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SI Financial Group 10-K 2007
form10-k.htm


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K  

 
S
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
 
For the Fiscal Year Ended December 31, 2006 
 
£
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
 
For the Transition Period from              to              
 
Commission File Number: 0-50801

SI FINANCIAL GROUP, INC.
(Exact name of registrant as specified in its charter)

 
United States
 
84-1655232
(State or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
 
803 Main Street, Willimantic, Connecticut
 
06226
(Address of principal executive offices)
 
(Zip Code)
 
(860) 423-4581
(Registrant’s telephone number, including area code)

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

Title of each class
Name of Exchange on which registered
Common stock, par value $0.01 per share
Nasdaq Stock Market LLC

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

 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes £  No S
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes £  No S

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 S  No £

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. £

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer £
Accelerated filer £
Non-accelerated filer S
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.) Yes £  No S

The aggregate market value of the voting and non-voting common equity held by non-affiliates was $54.1 million, which was computed by reference to the closing price of $11.00, at which the common equity was sold as of June 30, 2006. Solely for the purposes of this calculation, the shares held by SI Bancorp, MHC and the directors and officers of the registrant are deemed to be affiliates.

As of March 13, 2007, there were 12,421,920 shares of the registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated by reference in Part III of this Form 10-K.
 



TABLE OF CONTENTS

 
Page No.
Item 1.
1
     
Item 1A.
35
     
Item 1B.
39
     
Item 2.
39
     
Item 3.
41
     
Item 4.
41
     
   
Item 5.
41
     
Item 6.
43
     
Item 7.
45
     
Item 7A.
58
     
Item 8.
60
     
Item 9.
60
     
Item 9A.
61
     
Item 9B.
61
     
   
Item 10.
61
     
Item 11.
62
     
Item 12.
62
     
Item 13.
62
     
Item 14.
63
     
   
Item 15.
63
     
 
65


Forward-Looking Statements
This report contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of SI Financial Group, Inc. (the “Company”). These forward-looking statements are generally identified by the use of the words “believe,” “expect,” “intend,” “anticipate,” “estimate,” “project” or similar expressions. The Company’s ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors that 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 United States government, including policies of the United States Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Company’s market area, changes in real estate market values in the Company’s 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 that 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.



General

In certain instances where appropriate, the terms “we,” “us” and “our” refer to SI Financial Group, Inc. and Savings Institute Bank and Trust Company or both.

SI Financial Group, Inc. was established on August 6, 2004 to become the parent holding company for Savings Institute Bank and Trust Company (the “Bank” or “Savings Institute”) upon the conversion of the Bank’s former parent, SI Bancorp, Inc., from a state-chartered to a federally-chartered mutual holding company. At the same time, the Bank also converted from a state-chartered to a federally-chartered savings bank. The Bank is a wholly-owned subsidiary of the Company and management of the Company and the Bank are substantially similar. The Company neither owns nor leases any property, but instead uses the premises, equipment and other property of the Bank. Thus, the financial information and discussion contained herein primarily relates to the activities of the Bank.

The Bank was incorporated by an act of the Connecticut legislature in 1842 under the name Willimantic Savings Institute. It was shortened to Savings Institute in 1991 to reflect the Bank’s expanded geographic territory. In 2000, the Bank converted to stock form and became the wholly-owned subsidiary of SI Bancorp, Inc., a Connecticut-chartered mutual holding company. On August 6, 2004, Savings Institute converted to a federal charter and now operates under the name Savings Institute Bank and Trust Company. At that time, SI Bancorp, Inc. converted to a federal charter operating under the name SI Bancorp, MHC and transferred all of the common stock of the Bank to SI Financial Group, Inc. On September 30, 2004, the Company completed its minority stock offering with the sale of 5,025,500 shares of its common stock to the public, 251,275 shares contributed to SI Financial Group Foundation and 7,286,975 issued to SI Bancorp, MHC.

The Bank operates as a community-oriented financial institution offering a full range of financial services to consumers and businesses in its market area, including insurance, trust and investment services. The Bank attracts deposits from the general public and uses those funds to originate one- to four-family residential, multi-family and commercial real estate, commercial business and consumer loans, which it holds primarily for investment.


Definitive Agreement Signed

On September 5, 2006, the Bank signed a definitive agreement to purchase Fairfield Financial Mortgage Group, Inc. (“FFMG”). FFMG has branch offices in Texas, Massachusetts, New Hampshire, New Jersey, New York and Pennsylvania and is also a licensed mortgage banker in South Carolina, Florida, Georgia, Michigan, Rhode Island, Maryland, Delaware and California.

Availability of Information

The Company’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, are made available free of charge on the Company’s website, www.mysifi.com, as soon as reasonably practicable after the Company electronically files such material with, or furnishes it to, the Securities and Exchange Commission (the “SEC”). The information on the Company’s website shall not be considered as incorporated by reference into this Form 10-K.

Market Area

The Company is headquartered in Willimantic, Connecticut, which is located in eastern Connecticut approximately 30 miles east of Hartford. The Bank operates nineteen offices in Windham, New London, Tolland and Hartford Counties, which the Bank considers its primary market area. The economy in its market area is primarily oriented to the educational, service, entertainment, manufacturing and retail industries.

The major employers in the area include several institutions of higher education, the Mohegan Sun and Foxwoods casinos, General Dynamics Defense Systems and Pfizer, Inc. According to published statistics, Windham County’s population in 2006 was approximately 116,000 and consisted of 43,000 households. The population increased approximately 6.7% from 2000. Median household income in Windham County is $49,000, compared to $60,000 for Connecticut as a whole and $43,000 nationally. The surrounding counties of Hartford, New London and Tolland Counties have median household incomes of $56,000, $55,000 and $65,000, respectively.

Competition

The Bank faces significant competition for the attraction of deposits and origination of loans. The most direct competition for deposits has historically come from the several financial institutions operating in the Bank’s market area and, to a lesser extent, from other financial service companies, such as brokerage firms, credit unions and insurance companies. The Bank also faces competition for investors’ funds from money market funds and other corporate and government securities. At June 30, 2006, which is the most recent date for which data is available from the Federal Deposit Insurance Corporation (“FDIC”), the Bank held approximately 18.95% of the deposits in Windham County, which is the largest market share out of 11 financial institutions with offices in this county. Also, at June 30, 2006, the Bank held approximately 0.97% of the deposits in Hartford, New London and Tolland Counties, which is the 15th market share out of 36 financial institutions with offices in these counties. Banks owned by Bank of America Corp., Webster Bank Financial Corporation, TD Banknorth Group, Inc., Sovereign Bancorp., Inc. and Citizens Financial Group, Inc., all of which are large regional bank holding companies, also operate in the Bank’s market area. These institutions are significantly larger and, therefore, have significantly greater resources than the Bank does and may offer products and services that the Bank does not provide.


The Bank’s competition for loans comes primarily from financial institutions in its market area, and to a lesser extent from other financial service providers, such as mortgage companies and mortgage brokers. Competition for loans also comes from the increasing number of non-depository financial service companies entering the mortgage market, such as insurance companies, securities companies and specialty finance companies.

The Bank expects competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Changes in federal law permit affiliation among banks, securities firms and insurance companies, which promotes a competitive environment in the financial services industry. Competition for deposits and the origination of loans could limit the Company’s growth in the future.

Lending Activities

General. The Bank’s loan portfolio consists primarily of one- to four-family residential mortgage loans, multi-family and commercial real estate loans and commercial business loans. To a much lesser extent, the loan portfolio includes construction and consumer loans. The Bank historically and currently originates loans primarily for investment purposes. At December 31, 2006, the Bank had $135,000 in loans that were held for sale.

The following table summarizes the composition of the Bank’s loan portfolio in dollar amounts and as a percentage of the respective portfolio at the dates indicated.

   
At December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
2003
 
2002
 
   
Amount
 
Percent
of Total
 
Amount
 
Percent
of Total
 
Amount
 
Percent
of Total
 
Amount
 
Percent
of Total
 
Amount
 
Percent
of Total
 
Real estate loans:
                                         
Residential - 1 to 4 family
 
$
309,695
   
53.65
%
$
266,739
   
51.66
%
$
252,180
   
55.99
%
$
226,881
   
58.29
%
$
213,831
   
63.29
%
Multi-family and commercial
   
118,600
   
20.55
   
100,926
   
19.54
   
82,213
   
18.25
   
73,428
   
18.87
   
61,214
   
18.12
 
Construction
   
44,647
   
7.73
   
47,325
   
9.16
   
35,773
   
7.94
   
20,652
   
5.30
   
21,104
   
6.25
 
Total real estate loans
   
472,942
   
81.93
   
414,990
   
80.36
   
370,166
   
82.18
   
320,961
   
82.46
   
296,149
   
87.66
 
                                                               
Consumer loans:
                                                             
Home equity
   
18,489
   
3.20
   
20,562
   
3.98
   
18,335
   
4.07
   
14,411
   
3.70
   
10,786
   
3.19
 
Other
   
10,616
   
1.84
   
3,294
   
0.64
   
2,790
   
0.62
   
3,107
   
0.80
   
3,936
   
1.16
 
Total consumer loans
   
29,105
   
5.04
   
23,856
   
4.62
   
21,125
   
4.69
   
17,518
   
4.50
   
14,722
   
4.35
 
 
                                                             
Commercial business loans
   
75,171
   
13.03
   
77,552
   
15.02
   
59,123
   
13.13
   
50,746
   
13.04
   
27,003
   
7.99
 
                                                               
Total loans
   
577,218
   
100.00
%
 
516,398
   
100.00
%
 
450,414
   
100.00
%
 
389,225
   
100.00
%
 
337,874
   
100.00
%
                                                               
Deferred loan origination costs, net of fees
   
1,258
         
1,048
         
743
         
387
         
(209
)
     
Allowance for loan losses
   
(4,365
)
       
(3,671
)
       
(3,200
)
       
(2,688
)
       
(3,067
)
     
Loans receivable, net
 
$
574,111
       
$
513,775
       
$
447,957
       
$
386,924
       
$
334,598
       


One- to Four-Family Residential Loans. The Bank’s primary lending activity is the origination of mortgage loans to enable borrowers to purchase or refinance existing homes or to construct new residential dwellings in its market area. The Bank offers fixed-rate and adjustable-rate mortgage loans with terms up to 30 years. Borrower demand for adjustable-rate loans versus fixed-rate loans is a function of the level of interest rates, the expectations of changes in the level of interest rates, the difference between the interest rates and loan fees offered for fixed-rate mortgage loans and the initial period interest rates and loan fees for adjustable-rate loans. The relative amount of fixed-rate mortgage loans and adjustable-rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment and the effect each has on the Bank’s interest rate risk. The loan fees charged, interest rates and other provisions of mortgage loans are determined on the basis of the Bank’s own pricing criteria and competitive market conditions. Additionally, the Bank offers reverse mortgages to its customers, through a correspondent relationship with another institution, in response to increasing demand for this type of product.

The Bank offers fixed-rate loans with terms of 10, 15, 20 or 30 years. The Bank’s adjustable-rate mortgage loans are based on 15, 20 or 30 year amortization schedules. Interest rates and payments on adjustable-rate mortgage loans adjust annually after a one, three, five, seven or 10-year initial fixed period. Interest rates and payments on adjustable-rate loans are adjusted to a rate typically equal to 2.75% (2.875% for jumbo loans) above the one-year constant maturity Treasury index. The maximum amount by which the interest rate may be increased or decreased is generally 2% per adjustment period and the lifetime interest rate cap is generally 6% over the initial interest rate of the loan.

While the Bank anticipates that adjustable-rate loans will better offset the adverse effects of an increase in interest rates as compared to fixed-rate mortgages, the increased mortgage payments required of adjustable-rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults. The marketability of the underlying property also may be adversely affected in a high interest rate environment. In addition, although adjustable-rate mortgage loans help make the Bank’s asset base more responsive to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits.

Generally, the Bank does not originate conventional loans with loan-to-value ratios exceeding 95% and generally originates loans with a loan-to-value ratio in excess of 80% only when secured by first liens on owner-occupied one- to four-family residences. Loans with loan-to-value ratios in excess of 80% generally require private mortgage insurance or additional collateral. The Bank requires all properties securing mortgage loans to be appraised by a board approved independent licensed appraiser and requires title insurance on all first mortgage loans. Borrowers must obtain hazard insurance and flood insurance for loans on property located in a flood zone, before closing the loan.

In an effort to provide financing for moderate income and first-time buyers, the Bank offers Federal Housing Authority, Veterans Administration and Connecticut Housing Finance Agency loans and a first-time home buyers program. The Bank offers fixed-rate residential mortgage loans through these programs to qualified individuals and originates the loans using modified underwriting guidelines.

Multi-Family and Commercial Real Estate Loans. The Bank offers fixed-rate and adjustable-rate mortgage loans secured by multi-family and commercial real estate. The Bank’s multi-family and commercial real estate loans are generally secured by condominiums, apartment buildings, single-family subdivisions as well as owner-occupied properties located in its market area and used for businesses. The Bank intends to continue to emphasize this segment of its loan portfolio.


The Bank originates adjustable-rate multi-family and commercial real estate loans for terms up to 25 years. Interest rates and payments on these loans typically adjust every five years after a five-year initial fixed-rate period. Interest rates and payments on adjustable-rate loans are adjusted to a rate typically 2.0-3.0% above the classic advance rates offered by the Federal Home Loan Bank of Boston (the “FHLB”). There are no adjustment period or lifetime interest rate caps. Loans are secured by first mortgages that generally do not exceed 75% of the property’s appraised value. At December 31, 2006, the largest outstanding multi-family or commercial real estate loan was $3.0 million. This loan is secured by office and retail space and was performing according to its terms at December 31, 2006.

Loans secured by multi-family and commercial real estate generally have larger balances and involve a greater degree of risk than one- to four-family residential mortgage loans. Of primary concern in multi-family and commercial real estate lending is the borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income properties often depend on successful operation and management of the properties. As a result, repayment of such loans may be subject, to a greater extent than residential real estate loans, to adverse conditions in the real estate market or the economy. To monitor cash flows on income properties, the Bank requires borrowers and loan guarantors, if any, to provide annual financial statements on multi-family and commercial real estate loans. In reaching a decision on whether to make a multi-family or commercial real estate loan, consideration is given to the net operating income of the property, the borrower’s expertise, credit history and profitability and the value of the underlying property. In addition, with respect to commercial real estate rental properties, the Bank will also consider the term of the lease and the quality of the tenants. The Bank generally requires that the properties securing these real estate loans have debt service coverage ratios of at least 1.20. The debt service coverage ratio is equal to cash flows before interest, depreciation and required principal payments. Appropriate environmental assessments are generally required for commercial real estate loans over $100,000, based upon the environmental risk factors for the subject collateral property.

Construction and Land Loans. The Bank originates loans to individuals, and to a lesser extent, builders, to finance the construction of residential dwellings. The Bank also originates construction loans for commercial development projects, including condominiums, apartment buildings, single-family subdivisions as well as owner-occupied properties used for businesses. Residential construction loans generally provide for the payment of interest only during the construction phase, which is usually twelve months. At the end of the construction phase, the loan generally converts to a permanent mortgage loan. Commercial construction loans generally provide for the payment of interest only during the construction phase which may range from three months to a maximum of twenty-four months as allowed by the Bank’s Loan Policy. Generally, commercial loans on owner-occupied properties would convert to a permanent mortgage as the construction loan is repaid from the sale of individual units or houses. Loans generally can be made with a maximum loan-to-value ratio of 90% on residential construction and 75% on commercial construction for nonresidential properties and 80% on commercial multi-family construction of the lower of appraised value or cost of the project, whichever is less. At December 31, 2006, the largest outstanding residential construction loan commitment was for $1.0 million, of which $392,000 was outstanding. At December 31, 2006, the largest outstanding commercial construction loan commitment was $7.3 million, of which $4.7 million was outstanding. These loans were performing according to their terms at December 31, 2006. Primarily all commitments to fund construction loans require an appraisal of the property by a board approved independent licensed appraiser. Also, inspections of the property are required before the disbursement of funds during the term of the construction loan.
 
Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan depends largely upon the
 
 
accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost, including interest, of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or before the maturity of the loan, with a project having a value which is insufficient to assure full repayment. As a result of the foregoing, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest. If the Bank is forced to foreclose on a project before or at completion due to a default, there can be no assurance that the Bank will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

The Bank also originates land loans to individuals and local contractors and developers only for the purpose of making improvements on approved building lots, subdivisions and condominium projects within two years of the date of the loan. Such loans to individuals generally are written with a maximum loan-to-value ratio based upon the appraised value or purchase price of the land. Maximum loan-to-value ratio on raw land is 50%, while the maximum loan-to-value ratio for land development loans involving approved projects is 65%. The Bank offers fixed-rate land loans and variable-rate land loans that adjust annually. Interest rates and payments on adjustable-rate land loans are adjusted to a rate typically equal to the then current The Wall Street Journal prime rate plus a 1.0 - 2.0% margin. The maximum amount by which the interest rate may be increased or decreased is generally 2% annually and the lifetime interest rate cap is generally 6% over the initial rate of the loan.

Commercial Business Loans. The Bank originates commercial business loans to a variety of professionals, sole proprietorships and small businesses primarily in its market area. The Bank offers a variety of commercial lending products, the maximum amount of which is limited by the Bank’s in-house loans to one borrower limit. At December 31, 2006, the largest commercial loan was a $1.5 million loan, which is secured by a business asset consisting of a waste processing system. This loan was performing according to its terms at December 31, 2006.

The Bank offers loans secured by business assets other than real estate, such as business equipment and inventory. These loans are originated with maximum loan-to-value ratios of 75% of the value of the personal property. The Bank originates lines of credit to finance the working capital needs of businesses to be repaid by seasonal cash flows or to provide a period of time during which the business can borrow funds for planned equipment purchases. These loans convert to a term loan at the expiration of a draw period, which is not to exceed twelve months and will be paid over a pre-defined amortization period. Additional products such as time notes, letters of credit and Small Business Administration guaranteed loans are offered.

When originating commercial business loans, the Bank considers the financial statements of the borrower, the borrower’s payment history of both corporate and personal debt, the debt service capabilities of the borrower, the projected cash flows of the business, viability of the industry in which the customer operates and the value of the collateral.

Unlike residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment or other income, and which are secured by real property whose value tends to be more easily ascertainable, commercial loans are of higher risk and typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business. As a result, the availability of funds for the repayment of commercial loans may depend
 
substantially on the success of the business itself. Further, any collateral securing such loans may depreciate over time, may be difficult to appraise and may fluctuate in value.
 
The Bank offers equipment lease financing to its commercial customers. Financing is available up to 100% of the leased equipment and amortized over a period of one to three years. All commercial leasing loans, totaling $1.3 million, were performing according to terms at December 31, 2006.

Consumer Loans. The Bank offers a variety of consumer loans, primarily home equity lines of credit, and, to a lesser extent, loans secured by marketable securities, passbook or certificate accounts, motorcycles, automobiles and recreational vehicles as well as unsecured loans. Unsecured loans generally have a maximum borrowing limit of $15,000 and a maximum term of five years.

In February 2006, the Bank purchased a participation interest in a pool of automobile loans from UnitedOne Credit Union, which are serviced by Flatiron Financial Services, Inc. (formerly Centrix Financial, LLC), for a total purchase price of $10.3 million. These loans are secured by new and used automobiles. The indirect automobile loans have fixed interest rates and generally have terms up to seven years. Generally, the Bank offers automobile loans with a maximum loan-to-value ratio of 100% of the purchase price for new vehicles.

The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and their ability to meet existing obligations and payments on the proposed loans. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, to the proposed loan amount. Home equity lines of credit have adjustable rates of interest that are indexed to the prime rate as reported in The Wall Street Journal. The Bank will offer home equity loans with maximum combined loan-to-value ratios of 100%, provided that loans in excess of 80% will be charged a higher rate of interest. A home equity line of credit may be drawn down by the borrower for an initial period of five years from the date of the loan agreement. During this period, the borrower has the option of paying, on a monthly basis, either principal and interest or only interest. If not renewed, the borrower has to pay back the amount outstanding under the line of credit over a term not to exceed ten years, beginning at the end of the five-year period.

Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections depend on the borrower’s continuing financial stability, and therefore, are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

Loan Originations, Purchases, Sales and Servicing. Loan originations come from a number of sources. The primary source of loan originations are the Bank’s in-house loan originators, and to a lesser extent, local mortgage brokers, advertising and referrals from customers.

From time to time, the Bank will purchase whole participations in loans fully guaranteed by the United States Department of Agriculture and the Small Business Administration. The loans are primarily for commercial and agricultural properties located throughout the United States. The Bank purchased

 
$675,000 and $22.2 million of these loans in fiscal 2006 and 2005, respectively. Additionally, the Bank purchased $10.3 million of indirect automobile loans during 2006.
 
The Bank generally originates loans for portfolio but from time to time will sell loans in the secondary market, primarily fixed-rate one- to four-family residential mortgage loans with servicing retained, based on prevailing market interest rate conditions, an analysis of the composition and risk of the loan portfolio, liquidity needs and interest rate risk management. Generally, loans are sold without recourse. The Bank utilizes the proceeds from these sales primarily to meet liquidity needs and manage interest rate risk. The Bank sold $11.0 million, $35.5 million and $15.5 million of loans in the years ended December 31, 2006, 2005 and 2004, respectively.

At December 31, 2006, the Bank retained the servicing rights on $72.5 million of loans for others, consisting primarily of fixed-rate mortgage loans sold with or without recourse to third parties. Loan repurchase commitments are agreements to repurchase loans previously sold upon the occurrence of conditions established in the contract, including default by the underlying borrower. Loans sold with recourse totaled $59,000 at December 31, 2006. Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent mortgagors, processing insurance and tax payments on behalf of borrowers, assisting in foreclosures and property dispositions when necessary and general administration of loans. The gross servicing fee income from loans sold with servicing rights retained is typically 25.0 or 37.5 basis points of the total balance of serviced loans. The servicing rights related to these loans was $392,000 and $373,000 at December 31, 2006 and 2005, respectively. Amortization of mortgage servicing rights totaled $78,000, $64,000 and $24,000 for the years ended December 31, 2006, 2005 and 2004, respectively.

The following table sets forth the Bank’s loan originations, loan purchases, loan sales, principal repayments, charge-offs and other reductions on loans for the years indicated.

   
Years Ended December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
               
Loans at beginning of year
 
$
516,398
 
$
450,414
 
$
389,225
 
                     
Originations:
                   
Real estate loans
   
144,533
   
154,166
   
147,899
 
Commercial business loans
   
11,094
   
12,635
   
14,465
 
Consumer loans
   
13,096
   
17,011
   
16,063
 
Total loan originations
   
168,723
   
183,812
   
178,427
 
                     
Purchases
   
11,007
   
22,211
   
12,152
 
                     
Deductions:
                   
Principal loan repayments, prepayments and other, net
   
107,672
   
104,126
   
113,766
 
Loan sales
   
11,039
   
35,534
   
15,549
 
Loan charge-offs
   
199
   
29
   
75
 
Transfers to other real estate owned
   
-
   
350
   
-
 
Total deductions
   
118,910
   
140,039
   
129,390
 
                     
Net increase in loans
   
60,820
   
65,984
   
61,189
 
                     
Loans at end of year
 
$
577,218
 
$
516,398
 
$
450,414
 


Loan Maturity. The following table shows the contractual maturity of the Bank’s loan portfolio at December 31, 2006. The table does not reflect any estimate of prepayments, which significantly shortens the average life of all loans, and may cause actual repayment experience to differ from that shown below. Demand loans having no stated schedule of repayment and no stated maturity are reported as due in one year or less.

   
Amounts Due In
 
(Dollars in Thousands)
 
One Year or Less
 
More Than One Year
to Five Years
 
More Than Five Years
 
Total Amount Due
 
Real estate loans:
                 
Residential - 1 to 4 family
 
$
49
 
$
5,209
 
$
304,437
 
$
309,695
 
Multi-family and commercial
   
714
   
2,753
   
115,133
   
118,600
 
Construction
   
14,144
   
1,146
   
29,357
   
44,647
 
Total real estate loans
   
14,907
   
9,108
   
448,927
   
472,942
 
                           
Commercial business loans
   
7,595
   
6,897
   
60,679
   
75,171
 
                           
Consumer loans
   
200
   
9,135
   
19,770
   
29,105
 
                           
Total loans
 
$
22,702
 
$
25,140
 
$
529,376
 
$
577,218
 

While one- to four-family residential real estate loans are normally originated with up to 30-year terms; such loans typically remain outstanding for substantially shorter periods because borrowers often prepay their loans in full upon the sale of the property pledged as security or upon refinancing the original loan. Therefore, average loan maturity is a function of, among other factors, the level of purchase, sale and refinancing activity in the real estate market, prevailing interest rates and the interest rates payable on outstanding loans.

The following table sets forth, at December 31, 2006, the dollar amount of gross loans receivable contractually due after December 31, 2007, and whether such loans have either fixed interest rates, floating or adjustable interest rates. The amounts shown below exclude deferred loan fees and costs and the allowance for loan losses and include $806,000 of nonperforming loans.

   
Due After December 31, 2007
 
(Dollars in Thousands)
 
Fixed
Rates
 
Floating or
Adjustable Rates
 
Total
 
Real estate loans:
             
Residential - 1 to 4 family
 
$
199,744
 
$
109,902
 
$
309,646
 
Multi-family and commercial
   
8,842
   
109,044
   
117,886
 
Construction
   
21,976
   
8,527
   
30,503
 
Total real estate loans
   
230,562
   
227,473
   
458,035
 
                     
Commercial business loans
   
38,043
   
29,533
   
67,576
 
                     
Consumer loans
   
6,697
   
22,208
   
28,905
 
                     
Total loans
 
$
275,302
 
$
279,214
 
$
554,516
 


Loan Approval Procedures and Authority. The Bank’s lending activities follow written, nondiscriminatory, underwriting standards and loan origination procedures established by the Board of Directors and management. All residential mortgages and consumer home equity lines of credit in excess of $6.0 million or all commercial loans and other consumer loans in excess of $2.0 million require the approval of the Board of Directors. The Loan Committee of the Board of Directors has the authority to approve: (1) residential mortgage loans and consumer home equity lines of credit of up to $6.0 million and (2) commercial and other consumer loans of up to $2.0 million. The President and the Senior Credit Officer have approval for: (1) residential mortgage loans that conform to Fannie Mae and Freddie Mac standards up to $2.0 million or $417,000 for those that are non-conforming, (2) consumer and commercial loans up to $250,000 individually or $2.0 million jointly for consumer home equity lines of credit or $1.0 million jointly for commercial and other consumer loans. The Senior Commercial Real Estate Officer may approve home equity lines of credit and commercial loans of up to $250,000 individually or $500,000 with the additional approval of the President or Senior Credit Officer. Various bank personnel have been delegated authority to approve loans up to $417,000.

Loans to One Borrower. The maximum amount that the Bank may lend to one borrower and the borrower’s related entities is limited, by regulation, to generally 15% of the Bank’s stated capital and reserves. At December 31, 2006, the Bank’s regulatory limit on loans to one borrower was approximately $9.0 million. At that date, the Bank’s largest lending relationship was $8.6 million, representing two commercial business loans and a commercial construction loan for the construction of a nursing home and rehabilitation facility, of which $5.0 million was outstanding and performing according to the original repayment terms at December 31, 2006.

Loan Commitments. The Bank issues commitments for fixed-rate and adjustable-rate mortgage loans conditioned upon the occurrence of certain events. Commitments to originate mortgage loans are legally binding agreements to lend to customers and generally expire in 90 days or less from the date of the application.

Delinquencies. When a borrower fails to make a required loan payment, the Bank takes a number of steps to have the borrower cure the delinquency and restore the loan to current status. The Bank makes initial contact with the borrower when the loan becomes 15 days past due. If payment is not then received by the 30th day of delinquency, additional letters and phone calls generally are made. When the loan becomes 90 days past due, a letter is sent notifying the borrower that foreclosure proceedings will commence if the loan is not brought current within 30 days. Generally, when the loan becomes 120 days past due, the Bank will commence foreclosure proceedings against any real property that secures the loan or attempts to repossess any personal property that secures a consumer or commercial loan. If a foreclosure action is instituted and the loan is not brought current, paid in full, or refinanced before the foreclosure sale, the real property securing the loan is typically sold at foreclosure. The Bank may consider loan repayment arrangements with certain borrowers under certain circumstances.

On a monthly basis, management informs the Board of Directors of the amount of loans delinquent more than 30 days, all loans in foreclosure and all foreclosed and repossessed property.


The following table sets forth the delinquencies in the Bank’s loan portfolio as of the dates indicated.

   
December 31, 2006
 
December 31, 2005
 
(Dollars in Thousands)
 
60 - 89 Days
 
90 Days or More
 
60 - 89 Days
 
90 Days or More
 
   
Number of Loans
 
Principal Balance of Loans
 
Number of Loans
 
Principal Balance
of Loans
 
Number of Loans
 
Principal Balance of Loans
 
Number of Loans
 
Principal Balance of Loans
 
Real estate loans:
                                 
Residential - 1 to 4 family
   
2
 
$
256
   
-
 
$
-
   
-
 
$
-
   
1
 
$
80
 
Multi-family and commercial
   
-
   
-
   
-
   
-
   
-
   
-
   
1
   
74
 
Construction
   
-
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Total real estate loans
   
2
   
256
   
-
   
-
   
-
   
-
   
2
   
154
 
                                                   
Consumer loans:
                                                 
Home equity
   
-
   
-
   
-
   
-
   
-
   
-
   
-
   
-
 
Other (1)
   
15
   
134
   
99
   
1,039
   
-
   
-
   
2
   
5
 
Total consumer loans
   
15
   
134
   
99
   
1,039
   
-
   
-
   
2
   
5
 
                                                   
Commercial business loans
   
1
   
72
   
-
   
-
   
-
   
-
   
-
   
-
 
                                                   
Total delinquent loans
   
18
 
$
462
   
99
 
$
1,039
   
-
 
$
-
   
4
 
$
159
 
___________
(1)
Includes 110 indirect automobile loans totaling $1.2 million at December 31, 2006.

Classified Assets. Management of the Bank, including the Managed Asset Committee, consisting of a number of the Bank’s officers, review and classify the assets of the Bank on a monthly basis and the Board of Directors reviews the results of the reports on a quarterly basis. Federal regulations and the Bank’s internal policies require that management utilize an internal asset classification system to monitor and evaluate the credit risk inherent in its loan portfolio. The Bank currently classifies problem and potential problem assets as “substandard,” “doubtful,” “loss” or “special mention.” An asset is considered “substandard” if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. “Substandard” assets include those assets that are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected. Assets characterized as “doubtful” have all the weaknesses inherent in those classified as “substandard” with the additional characteristic that the weaknesses present make collection or liquidation in full, on the basis of currently existing facts, conditions and values, questionable, and there is a high probability of loss. Assets classified as “loss” are those assets considered uncollectible and of such little value that their continuance as assets, without the establishment of a specific loss reserve, is not warranted. In addition, assets that do not currently expose the Bank to sufficient risk to warrant classification in one of the aforementioned categories but possess credit deficiencies or potential weaknesses are required to be designated “special mention.” When an asset is classified as “substandard” or “doubtful,” a specific allowance for loan losses may be established. If an asset is classified as a “loss,” the Bank charges-off an amount equal to the portion of the asset classified as “loss.” All the loans mentioned above are included in the Bank’s Managed Asset Report. This report serves as an integral part in the evaluation of the adequacy of the Bank’s allowance for loan losses.


The following table sets forth the principal balance of the Bank’s classified loans as of December 31, 2006.

(Dollars in Thousands)
 
Loss
 
Doubtful
 
Substandard
 
Special
Mention
 
                   
Real estate loans:
                 
Residential - 1 to 4 family
 
$
-
 
$
-
 
$
780
 
$
736
 
Multi-family and commercial
   
-
   
-
   
3,723
   
4,504
 
Construction
   
-
   
-
   
2,405
   
3,848
 
Total real estate loans
   
-
   
-
   
6,908
   
9,088
 
                           
Consumer loans:
                         
Home equity
   
-
   
-
   
-
   
-
 
Other
   
-
   
64
   
976
   
35
 
Total consumer loans
   
-
   
64
   
976
   
35
 
                           
Commercial business loans
   
-
   
-
   
1,050
   
651
 
                           
Total classified loans
 
$
-
 
$
64
 
$
8,934
 
$
9,774
 

At December 31, 2006, the Bank had no loss rated loans and ten indirect automobile loans rated as doubtful. Of the $8.9 million of substandard loans at December 31, 2006, $1.4 million are considered nonperforming loans. The largest substandard loan is $2.9 million, which is not more than 30 days past due. Of the $9.8 million of special mention loans, only one loan totaling $150,000 was more than 30 days past due at December 31, 2006.

At December 31, 2006, total classified loans related predominately to six commercial real estate and business loans totaling $11.7 million and indirect automobile loans totaling $1.0 million. The increase in classified loans for 2006 was primarily the result of a slow-down in the local economy.

Nonperforming Assets and Restructured Loans. When a loan becomes 90 days delinquent, the loan is placed on nonaccrual status at which time the accrual of interest ceases and the allowance for any uncollectible accrued interest is established and charged against operations. Typically, payments received on nonaccrual loans are applied to the outstanding principal and interest balance as determined at the time of collection of the loan.

The Bank considers repossessed assets and loans that are 90 days or more past due to be nonperforming assets. Real estate acquired as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until it is sold. When property is acquired it is recorded at the lower of its cost, which is the unpaid balance of the loan plus foreclosure costs or fair value at the date of the foreclosure. Holding costs and declines in fair value after acquisition of the property are charged against income as incurred.


The following table provides information with respect to the Bank’s nonperforming assets and troubled debt restructurings as of the dates indicated.

   
December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
2003
 
2002
 
                       
Nonaccrual loans:
                     
Real estate loans
 
$
392
 
$
224
 
$
943
 
$
1,295
 
$
1,347
 
Commercial business loans
   
71
   
-
   
-
   
-
   
418
 
Consumer loans (1)
   
929
   
16
   
1
   
-
   
72
 
Total nonaccrual loans
   
1,392
   
240
   
944
   
1,295
   
1,837
 
                                 
Accruing loans past due 90 days or more:
                               
Real estate loans
   
-
   
-
   
-
   
-
   
5
 
Commercial business loans
   
-
   
-
   
-
   
-
   
-
 
Consumer loans
   
-
   
-
   
-
   
-
   
-
 
Total accruing loans past due 90 days or more
   
-
   
-
   
-
   
-
   
5
 
                                 
Total nonperforming loans
   
1,392
   
240
   
944
   
1,295
   
1,842
 
                                 
Real estate owned, net (2)
   
-
   
325
   
-
   
328
   
43
 
                                 
Total nonperforming assets
   
1,392
   
565
   
944
   
1,623
   
1,885
 
                                 
Troubled debt restructurings
   
72
   
74
   
76
   
77
   
78
 
                                 
Total nonperforming assets and troubled debt restructurings
 
$
1,464
 
$
639
 
$
1,020
 
$
1,700
 
$
1,963
 
                                 
Ratios:
                               
Total nonperforming loans to total loans
   
0.24
%
 
0.05
%
 
0.21
%
 
0.33
%
 
0.55
%
Total nonperforming loans to total assets
   
0.18
   
0.03
   
0.15
   
0.25
   
0.38
 
Total nonperforming assets and troubled debt restructurings to total assets
   
0.19
   
0.09
   
0.16
   
0.33
   
0.40
 
_________________________
 
(1)
Includes indirect automobile loans totaling $925,000 at December 31, 2006.
 
(2)
Real estate owned balances are shown net of related loss allowance.
 
In addition to the loans disclosed in the above table, at December 31, 2006, the Bank identified 116 loans totaling $8.9 million in which the borrowers had possible credit problems that caused management to have doubts about the ability of the borrowers to comply with the present loan repayment terms and that may result in the future inclusion of such loans in the table above. Indirect automobile loans totaling $972,000, representing 100 loans, are included in this amount. The aforementioned loans have been classified as substandard and are contained in the classified loan table on the previous page.


Interest income that would have been recorded for the year ended December 31, 2006 had nonaccruing loans and troubled debt restructurings been current in accordance with their original terms and had been outstanding throughout the period amounted to $110,000. The amount of interest related to nonaccrual loans and troubled debt restructurings included in interest income was $6,000 for the year ended December 31, 2006.

Allowance for Loan Losses. The allowance for loan losses, a material estimate which could change significantly in the near-term, is established through a provision for loan losses charged to earnings to account for losses that are inherent in the loan portfolio and estimated to occur, and is maintained at a level that management considers adequate to absorb losses in the loan portfolio. Loans are charged against the allowance for loan losses when management believes that the uncollectibility of principal is confirmed. Subsequent recoveries, if any, are credited to the allowance for loan losses when received. The Bank evaluates the allowance for loan losses on a monthly basis.

The methodology for assessing the appropriateness of the allowance for loan losses consists of the following key elements:

 
Specific allowances for identified problem loans, including certain impaired or collateral-dependent loans;
 
General valuation allowance on certain identified problem loans;
 
General valuation allowance on the remainder of the loan portfolio; and
 
Unallocated component

Specific Allowance on Identified Problem Loans. The loan portfolio is segregated first between loans that are on the Bank’s “Managed Asset Report” and loans that are not. The Managed Asset Report includes: (1) loans that are 60 or more days delinquent, (2) loans with anticipated losses, (3) loans referred to attorneys for collection or in the process of foreclosure, (4) nonaccrual loans, (5) loans classified as “substandard,” “doubtful,” “loss” or “special mention” by either the Bank’s internal classification system or by regulators during the course of their examination of the Bank and (6) troubled debt restructurings and other nonperforming loans.

The Managed Asset Committee, consisting of Bank officers, reviews each loan on the Managed Asset Report and may establish an individual reserve allocation on certain loans based on such factors as (1) the strength of the customer’s personal or business cash flow; (2) the availability of other sources of repayment; (3) the amount due or past due; (4) the type and value of collateral; (5) the strength of the borrower’s collateral position; (6) the estimated cost to sell the collateral; and (7) the borrower’s effort to cure the delinquency.

The Bank also reviews and establishes, as needed, a specific allowance for certain identified non-homogeneous problem loans. In accordance with the Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan” as amended by Statement of Financial Accounting Standards No. 118, “Accounting by Creditors for Impairment of a Loan--an amendment of FASB Statement No. 114,” a loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due under the contractual terms of the loan agreement. Measurement of the impairment is based on the present value of expected future cash flows or the fair value of the collateral, if the loan is collateral dependent. A specific allowance on impaired loans is established if the present value of the expected future cash flows, or fair value of the collateral for collateral dependent loans, is lower than the carrying value of the loan.


General Valuation Allowance on Certain Identified Problem Loans. The Bank establishes a general allowance for loans on the Managed Asset Report that do not have an individual allowance. The Bank segregates these loans by loan category and assigns allowance percentages to each category based on inherent losses associated with each type of lending and consideration that these loans, in the aggregate, represent an above-average credit risk and that more of these loans will prove to be uncollectible compared to loans in the general portfolio.

General Valuation Allowance on the Remainder of the Loan Portfolio. The Bank establishes another general allowance for loans that are not on the Managed Asset Report to recognize the probable losses associated with lending activities, but which, unlike specific allowances, has not been allocated to particular problem assets. This general valuation allowance is determined by segregating the loans by loan category and assigning allowance percentages based on the Bank’s historical loss experience and delinquency trends. The allowance may be adjusted for significant factors that, in management’s judgment, affect the collectibility of the portfolio as of the evaluation date. These significant factors may include changes in lending policies and procedures, changes in existing general economic and business conditions affecting the Bank’s primary lending areas, credit quality trends, collateral value, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, duration of the current business cycle and bank regulatory examination results. The applied loss factors are re-evaluated annually to ensure their relevance in the current economic environment.

Unallocated Component. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Although management believes that it uses the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and the Company’s results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while management believes it has established its allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing the Bank’s loan portfolio, will not request the Bank to increase its allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses would adversely affect the Company’s financial condition and results of operations.


The following table sets forth an analysis of the allowance for loan losses for the years indicated.

   
Years Ended December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
2003
 
2002
 
                       
Allowance at beginning of year
 
$
3,671
 
$
3,200
 
$
2,688
 
$
3,067
 
$
2,861
 
                                 
Provision for loan losses
   
881
   
410
   
550
   
1,602
   
537
 
                                 
Charge-offs:
                               
Real estate loans
   
-
   
(17
)
 
-
   
(1,523
)
 
(77
)
Commercial business loans
   
-
   
(1
)
 
(13
)
 
(374
)
 
(111
)
Consumer loans
   
(199
)
 
(11
)
 
(62
)
 
(216
)
 
(218
)
Total charge-offs
   
(199
)
 
(29
)
 
(75
)
 
(2,113
)
 
(406
)
                                 
Recoveries:
                               
Real estate loans
   
4
   
70
   
19
   
89
   
35
 
Commercial business loans
   
2
   
3
   
6
   
24
   
32
 
Consumer loans
   
6
   
17
   
12
   
19
   
8
 
Total recoveries
   
12
   
90
   
37
   
132
   
75
 
Net (charge-offs) recoveries
   
(187
)
 
61
   
(38
)
 
(1,981
)
 
(331
)
                                 
Allowance at end of year
 
$
4,365
 
$
3,671
 
$
3,200
 
$
2,688
 
$
3,067
 
                                 
Ratios:
                               
Allowance to total loans outstanding at end of year
   
0.76
%
 
0.71
%
 
0.71
%
 
0.69
%
 
0.91
%
                                 
Allowance to nonperforming loans
   
313.58
   
1529.58
   
338.98
   
207.57
   
166.50
 
                                 
Net (charge-offs) recoveries to average loans outstanding during the year
   
(0.03
)
 
0.01
   
(0.01
)
 
(0.55
)
 
(0.11
)
                                 
Recoveries to charge-offs
   
6.03
   
310.34
   
49.30
   
6.25
   
18.47
 

The higher provision for 2006 reflects increases in the Bank’s classified and nonperforming loans, charge-offs and loan growth from the prior year-end. Charge-offs for 2003 included the charge-off of two commercial business loans and two commercial real estate loans that aggregated $1.8 million. The larger of the two commercial real estate loans, which at the time of charge-off had a principal balance of $1.6 million, was charged-off after the loan was nonperforming and the Bank determined that the value of the real estate underlying the loan was insufficient to cover the outstanding principal balance. Additionally, because we held a junior collateral position, the Bank determined that the likelihood of any recovery was remote. During the year ended December 31, 2003, charge-offs exceeded the provision for loan losses as specific allowances of $237,000 were established in prior periods for a portion of the charged-off loans once it had been determined that collection or liquidation in full was unlikely.


The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated.

   
December 31,
 
   
2006
 
2005
 
2004
 
(Dollars in Thousands)
 
Amount
 
% of Allowance in each Category to Total Allowance
 
% of Loans in each Category to Total Loans
 
Amount
 
% of Allowance in each Category to Total Allowance
 
% of Loans in each Category to Total Loans
 
Amount
 
% of Allowance in each Category to Total Allowance
 
% of Loans in each Category to Total Loans
 
                                       
Real estate loans
 
$
3,244
   
74.32
%
 
81.93
%
$
2,639
   
71.89
%
 
80.36
%
$
2,403
   
75.08
%
 
82.18
%
Commercial business
   
783
   
17.94
   
13.03
   
892
   
24.29
   
15.02
   
641
   
20.02
   
13.13
 
Consumer loans
   
338
   
7.74
   
5.04
   
140
   
3.82
   
4.62
   
152
   
4.74
   
4.69
 
Unallocated
   
-
   
-
   
-
   
-
   
-
   
-
   
4
   
0.16
   
-
 
Total allowance for loan losses
 
$
4,365
   
100.00
%
 
100.00
%
$
3,671
   
100.00
%
 
100.00
%
$
3,200
   
100.00
%
 
100.00
%


   
December 31,
 
   
2003
 
2002
 
(Dollars in Thousands)
 
Amount
 
% of Allowance in each Category to Total Allowance
 
% of
Loans in each Category
to Total Loans
 
Amount
 
% of Allowance in each Category to Total Allowance
 
% of
Loans in each Category
to Total Loans
 
                           
Real estate loans
 
$
2,093
   
77.86
%
 
82.46
%
$
2,237
   
72.94
%
 
87.66
%
Commercial business
   
461
   
17.15
   
13.04
   
488
   
15.91
   
7.99
 
Consumer loans
   
80
   
2.98
   
4.50
   
318
   
10.37
   
4.35
 
Unallocated
   
54
   
2.01
   
-
   
24
   
0.78
   
-
 
Total allowance for loan losses
 
$
2,688
   
100.00
%
 
100.00
%
$
3,067
   
100.00
%
 
100.00
%

Investment Activities

The Company has legal authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, government-sponsored enterprises, state and municipal governments, mortgage-backed securities and certificates of deposit of federally-insured institutions. Within certain regulatory limits, the Company also may invest a portion of its assets in corporate securities and mutual funds. The Company is also required to maintain an investment in FHLB stock. While the Company has the authority under applicable law and its investment policies to invest in derivative securities, the Company had no such investments at December 31, 2006.
 
The Company’s primary source of income continues to be derived from its loan portfolio. The investment portfolio is mainly used to meet the cash flow needs of the Company, provide adequate liquidity for the protection of customer deposits and yield a favorable return on investments. The type of securities and the maturity periods are dependent on the composition of the loan portfolio, interest rate risk, liquidity position and tax strategies of the Company. The Company’s investment objectives are to provide and maintain liquidity, to maintain a balance of high quality, diversified investments to minimize risk, to provide collateral for pledging requirements, to establish an acceptable level of interest rate and credit risk, to provide an alternate source of low-risk investments when demand for loans is weak, to generate a favorable return and to assist in the financing needs of various local public entities, subject to credit quality review and liquidity concerns. The Company’s Board of Directors has the overall
 
 
responsibility for the investment portfolio, including approval of the Company’s Investment Policy and appointment of the Investment Committee. The Investment Committee is responsible for the approval of investment strategies and monitoring investment performance. The execution of specific investment initiatives and the day-to-day oversight of the Company’s investment portfolio is the responsibility of the Chief Executive Officer and the Chief Financial Officer. These officers, and others designated by the Board, are authorized to execute investment transactions up to specified limits based on the type of security without prior approval of the Investment Committee. Transactions exceeding these limitations require the approval of two of these officers, one of whom must be either the President and Chief Executive Officer or the Chief Financial Officer. Individual investment transactions are reviewed and approved by the Board of Directors on a monthly basis, while portfolio composition and performance are reviewed at least quarterly by the Investment Committee.

Statement of Financial Accounting Standards No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS No. 115”), requires that securities be categorized as either “held to maturity,” “trading securities” or “available for sale” based on management’s intent as to the ultimate disposition of each security. Debt securities may be classified as “held to maturity,” and reported in the financial statements at amortized cost, only if the Company has the positive intent and ability to hold those securities until maturity. Securities purchased and held principally for the purpose of trading in the near term are classified as “trading securities.” These securities are reported at fair value in the financial statements, with unrealized gains and losses recognized in earnings. Debt and equity securities not classified as either “held to maturity” or “trading securities” are classified as “available for sale securities.” These securities are reported at fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income, net of taxes.

At December 31, 2006, the Company’s investment portfolio, which consisted solely of available for sale securities, totaled $119.5 million and represented 15.8% of assets. The Company’s available for sale securities consisted primarily of government-sponsored enterprises with maturities of seven years or less, mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae with stated final maturities of 30 years or less, corporate debt securities, U.S. Government and agency securities and securities of state and municipal governments.

The following table sets forth the amortized costs and fair values of the Company’s securities portfolio at the dates indicated.
 
   
December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
   
Amortized Cost
 
Fair
Value
 
Amortized Cost
 
Fair
Value
 
Amortized Cost
 
Fair
Value
 
U.S. Government and agency securities
 
$
1,596
 
$
1,602
 
$
4,820
 
$
4,813
 
$
6,039
 
$
6,066
 
Government-sponsored enterprises
   
66,190
   
65,263
   
73,135
   
71,490
   
67,911
   
67,610
 
Mortgage-backed securities
   
45,481
   
44,815
   
37,346
   
36,538
   
40,926
   
40,594
 
Corporate debt securities
   
3,917
   
3,903
   
4,537
   
4,528
   
3,498
   
3,563
 
Obligations of state and political subdivisions
   
2,000
   
2,024
   
1,499
   
1,546
   
1,499
   
1,584
 
Tax-exempt
   
420
   
420
   
490
   
490
   
560
   
560
 
Other debt securities
   
100
   
99
   
75
   
74
   
75
   
75
 
Total debt securities
   
119,704
   
118,126
   
121,902
   
119,479
   
120,508
   
120,052
 
 
                                     
Marketable equity securities
   
1,336
   
1,382
   
555
   
540
   
488
   
505
 
 
                                     
Total available for sale securities
 
$
121,040
 
$
119,508
 
$
122,457
 
$
120,019
 
$
120,996
 
$
120,557
 


The Company had no individual investments that had an aggregate book value in excess of 10% of its stockholders’ equity at December 31, 2006.

The following table sets forth the amortized cost, weighted average yields and contractual maturities of securities at December 31, 2006. Weighted average yields on tax-exempt securities are not presented on a tax equivalent basis because the impact would be insignificant. Certain mortgage-backed securities have adjustable interest rates and will reprice periodically within the various maturity ranges. These repricing schedules are not reflected in the table below. At December 31, 2006, the amortized cost of mortgage-backed securities with adjustable rates totaled $7.6 million.

   
One Year or Less
 
More than One Year to Five Years
 
More than Five Years to Ten Years
 
More than Ten Years
 
Total
 
(Dollars in Thousands)
 
Amortized
Cost
 
Weighted Average Yield
 
Amortized
Cost
 
Weighted Average Yield
 
Amortized
Cost
 
Weighted Average Yield
 
Amortized
Cost
 
Weighted Average Yield
 
Amortized
Cost
 
Weighted Average Yield
 
                                           
U.S. Government and agency securities
 
$
-
   
-
%
$
16
   
9.56
%
$
452
   
8.18
%
$
1,128
   
7.01
%
$
1,596
   
7.37
%
Government-sponsored enterprises
   
17,775
   
4.42
   
48,043
   
4.02
   
372
   
6.83
   
-
   
-
   
66,190
   
4.14
 
Mortgage-backed securities
   
8,127
   
4.33
   
2,765
   
4.09
   
7,243
   
4.84
   
27,346
   
5.07
   
45,481
   
4.84
 
Corporate debt securities
   
-
   
-
   
-
   
-
   
-
   
-
   
3,917
   
6.18
   
3,917
   
6.18
 
Obligations of state and political subdivisions
   
-
   
-
   
1,000
   
6.79
   
-
   
-
   
1,000
   
4.97
   
2,000
   
5.88
 
Tax-exempt securities
   
70
   
3.87
   
280
   
3.87
   
70
   
3.88
   
-
   
-
   
420
   
3.87
 
Other debt securities
   
-
   
-
   
100
   
5.29
   
-
   
-
   
-
   
-
   
100
   
5.29
 
Total debt securities
   
25,972
   
4.39
   
52,204
   
4.08
   
8,137
   
5.10
   
33,391
   
5.26
   
119,704
   
4.55
 
 
                                                             
Marketable equity securities
   
-
   
-
   
-
   
-
   
-
   
-
   
1,336
   
6.43
   
1,336
   
6.43
 
Total available for sale securities
 
$
25,972
   
4.39
 
$
52,204
   
4.08
 
$
8,137
   
5.10
 
$
34,727
   
5.31
 
$
121,040
   
4.57
 

Deposit Activities and Other Sources of Funds

General. Deposits and loan repayments are the major sources of the Company’s funds for lending and other investment purposes. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general interest rates and money market conditions.

Deposit Accounts. Substantially all of the Bank’s depositors are residents of the State of Connecticut. Deposits are attracted from within the Bank’s market area through the offering of a broad selection of deposit instruments, including NOW, money market accounts, regular savings accounts and certificates of deposit. The Bank also utilizes brokered certificates of deposits, which at December 31, 2006 amounted to $7.1 million, as an alternate source of funds. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rates offered, among other factors. In determining the terms of the Bank’s deposit accounts, the Bank considers the rates offered by its competition, liquidity needs, profitability, matching deposit and loan products and customer preferences and concerns. The Bank generally reviews its deposit mix and pricing weekly. The Bank’s current strategy is to offer competitive rates, and even higher rates on long-term deposits, but not be the market leader in every account type and maturity.

The Bank also offers a variety of deposit accounts designed for the businesses operating in its market area. Business banking deposit products include a commercial checking account that provides an earnings credit to offset monthly service charges and a checking account specifically designed for small

 
business and nonprofit organizations. Additionally, sweep accounts and money market accounts are available for businesses. The Bank has sought to increase its commercial deposits through the offering of these products, particularly to its commercial borrowers and to local municipalities.
 
The following table sets forth the deposit activity for the years indicated, including mortgagors’ and investors’ escrow accounts and brokered deposits.

   
Years Ended December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
               
Beginning balance
 
$
512,282
 
$
460,480
 
$
417,311
 
                     
Increase before interest credited
   
16,483
   
43,265
   
36,833
 
Interest credited
   
13,157
   
8,537
   
6,336
 
Net increase in deposits
   
29,640
   
51,802
   
43,169
 
                     
Ending balance (1)
 
$
541,922
 
$
512,282
 
$
460,480
 
_________________
 
(1)
Includes mortgagors’ and investors’ escrow accounts in the amount of $3.2 million, $3.0 million and $2.7 million at December 31, 2006, 2005 and 2004, respectively. Includes brokered deposits of $7.1 million at December 31, 2006 and $5.0 million at December 31, 2005 and 2004.

The following table sets forth the distribution of the Bank’s deposit accounts for the dates indicated.

   
December 31,
 
(Dollars in Thousands)
 
2006
 
2005
 
2004
 
   
Balance
 
% of
Total
 
Balance
 
% of
Total
 
Balance
 
% of
Total
 
                           
Noninterest-bearing demand deposits
 
$
55,703
   
10.28
%
$
51,996
   
10.15
%
$
46,049
   
10.00
%
NOW and money market accounts
   
126,567
   
23.36
   
125,156
   
24.43
   
110,564
   
24.01
 
Savings accounts (1)
   
81,020
   
14.94
   
90,879
   
17.74
   
95,310
   
20.70
 
Certificates of deposit (2)
   
278,632
   
51.42
   
244,251
   
47.68
   
208,557
   
45.29
 
                                       
Total deposits
 
$
541,922
   
100.00
%
$
512,282
   
100.00
%
$
460,480
   
100.00
%
___________
(1)
Includes mortgagors’ and investors’ escrow accounts in the amount of $3.2 million, $3.0 million and $2.7 million at December 31, 2006, 2005 and 2004, respectively.
(2)
Includes brokered deposits of $7.1 million at December 31, 2006 and $5.0 million at December 31, 2005 and 2004.


The Bank had $74.3 million of certificates of deposit of $100,000 or more outstanding as of December 31, 2006, maturing as follows:

(Dollars in Thousands)
 
Amount
 
Weighted Average
Rate
 
           
Maturity Period:
         
Three months or less
 
$
12,895
   
4.41
%
Over three through six months
   
14,011
   
4.48
 
Over six through twelve months
   
30,165
   
4.94
 
Over twelve months
   
17,245
   
4.80
 
               
Total
 
$
74,316
   
4.73
%

The following table presents the amount of certificates of deposit accounts outstanding by the various rate categories, years to maturity and percent of total certificate accounts at December 31, 2006.

   
Amount Due
     
(Dollars in Thousands)
 
Less Than One Year
 
One to Two Years
 
Two to Three Years
 
Three to Four Years
 
More Than Four Years
 
Total
 
Percent of Total Certificate Accounts
 
                               
0.51 - 2.00%
 
$
13,513
 
$
18
 
$
-
 
$
-
 
$
-
 
$
13,531
   
4.86
%
2.01 - 3.00%
   
21,830
   
1,680
   
277
   
-
   
-
   
23,787
   
8.54
 
3.01 - 4.00%
   
15,456
   
10,240
   
5,767
   
1,343
   
56
   
32,862
   
11.79
 
4.01 - 5.00%
   
92,282
   
283
   
3,510
   
7,728
   
1,337
   
105,140
   
37.73
 
5.01 - 6.00%
   
72,638
   
20,305
   
9,464
   
-
   
706
   
103,113
   
37.01
 
6.01 - 6.78%
   
83
   
116
   
-
   
-
   
-
   
199
   
0.07