Legacy Bancorp 10-K 2009
Documents found in this filing:
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
COMMISSION FILE NUMBER : 000-51525
Securities registered pursuant to section 12(b) of the Act:
Common Stock ($0.01 par value per share)
NASDAQ Stock Market, LLC
Securities registered pursuant to section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ.
Indicate by check mark if the registrant is not required to file reports pursuant to section 13 or Section 15(d) of the Act. Yes o No þ.
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 þ No o.
Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Se. 229.405) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ.
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 the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes o No þ
Based upon the closing price of the registrants common stock as of the last business day of the registrants most recently completed second fiscal quarter, the aggregate market value of the voting and non-voting common equity held by non-affiliates was $80,076,576.
The number of shares of Common Stock outstanding as of March 5, 2009 was 8,781,912.
Portions of the Proxy Statement for the 2009 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.
Forward-Looking Statements: This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Legacy Bancorp, Inc. (the Company) and Legacy Banks (the Bank). These forward-looking statements are generally identified by use of the words believe, expect, intend, anticipate, estimate, project or similar expressions. Legacy Bancorps and Legacy Banks ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the effect of a dramatically slowing economy on our lending portfolio and investments, the impact of the U.S. governments economic stimulus program and its various financial institution rescue plans, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Companys market area, changes in real estate market values in the Companys market area, and changes in relevant accounting principles and guidelines. These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, the Company does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions which may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.
Financial Statements: Effective as of October 26, 2005, Legacy Bancorp, Inc., a Delaware corporation became the holding company of Legacy Banks, a Massachusetts-chartered stock savings bank, in connection with the conversion of the holding company structure of Legacy Banks from mutual to stock form. Prior to October 26, 2005, Mutual Bancorp of the Berkshires, Inc., a Massachusetts-chartered mutual holding company (referred to herein as the Predecessor), owned all of the outstanding common stock of Legacy Group, Inc., the Massachusetts-chartered mid-tier bank holding company of Legacy Banks (the Mid-Tier), and the Mid-Tier owned all of the outstanding common stock of Legacy Banks. Effective as of October 26, 2005, the Predecessor and the Mid-Tier merged out of existence, and the Company consummated the sale of 9,545,000 shares of its common stock to the public at a price of $10.00 per share, and contributed an additional 763,600 shares of its outstanding common stock to The Legacy Banks Foundation. Also on October 26, 2005, Legacy Banks issued all of its shares of common stock to the Company in exchange for 50% of the net proceeds of the public offering. During any period prior to October 26, 2005 the Company was newly organized and owned no assets. Therefore, the financial information for any period prior to October 26, 2005 presented in this report is that of Mutual Bancorp of the Berkshires, Inc. and its direct and indirect subsidiaries.
General: Legacy Banks is a full-service, community-oriented financial institution offering products and services to individuals, families and businesses through eighteen branch offices located in Berkshire County, Massachusetts and eastern New York State. Predecessors to Legacy Banks were originally organized as Massachusetts state-charted mutual savings banks dating back to 1890. Legacy Banks business consists primarily of making loans to its customers, including residential mortgages, commercial real estate loans, commercial loans and consumer loans, and investing in a variety of investment and mortgage-backed securities. Legacy Banks funds these lending and investment activities with deposits from the general public, funds generated from operations and select borrowings. Legacy Banks also provides insurance and investment products and services, investment portfolio management, debit and credit card products and online banking.
Market Area and Competition: We offer a variety of financial products and services designed to meet the needs of the communities we serve. Our primary deposit-gathering area is concentrated in Berkshire County, Massachusetts and eastern New York State. Legacy Banks is one of the largest banks in Berkshire County, Massachusetts in deposits and mortgage recordings. We are headquartered in Pittsfield, Massachusetts, located 120 miles west of Boston, Massachusetts and 30 miles east of Albany, New York. The Massachusetts and New York counties in which Legacy Banks currently operate include a mixture of rural, suburban and urban markets.
In the past few years part of our business strategy was the intent to expand geographically into areas contiguous to our existing markets, including into the State of New York, and to increase
our loan volume in all areas. One step in this strategy was achieved in 2007 when the Bank purchased five branch offices located in Eastern New York from First Niagara Bank, assuming approximately $76.6 million of deposit liabilities. This expansion into Eastern New York continued into 2008 as the Bank opened a denovo branch location in downtown Albany, New York. A second New York denovo office was also recently opened in Latham, New York. Additionally, our expansion strategy includes a national commercial real estate lending program which is not limited to our existing markets, and we intend to focus on growth of this program as well. See Lending Activities Commercial Real Estate Loans for more information regarding the national commercial real estate lending program.
We face substantial competition in our efforts to originate loans and attract deposits and other fee-based business. Achieving meaningful growth is very challenging given the number of competitors and the overall decline in the population in our market area. The major risks associated with our competitive environment in Berkshire County are that it is relatively small and over-banked, which results in limited asset and funding diversification. We face direct competition from a significant number of financial institutions within Berkshire County, many with a state-wide, regional or national presence. We also compete with five smaller community banks. Regional and national banks which have offices in our area include Citizens Bank of Massachusetts and TD Banknorth. We compete with these institutions through competitive pricing coupled with superior service and expertise in both commercial and retail banking. We also combine these same attributes to our expanded commercial lending in New York, our recently acquired New York branches and to our national commercial real estate lending program. In our markets, in addition to the local banks and credit unions, our competitors are brokerage houses, life insurance agents, and mortgage brokers. In our national commercial real estate lending program, our major competitors are life insurance companies and to a lesser extent pension funds and other banks.
Prior to the acquisition of the five branches in New York in 2007, our business outside Berkshire County was predominantly commercial real estate lending, and came from two sources. First, for several years lenders from our commercial banking group had developed contacts and clients in the Albany-Schenectady-Troy Metropolitan Statistical Area (MSA) and traveled there regularly. The opening of the loan production office during 2006 provided a base of operations for the New York commercial lending activity. Second, our national commercial lending program, Legacy Real Estate Finance or LREF, is targeted and specialized, and operates separately from our commercial banking group. LREF program guidelines are first mortgage loans on high quality, institutional grade income property generally ranging in size from $500,000 to $5.0 million, with preference in the $500,000 to $3.0 million size range. LREF works exclusively through a group of ten well-established mortgage banking correspondents who are designated and contracted to originate and service loans on behalf of Legacy Banks in approximately 20 major metropolitan markets, 16 of which are located in the eastern half of the United States.
The following table summarizes the composition of Legacy Banks loan portfolio (not including loans held for sale) as of the dates indicated:
General: Legacy Banks gross loan portfolio aggregated $700.4 million at December 31, 2008, representing 74.1% of the Companys total assets at that date. In its lending activities, Legacy Banks originates residential real estate loans secured by one-to-four-family residences, commercial real estate loans, residential and commercial construction loans, commercial loans, home equity lines-of-credit, fixed rate home equity loans and other personal
consumer loans. While Legacy Banks makes loans throughout Massachusetts and Eastern New York, most of its lending activities are concentrated in its market area. Loans originated totaled $181.0 million in 2008 as compared to $195.3 million in 2007. Residential mortgage loans sold into the secondary market, on a servicing-retained basis, totaled $17.1 million and $426,000 during 2008 and 2007, respectively.
Loans originated by Legacy Banks are subject to federal and state laws and regulations. Interest rates charged by Legacy Banks on its loans are influenced by the demand for such loans, the amount and cost of funding available for lending purposes, current asset/liability management objectives and the interest rates offered by competitors.
Residential Real Estate Loans: Legacy Banks offers fixed-rate and adjustable-rate residential mortgage loans with maturities of up to 30 years and maximum loan amounts generally of up to $3.0 million. As of December 31, 2008, this portfolio totaled $344.2 million, or 49.2% of the total gross loan portfolio on that date, and had an average yield of 5.88%. Residential mortgage loan originations totaled $73.7 million and $75.0 million for 2008 and 2007, respectively.
The decision to originate loans for portfolio or for sale into the secondary market is made by the Banks Asset/Liability Management Committee, and is based on the market rates for such loans and the organizations interest rate risk and liquidity profile. Current practice is to sell almost all newly originated fixed-rate 10, 15 and 30 year monthly payment loans, while 30 year fixed rate bi-weekly loans are generally held in the Banks portfolio. At December 31, 2008, 10, 15, 25 and 30 year fixed rate monthly payment loans held in the Banks portfolio totaled $211.6 million, or 61.5% of total residential real estate mortgage loans at that date, and these loans had an average yield of 6.03%. Legacy Banks services loans sold to Fannie Mae and earns a fee equal to 0.25% of the loan amounts outstanding for providing these services. The total of loans serviced for others as of December 31, 2008 is $24.0 million.
At December 31, 2008, adjustable-rate mortgage (ARM) loans totaled $132.7 million or 38.6% of total residential loans outstanding at that date, with an average yield of 5.66%. ARMs are offered for terms of up to 30 years with initial interest rates that are fixed for 1, 3, 5, 7 or 10 years. After the initial fixed-rate period, the interest rates on the loans are generally reset based on the relevant U.S. Treasury CMT (Constant Maturity Treasury) Index plus add-on margins of varying amounts, for periods of 1 year. Interest rate adjustments on such loans typically range from 2.0% to 5.0% during any adjustment period and 5.0% to 6.0% over the life of the loan. Periodic adjustments in the interest rate charged on ARM loans help to reduce Legacy Banks exposure to changes in interest rates. However, ARM loans generally possess an element of credit risk not inherent in fixed-rate mortgage loans, in that borrowers are potentially exposed to increases in debt service requirements over the life of the loan in the event market interest rates rise. Higher payments may increase the risk of default, though this risk has not had a materially adverse effect on Legacy Banks to date.
For residential mortgage loan originations to be held in portfolio, Legacy Banks lends up to a maximum loan-to-value ratio of 100% for first-time home buyers and 95% for other buyers on mortgage loans secured by owner-occupied property, with the general condition that private mortgage insurance is required for loans with a loan-to-value ratio in excess of 85%. Title insurance, hazard insurance and, if appropriate, flood insurance are required for all properties securing real estate loans made by Legacy Banks. A licensed appraiser appraises all properties securing residential first mortgage purchase loans.
In an effort to provide financing for low and moderate-income first-time home buyers, Legacy Banks originates and services residential mortgage loans with private mortgage insurance provided by the Mortgage Insurance Fund (MIF) of the Massachusetts Housing Finance Agency, or Mass Housing. The program provides mortgage payment protection as an enhancement to mortgage insurance coverage. This no-cost benefit, known as MI Plus, provides up to six monthly principal and interest payments in the event of a borrowers job loss.
Commercial Real Estate Loans: Legacy Banks originated $69.6 million and $69.4 million of commercial real estate loans in 2008 and 2007, respectively, and had $246.4 million of commercial real estate loans, with an average yield of 6.69%, in its portfolio as of December 31, 2008. We have placed increasing emphasis on commercial real estate lending over the past several years, and as a result such loans have grown from 15.2% of the total loan portfolio at December 31, 2001 to 35.2% as of December 31, 2008. Legacy Banks intends to further grow this segment of its loan portfolio, both in absolute terms and as a percentage of its total loan portfolio.
Legacy Banks generally originates commercial real estate loans for terms of up to 10 years with amortization schedules of up to 25 years, typically with interest rates that adjust over periods of one to seven years based on various rate indices. Commercial real estate loans are generally secured by multi-family income properties, small office buildings, retail facilities, warehouses, industrial properties and owner-occupied properties used for business. Generally, commercial real estate loans do not exceed 80% of the appraised value of the underlying collateral.
The national commercial real estate lending program, LREF, which was started in 2002, accounts for approximately 42.2%, 42.9%, and 46.5%, of our total commercial real estate loans as of December 31, 2008, 2007 and 2006, respectively. As of December 31, 2008, loans from this program amounted to $104.0 million, or 11.0% of the Companys total assets. These loans were made in 17 states and $83.1 million of these loans were made in states other than Massachusetts and New York. The LREF program is considered an important part of our overall commercial real estate lending activities, allowing for greater portfolio diversification while providing Legacy with lending opportunities greater than can be seen within the Banks geographical footprint. We intend to continue to focus on careful growth of this program as part of our business strategy, and in alignment with our overall growth strategy.
In its evaluation of a commercial real estate loan application, Legacy Banks considers the net operating income of the borrowers business, the borrowers expertise, credit history, and the profitability and value of the underlying property. In addition, for loans secured by rental properties, Legacy Banks will also consider the terms of the leases and the quality of the tenants. Legacy Banks generally requires that the properties securing these loans have debt service coverage ratios (the ratio of cash flow before debt service to debt service) of at least 1.20.
Commercial real estate loans generally have larger balances and involve a greater degree of risk than residential mortgage loans. Loan repayment is often dependent on the successful operation and management of the properties, as well as on the collateral value of the commercial real estate securing the loan. Economic events and changes in government regulations could have an adverse impact on the cash flows generated by properties securing Legacy Banks commercial real estate loans and on the value of such properties. As of December 31, 2008 Legacy Banks had $32.3 million in commercial real estate loans concentrated in the hospitality industry, representing 13.1% of the total commercial real estate loan portfolio.
Home Equity Lines-of-Credit and Loans: Legacy Banks offers home equity lines-of-credit and home equity term loans. Legacy Banks originated $18.8 million and $28.9 million of home equity lines-of-credit and loans during 2008 and 2007 respectively, and at December 31, 2008 had $63.1 million of home equity lines-of-credit and loans outstanding, representing 9.0% of the loan portfolio, with an average yield of 3.71% at that date.
Home equity lines-of-credit and loans are secured by first or second mortgages on one-to-four family owner occupied properties, and are made in amounts such that the combined first and second mortgage balances generally do not exceed 80% of the value of the property serving as collateral at time of origination. The lines-of-credit are available to be drawn upon for 10 years, at the end of which time they become term loans amortized over 10 years. Interest rates on home equity lines normally adjust based on the prime rate of interest as published by the Wall Street Journal. The undrawn portion of home equity lines-of-credit totaled $67.0 million at December 31, 2008.
Commercial Loans: Legacy Banks originates secured and unsecured commercial and industrial loans to business customers in its market area for the purpose of financing equipment purchases, working capital, expansion and other general business purposes. Legacy Banks originated $17.4 million and $18.9 million in commercial loans during 2008 and 2007, respectively, and as of December 31, 2008 had $34.2 million in commercial loans in its portfolio, representing 4.9% of such portfolio, with an average yield of 5.54%.
Legacy Banks commercial loans are generally collateralized by equipment, accounts receivable and inventory, supported by personal guarantees. Legacy Banks offers both term and revolving commercial loans. The former have either fixed or adjustable-rates of interest and generally fully amortize over a term of between three and seven years. Revolving loans are renewable annually, with floating interest rates that are generally indexed to the Wall Street Journal Prime Rate of interest. When making commercial loans, Legacy Banks considers the financial statements of the borrower, the borrowers payment history with respect to both corporate and personal debt, the debt service capabilities of the borrower, the projected cash flows of the business, the viability of the industry in which the borrower operates and the value of the collateral. Legacy Banks commercial loans are not concentrated
in any one industry. The repayment of commercial loans is often dependent on the successful operation of the business and may be affected by adverse changes in the economy and other external factors affecting the business. Collateral securing such loans may fluctuate in value and for that reason, may be difficult to appraise or liquidate.
Consumer and Other Loans: Legacy Banks offers a variety of consumer and other loans, including auto loans, manufactured housing loans and loans secured by passbook savings or certificate accounts. Legacy Banks originated or purchased $3.9 million and $7.1 million of consumer and other loans during 2008 and 2007, respectively, and at December 31, 2008 had $12.4 million of consumer and other loans outstanding, representing 1.8% of the loan portfolio at that date, with an average yield of 8.34%.
Loan Origination and Underwriting: Loan originations come from a variety of sources. The primary source of originations are our salaried and commissioned loan personnel, and to a lesser extent, local mortgage brokers, advertising and referrals from customers. Legacy Banks occasionally purchases participation interests in commercial real estate loans from banks located outside of Berkshire County. Legacy Banks underwrites such residential and commercial purchased loans using its own underwriting criteria.
Legacy Banks issues loan commitments to prospective borrowers conditioned on the occurrence of certain events. Commitments are made in writing on specified terms and conditions and are generally honored for up to 60 days from approval. At December 31, 2008, Legacy Banks had loan and other financial commitments totaling $135.1 million. For information about Legacy Banks loan commitments outstanding as of December 31, 2008, see Managements Discussion and Analysis of Financial Conditions and Results of Operations Quantitative and Qualitative Disclosures About Risk Management Loan Commitments.
Legacy Banks charges origination fees, or points, and collects fees to cover the costs of appraisals and credit reports on most residential mortgage loans originated. Legacy Banks also collects late charges on real estate loans, and origination fees and prepayment penalties on commercial mortgage loans. For information regarding Legacy Banks recognition of loan fees and costs, please refer to Note 1 to the Consolidated Financial Statements of Legacy Bancorp, Inc. and Subsidiaries.
The following table sets forth certain information concerning Legacy Banks portfolio loan originations, inclusive of loan purchases:
Residential mortgage loans are underwritten by Legacy Banks staff of residential loan underwriters. Residential mortgage loans less than the Federal National Mortgage Association (Fannie Mae) limit to be held in portfolio require the approval of a residential loan underwriter. Residential mortgage loans greater than the Fannie Mae limit but less than $1.0 million require the approval of either the CEO or Executive Vice President. Residential mortgage loans greater than $1.0 million but less than $3.0 million require the approval of the Loan Committee. Residential mortgage loans greater than $3.0 million but less than Legacy Banks legal lending limit require the approval of the Executive Committee of the board of directors of the Bank.
Commercial real estate and commercial loans are underwritten by commercial credit analysts. For commercial real estate loans, loan officers may approve loans up to their individual lending limits, which range from $50,000 to $400,000, while loans up to $1.0 million may be approved by the CEO and Executive Vice President. The Loan Committee may approve loans of up to $6.0 million, while loans over these limits require the approval of the Executive Committee of the board of directors of the Bank. LREF loans may generally be approved up to $5.0 million, with any loan over $3.0 million requiring the approval of at least two executive level officers.
Consumer loans are underwritten by consumer loan underwriters, including loan officers and branch managers who have approval authorities ranging from $20,000 to $40,000 for these loans. Senior loan committee officers may approve consumer loans of up to $75,000 while the management credit committee may approve loans of up to $1.5 million. All consumer loans in excess of these limits require the approval of the Executive Committee of the board of directors of the Bank.
Pursuant to its loan policy, Legacy Banks generally will not make loans aggregating more than 10% of the Banks retained earnings and capital stock accounts or $9.4 million as of December 31, 2008 to one borrower (or
related entity). Exceptions to this limit require the approval of the Executive Committee of the board of directors of the Bank prior to loan origination. Legacy Banks internal lending limit is lower than the Massachusetts legal lending limit, which is 20.0% of a banks retained earnings and capital stock accounts, or $18.8 million for Legacy Banks as of December 31, 2008.
Legacy Banks has established a risk rating system for its commercial real estate and commercial loans. This system evaluates a number of factors useful in indicating the risk of default and risk of loss associated with a loan. These ratings are performed by commercial credit analysts who do not have responsibility for loan originations. See Loan Quality Classification of Assets and Loan Review.
Maturity and Sensitivity of Loan Portfolio: The following table shows contractual final maturities of selected loan categories at December 31, 2008. The contractual maturities do not reflect premiums, discounts and deferred costs, and do not reflect prepayments:
Of the $190.3 million total of loans above which mature in more than one year, $117.0 million are fixed-rate and $73.3 million are adjustable rate.
General: One of Legacy Banks most important operating objectives is to maintain a high level of asset quality. Management uses a number of strategies in furtherance of this goal including maintaining sound credit standards in loan originations, monitoring the loan portfolio through internal and third-party loan reviews, and employing active collection and workout processes for delinquent or problem loans. Legacy has no subprime loan exposure anywhere on its balance sheet, and makes only loans and investments that we would be comfortable holding on our balance sheet from a quality perspective.
Delinquent Loans: Management performs a monthly review of all delinquent loans. The actions taken with respect to delinquencies vary depending upon the nature of the delinquent loans and the period of delinquency. Generally, the Banks requirement is that a delinquency notice be mailed no later than the 10 th or 16 th day, depending on loan type, after the payment due date. A late charge is assessed on loans where the scheduled payment remains unpaid after a 10 or 15 day grace period. After mailing delinquency notices, Legacy Banks loan collection personnel call the borrower to ascertain the reasons for delinquency and the prospects for repayment. On loans secured by one- to four-family owner-occupied property, Legacy Banks initially attempts to work out a payment schedule with the borrower in order to avoid foreclosure. Any such loan restructurings must be approved by the level of officer authority required for a new loan of that amount. If these actions do not result in a satisfactory resolution, Legacy Banks refers the loan to legal counsel and counsel initiates foreclosure proceedings. For commercial real estate, construction and commercial loans, collection procedures may vary depending on individual circumstances.
Other Real Estate Owned: Legacy Banks classifies property acquired through foreclosure or acceptance of a deed in lieu of foreclosure as other real estate owned (OREO) in its consolidated financial statements. When property is placed into OREO, it is recorded at the fair value less estimated costs to sell at the date of foreclosure or acceptance of deed in lieu of foreclosure. At the time of transfer to OREO, any excess of carrying value over fair value is charged to the allowance for loan losses. Management inspects all OREO property periodically. Holding costs and declines in fair value result in charges to expense after the property is acquired. At December 31, 2008,
Legacy Banks had no property classified as OREO. At December 31, 2007, Legacy Banks had two properties worth approximately $185,000 classified as OREO.
Classification of Assets and Loan Review: Legacy Banks uses an internal rating system to monitor and evaluate the credit risk inherent in its loan portfolio. At the time a loan is approved, all commercial real estate and commercial loans are assigned a risk rating based on all of the factors considered in originating the loan. The initial risk rating is recommended by the credit analyst charged with underwriting the loan, and subsequently approved by the relevant loan approval authority. Current financial information is sought for all commercial real estate and commercial borrowing relationships, and is evaluated on at least an annual basis to determine whether the risk rating classification is appropriate. This determination as to the classification of assets and the amount of the loss allowances established are subject to review by regulatory agencies, which can order the establishment of additional loss allowances. See Asset Quality Allowance for Loan Losses and Managements Discussion and Analysis of Financial Condition and Results of Operations Allowance for Loan Losses.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or 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 principal and interest payments when due. Impaired loans with payments past due at or greater than 90 days are generally maintained on a non-accrual basis. Impairment is measured on a loan by loan basis for commercial loans and commercial real estate loans by either the present value of expected future cash flows discounted at the loans effective interest rate, the loans obtainable market price, 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, the Bank generally does not separately identify individual consumer and residential loans for impairment disclosures. At December 31, 2008, loans which have been determined to possess an increased level of risk, which includes those loans deemed to be impaired, totaled $16.9 million, consisting of $15.4 million in commercial real estate loans and $1.5 million in other commercial loans. Within these amounts impaired loans totaled $10.4 million with a valuation allowance of approximately $966,000. Legacy Banks engages an independent third party to conduct an annual review of its commercial mortgage and commercial loan portfolios. These loan reviews provide a credit evaluation of selected individual loans to determine whether the risk ratings assigned are appropriate. Independent loan review findings are presented directly to the Audit Committee of the board of directors of the Bank.
Non-Performing Loan: The table below sets forth the amounts and categories of our non-performing assets at the dates indicated. At December 31, 2008 and 2007, Legacy Banks had no troubled debt restructurings (a loan for which a portion of interest or principal has been forgiven or the loan is modified at an interest rate less than current market rates).
If the non-accrual loans had been current, the gross interest income that would have been recorded for the year ended December 31, 2008 is equal to approximately $546,000. Interest income of approximately $186,000 was recorded in net income for the year ended December 31, 2008 on these loans prior to them being classified as non-accrual. No interest income from these loans was recorded in net income for the period they were classified as non-accrual.
The increase in nonperforming loans in 2008 relates primarily to a $5.5 million commercial construction loan the Bank placed on non-accrual status as of the end of the first quarter. The project is being monitored very closely and the current appraisal value is in excess of the loan balance. 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. Restructured loans represent performing loans for which concessions were granted due to a borrowers financial condition. Such concessions may include reductions of interest rates to below-market terms and/or extension of repayment terms.
Allowance for Loan Losses. In originating loans, Legacy Banks recognizes that losses will be experienced on loans and that the risk of loss will vary with many factors, including the type of loan being made, the creditworthiness of the borrower over the term of the loan, general economic conditions and, in the case of a secured loan, the quality of the security for the loan over the term of the loan. Legacy Banks maintains an allowance for loan losses to absorb losses inherent in the loan portfolio, and as such, this allowance represents managements best estimate of the probable known and inherent credit losses in the loan portfolio as of the date of the financial statements.
The Board and management take the following into consideration when determining the adequacy of the allowance for loan losses for each loan category or sub-category: (i) changes in the trend of the volume and severity of past due and classified loans, and trends in the volume of non-accrual loans, troubled debt restructurings and other loan modifications, (ii) changes in the trend of loan charge-offs and recoveries, (iii) changes in the nature, volume or terms of the loan portfolios, (iv) changes in lending policies or procedures, including the Banks loan review system, underwriting standards and collection, charge-off and recovery practices, and the degree of oversight by the Board, (v) changes in the experience, ability, and depth of lending management and staff,
(vi) changes in national and local economic and business conditions and developments, including the condition of various industry and market segments, (vii) the existence and effect of any concentrations of credit and changes in the level of such concentrations, and (viii) the effect of external factors such as competition and legal and regulatory requirements on the level of estimated credit losses in the portfolios. The allowance for loan losses is evaluated on a regular basis by management and is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of allocated and general components. The allocated component relates to loans classified as impaired, for which an allowance is established when the discounted cash flows or 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, as outlined above.
While Legacy Banks believes that it has established adequate allocated and general allowances for losses on loans, adjustments to the allowance may be necessary if future conditions differ substantially from the information used in making the evaluations. In addition, as an integral part of their examination process, Legacy Banks regulators periodically review the allowance for loan losses. These regulatory agencies may require the Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their examination, thereby negatively affecting Legacy Banks financial condition and earnings.
The following table sets forth activity in Legacy Banks allowance for loan losses for the periods indicated:
The allowance for loan losses to total loans increased from 0.76% as of December 31, 2004 to 0.95% as of December 31, 2008 primarily due to the increase over the years in the ratio of commercial loans to total loans, as commercial loans are generally reserved for at a higher rate than residential loans. The amount of the additions to the allowance charged to operating expense for each of the above years is a reflection of various factors analyzed by management, including the amount of loan growth in each year as well as the type of loan growth. Additionally, the amount of charge-offs and recoveries in a given year will impact the amount of provision expense. Our allowance for loan losses to total loans was 0.95% at December 31, 2008, an increase from 0.85% at December 31, 2007.
The following tables set forth Legacy Banks percent of allowance by loan category and the percent of the loans to total loans in each of the categories listed at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories:
General. Our investment policy is established and reviewed annually by the board of directors of the Bank. The Chief Executive Officer and Chief Financial Officer of the Bank, as authorized by the board, implement this policy based on the established guidelines within the written policy. The primary objective of the investment portfolio is to achieve a competitive rate of return without incurring undue interest rate and credit risk, to complement Legacy Banks lending activities, to provide and maintain liquidity, and to assist in managing the interest rate sensitivity of its balance sheet. Individual investment decisions are made based on the safety of the investment, liquidity requirements, potential returns, cash flow targets, and consistency with Legacy Banks asset/liability management objectives. Certain investment securities are held by Legacy Bancorp, which follows the same investment guidelines as Legacy Banks. The information about investments herein under Business Investment Activities includes the investment securities of Legacy Bancorp.
Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires Legacy Banks to designate its securities as held to maturity, available for sale or trading, depending on Legacy Banks intent with regard to its investments at the time of purchase. At December 31, 2008, $132.4 million or 99.9% of the portfolio was classified as available for sale, and $97,000 or 0.06% of the portfolio was classified as held to maturity. At December 31, 2008, the net unrealized loss on securities classified as available for sale was $6.9 million. Legacy Banks does not currently maintain a trading portfolio of securities.
During 2008, the investment portfolio increased by $585,000 or 0.4%, from a fair value of $152.1 million at December 31, 2007 to a fair value of $152.6 million at December 31, 2008. Increases during the year in mortgage-backed securities, municipal bonds and other investments were generally offset by decreases in government sponsored enterprise bonds and common stock investments. As of December 31, 2008 the investment portfolio consisted of the following:
Government Sponsored Enterprises (GSE). At December 31, 2008, Legacy Banks Government Sponsored Enterprises portfolio totaled $36.8 million, or 24.1% of the total portfolio on that date. Legacy invests in GSE securities with the purpose of both receiving a competitive rate of return and liquidity as these securities generally can be sold in a readily available market.
Municipal Bonds. At December 31, 2008, Legacy Banks Municipal Bond portfolio totaled $15.6 million, or 10.2% of the total portfolio on that date. This portfolio increased $5.7 million, or 57.3% over the December 31, 2007 amount of $9.9 million as the Bank took advantage of available bonds with an attractive tax-equivalent yield as part of its long-term strategy of lowering its overall effective tax rate.
Corporate Bonds and Other Obligations. At December 31, 2008, Legacy Banks portfolio of corporate bonds and other obligations totaled $363,000, or 0.2% of the portfolio at that date, made up entirely of one trust preferred backed bond. This bond was written down to market value as of December 31, 2008.
Mortgage-Backed Securities. Legacy invests in mortgage-backed securities with the purpose of receiving a competitive rate of return with a steady cash flow used for reinvestment and liquidity. At December 31, 2008, Legacy Banks portfolio of mortgage-backed securities totaled $74.0 million, or 48.5% of the portfolio on that date, and consisted of pass-through securities totaling $48.2 million and collateralized mortgage obligations totaling $25.8 million. Within the overall total, $52.5 million was directly insured or backed by Freddie Mac, Fannie Mae, Government National Mortgage Association (Ginnie Mae) or other GSEs, and $21.5 million was issued by certain private issuers. The unrealized losses on the Companys investment in mortgage-backed securities issued by certain private entities are primarily caused by (a) recent lack of liquidity in the market for these securities and (b) recent downgrades in certain levels of these securities by several industry analysts. The Company currently does not believe it is probable that it will be unable to collect all amounts due according to the contractual terms of the investments. Therefore, it is expected that the bonds would not be ultimately settled at a price less than the par value of the investment. Further problems in the current economic environment, however, could result in further deterioration of market values for these securities.
Marketable Equity Securities. At December 31, 2008, Legacy Banks portfolio of marketable equity securities totaled $5.5 million, or 3.6% of the portfolio at that date, and consisted entirely of common and preferred stock of various corporations. Legacy Banks investment policy requires stocks within this portfolio to be
diversified into several different business segments, actively traded and of high quality. At December 31, 2008, seventeen marketable equity securities have unrealized losses with aggregate depreciation of 25.4% from the Companys cost basis. Although some issuers may have shown declines in earnings as a result of the weakened economy, the Company has evaluated the near-term prospects of the issuers in relation to the severity and duration of the depreciation of value and has analyzed the issuers financial condition and financial performance as well as industry analysts reports. Based on that evaluation as well as the Companys ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2008. Further problems in the current economic environment, however, could result in further deterioration of market values for these securities.
Other Equity Securities and Investments. At December 31, 2008, Legacy Banks portfolio of restricted equity securities and other investments totaled $20.2 million or 13.2% of the portfolio at that date. These securities consisted primarily of stock in the Federal Home Loan Bank of Boston (FHLBB) totaling $10.9 million, which must be held as a condition of membership in the Federal Home Loan Bank System and as a condition to Legacy Banks borrowing under the FHLBB advance program. The remaining $9.3 million consisted of investments in Savings Bank Life Insurance of Massachusetts, Community Investment Fund, Depositors Insurance Fund and other pass-through investments.
The following table sets forth certain information regarding the amortized cost and market values of Legacy Banks investment securities at the dates indicated:
The table below sets forth certain information regarding the amortized cost, weighted average yields and contractual maturities of Legacy Banks debt securities portfolio at December 31, 2008. In the case of mortgage-backed securities, the table shows the securities by their contractual maturities, however there are scheduled principal payments for these securities and there will also be unscheduled prepayments prior to their contractual maturity:
Sources of Funds
General. Deposits are the primary source of Legacy Banks funds for lending and other investment purposes. In addition to deposits, Legacy Banks obtains funds from the amortization and prepayment of loans and mortgage-backed securities, the sale or maturity of investment securities, advances from the Federal Home Loan Bank of Boston, and cash flows generated by operations.
Deposits. Consumer and commercial deposits are gathered primarily from Legacy Banks primary market area through the offering of a broad selection of deposit products including checking, regular savings, money market deposits and time deposits, including certificate of deposit accounts and individual retirement accounts. The FDIC insures deposits up to certain limits and the Depositors Insurance Fund, or DIF, fully insures amounts in excess of such limits.
The maturities of Legacy Banks certificate of deposit accounts range from one month to five years. In addition, Legacy Banks offers a variety of commercial business products to small businesses operating within its primary market area. Legacy Banks will on occasion negotiate interest rates to attract jumbo certificates of deposit, and accepts deposits of $100,000 or more from customers based on posted rates. Legacy Banks also generates certificates of deposit through the use of brokers and internet-based network deposits. Brokered deposits and network deposits totaled $25.8 million and $8.6 million, respectively at December 31, 2008.
Legacy Banks relies primarily on competitive pricing of its deposit products, customer service and long-standing relationships with customers to attract and retain deposits. Market interest rates, rates offered by financial service competitors, the availability of other investment alternatives, and general economic conditions significantly affect Legacy Banks ability to attract and retain deposits.
The following tables set forth certain information relative to the composition of Legacy Banks average deposit accounts and the weighted average interest rate on each category of deposits:
The following table sets forth the time deposits of Legacy Banks classified by interest rate as of the dates indicated:
The following table sets forth the amount and maturities of time deposits at December 31, 2008:
As of December 31, 2008, the aggregate amount of outstanding certificates of deposit in amounts greater than or equal to $100,000 was approximately $107.1 million. The following table sets forth the maturity of those certificates:
Borrowings. Legacy Banks utilizes advances from the Federal Home Loan Bank of Boston, or FHLBB, primarily in connection with the funding of growth in its assets. FHLBB advances are secured primarily by certain of Legacy Banks mortgage loans, certain investment securities and by Legacy Banks holding of FHLBB stock. As of December 31, 2008, Legacy Banks had outstanding $197.9 million in FHLBB advances, and had the ability to borrow up to a total of $236.0 million based on available collateral. The following table sets forth certain information concerning balances and interest rates on Legacy Banks FHLBB advances at the dates and for the periods indicated:
Of the $197.9 million in advances outstanding at December 31, 2008, $88.0 million, bearing a weighted-average interest rate of 4.00%, are callable by the FHLBB at its option and in its sole discretion. In the event the FHLBB calls these advances, Legacy Banks will evaluate its liquidity and interest rate sensitivity position at that time and determine whether to replace the called advances with new borrowings.
Personnel. As of December 31, 2008, the Bank had approximately 182 full-time equivalent employees. The employees are not represented by a collective bargaining unit and the Bank considers its relationship with its employees to be excellent.
Segment Reporting: Generally, financial information is to be reported on the basis that is used internally for evaluating segment performance and deciding how to allocate resources to segments. Management evaluates the Companys performance and allocates resources based on a single segment concept. Accordingly, there are no separately identified material operating segments for which discrete financial information is available. The Company does not derive revenues from, or have assets located in foreign countries, nor does it derive revenues from any single customer that represents 10% or more of its total revenues. Therefore, all of the Companys operations are considered by management to be aggregated in one reportable operating segment.
Legacy Bancorp has two wholly-owned subsidiaries, LB Funding Corporation and Legacy Banks. The Company conducts its principal business activities through Legacy Banks. The Bank, in turn, has three operating subsidiaries, Legacy Insurance Services of the Berkshires, Legacy Securities Corporation and CSB Service Corporation.
LB Funding Corporation. LB Funding Corporation is wholly owned by Legacy Bancorp, Inc. and was established in 2005 to lend funds to Legacy Banks Employee Stock Ownership Plan (ESOP) to purchase shares of Legacy Bancorp, Inc. common stock in the open market subsequent to the initial public offering. The company is incorporated in Massachusetts.
Legacy Insurance Services of the Berkshires. Legacy Insurance Services of the Berkshires (LISB) is a Delaware limited liability company and is wholly-owned by Legacy Banks. LISB is an insurance agency that specializes in providing our clients with non-deposit insurance and investment products. LISB has been in operation since September 2001, however, the Bank has been associated with and selling Savings Bank Life Insurance (SBLI) since 1910.
Legacy Securities Corporation. Legacy Securities Corporation (LSC) is a Massachusetts securities corporation and a wholly owned subsidiary of Legacy Banks. LSC is an investment company that engages in buying, selling and holding securities on its own behalf. At December 31, 2008, LSC had total assets of approximately $72.1 million consisting primarily of government sponsored enterprises obligations and mortgage backed securities. As a Massachusetts securities corporation LSC has a lower state income tax rate compared to other corporations.
CSB Service Corporation. CSB Service Corporation is a Massachusetts company and is wholly-owned by Legacy Banks. CSB Service Corp. is a company utilized by Legacy Banks to hold real estate taken in foreclosure, and has been in operation since December 1975.
Portfolio Management Services. Legacy Banks offers portfolio management services through its trust division known as Legacy Portfolio Management (LPM). At December 31, 2008, LPM had total assets under management of $107.7 million.
General: As a savings and loan holding company, Legacy Bancorp is required to file reports with, and otherwise comply with the rules and regulations of, the Office of Thrift Supervision (OTS). As a savings bank chartered by the Commonwealth of Massachusetts, Legacy Banks is subject to extensive regulation, examination and supervision by the Massachusetts Commissioner of Banks, as its primary regulator, and the Federal Deposit Insurance Corporation (FDIC), as the deposit insurer. Legacy Banks is a member of the Federal Home Loan Bank (FHLB) system and, with respect to deposit insurance, of the Bank Insurance Fund managed by the FDIC. Legacy Banks must file reports with the Commissioner of Banks and the FDIC concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of other savings institutions. The Commissioner of Banks and /or the FDIC conduct periodic examinations to test Legacy Banks safety and soundness and compliance with various regulatory requirements. The description of statutory provisions and regulations applicable to savings institutions and their holding companies set forth in this Form 10-K does not purport to be a complete description of such statutes and regulations and their effects on Legacy Banks and Legacy Bancorp and is qualified in its entirety by reference to the actual laws and regulations.
Massachusetts Banking Laws and Supervision: Massachusetts savings banks are regulated and supervised by the Massachusetts Commissioner of Banks. The Massachusetts Commissioner of Banks is required to regularly examine each state-chartered bank. The approval of the Massachusetts Commissioner of Banks is required to establish or close branches, to merge with another bank, to form a holding company, to issue stock or to undertake many other activities. Any Massachusetts bank that does not operate in accordance with the regulations, policies and directives of the Massachusetts Commissioner of Banks may be sanctioned. The Massachusetts Commissioner of Banks may suspend or remove directors or officers of a bank who have violated the law, conducted a banks business in a manner that is unsafe, unsound or contrary to the depositors interests, or been negligent in the performance of their duties. In addition, the Massachusetts Commissioner of Banks has the authority to appoint a receiver or conservator if it is determined that the bank is conducting its business in an unsafe or unauthorized manner, and under certain other circumstances.
All Massachusetts-chartered savings banks are required to be members of the Depositors Insurance Fund, a private deposit insurer, which insures all deposits in member banks in excess of FDIC deposit insurance limits. Member banks are required to pay the assessments of the fund.
The powers that Massachusetts-chartered savings banks can exercise under these laws are summarized as follows:
Lending Activities: A Massachusetts-chartered savings bank may make a wide variety of mortgage loans including fixed-rate loans, adjustable-rate loans, variable-rate loans, participation loans, graduated payment loans, construction and development loans, condominium and co-operative loans, second mortgage loans and other types of loans that may be made in accordance with applicable regulations. Commercial loans may be made to corporations and other commercial enterprises with or without security. Consumer and personal loans may also be made with or without security. Loans to individual borrowers generally must be limited to 20% of the total of a banks capital accounts.
Insurance Sales: Massachusetts banks may engage in insurance sales activities if the Massachusetts Commissioner of Banks has approved a plan of operation for insurance activities and the bank obtains a license from the Massachusetts Division of Insurance. A bank may be licensed directly or indirectly through an affiliate or a subsidiary corporation established for this purpose. Legacy Banks has a subsidiary, Legacy Insurance Services of the Berkshires, which is licensed to sell insurance products.
Investment Activities: In general, Massachusetts-chartered savings banks may invest in preferred and common stock of any corporation organized under the laws of the United States or any state provided such investments do not involve control of any corporation and do not, in the aggregate, exceed 4.0% of the banks deposits. Massachusetts-chartered savings banks may in addition invest an amount equal to 1.0% of their deposits in stocks of Massachusetts corporations or companies with substantial employment in the Commonwealth which have pledged to the Massachusetts Commissioner of Banks that such monies will be used for further development within the Commonwealth. At the present time, Legacy Banks does have authority to invest in equity securities.
Dividends: A Massachusetts stock bank may declare from net profits cash dividends not more frequently than quarterly and non-cash dividends at any time. No dividends may be declared, credited or paid if the banks capital stock is impaired. The approval of the Massachusetts Commissioner of Banks is required if the total of all dividends declared in any calendar year exceeds the total of its net profits for that year combined with its retained net profits of the preceding two years. Net profits for this purpose means the remainder of all earnings from current operations plus actual recoveries on loans and investments and other assets after deducting from the total thereof all current operating expenses, actual losses, accrued dividends on preferred stock, if any, and all federal and state taxes.
Parity Regulation: A Massachusetts bank may engage in any activity or offer any product or service if the activity, product or service is engaged in or offered in accordance with regulations promulgated by the Massachusetts Commissioner of Banks and has been authorized for national banks, federal thrifts or state banks in a state other than Massachusetts; provided that the activity is permissible under applicable federal and Massachusetts law and subject to the same limitations and restrictions imposed on the national bank, federal thrift or out-of-state bank that had previously been granted the power.
Capital Requirements. Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System (state non-member banks), such as Legacy Banks, are required to comply with minimum leverage capital requirements. For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to be, in general, a strong banking organization rated composite 1 under the Uniform Financial Institutions Ranking System established by the Federal Financial Institutions Examination Council, the minimum capital leverage requirement is a ratio of Tier 1 capital to total assets of 3.0%. For all other institutions, the minimum leverage capital ratio is not less than 4.0%. Tier 1 capital is the sum of common stockholders equity, noncumulative perpetual preferred stock (including any related surplus) and minority
investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships) and certain other specified items.
The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets. The ratio of regulatory capital to regulatory risk-weighted assets is referred to as a banks risk-based capital ratio. Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items (including recourse obligations, direct credit substitutes and residual interests) to four risk-weighted categories ranging from 0.0% to 100.0%, with higher levels of capital being required for the categories perceived as representing greater risk.
State non-member banks must maintain a minimum ratio of total capital to risk-weighted assets of at least 8.0%, of which at least one-half must be Tier 1 capital. Total capital consists of Tier 1 capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities. The includable amount of Tier 2 capital cannot exceed the amount of the institutions Tier 1 capital. Banks that engage in specified levels of trading activities are subject to adjustments in their risk based capital calculation to ensure the maintenance of sufficient capital to support market risk.
The Federal Deposit Insurance Corporation Improvement Act (the FDICIA) required each federal banking agency to revise its risk-based capital standards for insured institutions to ensure that those standards take adequate account of interest-rate risk, concentration of credit risk, and the risk of nontraditional activities, as well as to reflect the actual performance and expected risk of loss on multi-family residential loans. The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a banks capital and economic value to changes in interest rate risk in assessing a banks capital adequacy. The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon determination that an institutions capital level is, or is likely to become, inadequate in light of the particular circumstances.
Standards for Safety and Soundness. As required by statute, the federal banking agencies adopted final regulations and Interagency Guidelines Establishing Standards for Safety and Soundness to implement safety and soundness standards. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. The guidelines address internal controls and information systems, internal audit system, credit underwriting, loan documentation, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. Most recently, the agencies have established standards for safeguarding customer information. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard.
Investment Activities. Since the enactment of FDICIA, all state-chartered FDIC insured banks, including savings banks, have generally been limited in their investment activities to principal and equity investments of the type and in the amount authorized for national banks, notwithstanding state law. FDICIA and the FDIC permit exceptions to these limitations. For example, state chartered banks may, with FDIC approval, continue to exercise state authority to invest in common or preferred stocks listed on a national securities exchange or the Nasdaq Global Market and in the shares of an investment company registered under the Investment Company Act of 1940, as amended. The maximum permissible investment is 100.0% of Tier 1 Capital, as specified by the FDICs regulations, or the maximum amount permitted by Massachusetts law, whichever is less. Legacy Banks received approval from the FDIC to retain and acquire such equity instruments equal to the lesser of 100% of Legacy Banks Tier 1 capital or the maximum permissible amount specified by Massachusetts law. Any such grandfathered authority may be terminated upon the FDICs determination that such investments pose a safety and soundness risk. In addition, the FDIC is authorized to permit such institutions to engage in state authorized activities or investments not permissible for national banks (other than non-subsidiary equity investments) if they meet all applicable capital requirements and it is determined that such activities or investments do not pose a significant risk to the Bank Insurance Fund. The FDIC has adopted revisions to its regulations governing the procedures for institutions seeking approval to engage in such activities or investments. The Gramm-Leach-Bliley Act of 1999 specifies that a nonmember bank may control a subsidiary that engages in activities as principal that would only be permitted for a national bank to
conduct in a financial subsidiary if a bank meets specified conditions and deducts its investment in the subsidiary for regulatory capital purposes.
Interstate Banking and Branching. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, or the Interstate Banking Act, permits adequately capitalized bank holding companies to acquire banks in any state subject to specified concentration limits and other conditions. The Interstate Banking Act also authorizes the interstate merger of banks. In addition, among other things, the Interstate Banking Act permits banks to establish new branches on an interstate basis provided that such action is specifically authorized by the law of the host state. As a result of our acquisition of the five branch offices of First Niagara Bank in December of 2007, we may conduct any activity that is authorized under Massachusetts law that is permissible for either New York savings banks (subject to applicable federal restrictions) or a New York branch of an out-of-state national bank at our New York branch offices. The New York State Superintendent of Banks may exercise certain regulatory authority over the Banks New York branch offices.
Prompt Corrective Regulatory Action. Federal law requires, among other things, that federal bank regulatory authorities take prompt corrective action with respect to banks that do not meet minimum capital requirements. For these purposes, the law establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.
The FDIC has adopted regulations to implement the prompt corrective action legislation. An institution is deemed to be well capitalized if it has a total risk-based capital ratio of 10.0% or greater, a Tier 1 risk-based capital ratio of 6.0% or greater and a leverage ratio of 5.0% or greater. An institution is adequately capitalized if it has a total risk-based capital ratio of 8.0% or greater, a Tier 1 risk-based capital ratio of 4.0% or greater, and generally a leverage ratio of 4.0% or greater. An institution is undercapitalized if it has a total risk-based capital ratio of less than 8.0%, a Tier 1 risk-based capital ratio of less than 4.0%, or generally a leverage ratio of less than 4.0%. An institution is deemed to be significantly undercapitalized if it has a total risk-based capital ratio of less than 6.0%, a Tier 1 risk-based capital ratio of less than 3.0%, or a leverage ratio of less than 3.0%. An institution is considered to be critically undercapitalized if it has a ratio of tangible equity (as defined in the regulations) to total assets that is equal to or less than 2.0%. As of December 31, 2008, Legacy Banks was classified as a well capitalized institution.
Undercapitalized banks must adhere to growth, capital distribution (including dividend) and other limitations and are required to submit a capital restoration plan. A banks compliance with such a plan is required to be guaranteed by any company that controls the undercapitalized institution in an amount equal to the lesser of 5.0% of the institutions total assets when deemed undercapitalized or the amount necessary to achieve the status of adequately capitalized. If an undercapitalized bank fails to submit an acceptable plan, it is treated as if it is significantly undercapitalized. Significantly undercapitalized banks must comply with one or more of a number of additional restrictions, including but not limited to an order by the FDIC to sell sufficient voting stock to become adequately capitalized, requirements to reduce total assets, cease receipt of deposits from correspondent banks or dismiss directors or officers, and restrictions on interest rates paid on deposits, compensation of executive officers and capital distributions by the parent holding company. Critically undercapitalized institutions are subject to additional measures including, subject to a narrow exception, the appointment of a receiver or conservator within 270 days after it obtains such status.
Transaction with Affiliates and Regulation W of the Federal Reserve Regulations. Transactions between banks and their affiliates are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. In a holding company context, the parent bank holding company and any companies which are controlled by such parent holding company are affiliates of the bank. Generally, Sections 23A and 23B of the Federal Reserve Act and Regulation W (i) limit the extent to which the bank or its subsidiaries may engage in covered transactions with any one affiliate to an amount equal to 10.0% of such institutions capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20.0% of such institutions capital stock and surplus and (ii) require that all such transactions be on terms substantially the same, or at least as favorable, to the institution or subsidiary as those provided to a non-affiliate. The term covered transaction includes the making of loans, purchase of assets, issuance of a guarantee and other similar transactions. In addition, loans or other extensions of
credit by the financial institution to the affiliate are required to be collateralized in accordance with the requirements set forth in Section 23A of the Federal Reserve Act.
The Gramm-Leach-Bliley Act amended several provisions of Sections 23A and 23B of the Federal Reserve Act. The amendments provide that so-called financial subsidiaries of banks are treated as affiliates for purposes of Sections 23A and 23B of the Federal Reserve Act, but the amendment provides that (i) the 10.0% capital limit on transactions between the bank and such financial subsidiary as an affiliate is not applicable, and (ii) the investment by the bank in the financial subsidiary does not include retained earnings in the financial subsidiary. Certain anti-evasion provisions have been included that relate to the relationship between any financial subsidiary of a bank and sister companies of the bank: (1) any purchase of, or investment in, the securities of a financial subsidiary by any affiliate of the parent bank is considered a purchase or investment by the bank; or (2) if the Federal Reserve Board determines that such treatment is necessary, any loan made by an affiliate of the parent bank to the financial subsidiary is to be considered a loan made by the parent bank.
In addition, Sections 22(h) and (g) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h) of the Federal Reserve Act, loans to a director, an executive officer and to a greater than 10.0% stockholder of a financial institution, and certain affiliated interests of these, may not exceed, together with all other outstanding loans to such person and affiliated interests, the financial institutions loans to one borrower limit, generally equal to 15.0% of the institutions unimpaired capital and surplus. Section 22(h) of the Federal Reserve Act also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons and also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a financial institution to insiders cannot exceed the institutions unimpaired capital and surplus. Furthermore, Section 22(g) of the Federal Reserve Act places additional restrictions on loans to executive officers.
Enforcement. The FDIC has extensive enforcement authority over insured state savings banks, including Legacy Banks. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease and desist orders and remove directors and officers. In general, these enforcement actions may be initiated in response to violations of laws and regulations and unsafe or unsound practices. The FDIC has authority under federal law to appoint a conservator or receiver for an insured bank under limited circumstances. The FDIC is required, with certain exceptions, to appoint a receiver or conservator for an insured state non-member bank if that bank was critically undercapitalized on average during the calendar quarter beginning 270 days after the date on which the institution became critically undercapitalized. The FDIC may also appoint itself as conservator or receiver for an insured state non-member institution under specific circumstances on the basis of the institutions financial condition or upon the occurrence of other events, including: (1) insolvency; (2) substantial dissipation of assets or earnings through violations of law or unsafe or unsound practices; (3) existence of an unsafe or unsound condition to transact business; and (4) insufficient capital, or the incurring of losses that will deplete substantially all of the institutions capital with no reasonable prospect of replenishment without federal assistance.
Insurance of Deposit Accounts. The Bank is a member of the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation. Deposit accounts at the Bank are insured by the Federal Deposit Insurance Corporation, generally up to a maximum of $100,000 for each separately insured depositor and up to a maximum of $250,000 for self-directed retirement accounts. However, the Federal Deposit Insurance Corporation increased the deposit insurance available on all deposit accounts to $250,000, effective until December 31, 2009. In addition, certain noninterest-bearing transaction accounts maintained with financial institutions participating in the Federal Deposit Insurance Corporations Temporary Liquidity Guarantee Program are fully insured regardless of the dollar amount until December 31, 2009. The Bank has opted to participate in the Federal Deposit Insurance Corporations Temporary Liquidity Guarantee Program. See Temporary Liquidity Guarantee Program.
The Federal Deposit Insurance Corporation imposes an assessment against all depository institutions for deposit insurance. This assessment is based on the risk category of the institution and, prior to 2009, ranged from five to 43 basis points of the institutions deposits. On February 27, 2009, the Federal Deposit Insurance Corporation published a final rule raising the current deposit insurance assessment rates to a range from 12 to 45 basis points beginning April 1, 2009. Additionally, the Federal Deposit Insurance Corporation issued an interim final rule that
would impose a special 20 basis points special assessment on all insured deposits as of June 30, 2009, which would be payable on September 30, 2009.
On February 27, 2009, the Federal Deposit Insurance Corporation announced a one-time special assessment of 20 basis points on all insured deposits regardless of the risk or size of the depository institution. This special assessment is payable by September 30, 2009 based on deposits as of June 30, 2009, and would result in additional non-interest expense of approximately $1.2 million based on our deposits as of December 31, 2008. In addition, the Federal Deposit Insurance Corporation may assess additional special premiums in the future.
Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation upon a finding that an 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 Federal Deposit Insurance Corporation. We do not currently know of any practice, condition or violation that might lead to termination of our deposit insurance.
In addition to the Federal Deposit Insurance Corporation assessments, the Financing Corporation (FICO) is authorized to impose and collect, with the approval of the Federal Deposit Insurance Corporation, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO are due to mature in 2017 through 2019. For the quarter ended December 31, 2008, the annualized FICO assessment was equal to 1.10 basis points for each $100 in domestic deposits maintained at an institution.
Temporary Liquidity Guarantee Program. On October 14, 2008, the Federal Deposit Insurance Corporation announced a new program the Temporary Liquidity Guarantee Program. This program has two components. One guarantees newly issued senior unsecured debt of a participating organization, up to certain limits established for each institution, issued between October 14, 2008 and June 30, 2009. The Federal Deposit Insurance Corporation will pay the unpaid principal and interest on a Federal Deposit Insurance Corporation-guaranteed debt instrument upon the uncured failure of the participating entity to make a timely payment of principal or interest in accordance with the terms of the instrument. The guarantee will remain in effect until June 30, 2012. In return for the Federal Deposit Insurance Corporations guarantee, participating institutions will pay the Federal Deposit Insurance Corporation a fee based on the amount and maturity of the debt. Legacy opted not to participate in this component of the Temporary Liquidity Guarantee Program.
The other component of the program provides full federal deposit insurance coverage for non-interest bearing transaction deposit accounts, regardless of dollar amount, until December 31, 2009. An annualized 10 basis point assessment on balances in noninterest-bearing transaction accounts that exceed the existing deposit insurance limit of $250,000 will be assessed on a quarterly basis to insured depository institutions that have not opted out of this component of the Temporary Liquidity Guarantee Program. Legacy opted to participate in this component of the Temporary Liquidity Guarantee Program.
U.S. Treasurys Troubled Asset Relief Program Capital Purchase Program. On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was enacted that provides the U.S. Secretary of the Treasury with broad authority to implement certain actions to help restore stability and liquidity to U.S. markets. One of the provisions resulting from the legislation is the Troubled Asset Relief Program Capital Purchase Program (CPP), which provides direct equity investment in perpetual preferred stock by the U.S. Treasury Department in qualified financial institutions. The program is voluntary and requires an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends. The CPP provides for a minimum investment of one percent of total risk-weighted assets and a maximum investment equal to the lesser of three percent of total risk-weighted assets or $25 billion. Participation in the program is not automatic and is subject to approval by the U.S. Treasury Department. Legacy opted not to participate in the CPP.
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. Legacy Banks currently has a privacy protection policy in place and believes that such policy is in compliance with the regulations. The privacy provisions of the Act affect how consumer information is transmitted through diversified financial companies and conveyed to outside vendors.
Community Reinvestment Act. Under the Community Reinvestment Act, or CRA, as amended and as implemented by FDIC regulations, a bank 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 institutions 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 does require the FDIC, in connection with its examination of a bank, to assess the institutions record of meeting the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution, including applications to acquire branches and other financial institutions. The CRA requires the FDIC to provide a written evaluation of an institutions CRA performance utilizing a four-tiered descriptive rating system. Legacy Banks latest FDIC CRA rating was Outstanding.
Massachusetts has its own statutory counterpart to the CRA which is also applicable to Legacy Banks. The Massachusetts version is generally similar to the CRA but utilizes a five-tiered descriptive rating system. Massachusetts law requires the Massachusetts Commissioner of Banks to consider, but not be limited to, a banks record of performance under Massachusetts law in considering any application by the bank to establish a branch or other deposit-taking facility, to relocate an office or to merge or consolidate with or acquire the assets and assume the liabilities of any other banking institution. Legacy Banks most recent rating under Massachusetts law was Outstanding.
Consumer Protection and Fair Lending Regulations. Massachusetts savings banks are subject to a variety of federal and Massachusetts statutes and regulations that are intended to protect consumers and prohibit discrimination in the granting of credit. These statutes and regulations provide for a range of sanctions for non-compliance with their terms, including imposition of administrative fines and remedial orders, and referral to the Attorney General for prosecution of a civil action for actual and punitive damages and injunctive relief. Certain of these statutes authorize private individual and class action lawsuits and the award of actual, statutory and punitive damages and attorneys fees for certain types of violations.
The USA PATRIOT Act. Legacy Banks is subject to the USA PATRIOT Act, which gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents, and parties registered under the Commodity Exchange Act.
The Federal Reserve Board regulations require depository institutions to maintain non-interest-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The Federal Reserve Board regulations generally require that reserves be maintained against aggregate transaction accounts as follows: for that portion of transaction accounts aggregating $45.8 million or less (which may be adjusted by the Federal Reserve Board) the reserve requirement is 3.0%; and the amounts greater than $45.8 million require a 10.0% reserve (which may be adjusted by the Federal Reserve Board between 8.0% and 14.0%). The first $8.5 million of otherwise reservable balances (which may be adjusted by the Federal Reserve Board) are exempted from the reserve requirements. Legacy Banks is in compliance with these requirements.
The Bank is a member of the Federal Home Loan Bank (FHLB) system, which consists of 12 regional Federal Home Loan Banks. The FHLB provides a central credit facility primarily for member institutions. Legacy Banks, as a member of the FHLB of Boston, is required to acquire and hold shares of capital stock in the FHLB of Boston. Legacy Banks was in compliance with this requirement with an investment in FHLB of Boston stock at December 31, 2008 of $10.9 million.
The Federal Home Loan Banks are required to provide funds for certain purposes including contributing funds for affordable housing programs. These requirements could reduce the amount of dividends that the FHLB pay to their members and result in the FHLB imposing a higher rate of interest on advances to their members. For the years ended 2008, 2007, and 2006 cash dividends from the FHLB of Boston to Legacy Banks amounted to approximately $412,000, $572,000, and $498,000, respectively. As a result of the current economic conditions and the reduced levels of capital, the FHLB has announced that they will suspend the payment of any future dividends until such time as their financial condition improves. The Bank, therefore, does not anticipate receiving any cash dividends from this investment in 2009. Further, there can be no assurance that the impact of recent or future legislation on the FHLB will not also cause a decrease in the value of the FHLB stock held by the Bank.
General: Federal law allows a state savings bank that qualifies as a Qualified Thrift Lender, discussed below, to elect to be treated as a savings association for purposes of the savings and loan holding company provisions of federal law. Such election allows its holding company to be regulated as a savings and loan holding company by the OTS rather than as a bank holding company by the Federal Reserve Board. Legacy Banks made such election and the Company is a non-diversified unitary savings and loan holding company within the meaning of federal law. As such, the Company is registered with the OTS and has adhered to the OTSs regulations and reporting requirements. In addition, the OTS may examine and supervise the Company and the OTS has enforcement authority over the Company and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. Additionally, Legacy Banks is required to notify the OTS at least 30 days before declaring any dividend to the Company. By regulation, the OTS may restrict or prohibit the Bank from paying dividends.
The Gramm-Leach-Bliley Act of 1999 expanded the authority of bank holding companies to affiliate with other financial services companies such as insurance companies and investment banking companies. The Act, however, provided that unitary savings and loan holding companies, such as the Company, may only engage in activities permitted to a financial holding company under the legislation and those permitted for a multiple savings and loan holding company. Upon any non-supervisory acquisition by the Company of another savings association as a separate subsidiary, the Company would become a multiple savings and loan holding company. Federal law limits the activities of a multiple savings and loan holding company and its non-insured institution subsidiaries primarily to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, provided the prior approval of the OTS is obtained, to other activities authorized by OTS regulation and to those permitted for financial holding companies. Multiple savings and loan holding companies are generally prohibited from acquiring or retaining more than 5% of a non-subsidiary company engaged in activities other than those permitted by federal law.
Federal law prohibits a savings and loan holding company from, directly or indirectly, acquiring more than 5% of the voting stock of another savings association or savings and loan holding company or from acquiring such an institution or company by merger, consolidation or purchase of its assets, without prior written approval of the OTS. In evaluating applications by holding companies to acquire savings associations, the OTS considers the financial and managerial resources and future prospects of the Company and the institution involved, the effect of the acquisition on the risk to the insurance funds, the convenience and needs of the community and competitive factors.
To be regulated as a savings and loan holding company by the OTS (rather than as a bank holding company by the Federal Reserve Board), the Bank must qualify as a Qualified Thrift Lender. To qualify as a Qualified Thrift Lender, the Bank must maintain compliance with the test for a domestic building and loan association, as defined in the Internal Revenue Code, or with a Qualified Thrift Lender Test. Under the Qualified Thrift Lender Test, a
savings institution is required to maintain at least 65% of its portfolio assets (total assets less: (1) specified liquid assets up to 20% of total assets; (2) intangibles, including goodwill; and (3) the value of property used to conduct business) in certain qualified thrift investments (primarily residential mortgages and related investments, including certain mortgage-backed and related securities) in at least 9 months out of each 12 month period. As of December 31, 2008, Legacy Banks maintained 79% of its portfolio assets in qualified thrift investments.
Acquisition of the Company: Under the Federal Change in Bank Control Act, a notice must be submitted to the OTS if any person (including a company), or group acting in concert, seeks to acquire control of a savings and loan holding company. Under certain circumstances, a change in control may occur, and prior notice is required, upon the acquisition of 10% or more of the Companys outstanding voting stock, unless the OTS has found that the acquisition will not result in a change of control of the Company. Under the Change in Bank Control Act, the OTS has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that acquires control would then be subject to regulation as a savings and loan holding company.
Massachusetts Holding Company Regulation: In addition to the federal holding company regulations, a bank holding company organized or doing business in Massachusetts must comply with any regulation under the Massachusetts law. The term bank holding company, for the purposes of Massachusetts law, is defined generally to include any company which, directly or indirectly, owns, controls or holds with power to vote more than 25% of the voting stock of each of two or more banking institutions, including commercial banks and state co-operative banks, savings banks and savings and loan associations and national banks, federal savings banks and federal savings and loan associations. In general, a holding company controlling, directly or indirectly, only one banking institution will not be deemed to be a bank holding company for the purposes of Massachusetts law. Under Massachusetts law, the prior approval of the Board of Bank Incorporation is required before the following: any company may become a bank holding company; any bank holding company acquires direct or indirect ownership or control of more than 5% of the voting stock of, or all or substantially all of the assets of, a banking institution; or any bank holding company merges with another bank holding company. Although the Company is not a bank holding company for purposes of Massachusetts law, any future acquisition of ownership, control, or the power to vote 25% or more of the voting stock of another banking institution or bank holding company would cause it to become such.
Federal Securities Laws: The Companys common stock is registered with the Securities and Exchange Commission under Section 12(b) of the Securities Exchange Act of 1934. The Company is subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Exchange Act.
Federal taxes: In general the Company and Legacy Banks report their income on a calendar year basis using the accrual method of accounting. The federal income tax laws apply to the Company and Legacy Banks in the same manner as to other corporations with some exceptions, including particularly Legacy Banks reserve for bad debts discussed below. The following discussion of tax matters is intended only as a summary and does not purport to be a comprehensive description of the tax rules applicable to Legacy Banks or the Company. Legacy Banks federal income tax returns have been either audited or closed under the statute of limitations through tax year 2004.
Bad Debt Reserves: For fiscal years beginning before December 31, 1995, thrift institutions which qualified under certain definitional tests and other conditions of the Internal Revenue Code of 1986, as amended, were permitted to use certain favorable provisions to calculate their deductions from taxable income for annual additions to their bad debt reserve. A reserve could be established for bad debts on qualifying real property loans, generally secured by interests in real property improved or to be improved, under the percentage of taxable income method or the experience method. The reserve for non-qualifying loans was computed using the experience method. Federal legislation enacted in 1996 repealed the reserve method of accounting for bad debts and the percentage of taxable income method for tax years beginning after 1995 and required savings institutions to recapture or take into income certain portions of their accumulated bad debt reserves. Approximately $5.4 million of the Banks accumulated bad debt reserves will not be recaptured into taxable income unless the Bank makes a nondividend distribution to the Company as described below.
Distributions: If the Bank makes nondividend distributions to the Company, they will be considered to have been made from the Banks unrecaptured tax bad debt reserves, including the balance of its reserves as of December 31, 1987, to the extent of the those reserves and then from the Banks supplemental reserve for losses on loans, to the extent of those reserves, and an amount based on the amount distributed, but not more than the amount of those aggregate reserves, will be included in the Banks taxable income. Nondividend distributions include distributions in excess of the Banks current and accumulated earnings and profits, as calculated for federal income tax purposes, distributions in redemption of stock, and distributions in partial or complete liquidation. Dividends paid out of the Banks current or accumulated earnings and profits will not be included in the Banks taxable income. The amount of additional taxable income triggered by a nondividend distribution is an amount that, when reduced by the tax attributable to the income, is equal to the amount of the distribution. Therefore, if the Bank makes a nondividend distribution to the Company, approximately one and one-half times the amount of the distribution not in excess of the amount of the reserves would be includable in income for federal income tax purposes, assuming a 35% federal corporate income tax rate. The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.
Massachusetts Taxation: The Massachusetts excise tax rate for savings banks is currently 10.5% of federal taxable income, adjusted for certain items, but recent legislation will reduce this rate to 9.0% on a phase-in basis in the years 2010 2012. Taxable income includes gross income as defined under the Internal Revenue Code, plus interest from bonds, notes and evidences of indebtedness of any state, including Massachusetts, less deductions, but not the credits, allowable under the provisions of the Internal Revenue Code, except no deduction is allowed for bonus depreciation or for taxes paid to the state which are based on income. Carryforwards and carrybacks of net operating losses are not allowed.
A financial institution or business corporation is generally entitled to special tax treatment as a securities corporation, provided that: (a) its activities are limited to buying, selling, dealing in or holding securities on its own behalf and not as a broker; and (b) it has applied for, and received, classification as a securities corporation by the Commissioner of the Massachusetts Department of Revenue. A securities corporation that is also a bank holding company under the Code must pay a tax equal to 0.33% of its gross income. A securities corporation that is not a bank holding company under the Code must pay a tax equal to 1.32% of its gross income. Legacy Bancorp, Inc., as well as one of the Banks subsidiaries, Legacy Securities Corporation Inc., are considered securities corporations for Massachusetts excise tax purposes.
New York Taxation: We are subject to state income tax based on our physical presence within the state from our loan production office and branch offices. We report New York apportioned income on a calendar year basis to New York State. New York State franchise tax on corporations is imposed in an amount equal to the greater of (a) 7.1% of entire net income allocable to New York State, (b) 3% of alternative entire net income allocable to New York State, (c) 0.01% of the average value of assets allocable to New York State, or (d) nominal minimum tax. Entire net income is based on Federal taxable income, subject to certain modifications.
Delaware Taxation: As a Delaware holding company not earning income in Delaware, the Company is exempt from Delaware corporate income tax but is required to file an annual report with and pay an annual franchise tax to the State of Delaware.
Available Information: The Companys website is http://www.LegacyBanks.com. The Company makes available free of charge through its website, its annual reports on Form 10-K; quarterly reports on Form 10-Q; current reports on Form 8-K; and any amendments to those reports led or furnished pursuant to the Securities Exchange Act of 1934 as soon as reasonably practicable after such material is electronically filed with, or furnished to the SEC. The reference to our website does not constitute incorporation by reference of the information contained in the website and should not be considered part of this document.
The following risk factors are relevant to our future results and financial success, and should be read with care.
Risks Related to Our Business
The United States Economy Is In Recession. A Prolonged Economic Downturn, Especially One Affecting Our Geographic Market Area, Could Materially Affect our Business and Financial Results.
The United States economy entered a recession in the fourth quarter of 2007. Throughout the course of 2008 and in the first quarter of 2009, economic conditions continued to worsen, due in large part to the fallout from the collapse of the sub-prime mortgage market. While we did not originate or invest in sub-prime mortgages, our lending business is tied, in large part, to the housing market. The continuing housing slump has resulted in reduced demand for the construction of new housing, declines in home prices, and could ultimately result in increased delinquencies on our residential, commercial and construction mortgage loans. Further, the ongoing concern about the stability of the financial markets in general has caused many lenders to reduce or cease providing funding to borrowers. These conditions may also cause a further reduction in loan demand, and increases in our non-performing assets, net charge-offs and provisions for loan losses.
Legislative or Regulatory Actions Responding to Financial and Market Weakness Could Affect Us Adversely. There Can Be No Assurance that Actions of the U.S. Government, Federal Reserve and Other Governmental and Regulatory Bodies For the Purpose of Stabilizing the Financial Markets Will Achieve the Intended Effect.
In response to the financial crises affecting the banking system and financial markets, the U.S. Congress has passed legislation and the U.S. Treasury has promulgated programs designed to purchase assets from, provide equity capital to, and guarantee the liquidity of the financial services industry. Specifically, Congress adopted the Emergency Economic Stabilization Act of 2008, under which the U.S. Treasury has the authority to expend up to $700 billion to assist in stabilizing and providing liquidity to the U.S. financial system. On October 14, 2008, the U.S. Treasury announced the Capital Purchase Program, under which it will purchase up to $250 billion of non-voting senior preferred shares of certain qualified financial institutions in an attempt to encourage financial institutions to build capital to increase the flow of financing to businesses and consumers and to support the economy. In addition, Congress temporarily increased FDIC deposit insurance from $100,000 to $250,000 per depositor through December 31, 2009. The FDIC has also announced the creation of the Temporary Liquidity Guarantee Program which is intended to strengthen confidence and encourage liquidity in financial institutions by temporarily guaranteeing newly issued senior unsecured debt of participating organizations and providing full insurance coverage for noninterest-bearing transaction deposit accounts (such as business checking accounts, interest-bearing transaction accounts paying 50 basis points or less and lawyers trust accounts), regardless of dollar amount until December 31, 2009. Finally, in February 2009, the American Recovery and Reinvestment Act of 2009 was enacted, which is intended to expand and establish government spending programs and provide certain tax cuts to stimulate the economy. The U.S. government continues to evaluate and develop various programs and initiatives designed to stabilize the financial and housing markets and stimulate the economy, including the U.S. Treasurys recently announced Financial Stability Plan and the recently announced foreclosure prevention program.
The potential exists for additional federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, and the issuance of many formal enforcement orders is expected. Actions taken to date, as well as potential actions, may not have the beneficial effects that are intended, particularly with respect to the extreme levels of volatility and limited credit availability currently being experienced. In addition, new laws, regulations, and other regulatory changes will increase our costs of regulatory compliance and of doing business, and otherwise affect our operations. Our FDIC insurance premiums have increased, and may continue to increase, because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits. New laws, regulations, and other regulatory changes, along with negative developments in the financial services industry and the credit markets, may significantly affect the markets in which we do business, the markets for and value of our loans and investments, and our ongoing operations, costs and profitability.
The Federal Deposit Insurance Corporation is imposing an emergency assessment on financial institutions, which will decrease our earnings in 2009.
On February 27, 2009, the Federal Deposit Insurance Corporation announced a one-time special assessment of 20 basis points on all insured deposits regardless of the risk or size of the depository institution. This special assessment is payable by September 30, 2009 based on deposits as of June 30, 2009, and, if implemented, would result in additional non-interest expense of approximately $1.2 million based on our deposits as of December 31, 2008. In addition, the Federal Deposit Insurance Corporation may assess additional special premiums in the future.
The FDIC imposes an assessment against financial institutions for deposit insurance. This assessment is based on the risk category of the institution and currently ranges from 5 to 43 basis points of the institutions deposits. On February 27, 2009, the FDIC issued a final rule that increases the current deposit insurance assessment rates to a range from 12 to 45 basis points beginning April 1, 2009. The increase in the assessment rates will increase our expenses.
If our Investment in the Federal Home Loan Bank of Boston is Classified as Other-Than-Temporarily Impaired or as Permanently Impaired, our Earnings and Stockholders Equity Would Decrease.
We own common stock of the Federal Home Loan Bank of Boston (FHLBB). We hold this stock to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the FHLBBs advance program. The aggregate cost and fair value of our FHLBB common stock as of December 31, 2008 was $10.9 million based on its par value. There is no market for our FHLBB common stock. Recent published reports indicate that certain member banks of the Federal Home Loan Bank System may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels. In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLBB, could be substantially diminished. Consequently, we believe that there is a risk that our investment in FHLBB common stock could be impaired at some time in the future. If this occurs, it would cause our earnings and stockholders equity to decrease by the after-tax amount of the impairment charge.
The Federal Home Loan Bank of Boston Suspended Dividends During the Fourth Quarter of 2008. This Will Negatively Affect our Earnings.
The Federal Home Loan Bank of Boston suspended dividends during the fourth quarter of 2008, and has stated that resuming payment of dividends in 2009 is unlikely. We received $413,000 in dividends from the Federal Home Loan Bank of Boston during the year ended December 31, 2008, and the failure of the Federal Home Loan Bank of Boston to pay dividends for any quarter will reduce our earnings during that quarter.
Our level of deposits may be affected by lack of consumer confidence in financial institutions, which has resulted in large numbers of depositors unwilling to maintain deposits that are not insured by the Federal Deposit Insurance Corporation. In some cases, depositors have withdrawn deposits and invested uninsured funds in investments perceived as being more secure, such as securities issued by the U.S. Treasury. These consumer preferences may force us to pay higher interest rates to retain deposits as we seek to meet funding needs caused by reduced deposit levels.
In the past year, significant declines in the values of mortgage-backed securities and derivative securities issued by financial institutions, government sponsored entities, and major commercial and investment banks has led to decreased confidence in financial markets among borrowers, lenders, and depositors, as well as disruption and extreme volatility in the capital and credit markets and the failure of some entities in the financial sector. As a result, many lenders and institutional investors have reduced or ceased to provide funding to borrowers. Continued
turbulence in the capital and credit markets may adversely affect our liquidity and financial condition and the willingness of certain counterparties and customers to do business with us.
Future legislative or regulatory actions responding to perceived financial and market problems could impair our rights against borrowers.
As a result of the recent financial crisis, the potential exists for the promulgation of new federal or state laws and regulations regarding lending and funding practices and liquidity standards, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, which are expected to result in the issuance of many formal enforcement orders. Negative developments in the financial services industry and the credit markets, and the impact of new legislation in response to these developments, may negatively affect our operations by restricting our business operations, including our ability to originate or sell loans and pursue business opportunities. Compliance with such regulation also will likely increase our costs.
There have been proposals made by members of Congress and others that would reduce the amount distressed borrowers are otherwise contractually obligated to pay under their mortgage loans and limit an institutions ability to foreclose on mortgage collateral. Were proposals such as these, or other proposals limiting our rights as a creditor, to be implemented, we could experience increased credit losses or increased expense in pursuing our remedies as a creditor.
Our Commercial Real Estate and Commercial Loans Expose Us to Increased Credit Risks, and These Risks Will Increase if We Succeed in Increasing These Types of Loans.
We intend to grow commercial real estate and commercial loans further as a proportion of our portfolio over the next several years. In general, commercial real estate loans and commercial loans generate higher returns, but also pose greater credit risks, than do owner-occupied residential mortgage loans. As our various commercial loan portfolios increase, the corresponding risks and potential for losses from these loans will also increase.
We make both secured and some short-term unsecured commercial loans. Unsecured loans generally involve a higher degree of risk of loss than do secured loans because, without collateral, repayment is wholly dependent upon the success of the borrowers businesses. Secured commercial loans are generally collateralized by equipment, leases, inventory and accounts receivable. Compared to real estate, that type of collateral is more difficult to monitor, its value is harder to ascertain, it may depreciate more rapidly and it may not be as readily saleable if repossessed.
Our success depends primarily on the general economic conditions in the counties in which we conduct business. Unlike larger banks that are more geographically diversified, we provide banking and financial services to customers primarily in Berkshire County, in Western Massachusetts, as well as in Eastern New York. The local economic conditions in our market areas have a significant impact on our loans, the ability of the borrowers to repay these loans and the value of the collateral securing these loans. A significant decline in general economic conditions caused by inflation, recession, unemployment or other factors beyond our control would affect these local economic conditions and could adversely affect our financial condition and results of operations. Additionally, because we have a significant amount of commercial real estate loans, decreases in tenant occupancy may also have a negative effect on the ability of many of our borrowers to make timely repayments of their loans, which would have an adverse impact on our earnings.
Within the investment portfolio, the Company has a significant amount of marketable equity securities and corporate debt securities, including mortgage-backed securities, issued by companies in the financial services sector. Given the current market conditions, this sector has an enhanced level of credit risk.
Changes in Market Interest Rates Could Adversely Affect Our Financial Condition and Results of Operations.
Our profitability, like that of most financial institutions, depends to a large extent upon our net interest income, which is the difference, or spread, between our gross interest income on interest-earning assets, such as loans and securities, and our interest expense on interest-bearing liabilities, such as deposits and borrowed funds. Accordingly, our results of operations and financial condition depend largely on movements in market interest rates and our ability to manage our interest-rate-sensitive assets and liabilities in response to these movements, including our adjustable-rate mortgage loans, which represent a large portion of our residential loan portfolio. Changes in interest rates could have a material adverse effect on our business, financial condition, results of operations and cash flows. Because, as a general matter, our interest-bearing liabilities re-price or mature more quickly than our interest-earning assets, an increase in interest rates generally would result in a decrease in our interest rate spread and net interest income. See Item 7a: Quantitative and Qualitative Disclosures About Risk Management.
We are also subject to reinvestment risk relating to interest rate movements. Decreases in interest rates can result in increased prepayments of loans and mortgage-related securities, as borrowers refinance to reduce their borrowing costs. Under these circumstances, we are subject to reinvestment risk to the extent that we are not able to reinvest funds from such prepayments at rates that are comparable to the rates on the prepaid loans or securities. On the other hand, increases in interest rates on adjustable-rate mortgage loans result in larger mortgage payments due from borrowers, which could potentially increase our level of loan delinquencies and defaults.
We May Have Difficulty Meeting Our Branch Expansion Goals, and Our Branch Expansion Strategy May Not Be Accretive to Earnings.
Our growth plans include the opening of new branch offices in communities served by Legacy Banks as well as in other communities contiguous to those currently served by Legacy Banks. Our ability to establish new branches will depend upon whether we can identify suitable sites and negotiate acceptable lease or purchase and sale terms, and we may not be able to do so, or it may take longer than we expect. Moreover, once we establish a new branch, numerous factors will contribute to its performance, such as a suitable location, qualified personnel and an effective marketing strategy. Additionally, it takes time for a new branch to gather significant loans and deposits to generate enough income to offset its expenses, some of which, like salaries and occupancy expense, are relatively fixed costs. There can be no assurance that our branch expansion strategy will be accretive to our earnings, or that it will be accretive to earnings within a reasonable period of time.
In an effort to increase our loan and deposit growth, we will continue to seek to expand our banking franchise, including through acquisitions of other financial institutions or branches if opportunities arise. Our ability to grow through selective acquisitions of other financial institutions or branches will depend on successfully identifying, acquiring and integrating them. We compete with other financial institutions with respect to proposed acquisitions. We cannot assure you that we will be able to identify attractive acquisition candidates or make acquisitions on favorable terms. In addition, we cannot assure you that we can successfully integrate any acquired financial institutions or branches into our banking organization in a timely or efficient manner, that we will be successful in retaining existing customer relationships or that we can achieve anticipated operating efficiencies.
We face significant competition both in attracting deposits and in the origination of loans. Savings banks, credit unions, savings and loan associations and commercial banks operating in our primary market area have historically provided most of our competition for deposits. In addition, and particularly in times of high interest rates, we face additional and significant competition for funds from money-market mutual funds and issuers of corporate and government securities. Competition for the origination of real estate and other loans comes from other thrift institutions, commercial banks, insurance companies, finance companies, other institutional lenders and mortgage companies. Many of our competitors have substantially greater financial and other resources than us. Moreover, we may face increased competition in the origination of loans if competing thrift institutions convert to
stock form, because such converting thrifts would likely seek to invest their new capital into loans. Finally, credit unions do not pay federal or state income taxes and are subject to fewer regulatory constraints than savings banks and as a result, they may enjoy a competitive advantage over us. This advantage places significant competitive pressure on the prices of our loans and deposits.
We Operate in a Highly Regulated Environment and May Be Adversely Affected by Changes in Law and Regulations.
We are subject to extensive regulation, supervision and examination as outlined in the Regulation And Supervision section of this report. Any change in the laws or regulations applicable to us, or in banking regulators supervisory policies or examination procedures, whether by the Massachusetts Commissioner of Banks, the FDIC, the Federal Reserve Board, the Office of Thrift Supervision, other state or federal regulators, the United States Congress or the Massachusetts legislature could have a materialy adverse effect on our business, financial condition, results of operations and cash flows.
Legacy Banks conducts its business through its main office located in Pittsfield, Massachusetts and seventeen other full-service branch offices located in Berkshire County, Massachusetts and Eastern New York. The Bank is currently scheduled to acquire one full-service branch office located in Haydenville, Massachusetts in March 2009. The following table sets forth information about our offices as of December 31, 2008:
We are not involved in any legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Management believes that those routine legal proceedings involve, in the aggregate, amounts that are immaterial to our financial condition and results of operations.
The common stock is traded on the NASDAQ Stock Market, LLC under the symbol LEGC. As of March 2, 2009, the Company had approximately 1,027 registered holders of record. The following table sets forth, for the quarters indicated, the daily high and low sales price for the common stock and the dividends declared. The closing price of the Companys common stock on March 6, 2009 was $8.08. The Company is subject to the requirements of Delaware law, which generally limits dividends to an amount equal to the excess of the net assets of the Company (the amount by which total assets exceed total liabilities) over its statutory capital or, if there is no excess, to its net profits for the current and/or immediately preceding two fiscal years.
Repurchase of Our Equity Securities: In December 2007 the Company announced that its Board of Directors authorized a stock repurchase program (the Stock Repurchase Program) for the purchase of up to 462,048 shares of the Companys common stock or approximately 5% of its outstanding common stock. Purchases under this Stock Repurchase Program in the fourth quarter of 2008 were as follows:
Stock Repurchase Overview: Legacy purchased 412,344 shares of Company stock at an average price of $16.15 per share in the first quarter of 2007 in order to fund the restricted stock portion of the 2006 Equity Incentive Plan (EIP) approved by shareholders in November 2006. Additionally the Company purchased 515,430 shares at an average price of $14.62 during the second and third quarters of 2007 as part of a stock repurchase program announced in April and completed in August 2007. The Company also purchased 486,366 shares at an average price of $13.95 during the third and fourth quarters of 2007 as part of a stock repurchase program announced in August and completed in December 2007. In 2008 the Company purchased 462,048 shares at an average price of $13.24 as part of the stock repurchase program announced in December 2007. Information regarding securities authorized for issuance under equity compensation plans appears in Part III, Item 12 (d) of this report.
Stock Performance Graph: The following graph shows a comparison of shareholder return on the Companys common stock, with the returns of both a broad-market index and a peer group index for the period October 26, 2005 (the date of the Companys initial public offering) through December 31, 2008. The broad-market index chosen was the S&P 500 Market Index, and the peer group index chosen was the SNL Thrift Index. The index level for all series was set to $100 on 10/25/05, with a starting price for LEGC of $10 per share (price through initial public offering).
Comparison Of Cumulative Return Among Legacy Bancorp,
Peer Group Index and Broad Market Index
There can be no assurance that the Companys common stock or the indices included above will continue in the future with the same or similar trend depicted in the graph. The Company will not make or endorse any predictions as to future stock performance.
The following summary data is based in part on the consolidated financial statements and accompanying notes, and other schedules appearing elsewhere in this Form 10-K. Historical data is also based in part on, and should be read in conjunction with, prior filings with the SEC. Because shares had not been issued and outstanding during the entire year, earnings per share have not been reported for the year ended December 31, 2005 and prior.
General: Managements discussion and analysis of financial condition and results of operations is intended to assist in understanding the financial condition and results of operations of the Company. The information contained in this section should be read in conjunction with the consolidated financial statements and accompanying notes contained in this report.
Dividend and stock repurchase plan: On March 4, 2009 the Company announced that its Board of Directors had declared a cash dividend of $0.05 per common share. The dividend will be paid on April 1, 2009 to stockholders of record as of March 20, 2009. The Company also announced that its Board of Directors authorized a stock repurchase program (the Stock Repurchase Program) for the purchase of up to 439,095 shares of the Companys
common stock or approximately 5% of its outstanding common stock. Any repurchases under the Stock Repurchase Program will be made through open market purchase transactions or privately negotiated transactions from time to time. The amount and exact timing of any repurchases will depend on market conditions and other factors. There is no assurance that the Company will repurchase shares during any period.
Stock-based compensation: In accordance with the Companys 2006 Equity Incentive Plan, approved by shareholders on November 1, 2006, the Companys Compensation Committee awarded 892,200 stock options with an exercise price of $16.03 per share and 346,500 shares of restricted stock with a grant date fair value of $16.03 per share to directors and certain employees on November 29, 2006. Additionally, the Compensation Committee awarded 22,500 stock options with an exercise price of $12.91 per share and 1,000 shares of restricted stock with a grant date fair value of $12.91 per share to certain employees on December 14, 2007. On March 4, 2008 the Compensation Committee awarded 63,860 stock options with an exercise price of $14.16 per share to certain employees. The Stock Incentive Plan provides for total awards of 1,030,860 stock options and 412,344 shares of restricted stock, and there are 226,580 stock options and 74,404 shares of restricted stock available for future awards as of December 31, 2008. The shares of common stock underlying any awards that are forfeited, cancelled, reacquired by Legacy Bancorp or otherwise terminated (other than by exercise), shares that are tendered or withheld in payment of the exercise price of any award, and shares that are tendered or withheld for tax withholding obligations will be added back to the shares of common stock with respect to which new awards may be granted under the plan.
All stock options awarded to date are for a term of ten years and will vest over a period of five years. Upon a change in control (as defined in the plan) or the death or disability of the individual to whom options or shares were awarded, all options and restricted shares awarded immediately vest. Of the options awarded, 361,300 were incentive stock options and 617,260 were non-statutory options. Of the 978,560 options granted to date, 804,280 remain outstanding and 174,280 have been forfeited. Of the 804,280 options outstanding, 144,380, representing the first 20% traunch of options granted in 2006, vested in 2008. On January 1, 2009 the second 20% traunch of options granted in 2006 vested, and the first 20% traunch of options granted in 2007 and 2008 vested. The following table presents the fair value and related assumptions using the Black-Scholes Option Pricing Model for stock options granted:
All of the restricted share awards granted vest over a five year period. Of the 349,500 shares awarded to date, 268,640 remain outstanding, 11,560 have been forfeited and 69,300, representing the first 20% traunch of awards granted in 2006, vested in 2008. On January 1, 2009 the second 20% traunch of awards granted in 2006 vested, as well as the first 20% traunch of awards granted in 2007 and 2008.
For the year ended December 31, 2008, the Company recognized compensation cost on stock options of approximately $784,000. The Company is employing an accelerated method of expense recognition for options, whereby compensation cost is measured on a straight-line basis over the requisite service period for each separately vesting portion of the award, as if the award was, in-substance, multiple awards. For restricted stock awards, the cost recognized during the year ended December 31, 2008 amounted to approximately $840,000.
Growth Strategy and Challenges: Long term growth is an essential element in our business plan. Lending is the major driver of revenue and we are committed to supporting our loan growth. We recognize that loan and deposit growth are interdependent, and over the long term both must grow consistently. One of our biggest challenges is to grow our customer base and to grow the depth and breadth of our customer relationships. We address this challenge by maintaining our focus on anticipating, understanding and assisting our customers in achieving their financial goals.
Our deposit pricing strategy is two fold. First, our relationship savings product is important to our deposit mix. It requires customers to maintain a checking account as part of the relationship, the goal being to create multiple relationships with our customers to aid both profitability and customer retention. The relationship savings product is structured and priced like a money market deposit or fund, except that it does not offer check writing. Relationship savings deposits amounted to $121.4 million as of December 31, 2008. Our experience with money market type deposit accounts has been that they become a long term, stable funding source at reasonable cost. The second component in our pricing strategy is to continuously offer a selection of special certificates of deposit with competitive interest rates.
Another challenge is being able to maintain sufficient asset size or scale to provide the marketing, technology, service and other support functions so that we will continue to be relevant and competitive. It is for these reasons that management emphasizes and monitors growth in terms of customers, customer households, customer relationships, assets, revenue per employee, and efficiency. We also know that to successfully grow, our employees must be extremely well trained and experienced. We regularly monitor training hours per employee, employee turnover and employee (and customer) satisfaction surveys. We also engage a mystery shopping firm that sends representatives into each of our locations to experience and witness what the customer experiences and then provide us with constructive feedback.
The Company has established various accounting policies, which govern the application of generally accepted accounting principles in the preparation of the financial statements. Certain accounting policies involve significant judgments and assumptions by management that have a material impact on the carrying value of certain assets and liabilities. Management considers such accounting policies to be critical accounting policies. The judgments and assumptions used by management are based on historical experience and other factors, which are believed to be reasonable under the circumstances. Because of the nature of the judgments and assumptions made by management, actual results could differ from these judgments and estimates that could have a material impact on the carrying values of assets and liabilities and the results of operations of the Company. Refer to Footnote 1 to the Consolidated Financial Statements, Summary of Significant Accounting Policies. We consider the following to be critical accounting policies:
Allowance for Loan Losses: The determination of the allowance for loan losses is considered critical due to the high degree of judgment involved, the subjectivity of the underlying assumptions used, and the potential for changes in the economic environment that could result in material changes in the amount of the allowance for loan losses considered necessary. The allowance is evaluated on a regular basis by management and is based on a periodic review of the collectibility of the loans in light of historical experience, the nature and size of the loan portfolio, adverse situations that may affect borrowers ability to repay, the estimated value of any underlying collateral and prevailing economic conditions. For a full discussion of the allowance for loan losses, please refer to Business of Legacy Bancorp and Subsidiaries Asset Quality.
Income Taxes: Legacy Bancorp uses the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. A valuation allowance related to deferred tax assets is established when, in managements judgment, it is more likely than not that all or a portion of such deferred tax assets will not be realized.
Deferred tax assets applicable to capital loss carryforwards of $827,000 which expire in 2011, are recoverable only to the extent that capital gains can be realized during the carryforward period. The judgments applied by management consider the likelihood that capital gain income will be realized within the carryforward period in light of our tax planning strategies and changes in market conditions. As of December 31, 2008 management has not established a valuation allowance against the deferred tax assets related to capital loss carryforwards.
As of December 31, 2005 a valuation allowance was established against deferred tax assets related to the uncertain utilization of the charitable contribution carryforward created primarily by the donation to The Legacy Banks Foundation as part of the conversion. The contribution carryforward expires in 2010, and the allowance amounted to $1.7 million as of December 31, 2008.
Other-Than-Temporary Impairment: Certain equity security investments that do not have readily determinable fair values are carried at cost. All investments are reviewed for impairment at least quarterly or sooner if events or changes occur which indicate that the carrying value may not be recoverable. Declines in the fair value of held-to-maturity and available-for-sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.
Fair Values of Assets and Liabilities: The Company adopted SFAS No. 157, Fair Value Measurements, which provides a framework for measuring fair value under generally accepted accounting principles. In accordance with SFAS No. 157, the Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. The Company has classified all private issue collateralized mortgage obligations and trust-preferred backed bonds as level 3 assets, the valuation of which is based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Management determined that an orderly and active market for these securities did not exist based on a significant reduction in trading volume and widening spreads during the third and fourth quarters of 2008. For a full discussion of SFAS 157 and the Companys methods in determining fair value, see footnote 19 Fair Value of assets and Liabilities within Item 8: Financial Statements And Supplemental Data.
This discussion has highlighted those accounting policies that management considers to be critical; however all accounting policies are important, and therefore you are encouraged to review each of the policies included in Note 1 to the consolidated financial statements to gain a better understanding of how our financial performance is measured and reported.
Total Assets: Total assets increased by $20.1 million, or 2.2%, from $924.5 million at December 31, 2007 to $944.7 million at December 31, 2008. This 2008 increase was primarily the result of growth in the loan portfolio, offset somewhat by a decrease in cash and cash equivalents, as described below.
Cash and Short-term Investments: Overall, cash and short-term investments decreased by $28.6 million, or 46.0%. Cash and correspondent bank balances remained relatively flat from year to year, while short-term investments, comprised of federal funds sold, FHLB overnight deposits and short-term money market balances decreased $27.9 million, or 57.9%, from $48.3 million at December 31, 2007 to $20.4 million at December 31, 2008. The high balance in short-term investments as of the end of 2007 was influenced by the receipt of deposits from the five New York state branch offices acquired in December 2007.
Securities: Our investment portfolio aggregated $152.6 million at December 31, 2008, an increase of $585,000, or 0.4%, from $152.1 million at December 31, 2007. Please refer to the Investment Activities section included in Item 1 for a detailed discussion of the securities portfolio.
Net Loans: Net loans as of December 31, 2008 were $695.3 million, an increase of $41.6 million, or 6.4%, over net loan balances of $653.6 million as of December 31, 2007. Year to date growth was focused primarily in commercial real estate loans and home equity loans, which grew by $34.2 million and $6.4 million, respectively, in 2008. Please refer to the Lending Activities section included in Item 1 for a detailed discussion of the loan portfolio.
Deposits: Deposits decreased by $2.4 million, or 0.4%, to $608.1 million at December 31, 2008 from $610.4 million at December 31, 2007. This overall decline was caused by a decrease of $3.5 million, or 1.3%, in certificates of deposit (CDs), from a balance of $273.4 million at December 31, 2007 to $269.8 million at the end of 2008. Other decreases in certain money market and savings accounts were offset by an increase in relationship savings accounts of $8.7 million, or 7.7%. For much of 2008, the Bank aligned its CD pricing with the yield curve and allowed the runoff of higher rate, single-service CDs. CDs represent 44.4% of overall deposits at the end of 2008, a slight decrease from the 44.8% as of the end of 2007. Please refer to the Sources of Funds section included in Item 1 for a detailed discussion of the Banks deposits.
Borrowed Funds: The Company relies on borrowings from the Federal Home Loan Bank of Boston (FHLBB) as an additional funding source as liquidity needs dictate. The balance of these borrowings will fluctuate depending on the Banks ability to grow deposits as well as the amount of loan demand in the market. Advances from the FHLBB increased by $30.5 million or 18.2% to $197.9 million at December 31, 2008 from a balance of $167.4 million at December 31, 2007 as the Bank took advantage of lower cost borrowing alternatives while also lengthening certain liabilities, which in turn has improved its asset and liability management position. Please refer the Sources of Funds section included in Item 1 for a detailed discussion of the Banks borrowings.
Stockholders Equity: Stock repurchases were a primary contributor to an overall decrease in stockholders equity of $9.0 million, or 6.7%, from $133.1 million at December 2007 to $124.1 million at December 31, 2008. Legacy purchased 462,048 shares of stock at an average price of $13.24 per share during 2008 as part of the Stock Repurchase Program announced in December 2007. Equity has also decreased as current market conditions have resulted in an increase in the unrealized loss on available-for-sale investment securities. Total equity was positively affected by a contribution of $1.4 million from net income and the amortization of unearned compensation, offset somewhat by the declaration of a dividend of $0.05 per share during each quarter of 2008.
Legacy Bancorp, Inc. reported a net loss of $451,000, or $0.06 per diluted share for the quarter ended December 31, 2008, and net income of $1.4 million, or $0.18 per diluted share for the twelve months ended December 31, 2008, an increase of $199,000, or 16.0% from net income of $1.2 million in 2007. The increase in year to date net income is primarily a result of an increase in net interest income and a decrease in non-interest expenses, particularly in the salaries and benefits categories. These expense categories were impacted in 2007 by the reduction in workforce and executive retirements which occurred at the end of the year. This decrease in operating expenses was offset by a decrease in non-interest income in 2008, caused primarily by charges incurred for the reduction of value of certain investment securities deemed to be other-than temporarily impaired. The book value per share and tangible book value per share were $14.14 and $12.74, respectively, at December 31, 2008.
Net Interest Income: Legacy Bancorps results of operations, or net income, are dependent mainly on net interest income, which is the difference between the income earned on its loan and investment portfolios and interest expense incurred on its deposits and borrowed funds. Net interest income represented 92.0% and 80.2% of our total net revenue (net interest income plus non-interest income) for the years ended December 31, 2008 and 2007, respectively. Our net interest margin was 3.27% and 3.01% for the years ended December 31, 2008 and 2007, respectively. The overall interest rate environment and changes in interest rates have a direct impact on net interest income. We utilize a rigorous asset and liability management process to manage interest rate risk. We monitor the interest rate environment and set interest rates on our deposit and loan products to effectively manage interest rate risk. To this end, we are aided by a quarterly review of critical assumptions, modeling projections, back testing of the models previous projections against actual results, analysis of changes, opportunities and risks associated with changes in market interest rates, and liquidity analysis. For a more detailed description of our asset and liability management process, see Item 7a: Quantitative and Qualitative Disclosures About Market Risk Management of Market Risk.
Non-Interest Expense: Legacy Bancorps non-interest expense consists primarily of compensation and employee benefits, office occupancy, technology, marketing, general administrative expenses and income tax expense. We use the efficiency ratio (non-interest expense for the period minus expenses related to the amortization of intangible assets divided by the sum of net interest income before the loan loss provision, plus non-interest income, not including gains or losses on the sale or impairment of securities) and the expense ratio (non-interest expense to total average assets) as the primary measurements to monitor and control non-interest expense. For the year ended December 31, 2008, the efficiency and expense ratios were 77.5% and 2.89%, respectively. For the year ended December 31, 2007, the efficiency and expense ratios were 93.0% and 3.23%, respectively. The improvement in the efficiency ratio was primarily a result of the increase in net interest margin coupled with a decrease in operating expenses. Operating expenses decreased in 2008 primarily as a result of lower salaries and benefits, including the amortization of the expense associated with the 2006 Equity Incentive Plan, as well as savings achieved as a result of the reduction in workforce and executive retirements which occurred in the fourth quarter of 2007.
Net income: Return on average assets (ROAA) is a primary measurement of net income relative to peer banks. In 2008, ROAA was significantly impacted by charges related to decreases in the value of certain investment securities deemed to be other-than-temporarily impaired. In 2007, the ROAA was impacted by the non-interest expenses related to the reduction in workforce and executive retirements, as well as the amortization expense associated with the 2006 Equity Incentive Plan. For the years ended December 31, 2008 and 2007 the ROAA was 0.16% and 0.15%, respectively. In addition to net interest income and non-interest expense, results of operations are also affected by fee income from banking and non-banking operations, provisions for loan losses, gains (losses) on sales of loans and securities available for sale, loan servicing income and other miscellaneous income.
Comparison of Operating Results For the Years Ended December 31, 2008 and 2007
Analysis of Net Interest Income: Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the relative amounts of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated. All average balances are daily average balances. The yields set forth below include the effect of deferred fees, and discounts and premiums that are amortized or accreted to interest income or expense. Legacy does not accrue interest on loans on non-accrual status, however, the balance of these loans is included in the total average balance, which has the effect of lowering average loan yields.
The following table presents the dollar amount of changes in interest income and interest expense for the major categories of the Banks interest-earning assets and interest-bearing liabilities. Information is provided for each category of interest-earning assets and interest-bearing liabilities with respect to (i) changes attributable to changes in volume (i.e., changes in average balances multiplied by the prior-period average rate) and (ii) changes attributable to rate (i.e., changes in average rate multiplied by prior-period average balances).
Net Income: Net income for the year ended December 31, 2008 was $1.4 million, an increase of $199,000 from net income of $1.2 million in the prior year. The increase is primarily a result of an increase in net-interest income coupled with a decrease in non-interest expenses, offset by a decrease in non-interest income as described below.
Net Interest Income: The tables above set forth the components of the Companys net interest income, yields on interest earning assets and interest bearing liabilities, and the effect on net interest income arising from changes in volume and rate. Net interest income increased from $23.8 million in 2007 to $27.9 million in 2008. The increase of $4.0 million, or 16.8%, is due mainly to an increase in the Companys net interest margin from 3.01% in 2007 to 3.27% in 2008.
Interest Income: Interest and dividend income increased $970,000, or 2.0%, to $50.3 million for the year ended December 31, 2008 from $49.4 million for the year ended December 31, 2007. The increase was caused by a $59.7 million increase in average interest-earning assets, which had the effect of increasing interest income by $3.4 million. Loans increased on average by $61.7 million between the two periods which was partially offset by a decrease in the average balances of short-term investments of $2.3 million. Changes in the interest rate environment contributed to a decrease in the average yield on loans from 6.58% for the year ended December 31, 2007 to 6.20%
for the same period in 2008, while the overall yield on interest earning assets decreased from 6.23% to 5.91% for the 2007 and 2008 periods, respectively. These changes in overall yields had the effect of decreasing interest income by $2.5 million.
Interest Expense: Changes in interest rates also helped lower interest expense for the year ended December 31, 2008 by $1.6 million or 23.6% to $22.5 million compared to interest expense of $25.5 million for the year ended December 31, 2007. The effect of an increase in interest-bearing liabilities, which grew by an average of $80.5 million in 2008, was to increase interest expense by $3.4 million, while a decrease of 86 basis points, or 21.7%, in the average rates paid on interest-bearing liabilities decreased interest expense by $6.5 million. Both the changes in the yield curve and the banks liability pricing efforts resulted in the decrease in interest expense during the year.
Provision for Loan Losses: The Bank records a provision for loan losses as a charge to its earnings when necessary in order to maintain the allowance for loan losses at a level sufficient to absorb losses inherent in the loan portfolio. Refer to Business Asset Quality for additional information about the Banks methodology for establishing its allowance for loan losses. The Bank recorded $1.5 million and $1.1 million in loan loss provisions during the years ended December 31, 2008 and 2007, respectively, representing an increase of $414,000, or 39.4%. This increase was a reflection of both the difference in the amount of and mix of loan growth for the respective periods, higher net charge-offs in 2008 and a continuous review and analysis of current market and economic conditions by management. At December 31, 2008, the allowance for loan losses totaled $6.6 million, or 0.95% of the loan portfolio, compared to $5.6 million, or 0.85%, of total loans at December 31, 2007.
Non-interest Income: Non-interest income for the year ended December 31, 2008 decreased $3.5 million, or 59.1% to $2.4 million as compared to $5.9 million in 2007. The decrease is primarily due to the change from year to year in the net gain or loss on the sale of securities and accounting charges for securities which are deemed to be other-than-temporarily impaired (OTTI). For these items the Bank recorded a net loss of $3.2 million in 2008 as compared to a net gain of $510,000 in 2007. The primary cause of this decrease was an OTTI charge of $2.3 million in fourth quarter of 2008 related to the writedown of the Banks investments in certain equity securities and trust preferred backed bonds. For all of 2008, OTTI charges totaled $3.6 million, which included $972,000 related to the Banks investment in Freddie Mac and Fannie Mae preferred stock. The year to date decrease in non-interest income was partially offset by an increase of $214,000, or 42.8%, in income from bank-owned life insurance (BOLI) as a result of the Banks 2007 investment in $9.8 million of BOLI.
Non-interest Expense: Non-interest expenses for the year ended December 31, 2008 decreased by $603,000, or 2.2% year to date. The December 2007 acquisition of five full service branch offices in eastern New York contributed to increases in occupancy and equipment, data processing, advertising and other general and administrative (G&A) expenses in 2008. Salary and benefit increases related to these offices were offset by decreases achieved from the reduction in workforce which occurred in the fourth quarter of 2007, resulting in a $1.5 million severance charge during that period. Salary and benefit expenses also benefited from a $1.4 million decrease in amortization expense related to the 2006 Equity Incentive Plan due primarily to the accelerated nature of the amortization. Conversely, other G&A expenses increased as a result of amortization expense of $653,000 related to the $3.2 million core deposit intangible acquired as part of the New York branch acquisition.
Income Taxes: Income tax expense was $776,000 for the year ended December 31, 2008, an increase of $527,000 compared to $249,000 for the year ended December 31, 2007. The Companys 2008 combined federal and state effective tax rate was 35.0% as compared to 16.7% for 2007. The 2008 tax expense was impacted by a third quarter state tax expense of $115,000 to adjust deferred income taxes as a result of a legislative change in the Massachusetts income tax rate scheduled to go into effect in the years 2010 through 2012. Additionally, tax expense was impacted by an adjustment of $125,000 in 2008 related to the valuation reserve established in 2005 related to the federal charitable contribution carryforward, as compared to a similar adjustment of $40,000 in 2007.
Comparison of Operating Results For the Years Ended December 31, 2007 and December 31, 2006
Net Income: Net income for the year ended December 31, 2007 was $1.2 million, a decrease of $1.6 million from net income of $2.8 million in the prior year. The decrease is primarily a result of an increase in non-interest expenses as described below.
Net Interest Income: The tables above set forth the components of the Companys net interest income, yields on interest earning assets and interest bearing liabilities, and the effect on net interest income arising from changes in volume and rate. Net interest income increased from $23.6 million in 2006 to $23.8 million in 2007. The increase of $270,000, or 1.1%, is due mainly to the growth in interest earning assets, as well as the corresponding yield on all interest earning assets. This growth, net of the increase in interest bearing liabilities, had the effect of increasing net interest income by $230,000.
Interest Income: Interest and dividend income increased $5.4 million, or 12.4%, to $49.4 million for the year ended December 31, 2007 from $43.9 million for the year ended December 31, 2006. The increase was caused by a $43.1 million increase in average interest-earning assets, which had the effect of increasing interest income by $3.0 million. Loans increased on average by $50.1 million between the two periods, along with an increase in the average balances of short-term investments of $4.2 million, partially offset by a decrease in investment securities of $11.1 million. The average yield on loans increased from 6.36% for the year ended December 31, 2006 to 6.58% for the same period in 2007, and the overall yield on interest earning assets increased from 5.86% to 6.23% for the 2006 and 2007 periods, respectively, which had the effect of increasing interest income by $2.4 million.
Interest Expense: Interest expense for the year ended December 31, 2007 increased by $5.2 million or 25.4% to $25.5 million compared to interest expense of $20.3 million for the year ended December 31, 2006. The effect of an increase in interest-bearing liabilities, which grew by an average of $55.2 million in 2007, was to increase interest expense by $2.8 million, while an increase of 50 basis points, or 14.4%, in the average rates paid on interest-bearing liabilities increased interest expense by $2.4 million. Both the yield curve and the non-core certificate of deposit specials related to the Massachusetts branch office openings in the first and second quarters of 2007 resulted in interest expense pressure during the year.
Provision for Loan Losses: The Bank records a provision for loan losses as a charge to its earnings when necessary in order to maintain the allowance for loan losses at a level sufficient to absorb losses inherent in the loan portfolio. Refer to Business Asset Quality for additional information about the Banks methodology for establishing its allowance for loan losses. The Bank recorded $1.1 million and $233,000 in loan loss provisions during the years ended December 31, 2007 and 2006, respectively, representing an increase of $818,000, or 351.1%. This increase was a reflection of both the difference in the amount of and mix of loan growth for the respective periods, as well as net charge-offs of $160,000 in 2007 versus net recoveries of $224,000 in 2006. At December 31, 2007, the allowance for loan losses totaled $5.6 million, or 0.85% of the loan portfolio, compared to $4.7 million, or 0.80%, of total loans at December 31, 2006.
Non-interest Income: Non-interest income for the year ended December 31, 2007 increased by $2.4 million, or 70.5% to $5.9 million as compared to $3.5 million in 2006. In 2006, the Bank incurred a $1.7 million loss on the sales of securities, primarily as a result of the partial balance sheet restructuring in the fourth quarter of that year. Non-interest income in 2006 was also impacted by a gain of $605,000 on the termination of the Banks defined benefit pension plan. Customer service fees increased by $227,000, or 8.0% in 2007 as compared to 2006 while portfolio management fees increased by $182,000, or 18.2%. Additionally, the Banks investment in $9.9 million of new BOLI increased this non-interest income item by $278,000, or 125.2%.
Non-interest Expense: Non-interest expense increased by $5.9 million or 27.4%, to $27.2 million for the year ended December 31, 2007, compared to $21.3 million for the same period in 2006. The expense increase is primarily in the salaries and benefit categories which increased by $4.9 million, or 41.3% as compared to the same prior year period. The reduction in workforce and executive retirements announced in the fourth quarter of 2007 resulted in a severance accrual of $1.1 million during that period, as well as the acceleration of $499,000 of amortization expense associated with the Equity Incentive Plan. For the full year the Equity Incentive Plan amortization amounted to $3.0 million as compared to $417,000 expensed in 2006. Salary and benefits have also increased as a result of new branch and lending personnel associated with the de novo and acquired branch offices during the year. These new branches also had the impact of increasing occupancy and equipment, data processing, marketing and other expenses.
Income Taxes: Income tax expense was $249,000 for the year ended December 31, 2007, a decrease of $2.4 million compared to $2.7 million for the year ended December 31, 2006. The combined federal and state effective tax rate changed significantly between the two years, from 48.6% in 2006 to 16.7% in 2007, primarily as a
result of higher permanent tax versus book differences and lower separate company state income taxes. Additionally, the Company incurred an increase of $40,000 in the tax valuation reserve related to the federal charitable contribution carryforward in 2007 as compared to an increase of $659,000 in 2006.
Management recognizes that taking and managing risk is fundamental to the business of banking. Through the development, implementation and monitoring of its policies with respect to risk management, the Bank strives to measure, evaluate and control the risks it faces. Management understands that an effective risk management system is critical to the safety and soundness of the Bank. Chief among the risks faced by Legacy Banks are credit risk, market risk including interest rate risk, liquidity risk, operational (transaction) risk and compliance risk.
Within management, the responsibility for risk management rests with the Risk Management department, headed by the Senior Vice President and General Counsel, other members of the department, and the senior officers responsible for lending, retail banking and human resources. The Risk Management department continually reviews the status of our risk management efforts, including reviews of internal and external audit findings, loan review findings, and the activities of the Asset/Liability Committee with respect to monitoring interest rate and liquidity risk. The Committee tracks any open items requiring corrective action with the goal of ensuring that each is addressed on a timely basis. The Senior Vice President and General Counsel reports all findings of the Risk Management department directly to the Audit Committee of the Bank.
Management of Credit Risk: Legacy Banks considers credit risk to be the most significant risk it faces, in that it has the greatest potential to affect the financial condition and operating results of Legacy Banks. Credit risk is managed through a combination of policies established by the board of directors of the Bank, the monitoring of compliance with these policies, and the periodic evaluation of loans in the portfolio, including those with problem characteristics. In general, the Banks policies establish maximums on the amount of credit that may be granted to a single borrower (including affiliates), the aggregate amount of loans outstanding by type in relation to total assets and capital, and loan concentrations. Collateral and debt service coverage ratios, approval limits and other underwriting criteria are also specified. Policies also exist with respect to performing periodic credit reviews, the rating of loans, when loans should be placed on non-performing status and factors that should be considered in establishing the Banks allowance for loan losses.
Management of Market Risk: Market risk is the risk of loss due to adverse changes in market prices and rates, and typically encompasses exposures such as sensitivity to changes in market interest rates, foreign currency exchange rates, and commodity prices. The Bank has no exposure to foreign currency exchange or commodity price movements. Because net interest income is the Banks primary source of revenue, interest rate risk is a significant market risk to which the Bank is exposed.
Interest rate risk is the exposure of the Banks net interest income to adverse movements in interest rates. Net interest income is affected by changes in interest rates as well as by fluctuations in the level and duration of the Banks assets and liabilities. Over and above the influence that interest rates have on net interest income, changes in rates may also affect the volume of lending activity, the ability of borrowers to repay variable rate loans, the volume of loan prepayments and refinancings, the flow and mix of deposits, and the market value of the Banks assets and liabilities.
Exposure to interest rate risk is managed by the Bank through periodic evaluations of the current interest rate risk inherent in its rate-sensitive assets and liabilities, primarily deposits, borrowings, loans and securities, coupled with determinations of the level of risk considered appropriate given the Banks capital and liquidity requirements, business strategy and performance objectives. Through such management, the Bank seeks to manage the vulnerability of its net interest income to changes in interest rates.
Strategies used by the Bank to manage the potential volatility of its earnings may include:
Legacy Banks Asset/Liability Committee, comprised of several members of senior management, is responsible for managing interest rate risk. On a quarterly basis, the Committee reviews with the board of directors its analysis of the Banks exposure to interest rate risk, the effect subsequent changes in interest rates could have on the Banks future net interest income, its strategies and other activities, and the effect of those strategies on the Banks operating results. The Committee is also actively involved in the Banks planning and budgeting process as well as in determining pricing strategies for deposits and loans.
The Committees primary method for measuring and evaluating interest rate risk is income simulation analysis. This analysis considers the maturity and interest rate repricing characteristics of interest-bearing assets and liabilities, as well as the relative sensitivities of these balance sheet components over a range of interest rate scenarios. Interest rate scenarios tested generally include parallel and flattening/steepening rate changes over a one year period, and static (or flat) rates. The simulation analysis is used to measure the exposure of net interest income to changes in interest rates over specified time horizon, usually one and two year periods. The simulations also show the net interest income volatility for up to five years.
The table below sets forth, as of December 31, 2008, the estimated changes in the Banks net interest income that would result from the designated twelve-month changes in the U.S. Treasury yield curve. Computations of prospective effects of hypothetical interest rate changes are based on numerous assumptions including relative levels of market interest rates, loan prepayments and deposit run-off, and should not be relied upon as indicative of actual results.
As indicated in the table above, the result of a 200 basis point parallel increase in interest rates is estimated to increase net interest income by 3.9% over a 12-month horizon, when compared to the flat rate scenario. For a 200 basis point flattening increase in the level of interest rates (shorter term rates increasing at a greater level than longer term rates), net interest income is estimated to increase by 2.3% over a 12-month horizon, when compared against the flat rate scenario. Inherent in these estimates is the assumption that certain transaction and savings account deposit rates would not increase while certain money market and relationship savings accounts would increase by 75 basis points for each 100 basis point increase in market interest rates. These assumptions are based on the Banks past experience with the changes in rates paid on these non-maturity deposits coincident with changes in market interest rates.
The estimated change in net interest income from the flat rate scenario for a 100 basis point parallel decline in the level of interest rates is a decrease of 1.1%, which assumes little, if any, decrease in savings and interest-bearing checking rates, and an average decrease of approximately 57 basis points in money market and relationship savings rates, respectively, for each 100 basis point decrease in market interest rates. Given the level of market interest rates as of the end of 2008, the Bank did not measure the impact of a 200 basis point decline. Effectively, in the declining interest rate scenario, the Bank would be limited in its ability to lower rates given the already low rate environment, and the rates on certain interest-earning assets would thus decrease somewhat faster than the rates on liabilities. This simulation also incorporates the assumption that shorter-term FHLBB borrowings at December 31, 2008 are replaced mainly with borrowings with maturities averaging 2.5 years.
There are inherent shortcomings in income simulation, given the number and variety of assumptions that must be made in performing the analysis. The assumptions relied upon in making these calculations of interest rate sensitivity include the level of market interest rates, the shape of the yield curve, the degree to which certain assets and liabilities with similar maturities or periods to repricing react to changes in market interest rates, the degree to which non-maturity deposits (e.g. checking) react to changes in market rates, the expected prepayment rates on loans and mortgage-backed securities, the degree to which early withdrawals occur on certificates of deposit and the volume of other deposit flows. As such, although the analysis shown above provides an indication of the Banks sensitivity to interest rate changes at a point in time, these estimates are not intended to and do not provide a precise forecast of the effect of changes in market interest rates on the Banks net interest income and will differ from actual results.
In its management of interest rate risk, the Bank also relies on the analysis of its interest rate gap, which is the measure of the mismatch between the amount of Legacys interest-earning assets and interest-bearing liabilities that mature or reprice within specified timeframes. An asset-sensitive position (positive gap) exists when there are more rate-sensitive assets than rate-sensitive liabilities maturing or repricing within a particular time horizon, and generally signifies a favorable effect on net interest income during periods of rising interest rates and a negative effect during periods of falling interest rates. Conversely, a liability-sensitive position (negative gap) would generally indicate a negative effect on net interest income during periods of rising rates and a positive effect during periods of falling rates. Certain factors may serve to limit the usefulness of the measurement of the interest rate gap. For example, interest rates on certain assets and liabilities are discretionary and may change in advance of, or may lag behind, changes in market rates. The gap analysis does not give effect to changes Legacy may undertake to mitigate interest rate risk. Certain assets, such as adjustable-rate loans, have features that may restrict the magnitude of changes in interest rates both on a short-term basis and over the life of the assets. Further, in the event of changes in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in the gap analysis. Lastly, should interest rates increase, the ability of borrowers to service their debt may decrease.
Liquidity Risk Management: Liquidity risk, or the risk to earnings and capital arising from an organizations inability to meet its obligations without incurring unacceptable losses, is managed by the Banks Chief Financial Officer, who monitors on a daily basis the adequacy of the Banks liquidity position. Oversight is provided by the Asset/Liability Committee, which reviews the Banks liquidity on a periodic basis, and by the board of directors of the Bank, which reviews the adequacy of our liquidity resources on a quarterly basis.
Our primary sources of funds are from deposits, amortization of loans, loan prepayments and the maturity of loans, mortgage-backed securities and other investments, and other funds provided by operations. While scheduled payments from amortization of loans and mortgage-backed securities and maturing loans and investment securities are relatively predictable sources of funds, deposit flows and loan prepayments can be greatly influenced by general interest rates, economic conditions and competition. We maintain excess funds in cash and short-term interest-bearing assets that provide additional liquidity. At December 31, 2008, cash and due from banks, short-term investments and debt securities maturing within one year totaled $34.6 million or 3.7% of total assets.
We also rely on outside borrowings from the Federal Home Loan Bank of Boston, as an additional funding source. Over the past several years, the Bank has expanded its use of Federal Home Loan Bank of Boston borrowings to fund growth in the loan portfolio and to assist in the management of its interest rate risk. Federal Home Loan Bank of Boston borrowings outstanding totaled $197.9 million as of December 31, 2008. On that date, we had the ability to borrow an additional $38.1 million from the Federal Home Loan Bank of Boston, $10 million of which is in the form of an Ideal Way line of credit. Please refer Note 9 to the consolidated financial statements in Item 8 for a detailed discussion of Federal Home Loan Bank Advances.
As described within this report, the Bank intends to grow its loan assets. The cash flow required to fund those potential increases in loans will likely be provided primarily by increases in deposits, as we implement our strategy to expand our franchise geographically and to increase our deposit market share in the areas served by the Bank at present. To the extent that cash flow provided by our deposit-gathering efforts does not completely fund increases in assets, we will likely borrow funds from the FHLBB to provide the necessary cash flow. The capital necessary to support future growth in assets is anticipated to be provided by our capital resources in hand, augmented over time by increases from net income, net of dividends paid, if any.
Management of Other Risks: Two additional risk areas that receive significant attention by management and the board are operational risk and compliance risk. Operational risk is the risk to earnings and capital arising from control deficiencies, problems with information systems, fraud, error or unforeseen catastrophes. Compliance risk is the risk arising from violations of, or nonconformance with, laws, rules, regulations, prescribed practices, internal policies and procedures or ethical standards. Compliance risk can expose us to fines, civil money penalties, payment of damages and the voiding of contracts.
The Bank addresses such risks through the establishment of comprehensive policies and procedures with respect to internal control, the management and operation of its information and communication systems, disaster recovery, and compliance with laws, regulations and banking best practice. Monitoring of the effectiveness of such policies and procedures is performed through a combination of the Banks internal audit program, through periodic internal and third-party compliance reviews, and through the ongoing attention of its managers charged with supervising compliance and operational control. Oversight of these activities is provided by the Risk Management department and the Audit Committee of the board of directors of the Bank.
Other than loan commitments, the Bank does not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Contractual Obligations: The following tables present information indicating various contractual obligations and commitments of the Bank as of December 31, 2008 and the respective maturity dates:
Loan Commitments : Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and generally have fixed expiration dates or other termination clauses. The following table presents certain information about Legacy Banks loan commitments outstanding as of December 31, 2008:
The financial statements, accompanying notes, and related financial data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollar amounts without considering the changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Most of our assets and liabilities are monetary in nature, and therefore the impact of interest rates has a greater impact on its performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Please refer to the note on Recent Accounting Pronouncements in Note 1 to the consolidated financial statements in Item 8 for a detailed discussion of recent accounting pronouncements.
To the Board of Directors and Stockholders Legacy Bancorp, Inc.
We have audited the accompanying consolidated balance sheets of Legacy Bancorp, Inc. and subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income, changes in stockholders equity, and cash flows for each of the years in the three-year period ended December 31, 2008. We also have audited Legacy Bancorp, Inc.s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Legacy Bancorp, Inc.s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Managements Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Companys internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Legacy Bancorp, Inc. and subsidiaries as of December 31, 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2008, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, Legacy Bancorp, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
/s/ Wolf & Company
March 13, 2009