings’ authority to engage in transactions with its affiliates is limited by the Home Owner’s Loan Act, the OTS 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 OTS 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.

Regulation W of the Federal Reserve Board implements 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 does prohibit 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.

Anti-Money Laundering/Terrorist Financing Provisions. Lake Shore Savings is subject to the Bank Secrecy Act, as amended by the USA PATRIOT Act, which gives the federal government powers to address money laundering and terrorist threats through enhanced domestic security measures, expanded surveillance powers, and increased information sharing. Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among financial institutions, 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.

 

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Under applicable law:

 

   

All financial institutions must establish anti-money laundering programs that include, at minimum: (1) internal policies, procedures, and controls; (2) specific designation of an anti-money laundering compliance officer; (3) ongoing employee training programs; and (4) an independent audit function to test the anti-money laundering program.

 

   

Implement minimum standards for customer due diligence, identification and verification.

 

   

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) are required to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report instances of money laundering through those accounts.

 

   

May not establish, maintain, administer, or manage correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and requires financial institutions to take reasonable steps to ensure that correspondent accounts provided to foreign banks are not being used to indirectly provide banking services to foreign shell banks.

Bank regulators are directed to consider a holding company’s effectiveness in combating money laundering when ruling on various applications.

Enforcement. The OTS 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.

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, 2007 of $3.1 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.

Each Federal Home Loan Bank is 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.

 

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Membership in the Federal Home Loan Bank is voluntary for all federally-chartered savings associations, such as Lake Shore Savings. Each Federal Home Loan Bank System has adopted a capital structure meeting 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).

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 is 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 OTS. 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.

Federal Securities Laws

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

Our earnings will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board has, and is likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy, among other things, in order to curb inflation or combat a recession. The Federal Reserve Board affects the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

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Item 1A. Risk Factors.

Risks Related To Our Business

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 national or 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. There is currently a downturn in the national economy due to high gasoline and food prices, and the sub-prime lending crisis. The sub-prime lending issues have not affected Western New York in the same manner as other areas of the country and are not expected to affect our loan portfolio. Higher prices for business and consumers could affect our loan portfolio, if business owners or consumers are not able to make loan payments. We have not noticed any significant increases in delinquent loans due to the current state of the national economy.

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.

 

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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 had decreased in our market area as a result of interest rate increases during 2004 and 2005. In 2006, interest rates remained steady, and loan demand met our projections. In 2007, interest rates remained steady, and towards the end of the year began to fall, as a result of the sub-prime lending crisis. However, during 2006 and 2007 the weighted average interest rate on our loan portfolio was not enough to offset the higher interest expenses incurred on our deposit portfolio, which resulted in lower profitability.

We Have 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 non-interest expense, with compensation and occupancy costs constituting the largest amount of increased costs. Losses are expected from new branches 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, but is expected to be profitable by the end of the first quarter in 2008. 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.

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.

Our Ability To Grow May Be Limited If We Cannot Make Acquisitions. We intend to seek to expand our banking franchise, internally and by acquiring other financial institutions or branches and other financial service 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.

 

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If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud, and, as a result, investors and depositors could lose confidence in our financial reporting, which could adversely affect our business, the trading price of our stock and our ability to attract additional deposits. Beginning with this annual report for the fiscal year ending December 31, 2007, we have to include in our annual reports filed with the Securities and Exchange Commission (the “SEC”) a report of our management regarding internal control over financial reporting. As a result, we recently have begun to document and evaluate our internal control over financial reporting in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) and SEC rules and regulations, which require an annual management report on our internal control over financial reporting, including, among other matters, management’s assessment of the effectiveness of internal control over financial reporting. If we fail to identify and correct any significant deficiencies in the design or operating effectiveness of our internal control over financial reporting or fail to prevent fraud, current and potential stockholders and depositors could lose confidence in our financial reporting, which could adversely affect our business, financial condition and results of operations, the trading price of our stock and our ability to attract additional deposits.

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 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.

In 2007, our earnings were adversely impacted by an increase in short term interest rates, resulting in an inverted yield curve. The rates on our short term deposits increased significantly during

 

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2006 and into 2007, while rates on our long-term loan products remained steady. As a result, our net interest spread decreased from 2.60% as of December 31, 2006 to 2.42% as of December 31, 2007. In 2006, we entered into a derivative contract as part of our risk management strategy to protect against market fluctuation in interest rates. Refer to Note 4 in the Notes to our Consolidated Financial Statements for more information.

Changes In The Federal Reserve’s Monetary Or Fiscal Policies Could Adversely Affect Our Results Of Operations And Financial Condition. Our earnings will be affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Board has, and is likely to continue to have, an important impact on the operating results of commercial banks through its power to implement national monetary policy, among other things, in order to curb inflation or combat a recession. The Federal Reserve Board affects the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. We cannot predict the nature or impact of future changes in monetary and fiscal policies.

 

Item 1B. Unresolved Staff Comments.

None.

 

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Item 2. Properties.

We conduct our business through our corporate headquarters, administrative offices, and eight branch offices. At December 31, 2007, the net book value of the computer equipment and other furniture, fixtures, and equipment of our offices totaled $737,000. For more information, see Note 6 and Note 10 in the Notes to our Consolidated Financial Statements.

 

Location

   Leased
or
Owned
  Original
Date

Acquired
   Net Book Value
December 31, 2007
(In thousands)

Corporate Headquarters

       

125 East Fourth Street

Dunkirk, NY 14048

   Owned   1995    $ 92

Branch Offices:

       

Chautauqua County

       

128 East Fourth Street

Dunkirk, NY 14048

   Owned   1930      881

30 East Main Street

Fredonia, NY 14063

   Owned   1996      773

1 Green Avenue

Jamestown, NY 14701

   Owned/Leased(1)   1996      733

115 East Fourth Street

Jamestown, NY 14701

   Owned   1997      332

106 East Main Street

Westfield, NY 14787

   Owned/Leased(2)   1998      283

Erie County

       

5751 Transit Road

East Amherst, NY 14051

   Owned   2003      1,155

3111 Union Road

Orchard Park, NY 14127

   Leased(3)   2003      503

59 Main Street

Hamburg, NY 14075

   Leased(4)   2005      1,168

Administrative Offices:

       

31 East Fourth Street

Dunkirk, NY 14048

   Owned   2003      291

123 East Fourth Street

Dunkirk, NY 14048

   Owned   1995      98

 

(1) The building is owned. The land is leased. The lease expires in September 2015.
(2) The building is owned. Parking lot is leased on an annual basis.
(3) The lease expires in January 2017.
(4) The lease expires in 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.

None.

PART II

 

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

Market Information

On April 3, 2006, Lake Shore Bancorp, Inc. common stock commenced trading on the Nasdaq Global Market under the symbol “LSBK”. The table below shows the reported high and low sales prices of the common stock during the periods indicated.

 

     Sale Price    Dividend Information

Period

   High    Low    Amount per Share    Date of Payment

2006

           

First Quarter

     N/A      N/A      N/A    N/A

Second Quarter

   $ 10.80    $ 9.92      N/A    N/A

Third Quarter

   $ 11.10    $ 9.95      N/A    N/A

Fourth Quarter

   $ 14.50    $ 11.10    $ 0.03    November 15, 2006

2007

           

First Quarter

   $ 13.33    $ 11.50    $ 0.03    February 15, 2007

Second Quarter

   $ 12.65    $ 11.60    $ 0.03    May 15, 2007

Third Quarter

   $ 11.75    $ 9.50    $ 0.03    August 15, 2007

Fourth Quarter

   $ 10.58    $ 8.27    $ 0.04    November 16, 2007

On January 23, 2008, the Board of Directors of Lake Shore Bancorp declared a quarterly cash dividend of $0.04 per common share outstanding that was payable on February 15, 2008 to stockholders of record as of the close of business on February 4, 2008. Refer to Note 21 in the Notes to our Consolidated Financial Statements.

The Board of Directors intends to review the payment of dividends quarterly and plans to continue to maintain a regular quarterly dividend in the future, dependent upon our earnings, financial condition and other relevant factors.

As of March 21, 2008 there were approximately 1,491 holders of Lake Shore Bancorp common stock.

 

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The following table reports information regarding repurchases by the Company of its common stock in each month of the quarter ended December 31, 2007:

COMPANY PURCHASES OF EQUITY SECURITIES

 

Period

   Total Number
of Shares
Purchased (2)
   Average Price
Paid per Share
   Total Number
of Shares
Purchased as
Part of Publicly
Announced
Plans or
Programs
   Maximum
Number of
Shares that May
Yet be
Purchased
Under the Plans
or Programs (1)

October 1, 2007 through October 31, 2007

   —        —      —      —  

November 1, 2007 through November 30, 2007

   6,400    $ 9.27    6,400    134,942

December 1, 2007 through December 31, 2007

   29,524    $ 9.06    29,524    105,418

Total

   35,924    $ 9.10    35,924    105,418

 

(1) On November 16, 2007, the Company announced that the Board of Directors had approved it’s second stock repurchase plan pursuant to which the Company could repurchase up to 141,342 shares of its outstanding common stock. This amount represented 5% of the Company’s outstanding stock not owned by Lake Shore, MHC. The repurchase plan does not have an expiration date.
(2) Amounts do not reflect re-purchases of 4,124 shares of common stock from the trustee of the Company’s Recognition and Retention Plan on December 31, 2007.

 

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Item 6. Selected Financial Data.

Our selected consolidated financial and other data is set forth below, which is derived in part from, and should be read in conjunction with, our audited consolidated financial statements and notes thereto, beginning on page F-1 of this Form 10-K.

 

     As of December 31,
     2007    2006    2005    2004    2003
     (Dollars in thousands)

Selected financial condition data:

              

Total assets

   $ 357,801    $ 354,237    $ 333,724    $ 329,841    $ 303,511

Loans, net

     218,711      205,677      206,160      199,525      187,138

Securities available for sale

     105,922      108,016      94,082      99,170      83,027

Securities held to maturity

     —        —        2,275      2,359      371

Federal Home Loan Bank stock

     3,081      2,481      2,716      2,709      2,167

Total cash and cash equivalents

     10,091      18,682      12,053      11,577      16,753

Total deposits

     240,828      249,637      250,890      243,554      230,495

Short-term borrowings

     18,505      10,605      11,205      11,725      11,800

Long-term debt

     37,940      32,750      37,480      42,260      31,535

Total equity

     53,465      53,747      27,995      26,915      24,947

Allowance for loan losses

     1,226      1,257      1,240      1,288      1,293

Non-performing loans

     1,644      1,309      1,362      792      1,052

Non-performing assets

     1,705      1,492      1,448      932      1,506

 

     For the year ended December 31,
     2007    2006    2005    2004    2003
     (Dollars in thousands)

Selected operating data:

              

Interest income

   $ 18,622    $ 17,774    $ 15,956    $ 14,744    $ 12,780

Interest expense

     9,133      8,045      6,426      5,332      4,694
                                  

Net interest income

     9,489      9,729      9,530      9,412      8,086

Provision for loan losses

     105      158      20      267      345
                                  

Net interest income after provision for loan losses

     9,384      9,571      9,510      9,145      7,741

Total non-interest income

     2,002      1,805      1,847      1,875      1,728

Total non-interest expense

     9,118      8,646      8,350      7,939      7,218
                                  

Income before income taxes

     2,268      2,730      3,007      3,081      2,251

Income taxes

     451      911      953      902      744
                                  

Net income

   $ 1,817    $ 1,819    $ 2,054    $ 2,179    $ 1,507
                                  

Basic earnings per common share

   $ 0.29    $ 0.24    $ —      $ —      $ —  
                                  

Diluted earnings per common share

   $ 0.29    $ 0.24    $ —      $ —      $ —  
                                  

Dividends declared per share

   $ 0.13    $ 0.03    $ —      $ —      $ —  
                                  

 

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     At or for the year ended December 31,  
     2007     2006     2005     2004     2003  

Selected financial ratios and other data

          

Performance ratios:

          

Return on average assets

   0.52 %   0.52 %   0.62 %   0.68 %   0.58 %

Return on average equity

   3.39 %   4.05 %   7.47 %   8.45 %   6.24 %

Interest rate spread(1)

   2.42 %   2.60 %   2.93 %   3.03 %   3.18 %

Net interest margin(2)

   2.92 %   3.00 %   3.09 %   3.15 %   3.32 %

Efficiency ratio(3)

   79.35 %   74.96 %   73.39 %   70.34 %   73.55 %

Non interest expense to average total assets

   2.60 %   2.49 %   2.53 %   2.48 %   2.76 %

Average interest-earning assets to average interest-bearing liabilities

   117.94 %   116.16 %   107.51 %   106.35 %   107.49 %

Capital ratios:

          

Total risk-based capital to risk weighted assets

   23.72 %   23.88 %   17.06 %   16.34 %   16.37 %

Tier 1 risk-based capital to risk weighted assets

   22.90 %   22.81 %   16.00 %   15.18 %   15.19 %

Tangible capital to tangible assets

   12.28 %   11.68 %   8.47 %   7.99 %   7.97 %

Tier 1 leverage (core) capital to adjustable tangible assets

   12.28 %   11.68 %   8.47 %   7.99 %   7.97 %

Equity to total assets

   14.94 %   15.17 %   8.39 %   8.16 %   8.22 %

Asset quality ratios:

          

Non-performing loans as a percent of total net loans

   0.75 %   0.64 %   0.66 %   0.40 %   0.56 %

Non-performing assets as a percent of total assets

   0.48 %   0.42 %   0.43 %   0.28 %   0.50 %

Allowance for loan losses as a percent of total net loans

   0.56 %   0.61 %   0.60 %   0.65 %   0.69 %

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

   74.57 %   96.03 %   91.04 %   162.63 %   122.91 %

Other data:

          

Number of full service offices

   8     8     8     7     7  

 

(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 our financial statements and other relevant statistical data and is intended to enhance your understanding of our financial condition and results of operations. You should read the information in this section in conjunction with our consolidated financial statements and accompanying notes to consolidated financial statements beginning on page F-1 of this Form 10-K, and the other statistical data provided in this Form 10-K.

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.

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. We are among the largest lenders in market share of residential mortgages in Chautauqua County.

Important Note Regarding Forward-Looking Statements

Certain statements in this annual report are “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995, which statements generally can be identified by the use of forward-looking terminology, such as “may,” “will,” “expect,” “estimate,” “anticipate,” “believe,” “target,” “plan,” “project” or “continue” or the negatives thereof or other variations thereon or similar terminology, and are made on the basis of management’s current plans and analyses of our business and the industry in which we operate as a whole. These forward-looking statements are subject to risks and uncertainties, including, but not limited to, economic conditions, competition, interest rate sensitivity and exposure to regulatory and legislative changes. The above factors in some cases have affected, and in the future could affect, our financial performance and could cause actual results to differ materially from those expressed in or implied by such forward-looking statements. We do not undertake to publicly update or revise its forward-looking statements even if experience or future changes make it clear that any projected results expressed or implied therein will not be realized.

 

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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 over 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.

Branching. In 2003, we opened new branch offices in Orchard Park and East Amherst, New York. These new offices have generated deposits of $25.6 million and $15.7 million as of December 31, 2007, respectively. We opened an additional new branch office in Hamburg, New York in December 2005. This office had generated deposits of $11.3 million as of December 31, 2007. 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.

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, 2007 and 2006, we held $157.8 million and $149.4 million of residential mortgage loans, respectively, which constituted 72.4% and 72.7% of our total loan portfolio, at such respective dates. We originate commercial real estate loans to finance the purchase of real property, which generally consists of developed real estate. At December 31, 2007 and December 31, 2006, our commercial real estate loan portfolio consisted of loans totaling $20.4 million and $17.2 million, respectively, or 9.4% and 8.3%, 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, 2007 and December 31, 2006, our commercial loan portfolio consisted of loans totaling $8.2 million and $8.7 million, respectively, or 3.8% 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, 2007 and 2006, our investment securities totaled $109.0 million and $110.5 million, respectively.

Treasury Yield Curve. As with all community banks, we face a challenge in monitoring our interest rate risk. 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. This mismatch between shorter term deposits and longer term loans usually produces a positive contribution to earnings because the yield curve is normally positively sloped. During the third and fourth quarters of 2007, the Federal Reserve cut the federal funds rate by 100 basis points to 4.25%. That action, combined with anticipated additional reductions in the federal funds rate, continued weakness in

 

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the housing market, credit concerns over sub-prime loan defaults, and concern over downgrades to bond insurers has caused the treasury yield curve to shift. As of December 31, 2006, the treasury yield curve was inverted, with the federal funds rate and short-term treasury bill rates higher than rates on long-term treasury bills. On July 1, 2007, the yield curve was virtually flat at 5%. On December 31, 2007, rates on short-term treasury bills had fallen 175 basis points and rates on intermediate-term treasury bills had dropped 65 basis points in comparison to rates on December 31, 2006. As a result, the yield curve now has a positive slope. For example, the yield on the two year Treasury note declined from 4.79% as of December 31, 2006 to 3.05% as of December 31, 2007. The yield on the 10 year Treasury note declined from 4.68% as of December 31, 2006 to 4.02% as of December 31, 2007. However, because of credit concerns over mortgage related securities, the yield spread for mortgage securities widened over Treasury bonds. For example, on December 31, 2006, we offered a 30 year fixed rate mortgage at 6.250%. On December 31, 2007, the rate we offered on this loan type was 6.125%, a decline of only 12.5 basis points. Given the changes to the treasury yield curve and spread relationships, our net interest margin could improve if our funding costs decline and if interest rates on loans remain relatively unchanged.

The changes to the yield curve in 2007 will allow us to reprice some of our short term borrowings to lower interest rates and allow us to reduce the interest rates we offer on our certificates of deposit, which may increase our net interest margin. If we reduce rates on our deposit products, our deposit balances may decrease, which may require us to utilize other funding sources.

We anticipated that the housing crisis would create credit problems for the economy, so we avoided credit risk. We remain free of exposure to the credit problems that are affecting many lenders. We do not have any sub-prime loans or other high-risk mortgage products within our loan or investment portfolios. Our strategy to improve interest income was to increase our interest rate risk exposure. To mitigate the risk of falling interest rates on our adjustable rate home equity and commercial loans, we purchased an interest rate floor product during August 2006 on a notional principal amount of $10 million. This product allows us to receive payments if the prime rate drops below 8%. The prime rate as of December 31, 2007 was 7.25%. As a result, we will begin to receive payments on the interest rate floor product, which will partially offset the expected reduction in loan interest income on adjustable rate loans that are tied to the prime rate. The interest rate floor expires on August 11, 2011. Refer to Note 4 in the Notes to our Consolidated Financial Statements for more information.

We believe the cumulative impact of the strategies we elected to pursue will improve our earnings in a lower interest rate environment.

We employ a third party financial advisor to assist us in managing our investment portfolio and developing balance sheet strategies. At December 31, 2006 and 2007, we had $108.0 and 105.9 million, respectively, invested in securities available for sale, the majority of which are mortgage-backed and asset-backed securities. All of our mortgage-backed and asset-backed securities are rated AAA or are guaranteed by an agency of the federal government. We do not own any collateralized debt obligations (CDOs).

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,

 

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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.

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 in the Notes to our Consolidated 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 includes a tax equivalent adjustment for bank qualified municipals.

 

     At December 31, 2007     For the Year ended
December 31, 2007
    For the Year ended
December 31, 2006
    For the Year ended
December 31, 2005
 
     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:

                             

Interest-bearing deposits & Federal Funds Sold

   $ 2,712    3.63 %   $ 3,959    $ 130    3.28 %   $ 14,339      629    4.39 %   $ 6,560    $ 142    2.16 %

Securities

     109,003    4.60 %     110,535      5,010    4.53 %     104,424      4,498    4.31 %     101,532      4,021    3.96 %

Loans

     218,711    6.16 %     210,610      13,482    6.40 %     205,419      12,647    6.16 %     200,652      11,793    5.88 %
                                                                         

Total interest-earning assets

     330,426    5.64 %     325,104      18,622    5.73 %     324,182      17,774    5.48 %     308,744      15,956    5.17 %

Other assets

     27,375        25,351           23,650           21,373      
                                             

Total assets

   $ 357,801      $ 350,455         $ 347,832         $ 330,117      
                                             

Interest-bearing liabilities:

                             

Demand and NOW accounts

   $ 37,934    0.64 %     37,011      242    0.65 %     37,293      224    0.60 %   $ 38,163      152    0.40 %

Money market accounts

     23,202    1.39 %     24,324      323    1.33 %     25,525      265    1.04 %     29,413      268    0.91 %

Savings accounts

     25,282    0.53 %     26,722      135    0.51 %     25,890      139    0.54 %     29,833      151    0.51 %

Time deposits

     135,089    4.60 %     139,271      6,214    4.46 %     138,409      5,247    3.79 %     136,141      3,945    2.90 %

Borrowed funds

     56,445    3.72 %     46,948      2,099    4.47 %     48,454      2,027    4.18 %     51,357      1,824    3.55 %

Advances from borrowers on taxes and insurance

     —      —   %     —        —      —   %     2,101      22    1.05 %     1,890      45    2.38 %

Other interest-bearing liabilities

     1,384    8.67 %     1,394      120    8.61 %     1,414      121    8.56 %     368      41    11.14 %
                                                                         

Total interest bearing liabilities

     279,336    3.27 %     275,670      9,133    3.31 %     279,086      8,045    2.88 %     287,165      6,426    2.24 %
                                         

Other non-interest bearing liabilities

     25,000        21,239           23,786           15,345      

Equity

     53,465        53,546           44,962           27,607      
                                             

Total liabilities and equity

   $ 357,801      $ 350,455         $ 347,834         $ 330,117      
                                             

Net interest income

           $ 9,489         $ 9,729         $ 9,530   
                                         

Interest rate spread

              2.42 %         2.60 %         2.93 %

Net interest margin

              2.92 %         3.00 %         3.09 %

 

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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. The table 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, 2007
Compared to Year Ended December 31, 2006
    Year Ended December 31, 2006
Compared to Year Ended December 31, 2005
 
     Rate     Volume     Net Change     Rate     Volume     Net Change  
     (Dollars in thousands)  

Interest-earning assets:

            

Federal funds sold and other interest-bearing deposits

   $ (129 )   $ (370 )   $ (499 )   $ 226     $ 261     $ 487  

Securities

     242       270       512       360       117       477  

Loans

     510       325       835       569       285       854  
                                                

Total interest-earning assets

     623       225       848       1,155       663       1,818  
                                                

Interest-bearing liabilities:

            

Demand and NOW accounts

     20       (2 )     18       76       (4 )     72  

Money market accounts

     71       (13 )     58       35       (38 )     (3 )

Savings accounts

     (8 )     4       (4 )     9       (21 )     (12 )

Time deposits

     934       33       967       1,235       67       1,302  
                                                

Total deposits

     1,017       22       1,039       1,355       4       1,359  

Other interest-bearing liabilities:

            

Borrowed funds

     136       (64 )     72       311       (108 )     203  

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

     (22 )     (1 )     (23 )     (40 )     97       57  
                                                

Total interest-bearing liabilities

     1,131       (43 )     1,088       1,626       (7 )     1,619  
                                                

Net change in interest income

   $ (508 )   $ 268     $ (240 )   $ (471 )   $ 670     $ 199  
                                                

 

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Comparison of Financial Condition at December 31, 2007 and December 31, 2006

Total assets at December 31, 2007 were $357.8 million, an increase of $3.6 million from $354.2 million at December 31, 2006. The increase in total assets was primarily due to a $13.0 million increase in loans receivable, net, partially offset by an $8.6 million decrease in cash and cash equivalents.

Our cash and cash equivalents decreased by $8.6 million to $10.1 million at December 31, 2007, from $18.7 million at December 31, 2006. This was due to a decrease in federal funds, sold from $8.4 million at December 31, 2006 to $41,000 at December 31, 2007. Federal funds sold decreased due to cash being utilized to repurchase $2.2 million of outstanding common stock under our stock repurchase plans in 2007 and to fund loan originations and operations. Cash was utilized as there was an overall net decrease in total deposits of $8.8 million due to the competitive interest rate environment on deposit accounts in our market area. We opted to allow deposit outflows, primarily in certificates of deposit, rather than to reprice our deposit base at higher rates.

Investment securities decreased by $1.5 million to $109.0 million at December 31, 2007 from $110.5 million at December 31, 2006. The decrease was attributable to the use of paydowns on our securities portfolio to fund loans and operations, instead of re-investing the funds in other investments. We do not have any exposure to sub-prime loans in our investment portfolio. All of our mortgage-backed and asset-backed securities are rated AAA or are guaranteed by an agency of the federal government. We do not own any collateralized debt obligations (CDO’s).

Loans receivable, net increased by $13.0 million to $218.7 million at December 31, 2007 from $205.7 million at December 31, 2006. The table below shows the changes in loan volume by loan type between December 31, 2006 and December 31, 2007:

 

     December 31,
2007
    December 31,
2006
    Change  
         $     %  
     (in thousands)  

Real Estate Loans:

        

Residential, 1-4 Family

   $ 157,834     $ 149,408     $ 8,426     5.6 %

Home Equity

     26,569       25,896       673     2.6 %

Commercial

     20,394       17,150       3,244     18.9 %

Construction

     2,775       1,570       1,205     76.8 %
                              
     207,572       194,024       13,548     7.0 %

Commercial Loans

     8,246       8,746       (500 )   (5.7 )%

Consumer Loans

     2,306       2,689       (383 )   (14.2 )%
                              

Total Gross Loans

     218,124       205,459       12,665     6.2 %

Allowance for loan losses

     (1,226 )     (1,257 )     31     2.5 %

Net deferred loan costs

     1,813       1,475       338     22.9 %
                              

Loans receivable, net

   $ 218,711     $ 205,677     $ 13,034     6.3 %
                              

The increase in commercial real estate loans and construction loans in 2007 is attributable to our efforts to increase originations in this area. Residential mortgage loans increased due to increased sales of new and existing homes during the year ended December 31, 2007. Mortgage loans and commercial real estate loans represented 72.4% and 9.3%, respectively, of the loan portfolio at December 31, 2007. We do not carry any “sub-prime” loans in our mortgage portfolio.

 

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The table below shows changes in deposit volumes by type of deposit between December 31, 2006 and December 31, 2007:

 

     December 31,
2007
   December 31,
2006
   Change  
           $     %  
     (in thousands)  

Demand Deposits:

          

Non-interest bearing

   $ 19,321    $ 17,458    $ 1,863     10.7 %

Interest bearing

     37,934      38,992      (1,058 )   (2.7 )%

Money market

     23,202      24,551      (1,349 )   (5.5 )%

Savings

     25,282      25,922      (640 )   (2.5 )%

Time deposits

     135,089      142,714      (7,625 )   (5.3 )%
                            

Total Deposits

   $ 240,828    $ 249,637    $ (8,809 )   (3.5 )%
                            

The overall decrease in time deposits in 2007 may be attributed to the competitive interest rates being offered by other banks, credit unions, mutual funds and financial service groups in our market area and our unwillingness to pay premium rates that will increase our interest expense. We opted to allow deposit outflows, primarily in time deposits, rather than reprice our deposit base at higher rates.

Our borrowings, consisting of advances from the Federal Home Loan Bank of New York, increased by $13.1 million from $43.4 million at December 31, 2006 to $56.4 million at December 31, 2007. The increase in borrowings is attributed to the increase of $13.0 million in loans receivable and the decrease of $8.8 million in our deposit portfolio. Typically, we fund new loans with loan payments received from existing borrowers and from increases in our deposit portfolio. During the year ended December 31, 2007, we closed more new loans than funding was available from these two sources. As a result, we had to obtain the necessary funds for these new loans by drawing on our borrowing capabilities at the Federal Home Loan Bank.

Total stockholders’equity decreased by $282,000 from $53.7 million at December 31, 2006 to $53.5 million at December 31, 2007. The decrease in total stockholders’ equity was primarily due to the purchase of $2.2 million in outstanding common stock under our stock repurchase plans in 2007. The decrease was offset by net income of $1.8 million for the year ended December 31, 2007. Stockholders’ equity was also affected by an increase in the net of tax unrealized gain on securities available for sale of $63,000. Dividends declared and paid in 2007 reduced stockholders’ equity by $346,000 and stock-based compensation expenses increased stockholders’ equity by $399,000.

Comparison of Results of Operations for the Years Ended December 31, 2007 and 2006

General. Net income was $1.8 million for the years ended December 31, 2007 and 2006. Earnings per share was $0.29 for the year ended December 31, 2007 compared to $0.24 for the period from April 3, 2006 to December 31, 2006.

Net Interest Income. Net interest income decreased by $240,000, or 2.5%, to $9.5 million for the year ended December 31, 2007 as compared to $9.7 million for the year ended December 31, 2006. The decrease in net interest income is primarily due to an increase in interest expense of $1.1 million offset by an increase of $848,000 in interest income for the year ended December 31, 2007 in comparison to the year ending December 31, 2006.

 

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Interest Income. Interest income increased $848,000, or 4.8%, from $17.8 million for the year ended December 31, 2006 to $18.6 million for the year ended December 31, 2007. The increase is primarily due to an $835,000 increase in loan interest income, or 6.6%, from $12.6 million for the year ended December 31, 2006 to $13.5 million for the year ended December 31, 2007. Part of the increase in loan interest income occurred due to an increase in loan originations during 2007. During 2007, residential mortgage loan originations totaled $44.0 million, an increase of $13.2 million, or 39.6%, over residential mortgage loan originations in 2006 of $30.8 million. As a result, the average balance of our loan portfolio increased $5.2 million from an average balance of $205.4 million for the year ended December 31, 2006 to an average balance of $210.6 million for the year ended December 31, 2007. The average yield on our loan portfolio increased from 6.16% to 6.40% for the years ended December 31, 2006 and 2007, respectively. Interest income on our loan portfolio was also increased by a $299,000 gain on the fair value of our interest rate floor derivative product during the year ended December 31, 2007. Investment income increased by $512,000, or 11.4%, from $4.5 million for the year ended December 31, 2006 to $5.0 million for the year ended December 31, 2007. The investment portfolio had an average balance of $110.5 million and an average yield of 4.53% for the year ended December 31, 2007 compared to average balance of $104.4 million and an average yield of 4.31% for the year ended December 31, 2006. Other interest income decreased by $499,000, or 79.3%, from $629,000 for the year ended December 31, 2006 to $130,000 for the year ended December 31, 2007. This occurred due to the decrease in the average balance of federal funds sold and other interest bearing deposits from $14.3 million for the year ended December 31, 2006 to $4.0 million for the year ended December 31, 2007. The proceeds from our stock offering on April 3, 2006 were initially invested in federal funds sold. Since that time, the proceeds have been moved to other investments, resulting in the significant decrease in the average federal funds sold balance.

Interest Expense. Interest expense increased by $1.1 million, or 13.5%, from $8.0 million for the year ended December 31, 2006 to $9.1 million for the year ended December 31, 2007 primarily due to an increase in the interest paid on deposits of $1.0 million from $5.9 million for the year ended December 31, 2006 to $6.9 million for the year ended December 31, 2007. This was due to an increase in the average yield paid on interest-bearing deposits from 2.59% for the year ended December 31, 2006 to 3.04% for the year ended December 31, 2007. The interest expense related to advances from the Federal Home Loan Bank of New York increased by $72,000, or 3.6%, from $2.0 million for the year ended December 31, 2006 to $2.1 million for the year ended December 31, 2007. The average yield on these borrowings increased from 4.18% for the year ended December 31, 2006 to 4.47% for the year ended December 31, 2007.

Provision for Loan Losses. 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.

For the year ended December 31, 2007, the provision for loan losses decreased by $53,000 from $158,000 for the year ended December 31, 2006 to $105,000 for the year ended December 31, 2007. Total classified assets increased $1.6 million from $4.8 million as of December 31, 2006 to $6.8 million as of December 31, 2007. Included in the classified assets total as of December 31, 2007, was an increase of $306,000 in the “doubtful” assets category, which indicated a high probability of loss within the loan portfolio. Furthermore, the average balance of our loan portfolio increased from $205.4 million as of December 31, 2006 to $210.6 million as of December 31, 2007. Despite the increase in classified loans and the increase in the average balance of our loan portfolio, we did not deem it necessary to increase our provision for loan losses. The majority of the increase in classified loans was in the “special mention” category. The loans in the special mention category include commercial real estate loans and commercial loans that are under “watch” by the Bank for various reasons, such as being a new loan (i.e., less than 6 months old) or being in a riskier business (i.e. a restaurant). These loans possess certain weaknesses

 

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which deserve careful monitoring but in the current opinion of management, the risk of loss is minimal. The increase in the average balance of our loan portfolio is attributed to an increase in new residential mortgage loans originated in 2007. These loans are serviced by collateral which limits our risk of loss. 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.

Non-interest Income. For the year ended December 31, 2007, non-interest income, which is a total of service charges and fees, earnings on bank-owned life insurance, and other income totaled $2.0 million, which was an increase of $197,000, or 10.9%, in comparison to $1.8 million for the year ended December 31, 2006. The increase is attributed to $192,000 of increased earnings on bank-owned life insurance, resulting from the purchase of an additional $3.8 million of bank-owned life insurance in the fourth quarter of 2006 to fund supplemental employee retirement plans.

Non-interest Expense. Non-interest expense increased $472,000, or 5.5%, from $8.6 million for the year ended December 31, 2006 to $9.1 million for the year ended December 31, 2007. 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. Salaries and employee benefits increased $299,000, or 6.5%, due to $270,000 in additional expenses for stock-based plans that were implemented after being approved by shareholders in October 2006. Professional service fees increased $272,000, or 28.6%, due to increased SEC and Sarbanes-Oxley related compliance expenses as a result of being a public company. We also hired an outside consultant to assist us with fee income strategies, resulting in $127,000 of additional expenses in 2007. We expect to see increased fee income in 2008 as a result of this project. Occupancy and equipment expenses decreased by $85,000 for the year ended December 31, 2007, in comparison to the year ended December 31, 2006, primarily due to several assets that had become fully depreciated in 2007, but remained outstanding on the depreciation schedule during 2006. Lastly, management instituted cost-cutting measures in 2007 to improve efficiency, including a decrease in advertising expense of $48,000 and a decrease in office supplies and postage expenses of $25,000.

Income Tax Expense. Income tax expense decreased by $460,000, or 50.5%, from $911,000 for the year ended December 31, 2006 to $451,000 for the year ended December 31, 2007. The decrease was due to lower pre-tax income and higher levels of tax exempt income on bank owned life insurance and municipal bond investments. In 2007, the impact of this tax exempt income reduced the effective tax rate by 11.8%, in comparison to a 5.1% reduction to the effective tax rate in 2006.

Comparison of Results of Operations for the Years Ended December 31, 2006 and 2005

General. Net income was $1.8 million for the year ended December 31, 2006, a decrease of $235,000 or 11.4%, compared with net income of $2.1 million for the year ended December 31, 2005.

Net Interest Income. Net interest income increased by $199,000, or 2.1%, to $9.7 million for the year ended December 31, 2006 as compared to $9.5 million for the year ended December 31, 2005.

Interest Income. Interest income increased $1.8 million, or 11.4%, from $15.9 million for the year ended December 31, 2005 to $17.8 million for the year ended December 31, 2006. Approximately $854,000 of this increase was attributable to an increase in interest on loans, the average balance of which increased by $4.8 million over the year and had an average yield of 6.16% in 2006 as compared to an average yield of 5.88% in the prior year. $477,000 of the increase was attributable to an increase from interest on investment securities, the average balance of which increased by $2.9 million over the year and had an average yield of 4.31% in 2006 as compared to an average yield of 3.96% in the prior year.

Interest Expense. Interest expense increased by $1.6 million, or 25.2%, from $6.4 million for the year ended December 31, 2005 to $8.0 million for the year ended December 31, 2006. The interest paid on deposits increased by $1.4 million from $4.5 million for the year ended December 31, 2005 to $5.9

 

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million for the year ended December 31, 2006. This was due to an increase in the average yield paid on interest-bearing deposits over the year of 1.25% and was partially offset by a decrease of $6.4 million in the average balance of interest-bearing deposits. The interest expense related to advances from the Federal Home Loan Bank of New York which increased by $203,000 from $1.8 million for the year ended December 31, 2005 to $2.0 million for the year ended December 31, 2006 due to an increase in the average rate paid on our borrowings of 0.63% in comparison to the prior year.

Provision for Loan Losses. For the year ended December 31, 2006, the provision for loan losses was $158,000, an increase of $138,000 as compared to the provision for loan losses for the prior year which was $20,000. The increase is attributed to a $296,000 increase in total classified assets from $4.5 million as of December 31, 2005 to $4.8 million as of December 31, 2006. Included in the classified assets total as of December 31, 2006, was an increase of $187,000 in the “doubtful” assets category. Furthermore, the average balance of our loan portfolio increased from $200.7 million as of December 31, 2005 to $205.4 million as of December 31, 2006 and net charge-off’s increased from $68,000 for the year ended December 31, 2005 to $141,000 for the year ended December 31, 2006.

Non-interest Income. For each of the years ended December 31, 2006 and 2005 non-interest income, which is a total of service charges and fees, net gains or losses on sales of loans, earnings on bank owned life insurance, as well as other income, not including interest and dividends, totaled $1.8 million.

Non-interest Expense. Non-interest expense increased $296,000 from $8.3 million for the year ended December 31, 2005 to $8.6 million for the year ended December 31, 2006. Non-interest expense includes the expense of salaries and employee benefits, occupancy and equipment costs, data processing, and other costs not related to expenses on deposits or borrowings. Salaries and employee benefits increased $210,000, or 4.8%, primarily due to the expenses related to stock based compensation granted in 2006. Professional services increased $447,000, or 88.5%, due the costs associated with becoming a public company and the outsourcing of our check processing operations to a third party in the third quarter of 2005. Occupancy and equipment increased $42,000, or 3.1%, due to the expenses associated with maintaining our Hamburg branch, which opened in December 2005. These increases were offset by a decrease in other non-interest expenses of $402,000, or 34.7%. The decrease was attributable in part to a $252,000 decrease in check losses in 2006. In 2005, we had recorded a one-time loss of $188,000 for a single, isolated check kiting incident. In 2006, we collected $50,000 of this loss. We did not have a similar loss in 2006. The decrease is also due to a $53,000 decrease in training and travel expenses. In 2006, management curtailed training and travel expenses in an effort to control costs. In 2005, several assets were disposed of as a result of outsourcing our check processing operations to a third party, resulting in a loss on disposal of assets of $59,000 in 2005. A similar expense was not posted in 2006.

Income Tax Expense. Income tax expense decreased by $42,000 from $953,000 for the year ended December 31, 2005 to $911,000 for the year ended December 31, 2006. The decrease is largely attributed to a decrease in income before taxes of $277,000, as compared to 2005. The effective tax rate of 33.4% differs from the statutory rate of 34.0% primarily due to the impact of income on bank-owned life insurance and state income tax.

 

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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, 2007, allowed us to borrow up to $31.5 million on an overnight line of credit and $31.5 million on a one-month overnight repricing line of credit. As of December 31, 2007, we had no borrowings outstanding under 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, 2007, we had outstanding advances totaling $56.4 million under this agreement.

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, 2007, we originated loans of approximately $49.4 million in comparison to approximately $37.9 million of loans originated during the year ended December 31, 2006. Purchases of investment securities totaled $14.7 million in the year ended December 31, 2007 and $30.5 million in the year ended December 31, 2006.

At December 31, 2007, we had loan commitments to borrowers of approximately $5.0 million and overdraft lines of protection and unused home equity lines of credit of approximately $21.3 million.

Total deposits were $240.8 million at December 31, 2007, as compared to $249.6 million at December 31, 2006. Time deposit accounts scheduled to mature within one year were $122.2 million at December 31, 2007. 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 following their maturity.

We are committed to maintaining a strong liquidity position and 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.

We do not anticipate any material capital expenditures in 2008. 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 9 in the Notes to our Consolidated Financial Statements and the commitments and unused lines and letters of credit noted above.

 

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We are contractually obligated to make payments as of December 31, 2007 as follows:

 

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

Long term debt

   $ 37,940    $ 14,980    $ 20,050    $ 2,910    $ —  

Capital Leases

     2,991      145      304      306      2,236

Operating Leases

     916      88      254      274      300

Data processing contract

     442      279      163      —        —  

Time Deposits

     135,089      122,179      11,447      1,309      154
                                  

Total contractual obligations

   $ 177,378    $ 137,671    $ 32,218    $ 4,799    $ 2,690
                                  

Off-Balance Sheet Arrangements

Other than loan commitments, we do 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 17 in the Notes to our Consolidated Financial Statements for a summary of commitments as of December 31, 2007.

Recent Accounting Pronouncements

In May 2007, the FASB issued FASB Staff Position (“FSP”) FIN 48-1 “Definition of Settlement in FASB Interpretation No. 48” (FSP FIN 48-1). FSP FIN 48-1 provides guid